Monday, May 25, 2009

Problems with Clarke's Student Debt Post, Part I: Lifetime Consumption Issues

There are serious and very important problems with Conor Clarke's post, "Let College Students Get Into Debt". In part 1 of this series I discuss his statement, "…if the the point of credit-based consumption is to bring lifetime consumption more in line with lifetime income – as I believe it is – then college students more than anyone else should be getting into debt."

How in line does Clarke mean? In the real world, unlike in the simple classical lifetime consumption models, it is not optimizing to have consumption (spending) exactly equal throughout life. It's far from it. Did Clarke mean that it was optimal to perfectly even-out spending? I don't know, but a reader could interpret it this way. This is a misconception that comes from the all too common problem in economics of taking models with grossly simplifying assumptions literally, or overly literally.

First, spending usually just gets a lot more valuable with age – and non-spending gets a lot more costly and consequential. As you get older and your health, energy, and durability decrease you need a lot more spending on medical care and conveniences. At age 19 you can sleep like a baby on a beat up old discount futon or mattress. At age 45 or 60 or 75, this may lead to serious chronic back pain, and sleep/rest deprivation. And obviously at age 19 you need to spend far less on medical and dental care to avoid severe, or even deadly, consequences than you do at age 45, 60, or 75.

You can have the vacation of your life at age 19 sleeping at dirt cheap youth hostels, down and dirty motels, and campgrounds. It's going to probably be a lot less fun, and a lot more painful and risky, at age 50 or 70 (and this includes the fact that prestige externalities – that pink elephant of economics – get much greater with age). There's just a whole wealth of cheap or free activities that are great fun at 19, but are typically less fun, and less do-able, at 50 or 70. Examples include soccer, surfing, and even, how shall I put this, intimate activities.

And let's talk food. At 19, you can have a great time stuffing yourself with cheap and delicious Entenmann's and Whoppers, with relatively little or no weight gain. At 50 or 60, with a far lower metabolism, eating like that may preclude walking very well, or at all.

Now, even at 19, or 3 for that matter, there are, in fact, serious long-term risks to eating these things. The risks of cancer and heart disease drop much more, to extremely low levels, if a healthy, 80%+ little or unprocessed plant food diet is started in childhood (for the strong scientific case, see the books "Eat to Live" and "Disease-Proof Your Child", by Joel Fuhrman, M.D.)

But even eating healthy at age 19, you can still stuff yourself with delicious and fattening, but otherwise healthy and cheap foods like nuts, juices, 100% whole grain pasta, fresh backed whole grain breads smothered in zero trans-fat all vegetable margarine, 100% whole grain waffles swimming in 100% maple syrup, etc. At age 40 or 70, if you want to get as much taste pleasure in your life, or anything close, without ballooning up, you're going to have to spend a lot more for expensive ingredients and restaurants that can give you the same taste with far less calories.

And do you really think it's optimal to spend the same amount of money as a single 19 or 25 year old as when you're a 35 or 45 year old with three kids?

Of course eventually it can go in the other direction. By the time you're 100, you may not be in a condition to get much pleasure out of your money, at least with current medical and rejuvenation/restoration technology. But even there, it may be very important to you to help your children and grandchildren, or to leave a legacy with your wealth.

On top of this, as I've mentioned, positional/context/prestige externalities are far greater at 50 than at 19. If you're like the vast majority of people, you're going to get a lot less pleasure out of driving around in a beat-up 20 year old Honda Civic (with a great stereo), and being seen in it, (and trying to attract the opposite sex), when you're 19 than when your 50. Positional/context/prestige externalities are an extremely important factor in individual and societal utility maximization. The costs to society of academic economics treating them like a pink elephant are monumental.

I could go on; to put it in economics terms, the marginal utility function of money, despite the common simplifying implied assumption, is far from constant throughout life.

There are also some crucial behavioral factors that are ignored by simple lifetime consumption models. First, I've talked about positional/context/prestige externalities, where the utility you get from consumption depends on the level (and type) of consumption of others. It is also the case that the utility that you get out of current consumption is dependent on your own past levels of consumption; in fact it's highly dependent.

A typical person will get far more utility from $100,000 per year in consumption if his past consumption was $50,000 per year or less, than if it was $500,000 per year or more. This makes it so that a forced large decrease in consumption is especially utility decreasing. It can be devastating to be forced to experience a large and lasting drop in consumption (including its associated prestige – very much including this).

As a result, it's usually well worth it for people to play it relatively safe with their consumption, to try to decrease the odds of having to lower their spending greatly from what they've grown accustomed to, to try to insure against this. Taking out debt goes in the exact opposite direction, it increases the odds that you will grow accustomed to a certain consumption (and prestige) level and then have to go substantially below that due to something going wrong, or not as you had hoped.

The simple lifetime consumption models that conclude you should borrow extensively if necessary in an attempt to keep your consumption exactly the same throughout life don't take this into account. They assume a world with no risk.

In addition, people really enjoy constantly improving, or improving their circumstances. This is an important part of human nature. Thus, one might expect that a typical person would prefer, all other things equal, to have constantly increasing consumption throughout life over always having exactly the same consumption throughout life, if the total amount of consumption is equivalent. In fact, Andrew E. Clark, writes in his 1999 Journal of Economic Behavior & Organization article:

Recent years have seen the admission of a new member to the battery of explanations of increasing wage profiles. Commonly known as the Forced Saving Hypothesis, it states that workers prefer wages that rise over time. It has two components:

1. Workers make inter-temporal comparisons over their level of consumption. An increasing consumption stream is preferred to a flat consumption profile with the same present discounted value.

2. It is possible to create increasing consumption profiles from a flat or downward-sloping wage profile by saving appropriately. Agents, due to a lack of self-control, cannot do so. Increasing wage profiles are one way of giving some external actor the power to ensure that the agent’s consumption rises over time.

The basic classical lifetime consumption model, with its grossly simple utility function, is good for teaching the lesson that the phenomena of diminishing marginal returns for money makes it desirable to smooth consumption, all other things equal. This is a valuable lesson, but it's not the whole story. It's not all of the phenomena, or factors.

Like all models, the basic classical lifetime consumption model is only as good as its interpretation. It's not reality. It teaches some lessons, but not all. There are many additional important factors in lifetime consumption decisions than just what's best, all other things equal, when the marginal utility of money is decreasing.

And it's not always decreasing. The Law of Diminishing Returns does not say that marginal return is always decreasing. It just says that eventually you reach a point where the marginal return is decreasing. That point can be extremely far out (if it even exists. This is not a physics law. What's called, or what has been called, a "law" in economics can have many exceptions), and you may never get near it. This is why we often see the opposite of diminishing returns – economies of scale.

Upcoming:

Part 2: um, the interest rate does matter

Part 3: Very Asymmetric Information, Very Imperfect Decision Making

Part 4: Costs to Productive Risk Taking, Innovation, and Flexibility

Part 5: Consumption Smoothing through Taxes, Transfers, and Social Insurance