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Does Consumption Smoothing Really Work?
Several weeks ago, a reader suggested that I listen to the latest episode of the wonderful Freakonomics podcast. If you have a chance, I highly suggest listening to it – while I don’t always agree with the conclusions, I find most of the topics discussed to be really entertaining and often thought-provoking.
Since then, I’ve been digging backwards through the archives, listening to old episodes of the show. Just the other day, I came across a fascinating one – Episode #140, entitled “How to Think About Money, Choose Your Hometown, and Buy an Electric Toothbrush.”
In that episode, one of the hosts, Steve Levitt, makes an interesting argument. He states that young people should spend more and save less, leaving the saving until they’re older.
His reasoning for that idea is based in economic theory, using a concept called consumption smoothing. Consumption smoothing is the idea that people generally prefer to consume a consistent amount over the course of their lives. In other words, at any given point, people tend to prefer to be as close as possible to the “average” consumption of their lifetimes.
It’s easier to understand this with an example. Let’s say that over Alice’s lifetime, she earns an average of $35,000 per year (adjusted for inflation – we won’t worry about inflation here). During her first few professional years, she only earns about $20,000. However, during her peak earning years in her fifties and early sixties, she’s earning about $50,000 per year. The idea is that Alice should ideally spend some amount close to $35,000 throughout her lifetime, making up for the shortfalls in some years with higher earnings in other years.
(If you want to dive deep into the mathematics and theory behind the idea, go for it!)
On many levels, this makes sense. It ties in pretty well with the idea of a fulfillment curve in that your life is happiest when you strike a reasonable balance between overconsumption and spartanism. Given that we often see a smooth past and a smooth future for ourselves, it makes sense to spend as though things will always be smooth.
There’s a big problem with this idea, however. It requires a person to have a crystal ball when it comes to their future.
Let’s say you’re in your early twenties and you enter a field where you believe you’ll earn about $50,000 a year on average over the course of your career (adjusted for inflation, of course). Under this theory, you should start spending at that rate and always keep it at that level.
However, what if your field collapses? What if you’re unable to find work? What if you’re unable to work? If you spend the early years of your career digging yourself into a financial hole and then the expected doors never open for you, you’re setting yourself up for many years of struggle in the form of debt and unrealistic expectations.
The idea of consumption smoothing buys into what I consider the most dangerous concept in personal finance – the idea of the “perfect future self.”
All of us want to visualize a future version of ourselves that’s successful and makes the rational decisions we believe we’ll make at that point. Because that future version of ourselves is so much more responsible and efficient than we are today, it’s very tempting to assume that “future self” will just take care of things.
If I overspend and charge up my credit card today, my responsible future self will take care of it.
It’s a very tempting fairy tale, but it’s just that – a fairy tale.
There are two possible outcomes from that fairy tale.
One, you actually do become more responsible and mature and efficient, plus everything works out in the best possible way with no big unforeseen events. The only problem is that rather than getting ahead and building a great life, you’re just paying for the immaturity and mistakes of your younger self.
Two, you remain the same person you are right now or unforeseen events hit you (or both). In this scenario, you’re stuck where you are right now, but you’re shackled by more debt and fewer opportunities.
Every time you rely on your “future self,” you’re either putting a leash around the neck of your “better self” that could accomplish great things or putting shackles on the arms of a future you that’s a lot like you are today. In either case, it’s not good.
Ideas like “consumption smoothing” are tempting – and they make sense in theory – but they don’t account for the realities of life.
There is never, ever a good time to burden your “future self” with debts and responsibilities. Instead, you should do what you can to give your future self as much freedom as possible because you don’t know what obstacles and opportunities the future holds.