Consumer Time Travel
Explaining consumption behavior
Macrosight likes to cast U.S. consumers in the image of a Hungry Beast, whose voracious appetite never seems sated. That is not meant to disparage us as consumers. A hearty appetite does not imply the Hungry Beast is dumb or devoid of premeditated thought. Rather, the opposite is true. We as consumers use a combination of deliberate habit and foresight to carry out our spending. The Hungry Beast, you see, has intelligence. This intelligence, in fact, is one of the most important tenets of macroeconomics.
Consumer Consistency
Before we flesh that out, what has said Beast been up to? Consumer spending in February of this year, as reported by the BEA recently increased by about 5 percent at an annualized rate (or 0.4 percent monthly). This was a big rebound from the 2.6 percent decline in January (-0.2 monthly). While a decline in consumer spending is cause for concern for any business-cycle watcher, more often that not a decline is immediately followed by an increase, as happened from January to February.
Looking back on the last 12 months, for example, nine showed positive growth, while three had negative growth. Each of those three months were followed by a month with positive growth. Looking back further, over the time period beginning with the trough of the Great Recession (July 2009) to December 2019, in only 18 months out of 114 was consumer spending growth negative. And only on one occasion was there back-to-back months of negative growth (March and April of 2011). As pointed out on Macrosight previously, the Hungry Beast is consistent and gritty. Where does this consistency come from? From the aforementioned intelligence of the otherwise ravenous Beast.
Going Back in Time
Decades ago, influential economists Milton Friedman and Franco Modigliani—and many economists that followed them—provided an important insight into consumer behavior. Households (either individuals or as household unit) use foresight when making consumption decisions. With foresight in mind, when it comes to consumer spending, we like it smooth. That is, we like to keep the amount of stuff we buy pretty close to the same level month-to-month, if not year-after-year. The amalgam of ideas from which this observation arose became known as the “permanent-income-life-cycle” hypothesis—or PIHLC for short.
The key to consumption smoothing is that we base our spending in any given month on our best idea of what our permanent income is or will be over our lifetime. Permanent income is the sum of our current income plus our expected future stream of income.1 Given our careers, family situation, and so on, we make a guess as to what our future income will be, what our retirement fund should grow to, and what our home will be worth when the hair on our heads has turned grey. What we consume today and tomorrow is based on that combination of information.
The implication of this idea is that when we are younger we need to borrow money, and that borrowing is leveraged on the expectations of our future. Early on we need expensive things like a car, a college education, and, at some point, a house. But, those expensive things are not supported by our income at that point in our lives or the paltry level of our savings. So, many or most of us obtain those things with a loan (or multiple loans).
Yet, this decision is neither desperate nor irrational. The job we have and the career we are pursuing at that time provide a reasonable expectation that our income and wealth will grow.
The trade-off of that decision is that in future years, as we make a monthly payment of, say, $500, we give up the chance to buy $500 worth of consumer goods at that future point. Does that mean we consume more goods and services in our youth than in the future when we are older? No. Assuming our incomes and wealth do actually increase, we pay off our debt and buy as much stuff, and more likely more stuff, as we did previously.
Of this trade-off economists like to say that we bring future consumption forward in time. In a way, we as consumers put our consumer goods through a form of time travel. The funding for our cars, our college education, and other big-ticket items are sent to us from our future selves.
That time-travel is what consumption smoothing is all about. Of course, we might get it wrong, or weird and unanticipated stuff will happen in our lives—forcing us to change our estimate of permanent income—but we at least try to form a reasonable and rational expectation on what is to come.
This vision of us as consumers is vastly different than the alternative, that of a dumb and gluttonous Hungry Beast, devouring consumer goods in a wanton manner.
Smoothing and Macro Policy
The idea of consumption smoothing provides a baseline for how to understand consumer behavior, and how that behavior matters for the business cycle. For example, if enough of the 300 million or so people in the United States smooth consumption, then aggregate consumption should be relatively steady and predictable over the business cycle and over time. That is, in fact, what we see in the aggregate consumption data.
Consider also the following: imagine that a recession is looming and the Federal Government sends you a “tax rebate” check equal to $1,000. The point of the rebate is to buoy consumer spending and attempt to stave off the recession. However, if you have been paying taxes for enough years, and voting in elections for enough years, you might reasonably assume that, at some point in the future, the government is going to take that tax rebate back (in the form of higher future income taxes).
That $1,000, in other words, is not part of your permanent income. It is a temporary addition to your bank account. As such, as a consumption-smoother, you would spend very little, if any, of that money. The intended boost to consumer spending and the economy would not be as stimulative as the policy-makers might have hoped.
Consumer Kinks and Macro Policy
Alternatively, what if some, or many, households are not smoothing consumption, or are not able to smooth consumption in the manner described earlier? How does that matter for the business cycle? If consumers are not able to smooth, as the PIHLC hypothesis predicts, then those tax rebate checks will have an impact on consumer spending during a recession. The recipients of those rebate checks will spend most if not all of the amount relatively quickly. The stimulus policy will have its intended effect on consumer spending and the business cycle.
Consider also that if we are able to understand why some or many households cannot or do not smooth consumption, then public policy can be crafted with those households in mind. Student loans are predicated on this very idea. College-aged consumers do not have the employment history to warrant the kind of borrowing that consumption time-travel requires. Student loans remedy that consumption-smoothing kink. The very conceit of student loan programs is motivated by, if not justified by, the ideas that spring from the PIHLC.
Or, consider again the stimulus policy of tax rebate checks, as utilized by multiple presidential administrations over the past 24 years.2 If one wished to craft a more cost-effective3 stimulus policy during a recession the focus of that policy should be on younger and lower-income households. To provide rebate checks to those already able to smooth consumption, the older and wealthier, is not a very effective way to boost a faltering economy. Or so the PIHLC hypothesis informs us.
Part of this is our wealth. What we save from our income becomes our wealth. Or, our annual income represents a flow, and whatever we save of that adds to our stock of wealth—see explanation of a flow versus a stock in this post.
Tax rebate checks, mailed directly to households* were part of the following “stimulus” acts since 2000. (Presidents at the time of the rebates shown in parentheses.)
Economic Growth and Tax Relief Reconciliation Act of 2001 (Bush)
Economic Stimulus Act of 2008 (Bush)
American Recovery and Reinvestment Act of 2009 (Obama). *Tax rebates were in the form of lower withholding from paychecks, as opposed to checks mailed directly to households.
CARES Act 2020 (Trump)
American Rescue Plan 2021 (Biden)
By cost-effective I mean minimzing the impact on the national debt. Stimulus policy typically invovles an increase in deficit spending by the federal government.