The people inside our markets – part I SPECIAL GUEST BLOG BY NANDAN NILEKANI

Nandan Nilekani, author of Imagining India: Ideas for the New Century, blogs about the rationality of spending.

I recently had a very interesting conversation with the Harvard economist Dr. Sendhil Mullainathan. Economists have recently been looking at how large a role human behaviour and incentives play when it comes to markets, and how people treat money; this is a big part of Sendhil’s work.

Sendhil’s particular interest is in how the poor, especially in rural India, respond to the lending and savings solutions that banks offer them. Sendhil points out to me, that what the financial sector typically does is take the banking solutions they have for the middle class and offer it to the poor. This does not work well because the way the poor earn their incomes is very different from the salaried class. Indian farmers for example, typically earn a chunk of income every six months or so, after harvesting and selling their crops.

For these farmers, paying loans on monthly installments, and saving money becomes an extremely difficult thing to do. ‘Its difficult for people to spend a large amount of money they suddenly receive, very carefully,’ Sendhil points out. Its human nature – people who get rare windfalls of cash find it difficult to plan and spend the money in small amounts. The impulse is then to celebrate - what money they receive they splurge, spending on weddings, family events and ‘conspicuous consumption’. Such consumption is especially important for the poor. As recent work on low income communities points out:

“Conspicuous consumption…. is not an unambiguous signal of personal affluence. It’s a sign of belonging to a relatively poor group. Visible luxury thus serves less to establish the owner’s positive status as affluent than to fend off the negative perception that the owner is poor. ”

As a result, the poor often have little money leftover for monthly expenditures such as schooling for their children, and even food and clothing.

Sendhil and other economists have been trying to devise specific banking solutions, which for example, allow rural workers to pay out big chunks of their loans at the end of the harvesting season. They are also working on other solutions which help them manage their money better, through micro-insurance schemes and savings accounts that allow large deposits and automated monthly payouts.

This new focus on human behavior– and tailoring market solutions accordingly – has become a focus for economists across different fields. They argue that people don’t always keep a complete hold on the real value of an asset when they are buying or selling in a market. The truth of that is pretty apparent when I look at our everyday purchase decisions. My friend hankers after the newest mobile phone or PDA - even though he (and many other likely buyers) feel that a part of the high price comes from the hype, and that ten months later once the next version is out, this one is relatively worthless, both to him and on eBay. We are rarely completely rational in our purchases — whether that’s a house, the latest gizmo, or a car loan.

So new theories around real estate and credit bubbles – which is the root of the global downtown we are now facing– have focused on how people in real life react to regulation, easy credit, and speculative prices in real estate and the stock market, and how the collective mood, rather than any fundamental numbers, works in sending economies into upswings and downturns.

Tying our individual and collective behavior to economic theory is not going to be an exact science. But I am still betting that it will give us some new, powerful insights.

Visit the official site of Imagining India here; designed to serve as a living companion to the book for readers who want to delve deeper into the book’s material and themes, and who want to carry forward the discussion on the ideas that have shaped, and continue to shape India.