William J. Bernstein
The Retirement Calculator From Hell, Part V:
The Unhappy Implications of the Easterlin Hypothesis
"Anyone who says that money doesn’t buy happiness doesn’t know where to shop."—Anonymous
Finance and economics types—overly focused on the bottom line and congenitally unable to think about what makes humans really tick—are very easy targets. There are almost as many economist jokes as lawyer jokes. Of what use is the single-minded economic focus on increasing wealth if we are at the same time growing steadily more harried, insecure, and unhappy?
Over the past generation, a small group of sociologists, psychologists and, yes, economists has begun to examine the determinants of human happiness. Prime among them is Richard Easterlin, who has made a distinguished career out of the money-happiness nexus.
To those who doubt it, happiness (or "well-being," as it is known in the trade) can be measured with a wide variety of objective tools. The data are reproducible and correlate with other more easily identified characteristics. What makes people happy? In almost every culture where happiness has been studied, it comes down to four things: employment, family, health, and money. Unemployment, independent of financial status, seems to be the most powerful misery generator known to man. Divorce comes in a close second, and ill health is also a strong predictor of unhappiness.
Money, too, buys happiness. Within a society, the rich are happier than the poor. Below, I’ve plotted some representative summary data from many different nations:
In every nation, the wealthy are significantly happier than the poor. This relationship is progressive: the richer, the happier. And just as predicted by generations of economists, the relationship is logarithmic; increasing increments of wealth are required to move up the hedonic scale. Great happiness is obtained by increasing one’s income from $10,000 to $100,000 per year. To obtain yet another same-sized aliquot of joy requires a jump to $1,000,000 per year.
The stratification of happiness by wealth within a society is only one dimension of the issue. The second is the effect of national wealth on aggregate national happiness. Here, too, wealth exhibits a positive effect, but it is much weaker than might be expected on the basis of the data for individuals. Below, I’ve plotted the correlation of happiness and wealth among nations by income. There is clearly a relationship, but it is much weaker than predicted by the individual data.
The third dimension of the happiness puzzle is time. The real per capita GDP of the world’s most developed nations has been increasing at about 2% per year for more than a century. Surely, as we are growing ever more wealthy, we must be growing happier.
Alas, we are not. The below plot shows the percent of those describing themselves as "very satisfied" (as opposed to "fairly satisfied," "not very satisfied," or "not at all satisfied") in four representative European nations over a quarter century.
Europeans have not, as a group, gotten much happier during a period when real per capita GDP increased by about 60%. Even more puzzling are the extreme differences between the Danes, with an average of 60% of their population very satisfied, and the Italians, averaging only about 11%, with Britons falling about halfway between the two. Just why did the Belgians become more depressed during that quarter century? The answer is controversial, but likely has to do with that nation’s cultural and linguistic fissures erupting in the past few decades, resulting in a more fragmented political apparatus. (This is similar to a temporary drop in happiness in the U.S. during the Cold War and in the ex-communist world.)
The measurement of the sub-population describing itself as "very satisfied" does introduce a bit of distortion. For example, in a preliminary study done in 1965, only 12% of French subjects described themselves as "very satisfied," but 64% described themselves as "fairly satisfied." In the U.K., these numbers were 53% and 42%. Thus, 76% of French and 95% of English described themselves as at least "fairly satisfied," not nearly as impressive a difference as between the 12% and 53% figures for "very satisfied" in the two nations.
These differences among nations cannot be explained by economics alone—the gaps in per capita wealth among the four nations were relatively small throughout the period. Clearly, there must be cultural factors involved. Stereotypes—the good-humored Dane and the dour Belgian—only take us so far; the low scores of the outwardly ebullient Italians come as a bit of a surprise.
The stagnation in personal satisfaction with increasing wealth over time is even more strikingly demonstrated in Japan, where a somewhat different happiness scale shows almost no change between 1958 and 1987, a period when per capita GDP increased fivefold.
Money, then, does buy happiness, but only in a relative sense. What matters is not how much absolute wealth you have, but how much you possess relative to your neighbors. In the words of Marx:
A house may be large or small; as long as the surrounding houses are equally small it satisfies all social demands for a dwelling. If a palace rises beside the little house, the little house shrinks into a hut.
Or, as more succinctly put by Mencken, a wealthy man is one who earns more than his wife’s brother-in-law.
An important subtlety is just how we define our peer group. We gauge our wealth primarily against our friends and neighbors. The person earning $100,000 per year in an economically depressed rural community is likely to be far happier than someone earning the same amount—even adjusted upward for purchasing power—on Manhattan’s Upper East Side. This "neighbor effect," one of the bedrocks of human nature, applies in many other areas as well. Economist Paul Krugman describes his unhappiness as a well-paid, highly-respected academic with a secure position in one of the world’s great universities:
I had a very pleasant job that paid quite well and received lots of invitations to conferences around the world. Compared with 99.9 percent of humanity, I had nothing to complain about. But of course that isn't the way the human animal is constructed. My emotional reference group consisted of the most successful economists of my generation, and I was not generally counted among their number.
This gets to the heart of the meaning of inflation-adjusted security returns. You may think that a real dollar—one that has been adjusted for inflation—may buy you just as much satisfaction in the future as it does today. But you’d be wrong; in a world where the real wealth of you and your neighbors increases by 2% per year, you have to make a real 2% return each and every year just to keep your hedonic accounting even. Given the low expected returns of both stocks and bonds—about 4% and 2% real, respectively—and the effects of taxes, the average investor cannot reasonably expect to obtain from any investment policy more than a hedonically adjusted dollar at any point in the future from a dollar invested now.
A while back, Robert Arnott pointed out to me that this likely equivalency of present and future hedonic dollars suggests a strikingly simple, and frightening, calculus. For every hedonic dollar you want to spend in retirement, you must save at least one now. Say you plan to work from age twenty to age sixty, then live in retirement until age eighty. That’s two working years for every retirement year. In order to do so, you must save one-third of your salary. You say you want to retire at age fifty? Hey, no problem. All you have to do is save half your salary.
There is only one way out of this bind, and that’s to get off the "hedonic treadmill"—the constant upward ratcheting of our material expectations as we and our society grow ever wealthier. Downshifting can be a powerful way of regaining lost time and freedom, but not many are capable of voluntarily lowering their standard of living below that of their friends, family, and neighbors. How many would be happy with a real 1963 standard of living in 2003?
Of late, I’ve been accused of no small amount of pessimism. Actually, with a bit of rationality returning to the capital markets, my spirits have brightened. Falling stock prices have increased the expected return to the patient investor, and John and Jane Q’s headlong rush into bonds has lowered their returns to the point where there is now a reasonable equity risk premium. The rational and hedonically calibrated investor knows the difference between pessimism and realism and behaves accordingly.
Copyright © 2003, William J. Bernstein. All rights reserved.
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The right to download, store and/or output any material on this Web site is granted for viewing use only. Material may not be reproduced in any form without the express written permission of William J. Bernstein. Reproduction or editing by any means, mechanical or electronic, in whole or in part, without the express written permission of William J. Bernstein is strictly prohibited. Please read the disclaimer.