Miscalculating Human Interest

LUXURY FEVER: WHY MONEY FAILS TO SATISFY IN AN ERA OF EXCESS
Robert H. Frank
The Free Press, 1999, ix + 326 pgs.

In 1958, John Kenneth Galbraith assailed American spending patterns. Consumers, he told us in The Affluent Society, spend too much on such fripperies as large tailfins on cars. As the result of this wasteful spending, the government was starved of the money it needed to provide essential services. Not content to leave ill enough alone, Professor Frank has some forty years later given us an updated and theoretically sophisticated version of Galbraith. Fortunately, a useful idea can be salvaged from his effort.

Mr. Frank spends a great deal of time belaboring the obvious point that the rich have extravagant tastes. The Calibre '89 Patek Philippe wristwatch sold for a minimum of $2.7 million. For the less financially secure, bargain Patek Philippes can be had for $17,500. In Beverly Hills, California, 17 mansions with more than 10,000 square feet of living space were sold in 1997 (p. 21). Yachts can cost over $1.5 million per year to maintain (p. 23). And so on and so on.

All no doubt fascinating, if you are interested in this sort of thing, but why is luxury spending a problem? If rich people spend their money in a way Mr. Frank considers wasteful, is that not their business? No, our author replies: to take consumer preferences as givens not subject to rational criticism is to ignore important issues.

Those who pay $50 for a cigar are, by hypothesis, increasing their utility: otherwise they would not buy the cigar. But do these purchases, and others like them, really make consumers happy? Economists uncritically assume that preference satisfaction makes for happiness, but psychologists know better. "Unlike economists, psychologists and other behavioral scientists tend to have few preconceptions about the extent to which free-market transactions promote human satisfaction. Their approach is an empirical one that attempts to measure human satisfaction and identify the factors that influence it" (p. 67).

By "happiness," Mr. Frank means "life satisfaction," and the point he is concerned with is this. Even if you get what you choose, so your utility as economists define it increases, you may not find your life more satisfying. How does Mr. Frank know this?

The assured results of modern psychology, he replies, tell us. "[W]hat the psychologists call subjective well-being is a real phenomenon. The various empirical measures of it have high consistency, reliability, and validity" (p. 71). These measures bring bad news for luxury spenders. "One of the central findings in the large scientific literature on subjective well-being is that once income levels surpass a minimal absolute threshold, average satisfaction levels within a given country tend to be highly stable over time, even in the face of significant economic growth" (p. 72).

This appears paradoxical but in fact is not. How can it be that if you get the goods you want, you do not feel subjectively better? The answer, our author thinks, lies in the fact that people quickly adjust to a higher standard of living. If you sell your 3,000 square feet home and purchase one twice as large, you may at first feel elated. Soon, though, you will treat the new conditions as normal, and the extra space will give you no special thrill. You will have gone to a good deal of trouble and expense to wind up about as happy as you already were.

Mr. Frank has resolved his paradox only to raise another in its stead. If the pursuit of material wealth beyond a certain point does not lead to greater happiness, why do people continue to seek more and better things? If "the more we have, the more we seem to feel we need" (p. 74), will not at least some people after a while realize that the quest for more leads nowhere? If so, will they not rest content with what they have?

A further fact explains our getting and spending. People become happier by improvements from their position in the recent past. To an even greater extent, they dread a reduction in their standard of living. "The economist Richard Thaler coined the term loss aversion to describe this tendency. Loss aversion means not just that the pain of losing, say, $1,000, is larger, for most of us, than the pleasure of winning that same amount. It means that it is much larger" (p. 105).

Once more, our author has resolved a difficulty only to confront an even more formidable obstacle. If he is right, he has explained luxury spending: people wish to beat out others in the battle for prestige and power. They may find, once they have gotten their Patek Philippe watches, that these items evoke no long-lasting spasm of delight. Nevertheless, the struggle counts more than the arrival, and people always act to increase their happiness.

But here precisely is the problem for our social-reformist author: there appears to be no problem that requires tinkering with capitalism. If people did not have rivalrous impulses, maybe they would find it much easier to be happy. But Professor Frank cannot suggest a program to extinguish these desires, since he holds that evolution has implanted them firmly within us. Our author has explained the world, but what room has he left to alter it?

At last we are in a position to see Frank's major innovation: he has found a way to come to a Galbraithian conclusion without casting himself as a stern moralist who presumes to tell others what they "should" want. He argues that the struggle of rivals for material goods generates negative externalities. If these "public bads" can be reduced, people can seek superiority at less cost. This will free resources for projects that will genuinely increase happiness. Suffice it to say that these projects, including expanded public education, food inspection, and highway maintenance involve heavy government spending.

The negative externalities that concern our author can best be understood through an example. Among offensive linemen in professional football, it is an advantage to weigh more than one's rivals. "[O]ther things being equal, the job will always go to the larger and stronger of two rivals. Because size and strength...can be enhanced by the consumption of anabolic steroids, individual players confront compelling incentives to consume these drugs. Yet if all players take steroids, the rank ordering by size and strength-and hence the question of who lands the jobs-will be largely unaffected" (p. 154). Given the danger of steroids, would not players all be better off if the drugs were banned?

Mr. Frank generalizes the point of his example. A progressive tax on consumption will cut out much of the wasteful spending that rivalrous luxury spending involves. Once more, the spending is wasteful not because our author disapproves of it but because people engage in it only to forestall their rivals.

I cannot think that Mr. Frank's ingenious analysis gives us a good reason to institute the consumption tax he favors. He has made without evidence a crucial and questionable assumption. Let us return to his football example. He assumes that the rank order of players remains the same, whether or not they take steroids. Resources devoted to steroids are then a deadweight loss.

But why assume this? We have no grounds to assume that the ban leaves everything besides access to the dangerous drug as it otherwise was. Like our author, we may generalize our conclusion. Frank has not shown that a consumption tax will affect all rivals equally. Absent this showing, he has failed to show that rivalrous consumption generates pure waste. His argument collapses.

Further, Mr. Frank provides no support whatever for another key assumption. He devotes much attention to spending by the super-rich, who constitute only a minute part of the population, for what seems to him a compelling reason. If those not among the fortunate few learn of the extravagancies of Bill Gates et hoc genus omne, they in turn will spend more than they otherwise would have done. The cancer of wasteful luxury spending thus spreads through the economy.

A pretty theory, you may think. But, so far as I can see, Mr. Frank gives not one word of evidence that this demonstration effect exists. His "argument" is a mere free-floating fancy.

Our author does however have one excellent idea, though this has little to do with the book's central thesis. He points out the great value of saving and growth in capital goods. Through the "miracle of compound interest" deferred compensation now can give savers the means for much greater consumption in the not-too-distant future.

One application of this point is especially insightful: "The Social Security system...takes no advantage whatsoever of the miracle of compound interest.... Unlike private savings, our Social Security tax payments are spent almost immediately, and therefore do not draw interest over a period of many years. And this simple fact makes Social Security vastly more expensive than private savings as a means for financing retirement" (p. 103). Well said! Why did he have to write the rest of the book?