I’m pretty sympathetic to the general idea of consumption smoothing over time based on one’s expected average lifetime income; in particular, I think there are often cases where people are unnecessarily miserly with their money at a younger age in order to hit a certain saving rate, which isn’t optimal for them.
However, one very important angle that informs a lot of this is the fact that we don’t have efficient capital markets, which specifically here means that people don’t have frictionless access to unlimited amounts of credit. This means that there’s a very meaningful sense in which a “zero balance” is a meaningful lower bound, which means that it really does become important to save for emergencies, more than it otherwise would be (if your balance were allowed to go negative, then you wouldn’t need to save for emergencies that much, because you could always finance emergencies with credit and pay it back with future earnings).
A related angle, that further amplifies this, is the significant uncertainty people may have about their life trajectory and future earning potential. Depending on risk-aversion, therefore, it may make sense to adopt the “consumption smoothing” strategy against not the median value of one’s expected average income, but against a lower percentile (e.g., the 5th percentile or 25th percentile). In such situations, people would generally appear to see increasing consumption over time as it becomes clearer to them that they are not at the tail of worst outcomes with respect to lifetime income.
A good example is students living very frugally and refusing to take out loans even on extremely favorable terms. Or when there are particularly large and predictable future income increases, such as after a residency or analogous period.
I’m pretty sympathetic to the general idea of consumption smoothing over time based on one’s expected average lifetime income; in particular, I think there are often cases where people are unnecessarily miserly with their money at a younger age in order to hit a certain saving rate, which isn’t optimal for them.
However, one very important angle that informs a lot of this is the fact that we don’t have efficient capital markets, which specifically here means that people don’t have frictionless access to unlimited amounts of credit. This means that there’s a very meaningful sense in which a “zero balance” is a meaningful lower bound, which means that it really does become important to save for emergencies, more than it otherwise would be (if your balance were allowed to go negative, then you wouldn’t need to save for emergencies that much, because you could always finance emergencies with credit and pay it back with future earnings).
A related angle, that further amplifies this, is the significant uncertainty people may have about their life trajectory and future earning potential. Depending on risk-aversion, therefore, it may make sense to adopt the “consumption smoothing” strategy against not the median value of one’s expected average income, but against a lower percentile (e.g., the 5th percentile or 25th percentile). In such situations, people would generally appear to see increasing consumption over time as it becomes clearer to them that they are not at the tail of worst outcomes with respect to lifetime income.
A good example is students living very frugally and refusing to take out loans even on extremely favorable terms. Or when there are particularly large and predictable future income increases, such as after a residency or analogous period.