Smoothing consumption

Evolving pf recently had a post on smoothing consumption over time, and how she thinks that advice from Chicago-school economists (not to mention Suze Orman) to take out loans to buy stuff when you’re young and poor because you’ll be making a ton of money later is silly advice.  This is pretty standard Econ 101 or 102 stuff– why suffer now when you can borrow against your future?

(Note, this argument is about CONSUMPTION, not about INVESTMENT.  It is still generally wise to take out loans for things that will pay off later, like schooling, or reasonable transportation etc.  When you invest, you’re spending money now to make the money pie bigger.)

In the comments she asks why economists would think such a silly thing to begin with.  If you’re happier with constant consumption, why not make the consumption constant at a low rate so you never go into debt?

Here’s my reply:

Because of diminishing marginal utility. (See graph: https://nicoleandmaggie.wordpress.com/2011/10/24/marginal-tax-rates-why-they-make-sense/ )

You don’t just want any constant/fixed consumption– you want a constant utility that is going to be as high as possible given your total lifetime earnings. That’s going to give you the biggest bang for your utility buck.

That’s because you’re happier with two years consuming say 30K, than you would be consuming 0K one year and 60K the next year. (You’d also be dead if you did that.) The amount that 60K makes you happier than 30K is smaller than the amount 0K makes you sadder than 30K. (You can see that on the diminishing marginal utility curve– going down is steeper than going up. Each additional dollar provides less additional happiness, each dollar lost provides more additional grief.) Depending on interest rates etc., there’s going to be some optimal consumption level given your permanent income and the rate of return of your savings/cost of debt. And that’s going to be flat. (You can use a 2 period-model with interest rates to model this stuff. If you allow bequests you end up with an OLG model!)

So that’s the standard reasoning behind why we want to smooth consumption over our lifetimes– why if we had perfect foresight about our earning power it might make sense to take the average (adjusting for interest rates etc.) over time.

However, I have always thought that the idea of consumption smoothing over time is silly. 1. We don’t have perfect information, and we don’t know what negative (or positive) shocks we’re going to get. We don’t have perfect insurance, so we have to self-insure to guard against negative shocks that could cause low consumption. 2. People like having increasing consumption over time, not flat consumption. It is much more fun to increase your quality of life as you get older rather than having to cut it back. (Some of this may be because of how we view time horizons. It’s neat how psychologists and behavioral economists are really getting into these black boxes.) We get used to higher levels of spending and they don’t make us as much happier, so it’s good to stay at lower levels while they’re still not so painful. Also, as she notes, having a big savings cushion provides freedom to make choices that might maximize happiness even if they don’t maximize income.

Additionally, there’s another set of theories dealing with the lifecycle hypothesis that suggests that people consume in a hump shape– ramping up through middle age and then down again once the kids are gone, and some beliefs that people prefer that.   And that’s not even getting into how bad many of us are at forecasting our future earnings– college students tend to overestimate by wide margins what their starting salaries are going to be.

How about you, what are your thoughts on smoothing your consumption over time?  Do you think it’s worth going into debt to buy luxuries when you’re young because you’re going to pay them off when you’re older?  Did you when you were young?