Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday, 2 August 2014

US savings behaviour, and empirical research strategies

In this post I want to look at a paper by Chris Carroll, Jiri Slacalek and Martin Sommer for two reasons. The first is for what the paper tells us about US consumption behaviour, and potentially consumption behaviour in any advanced economy. The second thing I want to use it for is as an example of different ways of doing empirical research in a microfoundations world.

The mainstay of modern macroeconomics is the consumption Euler equation, where consumption is proportional to the sum of financial wealth and human wealth, where human wealth is the discounted present value of future labour income. This model implies consumption aims to smooth out erratic movements in income through borrowing and saving. In this model periods of high saving can reflect periods of temporarily higher income, or temporarily high real interest rates. Adaptations of this model that are commonplace are to assume that some proportion of consumers are liquidity constrained, and therefore consume all their income, or that consumption is subject to ‘habits’, which generates additional inertia. This model with or without these adaptations is not very helpful in explaining why savings rose sharply in the Great Recession.

Rather more worrying is that this model is not very good at explaining US savings behaviour before the Great Recession either. As I noted here, US savings rates fell steadily for about twenty years from the early 1980. You might think that explaining such a large and important trend would be a sine qua non of any consumption function routinely used in macromodels, but you would be wrong. Consistency with the data is not the admissibility criteria for a microfounded macromodel.

The Carroll et al paper finds two explanations for the pre-recession trend and the increase in savings during the recession. The first is easier credit conditions, and the second is employment uncertainty. The mechanism through which both work is precautionary savings. If the risk increases that your income will fall sharply because you will lose your job, you need to build up some capital to act as a buffer. The easier credit is to obtain, the less precautionary savings you need.

The reason why precautionary savings represents a significant departure from the basic Euler equation model is intuitive. If you want to hold a certain amount of precautionary savings, you have a target for wealth. A wealth target pulls in the opposite direction to consumption smoothing. If you have a one-off increase in income, consumption smoothing says you should consume it very gradually, perhaps only consuming the interest. The marginal propensity to consume that extra income is tiny. But this leaves wealth higher for a very long time. If you have a wealth target, your marginal propensity to consume that additional income will be larger, perhaps a lot larger.

Now for the methodology part. These empirical results are in sections 3 and 4 of their paper. They call their empirical results in section 4  ‘reduced form’, because they come from a regression relating saving to wealth, credit constraints and expected unemployment. However the authors feel that this is not enough. In section 2 they discuss a structural theoretical model. Because modelling labour income uncertainty is very difficult, their microfounded model assumes that once someone becomes unemployed, they become unemployed forever. Section 5 then estimates this structural model.

The authors describe a number of reasons why directly estimating the structural model may be better than estimating the reduced form. But in order to get their structural model they have to make the highly unrealistic assumption noted above. The reduced form, on the other hand, does not have this assumption imposed on it. So I do not think we can say that the results in Section 5 are more or less interesting than those in Section 4, which is why both are interesting, and why both are included in the paper. There does not seem to be any compelling reason to elevate one above the other.

OK, a last  - perhaps wild - pair of questions. Is it the case that, compared to a few decades ago, there are far fewer papers in the top journals that simply try and explain historical time series for a single key macro aggregate (like consumption or saving)? If that is the case, is this due to the difficulties in getting microfounded models to fit, or something else?  


  1. You should nave precautionary savings if you take a second or third order approximation of the super esistono instead of a linear one

  2. One interesting thing about the paper is that the conclusions work well with the empirical data but are not at all consistent with the wealth and savings model used in Piketty's book. In Piketty the "second fundamental law of capitalism" is that the Capital/Income ratio equals net savings divided by the real growth rate. (At least that it will stabilize at this level in the long run). According to this rule (β=s/g), the right side is exogenous and is what creates the level of the Capital/Income ratio (β).

    However if people start to save a lot less once they've reached their wealth targets (as the Carroll et al. paper says), a high capital/income ratio should lead to a much lower savings rate.

    I apologize for going slightly off-topic.

    1. Only if the target is does not change.

      A target of "Keeping up with the Jones's next door" may be hard to model, but seems plausible. Wealth as a positional good. Likewise

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  4. quote
    The mainstay of modern macroeconomics is the consumption Euler equation, where consumption is proportional to the sum of financial wealth and human wealth, where human wealth is the discounted present value of future labour income.

    re written
    The mainstay of modern macroneconomics is that consumption is proportional the sum of savings and expected income (Euler rule, more precisely, the discounted expected future income)

    now, why is this better?
    cause it follows abasic rule of expository writing: you introduce new terms only when the reader has a basis for understanding them; in your original, the reader has to stop at the 1st half of the sentance, go to the second, then go back...ugh

    of course as a tenured prof, you don't have to listen to anyone byt thge grant commmittee

  5. One of the conceptual problems with microfounded models is the idea of consumption. Consumption consists, according to the definitions of the national accounts, of household consumption, individual government financed consumption (large parts of education, in the UK health care) and collective government financed consumption. The border between government and household consumption is not set in stone and there are large differences between countries (compare health care in the UK and the USA). Statisticians, always quite a bit ahead of ecoomists, have developed the concept of Actual Individual Consumption to correct for this, which works quite well (check the Eurostat site). A New Keynesian models which takes this somewhat into account is the model by Kuehn, Muysken and Veen, which throws away the usual assumption that individual government financed consumption is wasteful by nature and seems to fit the data a lot better than the mainstream, market-fundamentalist models: This still only leave the purchase of items as consumption and not their use, but that's not connected to the flows of income and spending estimated by the national accounts.


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