Wednesday, June 17, 2009

Do people save optimally?

Behavioural economists have argued that contrary to the DSGE models based predictions about people optimizing on their spending and savings behaviour, people act in a not-so-rational manner when making savings decisions and save less than what is optimal. Therefore economists like Richard Thaler have proposed innovative "nudging" solutions like "Save More Tomorrow".

It is in this context that Chris Dillow strikes a contrarian note and points to a recent study by Laurie Pounder (full paper here), and earlier studies by John Karl Scholz and Martin Lettau and Sydney Ludvigson (full paper here), which appears to show that "far from being irrationally spendthrift, people are irrationally prudent".

All these studies find that "the propensity to consume out of expected future income and net wealth was lower than the DSGE model predicts", and in exactly the opposite direction (ie. save more than spend more, or spend less and not more) than what behavioural economics would suggest.

I am inclined to believe in a small sub-plot to this analysis. In the developed economies, where average incomes are high (in comparison to what is needed to buy the basic necessities of life), consumption opportunities are large and pervasive, savings outlets are numerous (apart from the conventional savings, there are the asset increases and the ability to capture and spend a share of those increases - wealth effect), social security and medical insurance net is extensive and robust, and access to finance is easy (so that financial risks can be modulated/hedged), it could be that all the afore-mentioned tip consumers to spending more than what is required. On a macro-level, this has been borne out by the consumption binge and steep decline in savings in the US over the past three decades, and more generally the low household savings rate in the developed economies.

In contrast, in the developing economies, average incomes are closer to the subsistence incomes, consumption opportunities limited, uncertainties and risks numerous and multi-dimensional, social safety nets are porous and virtually absent, and very few people have the ability (or opportunity) to partake of the gains in asset values. In such environments, people are naturally inclined towards saving more for the rainy day. The persistently high savings rate in developing economies can be partially explained by this.

May be the aforementioned analysis has to be situated within each of these contexts for drawing more meaningful conclusions about whether people save (or consume) more or less than required.

No comments: