Wednesday, May 27, 2009

Sotomayor’s Consumption as an Application of the Life-Cycle Model

I thought Greg Mankiw had a strong grasp of the life-cycle model of consumption:

Some save and intertemporally optimize their consumption plans, while others live paycheck to paycheck, spending their entire income as soon as it's received … Apparently, the new Supreme Court nominee Sonia Sotomayor is an example of the latter. The Washington Post reports that the 54-year-old Sotomayer has a $179,500 yearly salary but “On her financial disclosure report for 2007, she said her only financial holdings were a Citibank checking and savings account, worth $50,000 to $115,000 combined. During the previous four years, the money in the accounts at some points was listed as low as $30,000.” My grandmother would have been shocked and appalled to see someone who makes so much save so little.

That a 54 year woman with high income has only a modest amount in her bank accounts strikes Dr. Mankiw as strong evidence that she has consumed more of her past income than would be implied by the life-cycle model. But I can see at least two explanations for these facts that are entirely consistent with intertemporal optimization of one’s consumption plans. One has to do with the possibility that one’s expected future income can sustain high consumption in one’s later years, which conservative Tom Smith notes:

any day she wants to she could walk out of her current job and into a partnership at a law firm in Manhattan or DC and get paid (guessing again) maybe $2 million a year, with the potential for a lot more. In short, when you take Sotomayor's human capital and circumstances into account, there is nothing wrong with her balance sheet. Sure, she could have another $500,000 tucked away, and that would be nice. But why should she? She has no dependents, except maybe her mother, but her brother is a doctor who, let us assume, is doing well. She has a guaranteed job for life with very generous retirement and health benefits, and any day she decides she wants to be a millionaire, all she has to do is pick up the phone.

The other has to do with the possibility that her compensation includes more than simply this stated salary but also consists of deferred compensation in the form of contributions to a pension plan. Brad DeLong notes that Sotomayor’s wealth in the form of a defined pension plan may be $2.5 million:

Sonia Sotomayor has a large defined benefit pension with a current market value of roughly $2.5 million. Sonia Sotomayor has roughly $1 million in equity in her Greeenwich Village condo. Sonia Sotomayor has no descendents to bequeath wealth too.

How could someone as smart as Dr. Mankiw miss the obvious possibilities? Maybe he posted this very incomplete analysis as a test for his Harvard students to see if they could articulate the possible explanations of the facts presented in his post in a way that was consistent with the life-cycle model.


Shag from Brookline said...

Greg's thinking seems more libertine than libertarian.

I have noted other responses to Greg on the Blogosphere that indicate the disclosure requirements of judges regarding their assets are rather limited as compared to elected officials, such that Sotomayer's net worth could be significantly higher. Maybe Greg should make his own financial disclosure so that others may apply his grandmother's economics 101 standards to him.

Myrtle Blackwood said...

"Albert Ando, and Milton Friedman (1957) developed what became known as the life-cycle model. This model predicts that people consume an annuity of their expected lifetime income at all points in their life. Thus, the lifetime consumption profile was expected to be essentially flat, with people borrowing against future earnings during their early study and working life when income is low, saving greatly during their most productive working years and consuming saved assets during retirement. Windfall gains would be treated the same way as an unexpected increase in income - its lifetime annuity value would be consumed and the rest saved. (from Wikipedia on the 'Life Cycle Model')

How does Friedman's theorm fit with overproduction of goods, government/cartel-organised hikes in energy and water prices. Natural disasters, illness, war. And worst of all, SANITY?

"As we know, the consumption of goods - which comes doen always, in the present state of things, to the consumption of power -carries within itself the seeds of its own destruction and the conditions of its own transcendence. The consumer cannot and must not ever attain satisfction: the logic of the consumable object demands the cretion of fresh needs, yet the accumulation of such false needs exacerbates the malaise of [persons] confined with increasing difficuly solely to the status of consumers. Furthermore, the wealth of consumer goods impoverishes authentic life. It does so in two ways. First, it replaces authentic life with 'things'. Secondly, it makes it impossible, with the best will in the world, to become attached to these things, precisely because they have to be 'consumed', ie destroyed. Whence an absence of life which is ever more frustrating, a self-devouring dissatisfaction...."

'The Revolution of Everyday Life' by Raoul Vaneigem. Chapter 17 'Survival Sickness' Page 162

Shag from Brookline said...

Mankiw provides a couple of updates at his Blog in recognition of comments on his grandmother's creed. Does she appear in his Economics 101 text?

Richard H. Serlin said...

I teach personal finance at the University of Arizona, and I never teach that the goal is to save as much as possible, or to save just for the sake of saving. Saving is a means, not an end. The end is to optimize some combination of having the best possible life and doing good for others.

The riskier your life is, the more it makes sense to save. A Generation of Republican dominance has made life very risky for the vast majority of people. So for the vast majority, I agree with Harvard Professor Elizabeth Warren's recommendation to save at least 20% of after tax pay – and keep total fixed, "Must-Have", expenses at no more than 50% (see her book, "All Your Worth: The Ultimate Lifetime Money Plan" for details. I think it's by far the best personal finance book today).

But Judge Sotomayor is very different from the vast majority. She has a U.S. Government job that she can never lose, a huge pension, and extremely generous health, dental, disability, and other benefits that she can never lose, and she has no dependents. If she also has a paid for home (likely since she's 56 years old) and car and no other debts, she has an extremly high level of security that most people can only dream of. Plus, as noted, with her resume she could almost surely quickly get a private sector job paying hundreds of thousands or millions. For someone like that it's not that bad to have savings of $30,000 to $115,000.

Her big concern, though, is her health. She's had juvenille diabetes since age 8. If she suffers permanent disability, even with government sponsered medical and disability insurance she will have to greatly decrease her lifestyle. She will still be able to live in a way that most of us would consider materially well, but it will be a big drop from what she's grown accustomed to, and this is very hard for people. It can be devastating (for more on this see my current post).

So, unless there are some particulars I don't know about, like her government disability and medical insurance are even more generous than I'm assuming, I think she has saved less than the optimal amount. But given her relatively amazing level of security, this is not that bad. One could hardly call her an irresponsible person, especially given her amazing life story of hard work and determination.

It's probably more the case that, like most people, she is not very expert in personal finance, which has grown immensely more complicated, tricky, and risky, after a generation of Republican control in a world that's far more complicated than the world of 1810 that the Republicans would like to return us to (when most people lived harsh, poor lives, and life expectancy was in the 30's – the good old days of small government!)

We just need much more consumer protections and social insurance. Despite the fairy tale assumption of perfect competence and decision making in every area that right-wing economists love to make, no one has time to get advance degrees in everything so they can aviod horrible tircks, traps, mistakes, and in genreal risk; the more you force this, the more time people spend learning to protect themselves, doing a Ph.D. program and disertation on everything they buy or sign to know it's safe, and the less time they spend producing, and enjoying their lives.

Jack said...

This is an absurd non-issue and Mankiw adds to a growing list of concepts that distinguish him as a toady for the extremists who have been dominating the Republican Party. They are all out there with their individually concocted idiotic criticisms of Sotomayor. A little more substance would go a long way to distinguishing their complaints. So far nothing presented can be described that way. One might add that given the recent significant losses that so many have suffered in their "nest egg" savings, she appears to have avoided that plight. You can't lose on a fund you didn't have.