Our brain has a very complex relationship with money. From a purely economic perspective it really should be simple – money is a tool that’s used to get something done, no different to a shovel or a hammer.
But while the mathematics of economics may be coldly rational, our brain is not. The human brain is a biological filter, through which cash becomes more than an emotionless inanimate bit of paper with a number printed on it. And now thanks to a recent study we can see exactly how thinking about money changes the way brain works.

Pay cut or pay rise?

The revealing work published in PNAS this month, examines what happens in our brain when we experience the so called “money illusion”. In a nutshell this is where we see an increase in income as a positive thing even when costs go up by the same amount.

Let’s take a less abstract look at this by using a common thought experiment to demonstrate the illusion:

Let’s say your income goes up by 2% but inflation rises by 4% at the same time, completely negating the increase. Would you rather take a 2% pay cut and have the price of things remain the same, or take the 2% salary increase with 4% inflation? Clearly both things are the same so it doesn’t matter what you choose. But when we ask this question to large numbers of people the majority always choose the salary increase. But if it makes no difference, why is there a bias?

Economists have often been skeptical of the existence of the money illusion. The purchasing power of cash in the inflated financial example above has not changed, and people aren’t stupid they are aware of what is going on. A rational mind is right to see no change. But what do you know, the human mind is not a completely rational place. But skepticism of the money illusion was well founded, since other than question based surveys there really hasn’t been a lot of hard evidence to pin down why this illusion exists. Until now.

Big winners are big grinners

The subjects of the study were asked to solve a series of simple problems and were rewarded monetarily based on how well they performed. At the end of the test everyone had to spend their money by picking items they liked from a catalogue of goods ranging from CDs to computer accessories. The whole time they did this the researchers monitored their brain activity by fMRI.

The twist in this simple exercise comes when the experimenters tweaked this arrangement by getting subjects to do this whole process twice: The first time the cash rewards were small, and the cost of the catalogue items were also low. The second time around the cash prizes were doubled and the cost of the items in the catalogue were also twice as expensive.

Obviously there is no difference in how much purchasing power the money has between the two experiments, all the subjects knew this, and yet there was still a striking difference in the neuronal activity between experiments.
One region of the brain (the ventro-medial prefrontal cortex) had much higher levels of activity only when the numerical value of the cash prize was higher. And wouldn’t you know it, this region of the brain has been previously been associated with sensations of elation and joy in response to pleasurable experiences. Big numbers bring big joy it seems. David DiSalvo also has a good write up of this effect here.

Inflated consequences

This confirmation that the money illusion actually exists turns out to be pretty important. It explains for example, why the economy can be re-flated by liberal financial policies. It’s also probably a factor that explains why nominal salaries rarely fall, whereas the actual value of your salary in does drop in value during periods of inflation.

But this is just the tip of the economic iceberg, the effect of our irrational perception of money can go way beyond how much you think you get paid.

Take for example the housing market. It’s not breaking news to say that property prices rose quickly in the last few years and was followed by the current devastating bust. The money illusion can easily contribute to muddying understanding between the nominal and actual value of mortgage interest rates.

It seems like a logical thing that when inflation is low, the monthly nominal interest payments on mortgages are low compared to the rent of a similar property.
So property prices now appear to be cheap. People, for whom the money illusion is a factor, are now likely to buy instead of rent, which produces an upward trend on house prices when inflation declines. But when inflation decreases it also increases the “real” cost of mortgage payments in the future.

This is an example of how the money illusion can act irrationally with people basing their purchase decision on the current low nominal mortgage payments while failing to accurately asses the less obvious effect of future inflation – the real loan cost. Repeat this over thousands of customers and voila: a housing bubble.

Clearly the money illusion isn’t wholly and solely responsible for the mess we’re in now. But here’s one thing you can take to the bank: The human brain isn’t a purely rational economic machine, and it’s our weird relationship to money that we need to keep an eye on as well as the market.

Here’s something that’s no illusion though: the Email or RSS updates to Very Evolved. No inflated numbers, just cool science.

original image by kevin

Weber, B., Rangel, A., Wibral, M., & Falk, A. (2009). The medial prefrontal cortex exhibits money illusion Proceedings of the National Academy of Sciences DOI: 10.1073/pnas.0901490106

March 26th, 2009