Consumption Smoothing and Why It Doesn’t Work

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When I was a young professional, my income was relatively low – substantially lower than it was even five years later. I knew that over time, my income would go up; my career path offered lots of opportunities for growing one’s wage and I was dedicated to my career.

So, like many young professionals, I justified a lot of overspending with the excuse that I would be earning a lot more in the future and could make up for my spending then.

This is a well-known economic concept called consumption smoothing. In a nutshell, Consumption smoothing means balancing out spending and saving to maintain the highest possible standard of living over the course of one’s life.

The big reason in favor of consumption smoothing is that it in theory balances between the two extremes. On one end, overspending means that you consistently spend more than you earn, while oversaving means that you consistently spend less than you earn.

My argument, early on, was that I should overspend while I was a young professional and that I would spend less than I earned later on when I was earning more. This would allow me to have the same quality of living now that I would have later.

There’s a big problem with all of this, though: life happens. Seven years ago, I was unmarried. Five years ago, I was childless – my wife wasn’t even pregnant yet. Three years ago, I lived in a tiny apartment. Two years ago, I had a full time job with a large organization. Heck, three months ago we didn’t know we had a third child on the way.

Beyond that, I’ve watched my friends pretty much stumble onto successful dot-coms. I’ve watched other friends come down with life-altering illnesses. I’ve watched friends fall in love. I’ve watched friends get divorced. I’ve watched friends discover children they didn’t know they had.

Consumption smoothing only works if you can exactly predict the way your life will go. And you can’t. Life is too unpredictable for that.

My philosophy is much simpler: just consistently spend less than you earn and save the difference. If you’re early in your career and not earning much, these should be your salad years. When your life changes – you’re earning more and you have more responsibilities – spend more.

Spending less than you earn and saving the difference provides a much more important kind of smoothing, what I’d like to call “risk smoothing.” If you have money in the bank, it’s a lot easier to take a risk and start a new business. If you have money in the bank, you are much more likely to roll through personal crises.

This isn’t a call to “oversave” – that’s unhealthy. Just consistently save some percentage of what you earn – you can figure out what works in your own life. Then, when you need it to take advantage of the great opportunities life hands you or to deal with the problems that come up, it’s there for you.

Or, you can sit at home with your 72″ television while lamenting the fact that you missed out on the opportunity of your dreams.

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13 thoughts on “Consumption Smoothing and Why It Doesn’t Work

  1. Yeah I agree (from Toronto, where 5 years ago in NYC I never thought I’d be living) but think it applies to big purchases as well as the fun stuff too – ie don’t buy a house/car large enough for the life you “expect” to have in 5 or 10 years. The best laid plans and all that!

  2. I see this all the time around college. One of my buddies just bought a Macbook and iphone on the same day. His justification was that he will soon be earning good money and can pay off his credit card easily.

    Here’s the thing: when you are young you have very little overhead costs. The reason I save as much money as I do is because I live at home. Sure I will be making more money in a few years BUT I will probably be living on my own. I will be spending more money on different areas of life that I never even thought existed.

  3. What IS “oversaving,” for that matter, and why the scare quotes? If my after-tax income is, say, $50K, and I save half of it, is that oversaving? What if my needs and wants can be completely satisfied with $25K? How much stuff do I have to buy that I neither need nor want, in order to be healthy?

  4. I’m afraid I practice consumption smoothing right now while we have kids. I hope that in the future things will be less tight because it will just be us. I don’t wastefully spend on electronics and stuff, but I do spend a lot of money on quality food or on activities for the kids – at the expense of saving.

  5. I think oversaving is when you’re saving money to the detriment of your and your family’s life and physical, mental & emotional health.

    Saving $X amount could be oversaving or overspending depending upon the context of one’s life. Check on the lifestyle of early 20th century millionnaire Hetty Green for someone who oversaved. Among other odds behaviors to save money she ate oatmeal that was cooked on a heater, wore old clothes, and treated her own son’s broken leg (which had to be amputated due to gangrene). She moved from various locations to avoid having a taxable residence and refused to have surgery because it cost money.

  6. Youth plus youthful optimism usually means overspending. (The advertising media does it’s part too, specifically targeting the youth market)

    Trent, you make a brilliant point, especially in this economy. We SHOULD figure this out on our own, but it helps to have it in writing so we have a visual.

    This also goes for the not so youthful, in regard to handling windfalls. Just because you’re flush now, doesn’t mean it’ll always be that way.

  7. The other problem with overspending while you’re young — even if you earn enough to make up for it when you’re older — is that you miss out on interest and investment returns and throw money away paying interest on debt. Saving when you’re young provides the most time for your money to grow.

  8. Consumption smoothing seems to be what has gotten many people into a lot of trouble. If you spend more than you can afford with the belief that someday you will be able to afford it you are dreaming. Live for what you have today, if tomorrow is better, enjoy it then. It’s part of that patience thing that we’ve forgotten about.

  9. “I’ve watched friends discover children they didn’t know they had.”

    And now I have to go find something to clean up the coffee I just spit-taked onto the monitor, while I thank my lucky stars that as a woman I’ll never have to deal with THAT one.

  10. I have done consumption smoothing, the key is doing it right. When I was a student I did borrow money (but we’re only talking $10-20k). And when my salary has been high I saved almost half of it. It makes sense to borrow a bit as a student and then only gradually raise your living standard over time as the future becomes clearer. This is consumption smoothing compared to just spending whatever you earn…

  11. I think the real problem with consumption smoothing is that most people aren’t disciplined enough to run an annual budget and run their life according to a graph.

    those who are actually disciplined enough to run their life within a financial budget on a monthly and annual basis are probably tempermentally disinclined to consumption smooth, EXCEPT for life stages such as higher education.

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