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: )

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?

30 Responses to “Smoothing consumption”

  1. Debbie M Says:

    Ugh. Opposed.

    a) Who knows what you’ll make in the future or even how long you’ll live?
    b) Debt is stressful and expensive.
    c) If you’ve committed to making more money, that reduces your flexibility.
    d) It’s cheaper to be happy when you’re healthy (easier to bike/walk versus drive, etc.).
    e) It feels like a rationalization of what you want to do but know you shouldn’t.
    f) Moving downwards sucks.

    I’m into debt for investment reasons (that includes health as well as education).

    I’m into keeping expenses low and stable for purposes of building a financial cushion when income is higher.

    What did I actually do when I was young? Live on very little. Gradually I ratcheted my charitable contributions up to 10% and added health insurance, car ownership, home ownership, retirement savings, and early retirement savings. I love every one of those additions and am having trouble ratcheting down these last few years before my pension when I also am not working full time!

  2. Dame Eleanor Hull Says:

    I thought this was going to be about lowering tuberculosis rates, or at least providing good palliative care for consumptives. Too many 19th-c novels, I suppose. (I should have realized that I wasn’t reading The Little Professor.)

  3. Holly@ClubThrifty Says:

    I don’t think it’s wise to go into debt when you’re young with the hope of paying it all off later. So many things can go wrong. Plus, I agree with the commenter above that debt is just stressful. Why add that to your life when it isn’t entirely necessary?

  4. Liz Says:

    I don’t have enough data (i.e. I’m too young) to know how my consumption patterns will be over time. But I feel like I spent a lot of money in my early 20s (20-23) as I moved into my own place for the first time, and kept on moving… Now that I have the hang of what’s worth keeping, and I have the money needed to rent a moving truck, my spending on household items has gone down dramatically. Spending on retirement (i.e. saving) and paying off debt (student loans) has gone up dramatically. I’ve increased spending on food, in part because food costs are just up and in part because I feel I have the option to eat more organic/unprocessed/wheat-alternative/happy-meat kinds of foods, thanks to rising income. (Pay the farmer or pay the hospital – I choose farmer.)

    • nicoleandmaggie Says:

      Moving is freaking expensive, and particularly hard when you have to do it multiple times for school, early jobs, etc., when you have no money. Moving is probably what gave me the most debt. (Besides school loans)

  5. First Gen American Says:

    I’ve always been of the ilk that it’s better live modestly for as long as possible to pay down that “beginning of life” debt. College expenses, car, credit card, etc. I had very low expenses my first 5 years out of college so that I could pay down my debts and save for a house. I couldn’t imagine just piling on a mortgage on top of a bunch of other stuff. That being said, I’d like to think I looked at once in a lifetime opportunities and seized them even though they weren’t frugal. For example, my first year out of school, one of my close friends was from South Africa and when he invited me to go back with him, I said yes even though the ticket was expensive.

    I definitely see mine as a bell curve too. When I get older and the kids and parents are out of the house, I’m not going to want a huge property to maintain. It’s a lot of work to have a big house and lots of stuff. The problem with a high level of consumption is that there is a lot of time/maintenance involved in taking care of all that stuff.

  6. Cloud Says:

    Hmmm. I’m not sure I’d recommend going into expensive consumer level debt for travel, but I’d definitely encourage a young person who is interested in traveling the world to consider deferring earning potential to do it. It only gets harder as you get older! But, on the other hand, when I finally did get to take a long trip (in my early 30s) it was nice to be able to do so with more money than I would have had in my 20s.

  7. bogart Says:

    Well, luxuries, no, obviously (loaded question!), and sure, I agree with the basic cautionary point, absence of crystal ball, and so forth. But I’d move something approximating durables as well as things trending toward “easier undertaken young” into the “worth spending on” categories.

    In the durable category, DH and I lived in our (modest) (and fairly dreadful in original form: 1970s, not the best decade for home design) home for ~8 years before we remodeled/renovated half of it (the other half remains in need of attention, see below). It is SO MUCH BETTER now. Now, independent a sense that we want to live there forever (which has developed over time and is independent of the actual structure, rather, it’s location), taking out debt more or sooner would not have made sense, but I also sort of kick myself in that it is a SO much nicer place to live now and I wonder why we didn’t make it so sooner. Not just in a hindsight sense, but I’ve worked out how I want to remodel the other half and — really, what am I waiting for?

    Of course it really, really depends on what actual debt (or simply lost opportunity cost) costs, and right now it is cheap, cheap, cheap.

    And count me among those who believe it entirely makes sense to travel on the cheap before one takes on jobs, mortgages, dependents (even if travel delays taking them on). And this may apply to sporting activities as well. How long will I want to/be able to ride a horse? I look at the women in their 50s and 60s out where I ride, and it’s clear that the older you get, the harder and more dangerous many aspects of it are.

    On the other hand I am also very grateful that I took seriously the advice to contribute to retirement savings and maxed out my 403b from year 1 and pretty much every year since. It’s nice knowing those balances are there, now, and considering how long it’s taken to get them even to where they are, I’m sure glad I’m not starting now. And of course it was easier to get in the habit of doing THAT before I had a mortgage or dependents, also.

  8. rented life Says:

    No luxuries when young, but that depends on how you define luxuries I guess. When we first dated/got married, we lived on the super cheap, but almost too much so. We moved to a fantastic city but did not take advantage of the fun things there, not even to spend $10-20 on a rare occasion, which made us miserable. So I think we could have learned to at least do one thing every few months instead of nothing at all but work and stay home. (We should have just also walked the city more. People watching is free and fun.) We’ve learned that lesson and since then we still live on the cheap but if we save up for things like trips or going out to eat, some people around us think we’re being extravagant. But those things aren’t done without say “ok, we’ll eat out, but it’s sandwiches for dinner for x days” or whatever.

    I’m a money hoarder so I’d rather save, save, save than spend. The few things we did buy–the car, the house (which we sold when we moved), education, health were all investments to us. Having a car that doesn’t leak from the roof, need repairs all the time, or you need to hold the door closed in the winter while driving…well that was worth it. It’s almost paid off and we got a great interest rate. I wish we had done that sooner, rather than a string of cheap cars with expensive repair bills. We do spend more than we did when we were younger, but a lot of that is to alleviate stress and they are thought out decisions. We’re not just buying stuff. My parents, to me, are spending more now, but I think that it seems that way because they are spending more on themselves instead of debts. Dumping into retirement accounts, building buildings on their property, investing in themselves in ways I wish they had when we were younger but I know they couldn’t. And mom has come a long way with budgeting and plans out all those expenses so they are never hurting themselves (mom and dad lived the “pay for it later” model, and I watched how hard that was to recover. Brother and I are opposite from our parents.)

  9. Emily @ evolvingPF Says:

    Your comment definitely deserved its own post so I’m happy to see this! Thanks for linking to my post as well.

  10. Chelsea Says:

    After years of living frugally and saving a good portion of our incomes (we have 0 debt right now thanks to scholarships and assistantships in school) DH and I started borrowing against the future (in the form of spending some of our savings) for some luxury items since our son was born. The big changes are that we moved to a bigger apartment with a dishwasher and washer and dryer where our son could have his own room, we drive more because I can’t take the bus to work and get DS to daycare, I cut back on my hours at work so I could spend more time with my little guy, and we hired a cleaning service to come every other week. On the one hand, it’s stressful that we always spend every penny we make each month (and sometimes a bit of savings). On the other hand, I would say our quality of life is much higher than it would be if we hadn’t made those changes. DH is in the process of interviewing for TT jobs (1st campus visit at the end of the week!) so we are pretty sure that we will be able to keep up this level of spending without it being beyond our means once he gets a real job in the fall.

  11. plantingourpennies Says:

    Stuff like this tends to remind me of models of physics concepts that take place in an “ideal frictionless world”. Interesting, but not something I want to rely on for myself.
    Young people already have enough trouble conceiving of how much time they are potentially sacrificing when signing on for student loan debt, encouraging them to take on addional debt in order to fund a lifestyle they don’t yet have the earning capacity for (and may never) seems foolhardy.
    When I was in college, I presumed I would be A-ok with spending 30-40 years working a stable job as an employee for someone else. But 10 years later, that’s not what I want. I can’t imagine how frustrating it would be to know that the stable job isn’t what you want, yet know that you need to continue with it for another 20-30 years because you leveraged your way into a higher lifestyle while young.

    • nicoleandmaggie Says:

      I tell my students that we purchase various things at the physics store. You know, where you can buy infinitely thin strings and frictionless surfaces. They usually look at me like I’m nuts.

      Freedom is a wonderful thing to purchase. I’m very happy with our former selves in that respect.

      • nicoleandmaggie Says:

        I have physics notes that say, “Assume a spherical cow.” Must be some store.

      • First Gen American Says:

        I took an environmental engineering class and one of our textbooks was named something like picture a spherical cow. Ie…calculating how much methane comes out of a cow butt.

  12. chacha1 Says:

    Speaking as someone who got into significant financial trouble due to overspending … I am opposed to going into debt early in life for purposes unsupportive of career advancement or stability (as you indicate: reliable transportation or education? there’s a rationale. However, as previously noted, taking on more debt for education than = the first year’s average salary for the resulting job is financially unwise).

    I did not go into debt for any of my education, and my first (very good) car was a gift. I still got into trouble. Lifestyle inflation isn’t just for middle-aged professionals. I venture to guess it is much worse (in its effects) among post-college 24 – to 40 – yr – olds.

    The absolute worst thing to overspend on: food & beverage. I am very grateful that I was never a club-going type of gal, because damn.

    The second-worst thing to overspend on: housing. I am also very grateful I never bought into the buy-a-house peer pressure.

    “Travel” is a luxury but an educational one. I did not travel much in my younger years, and even now the travel I do is inexpensive – mostly car trips – because any change of scenery will convey the benefits. You don’t have to go to Thailand or France … Louisiana or Montreal may be, for someone who lives in (e.g.) Ohio, equally exotic. I am not in favor of going into debt for travel at any age.

    If you can’t pay cash for nonessentials (and by “pay cash” I mean, more properly, “pay off in full within six weeks” because most of us leverage these things by using credit, you can’t book an airline ticket online with a fistful of Benjamins) you shouldn’t be indulging. That is my puritanical side. There are just so many great things to do, almost everywhere, that cost almost no money. I wish it had been harder for me to get credit cards 20 years ago.

    • nicoleandmaggie Says:

      I’m definitely grateful to the me who didn’t overspend back in the day, even though she may have taken it to extremes, she opened up a lot of opportunities for me. (Though maybe we would have bought a smaller house if she hadn’t saved such a big downpayment… Still, it is a lovely house.)

  13. Rosa Says:

    I feel like I, personally, am really bad at predicting what will make me happy. Especially compared to an unknown. So how could I know if spending money on something now will be worth not having the money in the future for something else, not even knowing what “something else” is?

    My partner has a really good sense of what makes him happy, and always has. I like to try infinite things. So he would have done fine borrowing early and paying off later. Me, I have had the freedom to often choose stuff that I hadn’t even previously known existed, because of not getting into debt earlier.

  14. Favorite Posts, Mentions, and Top Comments Week of 20October2013 - Evolving Personal Finance | Evolving Personal Finance Says:

    […] out of her comment on my post You Should Spend More and Save Less (Especially Grad Students) on income smoothing (great to hear about this from an […]

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