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ECON 490 Joker Final Paper
ECON 490 Joker Final Paper
Introduction
In this paper, we first examine the theory of rational saving and then compare it to the
experiences of our classmates. Next we argue that the theory cannot adequately predict some
behavior and then discuss methods proposed by Sunstein and Thaler such as the Save More
Tomorrow program to address this discrepancy. Ultimately, we argue that the Save More
Tomorrow policy is effective given our information.
Rational Saving
The theory of saving based on rational behavior was established by economists decades
ago. This theory was developed by Modigliani (Deaton, 2005). The theory states that young
people will save so that when they are old and either cannot or do not wish to work, they will
have money to spend. The very young have little wealth, middle aged people have more, and
peak wealth is reached just before people retire. As they live through their golden years, retirees
sell off their assets to provide for food, housing, recreation, children and other expenses. The
assets shed by the old are taken up by the young who are still in the accumulation part of the
cycle. Exceptions can be made for those who spend at an early age on major investments like
education, which sends many young people into debt, as long as the basic principle described
above is followed.
According to Modigliani, if the economy is growing or if there are more young people
than old, then more people will be saving than dissaving, so that the total dissaving of the old
will be less than the total saving of the young, and there will be net positive saving. In other
words, if aggregate income is growing, ceteris paribus, the young will be saving on a larger scale
than the old are dissaving so that economic growth, like population growth, causes positive
saving, and the faster the growth, the higher the saving rate.
Burton G. Malkiel, in A Random Walk Down Wall Street, proposes a “Life cycle”
investment guide in order to help people efficiently allocate their assets at certain stages in their
life. The last two stages that Malkiel covers are particularly important in that individuals should
be in transition towards retirement. He explains that individuals whose age is around the mid-
twenties should allocate their investments into more risky options. Their lifestyle at such an age
is an abundance of time to ride out investment cycles and a solid stream of income not quite
enjoyed at an earlier point in life. The recommended efficient allocation of assets someone of
mid-twenties is 5% cash, 20% bonds, 65% stocks, and 10% real estate (Malkiel, 346).
As investors age, the opportunity to continue risky investment options diminishes as a
demand for family expenses increases such as needing to allocate money towards college tuition
for children. Yet, the opportunity to continue in more risky investments is still available to
couples without any children. The recommended efficient allocation of assets from someone of
late thirties to early forties is 5% cash, 25% bonds, 60% stocks, and 10% real estate (Malkiel,
346). As an individual reaches the age range of mid-fifties they should become retirement
focused in their asset allocation no matter the lifestyle factors. An emphasis upon income
protection during retirement over income production should correspond to more conservative
investments. The recommended efficient allocation of assets from someone of mid-Fifties is 5%
cash, 37.5% bonds, 50% stocks, and 12.5% real estate (Malkiel, 347). Finally, an individual in
their late Sixties and beyond have the lifestyle factors of being able to enjoy leisure activities,
protecting against healthcare costs, and be very risk averse. There should be a complete
emphasis upon income protection and investments should be made into bonds. The
recommended efficient allocation of assets for someone of late Sixties and beyond is 10% cash,
40% bonds, 35% stocks, and 15% real estate (Malkiel, 347).
This guide provides a great framework for how to plan out investments in assets or
saving allocations outside of just a 401k plan. It does however seem to require consulting a
broker or expert for advice upon how to effectively invest within bonds, stocks, and real estate.
That produces an issue of whether people are actually willing to seek advice and to do so in a
timely fashion.
A Culture of Spending
This paper will now turn to the discussion we had in class about savings and compare this
discussion to the theory. One theme which came up repeatedly in our conversation is what we
here call the “culture of spending.” This refers to the inescapable presence of consumerism in the
United States and is relevant to the topic of savings because money which is spent on non-
durable consumer goods cannot be saved. We assume that without these pressures to spend,
people would otherwise save; therefore, we want to understand the culture of spending and
compare it to standard economic theory to determine whether or not the theory predicts this
behavior.
From these comments which were raised in class, it would appear that consumerism is an
irrational behavior, though others pointed out that it can in some cases be rational. One student
noted that rising levels of inflation can make savings worth less in real dollars over time so there
is an incentive to spend in the current time period, although this pressure is low given that the
March 2010-2011 change in CPI was only 2.7% (Bureau of Labor Statistics, 2011). Some of
these reasons are old (social pressures) while
some are new (internet ads) but the effect is
that people are spending when they do not
need to, and this means that they are
proportionately saving less over time.
According to the theory of rational savings,
people should spend whatever money is left
over after taking savings into consideration
but our examples demonstrate that the
decision to spend is made independently of
these considerations. Granted, our information
is taken from college-aged students who may
not be generating income, though we argue
that this behavior is seen among Americans
generally, including those who are generating income.
According to the Bureau of Economic Analysis, while the personal savings rate is now a
few percentage points higher than it was just prior to the beginning of the Great Recession in
2008, it is still much lower than it has been in past decades, indicating that Americans are still
spending more than previous generations (Bureau of Economic Analysis, 2011).
However, one of the classmates raised a problem is conflict of interest: employers do not
want to contribute to employee’s funds. The point here is that employers might not want to
educate workers about retirement savings if that means they have to contribute to the employee's
savings account. The purpose of educating employees is to help them make better decisions, but
the decisions can still be overwhelming and complicated. So you have a trade-off between how
much education is needed and how well the policy will fit the needs of the employee. [we should
talk about the Save More Tomorrow program and move this part there, and then also talk
about the idea of having just a few options as opposed to many in that discussion as well]
This section is kind of a catch-all and provides a chance to discuss some of the alternative
strategies in which people save for retirement or nudges that aim to increase savings in general.
Not everyone has the opportunity to contribute to a 401k plan to save for retirement, or even
chooses to do so when the option is available.
The impact of trust funds was a topic discussed in class and how they can affect “Life
cycle” model of saving. The idea of the “Life cycle” model is that young people save for future
consumption and while in retirement they are in a state of dissaving where they consume out of
their savings. This initial accumulation of wealth could be due in part to a trust fund. A typical
time for a person to receive the benefits of a trust fund would be at a younger point in their life
after, around the age of eighteen, and is an example of an expected boost in wealth. Another
example where someone might acquire the benefits of a trust fund would be at the death of a
relative which can prove to be an example of an unexpected boost in wealth. In both instances,
the position of the saving and consumption rates of the beneficiary of the trust fund changes and
that person will have more spending power. Alternatively, not everyone is lucky enough to
benefit from the wealth of a trust fund given to them by their parents and instead have parents
that have accumulated debt in their lifetime. In the latter scenario, a child might have to help
finance the debt of their parents at an early stage of their “Life cycle” as they enter the
workforce.
Another topic of class discussion was the ownership of house or other housing property
as an asset that can experience capital gains and losses. Ownership of a house can be viewed
strictly as consumption but it is certainly viewed by most people as sort of savings investment.
At the end of the twentieth century, the value of houses was rising with seemingly no end in
sight creating capital gains and increased income for the owners. Sure enough, in the beginning
of the twenty-first century there was a burst in the housing bubble and the value of houses fell
creating capital losses and negative income for the owners. Outside of the other financial
complications that led to and followed the burst, the decrease in income from the previously
higher values of houses impacted the expected contribution of income to the retirement savings
of owners. Owning a house is something that a lot people plan on doing and using it as a sort of
investment towards saving for retirement seems to be more of an afterthought.
The discussion about the possibility of hiring a broker or consulting expert advice to
manage savings did not seem to be seriously considered by the class. An explanation for this
could be that the demographic of our class is all college students in their late teens and early
twenties with the possible attitude that saving for retirement is still in the distant future. The
amount of information and options in terms of saving for retirement is arguably inexhaustible
and some people prefer to seek the help of someone to help them navigate and plan for the
future. People procrastinate in seeking advice as in the example of signing up late or not at all
for a 401k plan. In doing so, they are only hurting themselves in the long run. Another reason in
which someone would not want to seek expert advice would be ignorance. They might feel as
though they should not have to pay someone for such a service instead opting to take their
chances at figuring it out themselves by reading their own literature, consulting friends, or just
using the Internet.
An automatic enrollment savings program for retirement was an idea that most people in
the class seemed to be wary of its implementation in the workplace. The reason for concern for
most students seems to be directed against government or institutional paternalism. Respect also
seems to be an important component of an automatic enrollment program. A member of the
class stated that they would be okay with the idea of such a program as long as they are informed
and made aware of the program beforehand.
Work Cited
Chilton, David. The Wealthy Barber: Everyone’s Commonsense Gudie to Becoming Financially
Independent. Roseville, CA: Prima Publishing: 32.
Malkiel, Burton G. A Random Walk Down Wall Street. New York: W.W. Norton & Company,
2007.
Bureau of Economic Analysis. United Stated Department of Commerce. National Income and
Product Accounts Table. Table 2.1: Personal Income and Its Disposition. Last Revised on April
28, 2011.
Deaton, Angus. Franco Modigliani and the Life Cycle Theory of Consumption. Rome Lecture..
March 2005.
Thaler, Richard and Cass Sunstein. Nudge. New Haven: Yale University Press, 2008: 113-4.