As an economist this makes me happy, but I feel it has to be pointed out that there are many assumptions underlying consumption smoothing that fail in consequential ways.
It assumes perfect credit markets. Saving is one thing, but if you think you’ll earn more in the future, smoothing requires actually borrowing. And no bank will lend you money for personal consumption on the premise of “I’m going to be good for it in a few years, just trust me bro”.
For many plausible utility functions, marginal utility is convex (U′′′(C)>0) and the optimal thing to do is to save more when there is more uncertainty about your future income… which is exactly what most people do, rather than just focusing on their expected future income.
(Most importantly) For most of us, the importance of saving is not smoothing across time but smoothing across states. I save not for my 65 year old self, but for myself tomorrow who breaks a limb and has to pay a large healthcare payment. Smoothing consumption over states is literally impossible in a world where we can’t draw perfect insurance contracts for every potential bad thing (or good thing) that we want to smooth over. When you have no insurance markets, it’s pretty simple to establish that savings are the only way you have to smooth consumption across states.
So what should this mean for you? Well, a) your preferences matter; if you are “sufficiently risk averse” (U′′′(C)>0) then save more than a risk neutral person would. b) saving is the only way to truly insure yourself across states, to guard against bad shocks to your livelihood and wellbeing. If you, like OP, want to do the “economically optimal” thing, I think you’d find that the answer will vary tremendously with your preferences and life circumstances, to the point where I think these frameworks should be taken as interesting ideas rather than prescriptions.
As an economist this makes me happy, but I feel it has to be pointed out that there are many assumptions underlying consumption smoothing that fail in consequential ways.
It assumes perfect credit markets. Saving is one thing, but if you think you’ll earn more in the future, smoothing requires actually borrowing. And no bank will lend you money for personal consumption on the premise of “I’m going to be good for it in a few years, just trust me bro”.
For many plausible utility functions, marginal utility is convex (U′′′(C)>0) and the optimal thing to do is to save more when there is more uncertainty about your future income… which is exactly what most people do, rather than just focusing on their expected future income.
(Most importantly) For most of us, the importance of saving is not smoothing across time but smoothing across states. I save not for my 65 year old self, but for myself tomorrow who breaks a limb and has to pay a large healthcare payment. Smoothing consumption over states is literally impossible in a world where we can’t draw perfect insurance contracts for every potential bad thing (or good thing) that we want to smooth over. When you have no insurance markets, it’s pretty simple to establish that savings are the only way you have to smooth consumption across states.
So what should this mean for you? Well, a) your preferences matter; if you are “sufficiently risk averse” (U′′′(C)>0) then save more than a risk neutral person would. b) saving is the only way to truly insure yourself across states, to guard against bad shocks to your livelihood and wellbeing. If you, like OP, want to do the “economically optimal” thing, I think you’d find that the answer will vary tremendously with your preferences and life circumstances, to the point where I think these frameworks should be taken as interesting ideas rather than prescriptions.
Wow, you made pretty much the same points (albeit with slightly different emphases) as I did in my comment https://forum.effectivealtruism.org/posts/RyRhT6EQjJgcwYmtd/popular-personal-financial-advice-versus-the-professors?commentId=uDdooGQDbXwnBiieW
You’re absolutely right, this is why I should read comments before posting redundancies at 2 am...