In the frame: why PPI refunds are boosting the UK economy

Press reports out this week highlight that refunds of mis-sold payment protection insurance (PPI) are providing a welcome boost to the UK economy. Some £4.8 billion has already been paid out with a further £5 billion yet to be claimed.

This unexpected cash – with average payouts of £2,750 – is encouraging people to fix the roof, go on holiday and generally start spending again. But why are people spending this cash and not saving it or paying down their debt? New theories from psychology can help to explain, and indeed predict, this type of economic activity.

Research on mental accounting shows that how people make sense of financial situations determines their financial decision making. Most critical is whether they frame the situation in terms of gains or losses. For example, a tax rebate is generally framed in terms of the return of a loss and this leads to a strong tendency for saving. In contrast to this, when money is given in ways that induce a positive framing – for example a bonus – they are less likely to save and more likely to spend it.

In 2001, the US Government failed to take account of this effect when using a tax rebate policy to try to stimulate the economy by increasing consumer spending. The policy was much less effective than predicted with most (78%) intending to save rather than spend this money.

These findings challenge a key assumption underpinning classical economic theory that assumes money is fungible – that is, a pound in one context is perfectly interchangeable with a pound in any another context. They also demonstrate that predicting how people react to changes in their economic circumstances depends crucially on how they make sense of the situation.

However, not all economists have learned these lessons. Jonathan Portes, director of the National Institute for Economic and Social Research has suggested that PPI refunds have had the same economic effect as a tax cut. Insights from mental accounting research suggest the opposite - the boost to the British economy is due to PPI payments being framed positively, unlike tax rebates which are generally framed negatively.

Professor John Maule,
Linstock Associate