This week, I visited a camera store to order two enlarged prints as a gift.  I don’t order photo prints very often; in fact, I’m not sure that I have ever ordered prints aside from graduation photos.  As I was making my purchase, the friendly, middle-aged woman who had been helping me asked whether I wanted to become a store “member.”  I learned that for only 13 dollars and change, I could save 10% on purchases at the store for the next year, including around five dollars on the order I was purchasing.  (I asked whether this discount applied to cameras.  It did not.)  After fleeting consideration, I explained that I did not think it was likely that I would be buying more prints in the next year, and hence membership was not a worthwhile purchase for me.

To the friendly saleswoman, this did not seem be a satisfactory answer.  She continued to push the membership offer, emphasizing the five dollars that I would be saving.  “I don’t know about you,” she said, “but I’m someone who likes saving money.”

As I walked from the camera store to my car, I couldn’t help but contemplate this saleswoman’s comment.  Did she actually believe that purchasing a camera store membership would benefit my bank account in the long run (as she appeared to), or was she simply a loyal store representative, eager to make additional sales (which seemed more likely)?  Either way, her comment reflected a “save by spending” mentality that permeates modern-day America.

Membership programs and customer reward programs that charge an initial fee are prime examples of the “save by spending” creed.  The customer is presented with various opportunities for future discounts, provided he or she coughs up money for a membership.  As in my camera store situation, the membership offer is usually presented right before purchase, and the amount saved on the purchase itself is highlighted by the salesperson.  The customer is forced to decide on the spot whether he or she would like to join.

Membership programs are rather curious in light of the established research finding that, in general, people will settle for less money if they can have it immediately – a tendency psychologists refer to as temporal discounting.  (Think Money Mart loans or pawnshops.)  In contrast, joining a membership program means foregoing money now for the possibility of earning that money back later on.

There are several reasons these programs may work.  First, they force the consumer to project the likelihood of future purchases in a biased setting.  People are notoriously bad at predicting the future; when buying an enticing summer novel at Barnes and Noble, surrounded by other books, one is more likely to consider spending money on books than on the variety of other products out there.  Second, when presented with the membership program, people may experience mild social pressure from the sales associate.  Third, if people are making their purchases with credit cards, they’ll be more willing to slap on an additional membership purchase; research attests that using credit cards makes people spend more, compared with cash.

Last but not least, the feeling of saving money is just plain rewarding.  We know that money is valuable.  At the same time, we don’t want to save by foregoing that sparkly new iPhone accessory.  Membership programs offer us the opportunity to have our cake and eat it too – to experience the joys of saving and spending at the same time.  And I’m guessing this makes companies pretty happy too.

Of course, membership programs aren’t the only example of our tendency toward saving by spending.  Who hasn’t relished in the experience of buying a product at 50% off, focusing on that 50% that they have magically “earned”?  I know I have.  This may be part of the reason that the average American has half as much personal savings as personal debt.

Thank you, kindly saleswoman, but I will simply pay for my photo prints this time.

~Heather Mann~

In Chile last June, I had the opportunity to spend some time with Felipe Kast, the new government’s minister of planning, and a few of his compadres. (We also went dancing, but that is another story.) One of the topics we talked about was the Chilean retirement saving plan.

By law, 11% of every employee’s salary is automatically transferred into a retirement account. Employees select their preferred level of risk, with the following restrictions: They may not choose either 100% equities or 100% bonds, and the percentage of equity that they can select diminishes as they age. When employees reach retirement, their savings are converted into annuities. The government auctions off the rights to annuitize retirees in groups of 250,000.

This brilliantly conceived approach solves thorny behavioral and institutional challenges. Behaviorally, it recognizes that people are not good at two aspects of financial planning for retirement—deciding to save and eliminating risk in later years—and it forces them to act in a better way. At the same time, the system acknowledges that people who enroll in retirement plans are reasonably good at managing their own risk. So investment choices are left to the individual, with limits on too-risky behavior, especially as a person ages, when bad choices can do irrecoverable damage.

Institutionally, Chile has cracked an age-old problem with annuities. It’s risky business to predict how long people will live, so insurance companies charge a high premium to cover that risk, which makes for an inefficient market. Annuities also suffer from an adverse selection problem, further increasing risk. (The classic example of adverse selection is health insurance: The healthiest people are the least likely to opt in, which increases the pool’s riskiness, making health care less appealing for insurance companies and policies more expensive for the people who want them.) By pooling the risk, the Chilean government makes annuities an attractive business with more competition and better prices. And since everyone is forced to annuitize, the adverse selection problem simply disappears.

I was impressed with this system and wondered how it would fly in the United States, where our own mandated savings program—Social Security—undergoes sporadic efforts to privatize it.

I suspect Americans would consider the Chilean system heavy-handed and limiting—a flagrant example of nanny-state control. You can force me to save money when you pry it from my cold, dead hands. Paradoxically, we happily accept deeply controlling (and expensive) regulation on our behavior in other areas with little thought or protest. Consider the strictures we allow on driving. Wear a seat belt. Drive this speed. Bear the cost of air bags. Pollute only this much. Don’t text while driving.

Why do we accept so much government intervention in driving but chafe when it comes to a few simple rules that would help us make better financial decisions? It’s probably not because we think we’re smarter about finances than driving. I think the reason has to do with our ability to imagine negative consequences. Car wrecks have a way of vividly communicating our incompetence as drivers and making the benefits of regulation crystal clear. Poor money management can carry similarly devastating consequences, but they are less readily apparent. Even in times of economic crisis, we don’t recognize our own bad judgment because people around us are in the same boat and we compare our fortune with theirs.

But the inability to see our own irrationality shouldn’t be an excuse to let it go unchecked. We need to analyze what people and markets are good at and what they’re not good at, and use those insights to improve our institutions. Chile’s approach to saving shows us that it can be done, and done well.

This post first appeared at HBR

Ever since the financial meltdown, and throughout this recession, people keep asking me if I’m optimistic about our future. I think people are actually asking two questions: Where does one naturally fall on the optimism spectrum? And is there a place for optimism in our present circumstances?

One of the most basic findings in behavioral economics is what’s called the “optimism bias,” also known as the “positivity” illusion.

The basic idea is that when people judge their chances of experiencing a good outcome–getting a great job or having a successful marriage, healthy kids, or financial security–they estimate their odds to be higher than average. But when they contemplate the probability that something bad will befall them (a heart attack, a divorce, a parking ticket), they estimate their odds to be lower than those of other people.

This optimism bias transcends gender, age, education, and nationality–although it seems to be correlated with the absence of depression. Depressed people tend to show a smaller optimism bias. They also have a more accurate take on reality–perceptions more in line with what actuaries figure to be their real chances of divorcing, suffering a heart attack, and so on.

UNDERESTIMATING RISK

It is interesting to ponder the utility of over-optimism. It’s not a simple matter, because it can both hurt and help us. Individuals often suffer because of an overly bright outlook. They wind up dead, or poor, or bankrupt because they underestimated the downside of taking a certain path. But society as a whole often benefits from behavior spurred by upbeat outlooks.

It’s the inverse of “the paradox of thrift,” which holds that saving money (instead of consuming) may be good for an individual but is bad for an economy trying to grow.

Overoptimism works the other way. Imagine a society in which no one would take on the risk of creating startups, developing new medications, or opening new businesses. We know most new enterprises fail in the first few years. Yet they crop up all the time, sometimes jump-starting entirely new sectors. A society in which no one is overly optimistic and no one takes too much risk? Such a culture wouldn’t advance much.

So are there objective reasons for optimism in the current recession? There are. Amid the countless half-empty glasses strewn about at the moment, there are many that could be viewed as half-full. Most important, there are lessons we can absorb–insights that point to ways we can improve things. And what’s more optimistic than believing in the possibility of improvement?

This recession has delivered a huge lesson in how far human folly and irrationality can lead us astray–into conflicts of interest, extrapolating long-term projections from short-term trends, putting too much trust in economic advisers, and so on. I don’t anticipate that the downturn will change human nature. We aren’t better, more thoughtful people now. And we’re unlikely to become phoenixes rising from our fiscal ashes. But I am hopeful that if we take these painful lessons to heart (and mind), we might create lasting changes.

There are signs we are doing so, sometimes because there’s no other choice. From my perch as a professor, I see undergraduates turning to volunteering, startups, and the pursuit of all kinds of dreams. And for the first time in many years, Americans are starting to save money. (This might not quicken the recovery, but it’s good for the economy long term.) Manufacturers are building smaller, more sustainable homes and cars. And some banks (banks!) are thinking about how to help consumers become more financially responsible.

Finally, it looks as if there are advances in banking regulations that will endure–those mandating clearer disclosures of mortgage rules, for instance, and those making banks more accountable. Changes like these are unlikely to prevent all future financial shenanigans. But I’m optimistic about their ability to prevent some of them.

This reflection first appeared in Businessweek