Consumption Smoothing for the Masses

According to an old aphorism, there is a conservation law that regulates the distribution of health, wealth, and time. Young people are be poor, but they make up for that with good health and plenty of time. As we age, we slowly exchange time for the almighty dollar, and finally, once we have enough money to retire, we have limitless time but no longer have the physical constitution to make the most of it.

While there's a zen-like beauty to the progression and the inevitability of it all, in an age of Soylent, Flappy Bird and Cow Clicker, shouldn't we expect more from ourselves? Shouldn't we push forward and demand a world in which money, time, and health can all be maximized, where we finally find a loophole around the law that holds them in such strict equality?

Fortunately, the hero of freshwater economics, Milton Friedman, left behind an academic legacy peppered with some basic tricks to get around this problem. Read on for more!

Consumption smoothing, as it's name suggests, borrows heavily from both the medical study of tuberculosis and my personal experience with a pumice stone trying to fix my feet after hiking through three days of mud and water on the Appalachian Trail.

Just kidding.

In actuality, consumption smoothing is a fairly intuitive concept. According to a model that assumes perfectly smooth consumption, your spending should track your permanent income, not your current income. Boom. Fancy economics, complete. But what does this mean...for you?

If you were guaranteed to earn a salary of $50,000 every year for your whole life, it's fairly obvious how much you should spend. We can quibble about the specifics, but if it were actually impossible to raise your income above $50,000, no matter how good you were at stocks, you probably shouldn't spend more than $50,000 each year.

Unfortunately, however, we have not yet encountered any Borg-like race that would be able to ensure this level of consistency. In the real world, we face tremendous uncertainty and risk when predicting the future, making it very rational to save for rainy days and old age. Saving is good.

But in my experience, many people could do with a slightly smoother lifestyle. The fact of the matter is that in a number of very particular circumstances, I think that consumption smoothing can be a prescriptive, rather than descriptive, concept. It can enable a more liberated life, one free from artificial financial constraint and with the ability to take control of your free time. While this may sound too good to be true (and in the worst case encourages a life of hedonistic excess) there is a particular group of people who could stand to learn a basic lesson in consumption smoothing.

Next week, we'll take a closer look at medical students and their frustratingly irrational inability to effectively finance their present spending by taking out loans against their future income.