4.6 Theory of the “Golden Eggs”
4.6.2 The Invalidity of the Permanent Income Hypothesis
In standard neoclassical economics, the income that is thought to determine the spending level at a given time is the permanent income—the average level of income one is expected to earn over a lifetime—rather than the current income at that time. Because people dislike consumption fluctuations and tend to try to smooth it out, they can achieve a high level of welfare by saving money when the current income is high and withdrawing savings or borrowing when the current income is low, rather than changing the spending level in line with temporary changes in current income. It is the permanent income that determines this smoothed spending level (see Fig.4.4). The thought that spending is determined by permanent income, based on this type of dynamic perspective, is referred to as the permanent income hypothesis.
However, as one can probably imagine from actual experience, the permanent income hypothesis does not explain real consumer behavior well. Our spending level actually has a strong positive correlation with income; the spending level is high when the economy happens to be strong and the income level is high, and it becomes low when the economy is weak and the income level is low. Figure4.5, which shows monthly data over 11 years starting from January 2000, plots changes in current income and consumer spending in real terms. We see that there is actually a strong positive correlation. The correlation coefficient is 27.5 %—a statistically strong correlation that can be shown to exceed the margin of error.
Based on the “golden eggs” model, this phenomenon can be explained as follows. As explained earlier, sophisticated consumers would hold their assets in illiquid forms from the beginning in order to cope with their self-control problems.
Since they do not have enough (liquid) assets to take out for spending, they are forced to lower their spending level when their income happens to drop due to the
effects of business fluctuation. Conversely, when the economy improves and their income increases more than they had expected, the present selves with a higher propensity to spend under the influence of hyperbolic discounting fully enjoy their good luck by increasing their spending rather than putting them aside for savings. In this way, the spending level aligns itself with the wave of income and exhibits a cycle.
Figure4.6is depicted by partially modifying the example provided in the paper by Laibson (1997). It uses a numerical example to show how the spending level correlates with the ups and downs of income.
What is interesting is that this curve is similar to the response curve obtained from animal experiments in behavioral psychology. When feed—referred to in psychology as a “reinforcer”—is given in line with certain rules, the response rate begins to oscillate cyclically with the timing of the feed (Hirota et al. 2006).
The argument inherent in the permanent income hypothesis is that because human consumers are unlike pigeons and have a rationality to smooth out spending by using the financial markets, they must maintain a certain spending level (response) without being affected, even when the “feed” (i.e., income) fluctuates. However, as indicated by the actual and strong correlation between income and consumption spending, consumers change their spending in response to changes in the income level, just as the pigeons act cyclically in response to the feed. It seems that there is an underlying self-control problem wherein we inevitably respond to the immediate benefit.
This type of income-spending cycle is observed in various forms of other economic behavior. Because you cannot stock up for later if you are lured by the
“feed” and eat too much, such an income-spending cycle often bears the problem of undersaving. The simplest example is a child who spends all his or her allowance as soon as he or she gets it and then waits for the next allowance day while feeling sorry for himself or herself. Similar income-spending cycles are observed among Fig. 4.4 Permanent income
recipients of pension or life security. We will look into this point in greater detail in the next chapter.
The following point is important to understand correctly the covariation of income and spending that would occur in the “golden eggs” model. When there are borrowing constraints, as in our scenario, spending begins to exhibit a
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
00 01 02 03 04 05 06 07 08 09 10
(a)
R² = 0.078
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
-12% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
Rea l income (b)
Fig. 4.5 Correlation between income and consumption spending. Note: Prepared based on the current income of working households, consumer spending, and consumer price index data from the Survey of Household Economy by the Statistics Bureau, the Ministry of Internal Affairs and Communications, Japan. (a) Time variation in real income and real consumption spending for working household (compared to the same month of the previous year) (January 2000–January 2011). (b) Scatter plot (log difference with the same month of the previous year)
correlation with income, even in a normal setting in which there is no self-control problem. This happens because there is no choice but to cut spending when the income drops and one cannot borrow money, even if one wishes to. However, in such a case, a positive correlation between spending and income is observed only among poor consumers who are hindered by borrowing constraints, because house- holds that have sufficient assets are able to smooth out their spending while using their assets as insurance.
The point of the “golden eggs” model is that it shows that consumers control themselves by holding illiquid assets and intentionally making themselves subject to borrowing constraints in order to avoid self-control problems, even if they possess sufficient assets. Naturally, this will generate welfare loss; however, they hold illiquid assets because there is a greater benefit in restraining the weak-willed future selves from overspending when the income level is sufficient. As a result, even wealthy households with assets exhibit an income-spending cycle.
One typical case of a rapid reduction in the consumption level caused by a decrease in current income, despite the holding of assets, is the change in consump- tion at the time of retirement. Although it is normal for one to suddenly reduce spending while holding assets as one retires, it seems that this is a large reduction that cannot be explained solely by the fact that work-related expenditures are no longer necessary. The explanation provided by the “golden eggs” model is that consumption is curbed upon retirement because retirees hold illiquid assets such as Fig. 4.6 Income-spending cycle in the “golden eggs” model. Note: Prepared by referencing the numerical examples in Figure II of Laibson (1997)
pension funds and real estate while the liquidity of current income is reduced.4 There seems to be one aspect of reduced consumer spending, wherein retirees are protecting their after-retirement lives by holding assets that are illiquid rather than liquid.