How is a self-respecting economist supposed to spend gift vouchers?

Our habit of having pots of money mentally devoted to particular spending drives financial advisers crazy

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Darth Vader already knew what you were getting for Christmas because he felt your presents – but these days I can usually tell simply by using my eyes. A chunky envelope, fatter and more rigid than a Christmas card, probably means gift vouchers. It was vouchers galore in the Chu household this holiday season: there were garden centre vouchers, IOUs from the local beauty spa and Amazon gift cards raining down on us.

We were not alone in being showered with valuable pieces of paper. The annual value of all gift card and vouchers sales is now more than £5bn according to the UK Gift Card & Voucher Association. They are exceedingly popular in America too.

To the eyes of the economist this burgeoning market is pretty weird. Gift vouchers are essentially an interest-free loan to the retailer from the buyer, with a high probability the loan will never be called in. Cards are often left unspent because they expire or are forgotten about. Industry figures suggest £250m a year, representing around 5 per cent of their annual value, is never cashed in. Shops love selling them for exactly that reason. And of course vouchers have to be spent in a particular store, or chain. Unlike cash they are not a “fungible” currency, usable anywhere.

Yet despite all this they are increasingly popular. Why?

From the point of view of the giver, it’s not difficult to fathom. Recipients may feel that it’s cold, and frankly lazy, to give cash as a present – more like tipping a hotel maid than showing affection for a cherished family member. And those on the receiving end seem to like them too, despite their inconvenience relative to cash. This is probably because the voucher economy plays to our psychological tendency for “mental accounting”.

I’ve always been a gift card sceptic. When I was given a preloaded £100 credit card as a “reward” for opening a new bank account with HSBC, I used it to pay off an electricity bill. Cash credited to my account would have saved a good deal of annoying fiddling about in authorising the card. But my wife explained to me that she would actually prefer to receive vouchers and gift cards to cash because it means she has no choice but to spend the money on something fun: “With cash I’d probably feel I had to use the money to pay down debt. Vouchers mean I have to buy myself a treat,” she says.

Mental accounting is our habit of having pots of money mentally devoted to particular future expenditures – whether that is saving up, buying a particular gift for a child, or medical emergencies. It’s the sort of practice that drives personal finance advisers crazy.

A few years ago my wife had money in a savings account while her current account was consistently overdrawn and she also had credit-card debt. The credit card and overdraft interest rates were far higher than the interest paid on the savings account. I eventually persuaded her to use the savings account money to slash her expensive credit-card debt. But it was a wrench. Despite the fact her overall finances would be improved, she felt pain at seeing her special savings “pot”, which she’d sacrificed spending to build up, shrink. That’s how our brains work.

Mental accounting is the reason we will cross the road to take advantage of an offer for sandwiches that are £1 cheaper, but we won’t expend the same effort to secure a new hi-fi that is £10 cheaper. The mental account in the first instance is our lunch budget and the mental account in the second instance is our hi-fi budget, even though it’s all coming from the same source and £10 saved on a hi-fi is worth 10 cheap sandwiches.

Why do people tend to splurge on expensive new furniture – more expensive than they’d otherwise feel able to afford – when they move house? Partly, it’s because the expense can be charged to their (unusually large) mental house-buying account. It’s all our money, of course, but we persist in separating these mental “pots” out.

Retailers know this and take advantage. The variation in prices for the same goods between stores for higher-value goods, such as electronics and furniture, is often to be much higher than for lower value goods. There’s more scope for getting people to pay more when the good or service is already expensive.

You might expect politicians, who are in charge of the nation’s finances and have access to the advice of expert civil servants, to be more sophisticated in their thinking about how they spend. Think again.

In the last general election campaign, Labour promised to use the proceeds from a new mansion tax to bolster spending on the NHS. The Conservatives promised to pay for a cut in inheritance tax by reducing pensions’ tax relief for high earners. Politicians talk as if taxing “bad” things pays for the good things, driving public finance experts round the twist. The truth is, just as with household budgets, that it all comes out of the same pot of tax revenues.

Are politicians trying to appeal to the electorate’s habits of mental accounting when they engage in this sort of thing? Or are they just indulging their own? Who knows, probably a bit of both.

So is mental accounting such a problem? Should we strive to stop being “irrational” when we think about money and spending?

The behavioural economist Richard Thaler, a pre-eminent researcher in this field, is surprisingly ambivalent. He points out that mental accounting is a habit mankind has developed over our evolutionary history. It may result in inconsistent behaviour, but it also helps us to economise on time when making decisions and it assists financial self-control, too. Perhaps if we didn’t pay attention to tiny price differences we’d stop paying attention to good value altogether.

So maybe it is better, after all, that we put our money in special mental pots. Enjoy spending those gift vouchers.