Consumption Smoothing

WCI touched on consumption smoothing in a recent post. This is one area where classical economics and real life observation (and behavioral economics) differ greatly.

Consumption smoothing is the act of consuming a more equal amount over your lifetime than just a percent of income or some other measure. The textbook says if you expect your earnings from 40 years old and on to be $1,000,000+ each year, but only $30,000 before that, you should borrow and spend as much as you can get your hands on in your 20s and 30s because you’re probably going to die sleeping on a fat pile of money anyway, so there is no reason to share the kitchen with cockroaches even when you are young and poor.

However, nobody knows the future, and as soon as we start looking even 5 years out, there are so many unknowns that from a stress minimizing perspective, any appreciable attempt to smooth consumption would, at least for me personally, be totally counter productive.

There is also a (puritanical?) values system that suggests living young and lean so that later you can be comfortable and use the optionality you’ve created. This is as opposed to consumption smoothing from the beginning, and getting yourself to a place of negative optionality because you’ve accumulated debt which you have to pay off, limited your future possibilities.

Now, don’t get me wrong, there is certainly some place for consumption smoothing, but as the original link says, moderation is key. When I moved to California after school, I was paying more than 50% of my take-home pay on rent and saving very little at all. This is definitely consumption smoothing in action, as my expenses have increased much more slowly than my (expected and actual) wages since then. However, I’m still early in my career, and classic consumption smoothing models should still have me saving very little, yet that is not my preference.

I’m not sure exactly why not, and haven’t come across (though I expect it exists) a model that describes my utility curve. Something about a very low/negative discount rate on future spending, a desire for optionality early on, and a high aversion to debt.

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