In 2002, psychologist and economist Daniel Kahneman won the Nobel Prize in Economics for his work in behavioural economics. His book Thinking, Fast and Slow lays out his life’s work (it is a good read, but you need to approach it like you’d eat an elephant, one bite at a time). But I recently came across another economist, James S. Duesenberry, who’s work at Harvard has largely been forgotten. Duesenberry wrote about consumption. The Relative Income hypothesis he came up with in 1949 is hugely relevant today in such a consumer driven economy.
Poorer people save at lower rates than richer people. You would think that is obvious, they have less income so a higher percentage of income goes on necessities. But they are also hugely influenced by what other people have and aspire to have what others have. They forgo saving for the long term in an effort to keep up with the Joneses.
A question I hear quite a lot is “how can they afford that?”. People who are earning good money but they are seeing others driving in bigger cars, going on more holidays, wearing more expensive clothes, always seem to be eating out.
That’s because national savings remain roughly constant even as income increases. In other words, people spend more of their increased income and save less.
The problem with that is that is you may want to stop working at some stage. And without savings, you may either have to keep working to fund your lifestyle or do less than you want to in retirement.
Duesenberry also found though that people have a difficulty in cutting back based on past experience. If you are used to a certain lifestyle, you will find it very difficult to reduce your consumption in times of recession…or if you reach retirement and your pension income is a lot lower than you are used to. How do you think you would adapt to a 60% – 70% cut in income?
We saw another example of this after the financial crisis with all the bank debt that people had. Banks were willing to write off debt but in exchange you had to cut right back to the minimum for 5 years and give them the savings. At the end of 5 years, you could get on with your life. Many people found it unpalatable that they could have Sky Sports or give up their golf club membership and preferred to fight it out with the banks.
Your children are also influenced by past experiences when it comes to consumption. If they grew up in a high consumption household, that is the life they know. If they are not able to financially support that kind of high consumption lifestyle as adults, they may accumulate debt to fund it or look to their parents to provide them with pocket money as adults.
Economists at the time felt uncomfortable with Duesenberry’s mix of economics and psychology and looked for alternative theories on consumption that they could adopt (see Friedman’s permanent income hypothesis). But in today’s world, it is certainly back to the fore and something that people can relate to.
If you have any questions, drop me an email at steven@bluewaterfp.ie
Steven Barrett
14 September 2020