What Is Consumption Smoothing?

What Is Consumption Smoothing?

Consumption smoothing is the practice of optimizing our standard of living by ensuring a proper balance between spending and saving during the different phases of our lives. Those who overspend and put off saving for retirement to enjoy a higher standard of living often have to work longer or reduce their standard of living in retirement. Those who oversave will live a more frugal lifestyle while working to enjoy a better lifestyle while retired.

In each case, the overall standard of living is less than optimal.

Understanding Consumption Smoothing

Saving for retirement is a delicate balancing act. By having a better understanding of the saving and spending requirements to smooth out the standard of living, it is possible to achieve a higher overall standard of living, at least in theory. Striking a balance is one of the major challenges of financial planning.

Consumption smoothing is also necessary in the short term. Millions of Americans have unsteady streams of income. A freelancer or shift worker might have $3,000 to spend in one month and only $1,000 to spend the next while living expenses such as rent and food remain the same. Consumption smoothing allows them to control their spending so that they can meet their various obligations when income is fluctuating. To achieve consumption smoothing, most people plan and try to stick to a budget so that they can pay their bills when they come due.

As an economics concept, consumption smoothing captures the desire of people to have a stable path of consumption. There are several related areas of study to consumption smoothing, such as behavioral economics, psychology, and even anthropology.

Special Considerations for Consumption Smoothing

Humans dislike and go to great lengths to eliminate uncertainty in their day-to-day lives, but it is impossible to do so completely. Consumption smoothing is an attempt by economists to identify how to eliminate the uncertainty by adjusting consumption (spending) patterns.

Consumption smoothing has some validity in the short run, but the long-term predictive value is mixed. Because it is hard to anticipate future events, such as a change in income (be it a raise at work or loss of employment), a change in the tax code, or unforeseen tragic events (loss of a loved one), it is even harder to predict future consumption patterns.

For instance, since the early 1980s to 2019, according to Centers for Medicare & Medicaid Services, Americans have steadily increased healthcare spending as a percentage of GDP while consumption of food-related items has remained flat, relatively, according to the United States Department of Agriculture. Consumption smoothing would seek to describe these changes in spending in economic terms.