To a modern economist, the farmers of the Luo tribe of Kenya have a very peculiar relationship to money. Instead of thinking of one dollar as equivalent to the next, the Luo draw rigorous distinctions between types of money, labeling some money "bitter," which means that it can be used only in certain ways.
According to anthropologist Parker Shipton, if a Luo sells his land and then uses the proceeds to buy cattle, for instance, the tribe assumes that the cattle will die. Not surprisingly, the Luo tend not to use the proceeds of land sales to buy cattle. And when they do need to use "bitter money," the Luo purify the cash in a formal ritual.
At first glance, the idea of "bitter money" looks like a legacy of a traditional society--a relic that has nothing to do with the way consumers and investors handle money in a modern economy. One of the fundamental assumptions of traditional economics, after all, is that all money is created equal. Whether won in a lottery, earned in a paycheck or accrued in a 401(k) account, a dollar is supposed to be a dollar.
And yet the truth is that much of the time people are a lot closer to the Luo than to the rational planners described in economics textbooks. We may not use labels like "bitter" (except when paying our bills, perhaps), but most of us treat different kinds of money very differently. In the words of the behavioral economist Richard Thaler, we engage in "mental accounting," putting our money in different accounts based on how we earned it, how easily we can access it, how long we've had it and so on. And that process of mental accounting ends up having a profound effect on the way we spend and invest.
Mental accounting manifests itself in a host of ways. First of all, where we get our money affects what we do with it. One study of prostitutes in Oslo, Norway, for instance, found that the women carefully segregated the money they earned on the street from the money they received from the government or from legal jobs. The clean money was used for rent and food. The "dirty money" was spent on parties and going out.
Similarly--though less dramatically--American consumers are far more likely to splurge with money that comes as a windfall than with the money they get in their weekly paycheck. More than that, they are likely to distinguish between different kinds of windfalls: Money won in the lottery is more likely to get spent than money that comes from an income-tax refund. In the same way, at the casino, people who win money become less risk averse, because they feel they're playing with the house's money. That way, losing it actually feels less painful.
We also use mental accounts to control our spending and saving. The sociologist Viviana Zelizer points out that middle-class households, instead of paying for things out of one big pool of family income, tend to set aside particular sums every month for particular purposes, often keeping it in separate bank accounts depending on its purpose. And many families also keep a sizable amount of money in their savings account or continue to put money into their 401(k)s, while still carrying thousands of dollars in credit-card debt--even though dipping into savings and paying off their credit-card bills would guarantee them an immediate return on investment of 15% or 18%.
A classic example of mental accounting were Christmas Club accounts, a staple of American banking in the 1970s. The Christmas Club account was, on the surface, a bizarre idea: You gave the bank money every month. The bank paid you no interest, and it would not let you take the money out until Dec. 1. This was not much of a bargain. And yet Americans happily put their money into Christmas Club accounts, even though that same money in a savings account would have earned them interest.
From an economic perspective, this kind of accounting is absurd: In keeping all of these accounts separate and refusing to treat one dollar as identical to the next, people are actually giving up real gains. And there are parts of the economy where the effects of mental accounting are far from benign. When it comes to investing, for instance, it almost certainly makes the market less efficient and makes individual investors less successful.
Mental accounting, for instance, helps explain investors' well-known tendency to sell winners too early and to hold on to losers too long--because we don't treat gains or losses as real until we actually sell the stock. It also influences the decisions people make about how to allocate money in their 401(k)s.
When employees are offered retirement plans that include no option for investing in their own company's stock, they typically allocate half of their money to bonds and half to stocks. But when they were given the option to invest in their own company's stock, they allocated more than 40% of their money to company stock and divided the rest equally between stocks and bonds--meaning that almost three-fourths of their portfolio was now in equities, simply because they put their own company's stock in a different mental account than other equity investments.
Mental accounting has macroeconomic effects as well. Until the reduction in the tax on dividends, it was economically inefficient for companies to pay dividends as opposed to buying back stock, because the tax on dividend payments was significantly higher than the capital gains tax. Yet many companies continued to pay out substantial dividends. One of the reasons for this is that investors treat dividend payments as different from capital gains: Dividends are often used as income to live off, while capital gains are treated as principal and left untouched. Billions of dollars were being spent by companies, in other words, so their investors could keep their mental accounts separate.
In other ways, though, mental accounting often turns out to be a useful way of controlling our own weaknesses and foibles. Mental accounts, it turns out, are often restraints we place on ourselves to keep us from doing what we shouldn't, and to help us do what we should. In particular, mental accounting is one way in which we strengthen our ability to delay gratification.
Study after study has shown that Americans (and, arguably, humans) are rational in our long-term goals--we want to build nest eggs, invest rather than consume, etc.--but irrational about achieving them in the short term. In other words, we know where we want to get, but we have a hard time actually taking the steps we need to get there.
Making sure you set aside money every month for the 401(k) or for your savings account, even as you're using your credit cards, is one way (flawed, but better than nothing) of taking those steps. People know that if they empty their savings accounts or cut back on their 401(k) payments, they may never get that money back--precisely because they have a hard time saving in the first place. So you keep saving and try to pay down the credit-card debt out of what's left over. In the same vein, consumers actually use debit cards instead of credit cards more often than economic theory would predict, in part as a way of limiting their own spending to money they actually have.
Put this way, the popularity of Christmas Club accounts isn't a mystery; if their money was in a regular account, people assumed they'd spend it. So they asked the bank to tie their hands. The same is true of certificates of deposit: They include heavy penalties, which at first glance seem to outweigh the slightly higher interest rate they offer over a typical savings account. Far from being a cost, the penalties may, in fact, be a kind of benefit, because they make it harder for people to do what they don't want to do but fear they will. (The same logic is at work in 401(k)s and so-called "tuition" investment accounts.)
Similarly, people prefer to pay for health club memberships by the month or year, rather than by daily visit, even though studies show that the vast majority of people never use the health club enough to justify the annual cost. You pay for the health club upfront because you know that if you had to pay every time you went to the club, you would never go. Even if you end up overpaying, you're at least giving yourself the chance to be responsible--and to go to the gym the way you know you should.
That's also why so many taxpayers actually ask the government to withhold more money from their paychecks than they need to--effectively paying their taxes upfront while giving the government an interest-free loan--because it's the only way they can be sure they'll have enough to pay the IRS when April 15 rolls around.
Ultimately, much of mental accounting stems from our recognition that we are not as strong as we wish we were. It's a way of binding ourselves, much as, in The Odyssey, Odysseus asks his men to lash him to the mast so he can guide the ship past the Sirens. It is, you might say, an irrational way to control our deeper irrationality. And there's nothing bitter about that.
James Suroweicki is a staff writer at The New Yorker, where he writes the popular business column "The Financial Page." His work has appeared in a wide range of publications, including The New York Times, The Wall Street Journal, Artforum, Wired and Slate. He is the author of The Wisdom of Crowds.