Savings and Emulation Could the U.S

SAVINGS AND EMULATION COULD THE U.S. SAVINGS PARADOX BE EXPLAINED BY AN ARMS RACE TO CONSUME?

Kevin Black

A Thesis

Submitted to the Graduate College of Bowling Green State University in partial fulfillment of the requirements for the degree of

MASTER OF ARTS

May 2009

Committee:

Dr. Kevin J. Quinn, Advisor

Dr. Mary Ellen Benedict

Kevin Black

ABSTRACT

Dr. Kevin J. Quinn, Advisor

Dr. Mary Ellen Benedict, Advisor

This paper builds on a minority view that consumer theory should include social variables rather than omit them. Using the theories first proposed by Thorstein Veblen and James Duesenberry this study analyzes the role which emulation plays in the U.S. Savings Paradox. At the micro level, an individual’s amount of savings was estimated with the 2004 Survey of Consumer Finances. By using consumer debt as the proxy for emulation, the results find that changes in individual and aggregate savings can be explained by emulative consumption. Furthermore, the consumption externalities from emulation were shown to granger cause income inequality, which in turn granger caused the personal savings rate. The results confirm the minority view that consumption behavior is dependent on others. It appears that the U.S. Savings Paradox is the result of increased emulative consumption. For that reason, consumer theory needs can longer omit relevant social variables.

“For most families, the current economic challenge is to acquire not the goods they need but the

goods they want (Frank, Luxury Fever 1999).”

I would like to dedicate this thesis to my professors, friends, and family members. Without their support, I would not be the person I am, nor would I have embarked on the path of higher learning in search of scientific answers.

ACKNOWLEDGMENTS

I would like to acknowledge Dr. Kevin J. Quinn and Dr. Mary Ellen Benedict for supporting my thesis. Without their input and guidance, I would not have undertaken this project. I truly cannot thank them enough. I would also like to thank Tim Bianco for helping me understand Eviews as well as listening to my many tirades. Finally, I would like to collectively thank everyone else who has contributed to this undertaking. Your support has been greatly appreciated.

vii

TABLE OF CONTENTS

Page

INTRODUCTION………………………………………………………………...... 1

THORSTEIN VEBLEN AND THE IDEA OF PECUNIARY EMULATION……...... 5

VEBLEN’S SOCIAL PREFERENCES AND INSTITUTIONAL CHANGE………… 8

JAMES DUESENBERRY AND THE DEMONSTRATION EFFECT……………….. 10

SIMILARITIES BETWEEN VEBLEN AND DUESENBERRY……………………… 12

TO CONSUME OR NOT CONSUME, THAT IS THE QUESTION………………… 13

SAVINGS IN LIGHT OF THE RACE FOR REPUTABILITY……………………….. 16

RESEARCH RELATING TO THE SAVINGS PARADOX……..…………………….. 17

METHODOLOGY FOR CAPTURING EMULATION……………………………….. 22

IS EMULATION EVIDENT IN THE SURVEY OF CONSUMER FINANCES?...... 24

COINTEGRATION RESULTS…………………………………………………………. 34

TESTING FOR A STRUCTURAL BREAK…………………………………………….. 36

SAVINGS RATE AND INCOME INEQUALITY……………………………………… 43

CONCLUSIONS…………………………………………………………………………. 49

BIBLIOGRAPHY………………………………………………………………………… 50

viii

LIST OF TABLES AND FIGURES

Figure/Table Page

1. Quarterly Personal Savings Ratio (NIPA)………………………………………… 1

2. Definitions of dependent and independent variables used in Survey of Consumer

Finances …………………………………………………………………. 25

3. Weighted Least Squares Results from 2004 Survey of Consumer Finances……….. 28

4. Descriptive Statistics of variables………………………………………………… 28

5. Savings versus Income……………………………………………………………. 33

6. Cointegration Results…………………………………………………………….. 35

7. Household Financial Obligations as a percent of Disposable Personal Income…… 36

8. Recursive Residuals Estimate of Savings Ratio………………………………….... 37

9. Results of Structural Break in Savings Rate……………………………………….. 39

10. Actual versus Estimated Savings…………………………………………………. 40

11. Actual versus Extrapolated Estimated Savings…………………………………… 40

12. Personal Savings ($Billions) versus Aggregate Disposable Personal Income……… 41

13. Aggregate Savings before Structural Break……………………………………….. 41

14. Aggregate Savings after Structural Break…………………………………………. 41

15. United States Income Inequality over time……………………………………….. 43

16. Results of Regressing Gini on Savings Rate………………………………………. 44

17. Savings Rate vs. Gini Coefficient………………………………………………… 45

18. Personal Savings Rate vs. Household Financial Obligations % Disposable Income.. 45

19. Savings Rate vs. 10 Year Treasury Constant Maturity…………………………….. 46

20. Household Financial Obligations % Disposable Income vs. Gini Coefficient……. 46

21. Granger Causality Results………………………………………………………… 47 1

INTRODUCTION

For the past two decades, the United States has experienced a declining personal savings rate. The paradox of low savings in the world’s wealthiest country has attracted the attention of many researchers. Unfortunately, the field of economics still lacks a generally acknowledged answer for the paradox’s existence. The literature has produced new theories, empirical testing, and the inclusion of social phenomena in the attempt to explain the decline. Given that the United States is often deemed the “consumer society,” an effort to bring together the theoretical and empirical underpinnings of the paradox should yield valuable macroeconomic implications. Hence, my motivation for writing this thesis is to find whether or not the aggregate and individual data reveals emulation as a cause for the lower savings.

Figure 1. Quarterly Personal Savings Ratio (NIPA)

14% 12% 10% 8% 6% 4%

Savings Ratio % 2% 0% ‐2%

Date Quarterly Personal Savings Ratio

Literature on the savings paradox often revolves around theories of consumer behavior. As a result, the theoretical framework describing how individual agents and society select their consumption behavior has implications for explaining changes to the personal savings rate. Many of 2

the ideas presented in this paper are taken from Thorstein Veblen’s Theory of the Leisure Class and

James Duesenberry’s Income, Saving, and the Theory of Consumer Behavior. Veblen approaches consumer behavior from a theoretic view, while Duesenberry brings a mathematical framework to his theory of consumer behavior. Similarly, each of their respective attempts to bring social elements into the consumption function was originally rejected on the basis of lacking economic justification.

The lack of justification is probably due to the fact that neoclassical theory is built around

the idea of utility maximization. This becomes problematic since a main assumption is that

consumers make their consumption decisions independently of other agents. Over the years,

evidence has repeatedly shown that consumers do not necessarily make consumption decisions

independent of others, but rather with others in mind. Given the difficulty of quantifying social

phenomena, neoclassical consumer theory originally avoided social elements. However, it is my

belief that social phenomena have contributed to the existence of the savings paradox.

In this paper, I analyze how Veblen’s pecuniary emulation and Duesenberry’s demonstration

effect result in the United States over-consuming at the expense of its aggregate personal savings

rate. The analysis is directed to conjure up thoughts about the modern consumption behavior of

individual agents as well as society as a whole. Much of the analysis is aimed at the idea of emulation

or keeping up with the Joneses as an explanation for the savings paradox. It is believed that the

consequences of emulating the consumption of an a priori reference group results in a society fixated

on keeping up with the Joneses. Here, the Joneses could be thought of as a reference group which

individuals seek to emulate in regards to consumption.

The motive for keeping up with the Joneses lies in the status attained of emulating the

reference group. Although everyone wants to live and experience the so-called American Dream,

the consumption arms race involved with trying to keep up with the Joneses can result in many

negative consequences for individuals and society. It is believed that the consequences of the drive 3 to increase or maintain a relative social position include increased income inequality, increased indebtedness, a lower aggregate personal savings rate, and an invalidation of Milton Friedman’s proportionality argument of savings to income.

Understanding the savings paradox requires a brief digression into the factors influencing the microeconomic and macroeconomic propensities to consume and save. Modern economic theory commonly recognizes John Maynard Keynes’ (91) factors influencing the propensity to consume to be:

• A change in the wage-unit. Consumption is obviously much more a function of real income than of money-income. • A change in the difference between income and net income. • Windfall changes in capital-values not allowed for in calculating net income. • Changes in the rate of time-discounting. • Changes in fiscal policy, i.e. taxes (income and capital gains) and the real rate of interest. • Changes in expectations of the relation between the present and future level of income.

Furthermore, Keynes lists the savings motives (107) as:

• To build up a reserve against unforeseen contingencies; • To provide for an anticipated future relation between the income and the needs of the individual or his family different from that which exists in the present, as for example, in relation to old age, family education, or the maintenance of dependents; • To enjoy interest and appreciation, i.e. because a larger real consumption at a later date is preferred to a smaller immediate consumption; • To enjoy a gradually increasing expenditure, since it gratifies a common instinct to look forward to a gradually improving standard of life rather than the contrary, even though the capacity for enjoyment may be diminishing; 4

• To enjoy a sense of independence and the power to do things, though without a clear idea or definite intention of specific action; • To secure a masse de manoeuvre to carry out speculative or business projects; • To bequeath a fortune; • To satisfy pure miserliness, i.e. unreasonable but insistent inhibitions against acts of expenditure as such.

The consumption and savings motives in bold are those relevant in this paper. Since the focus is on the savings paradox, especially in regards to emulated consumption, the focus is directed at factors influencing current consumption. In terms of the aggregate consumption decision, the subsequent analysis focuses on: interest rates (opportunity cost), time preference (discount rate), reference groups, taxes, consumer sentiment, the income distribution, consumer debt, and rates of income growth. Throughout this paper, it should be noted that savings will be regarded as the remainder after subtracting consumption expenditures from personal disposable income.

THORSTEIN VEBLEN AND THE IDEA OF PECUNIARY EMULATION

In The Theory of the Leisure Class, Thorstein Veblen was arguably the first economist to postulate the nature of consumer behavior in a socio-economic framework. His ideas regarding pecuniary emulation, particularly with respect to conspicuous consumption, profoundly affected the manner in which the economics profession acknowledged the social aspects influencing an agent’s

consumption behavior. Although the economics field originally disregarded the incorporation of

other social sciences into economic theory, the current savings paradox cast doubts about prevailing

theories that omit relevant socio-economic variables. For that reason, a minority view suggests that

individual agents strive to maintain or increase their relative status within society.

An economic agent’s easiest way of receiving validation for the attainment of a certain social

status is by emulating those whom he views as having higher status. According to Veblen, “the motive

that lies at the root of ownership is emulation; and the same motive of emulation continues active in the further

development of the institution to which it has given rise and in the development of all those features of the social

structure which this institution of ownership touches (17).” Hence emulation by means of ownership reveals

itself as the agent’s preferred method of attaining social reputability.

The need for reputability results from that fact that all agents are instinctively bestowed with

a need for invidious comparison. According to Veblen, “an invidious comparison is a process of valuation

of persons in respect of worth.” In such comparison, “relative success, tested by an invidious pecuniary comparison

with other men, becomes the conventional end of action. The accepted legitimate end of effort becomes the achievement of

a favourable comparison with other men; and therefore the repugnance to futility to a good extent coalesces with the

incentive of emulation (22).” Ultimately, such comparison allows for social structure based on relative

status and gives feedback to agents regarding their rank in relation to others.

In view of the fact that individuals are not specifically handed the methods of consumption

which yield the canon of reputability, they must witness the consumption behavior of others in 6 order to gain the knowledge of one’s relative ranking. In doing so, they are able to generalize which consumption quantities and qualities are deemed honorific by the underlying social norms. Once this knowledge of relative ranking is known:

the standard of expenditure which commonly guides our efforts is not the average, ordinary expenditure

already achieved; it is an ideal of consumption that lies just beyond our reach, or to reach which requires some

strain. The motive is emulation – the stimulus of an invidious comparison which prompts us to outdo those

with whom we are in the habit of classing ourselves (64).

Society’s division of classes coupled with the feedback of relative rank, or status, naturally gives way to reference groups. Reference groups are best thought of as the class an agent seeks to emulate in order to improve his relative ranking with individuals of his current social class. If successful, the agent will gain reputability. Unfortunately, an agent acting on his need to improve his relative ranking is offset by others trying to do the same. Veblen refers to the attempt to improve relative ranking as leading to an never-ending cycle where nobody gains in the following passage:

So far as concerns the present question, the end sought by accumulation is to rank high in comparison with

the rest of the community in point of pecuniary strength. So long as the comparison is distinctly unfavorable

to himself, the normal, average individual will live in chronic dissatisfaction with his present lot; and when he

was reached what may be called the normal pecuniary standard of the community, or of his class in the

community, this chronic dissatisfaction will give place to a restless straining to place a wider and ever-widening

pecuniary interval between himself and this average standard (20).

Given the innate need for comparison, a fair assumption is that each economic agent seeks to maximize the praise that society bestows on him. Seeking praise via pecuniary emulation is best thought of as keeping up with the Jones’ and is emphasized by Veblen in the following passage. 7

The canon of reputability is at hand and seizes upon such innovations as are, according to its standard, fit to

survive. Since the consumption of these more excellent goods is an evidence of wealth, it becomes honorific; and

conversely, the failure to consume in due quantity and quality becomes a mark of inferiority and demerit (46).

As previously mentioned, keeping up with the Joneses is an important social phenomenon influencing consumption behavior. According the Veblen’s framework, the need for an invidious comparison is influenced by the social norms and underlying institutions. However, the instinct originally had its roots in two forms, conspicuous leisure and conspicuous consumption, until social and economic advancement lead to a social preference of one over the other.

VEBLEN’S SOCIAL PREFERENCES AND INSTITUTIONAL CHANGE

Often recognized as the founder of the institutional school of economic theory, Veblen

asked what the impact of transforming social norms under evolving social institutions meant for

consumer behavior. According to Veblen, pecuniary emulation first took the form of conspicuous

leisure, and then was replaced by conspicuous consumption as society experienced economic and

institutional advancement.

Like many of his institutionalist ideas, Veblen interpreted preferences as the product of an

evolving process. Originally, conspicuous leisure was preferred to conspicuous consumption as the

means of acquiring reputability. Since Veblen believes economic and social advancement to be the

driving forces behind changes in the preference relation, the recognition of property rights led to

equal efficacy of the two means of comparison. Society’s acceptance of property rights allows

individuals the chance to accumulate wealth, and ultimately, to display their wealth by way of consuming high quality, luxury goods. Veblen argues that “the subsequent relative decline in the use of conspicuous leisure as a basis of repute is due partly to an increasing relative effectiveness of consumption as an evidence of wealth (57).”

However, as society adapts to its evolving institutions, conspicuous consumption becomes as efficacious as conspicuous leisure. Veblen writes “but when the differentiation has gone farther and it becomes necessary to reach a wider human environment, consumption begins to hold over leisure as an ordinary means of decency (53).” Given the underlying institutions within the social structure, society will either maintain this equivalence or conspicuous consumption will become the primary method of seeking an invidious comparison. At this point, society strictly prefers conspicuous consumption to conspicuous leisure as the means of gaining a favorable comparison. Since “no class of society, not even the most abjectly poor, forgoes all customary conspicuous consumption, (53)” the drive to conspicuously consume should increase. 9

As the preferences continue to evolve, so will the institutions. “Institutions are not only themselves the result of a selective and adaptive process which shapes the prevailing or dominant types of spiritual attitude and aptitudes; they are at the same time special methods of life and of human relations, and are therefore in their turn efficient factors of selection (117).” In order to satisfy the agent’s refined preferences, society must adapt its institutions and economic resources to meet the need for emulation.

To put things in perspective, the ideas Veblen put forth regarding the evolution of consumption behavior in response to institutional stimuli may have been ahead his time, since some recent work has begun to recognize the social influences on consumption. If neoclassical consumer theory was correct, then any form of emulation would be difficult to explain. So far as individuals take into account the merit earned from conspicuously consuming or the gain from an invidious comparison, the consumer theory must incorporate social elements to explain individual consumption behavior.

JAMES DUESENBERRY AND THE DEMONSTRATION EFFECT

In Income, Savings, and the Theory of Consumer Behavior, Duesenberry begins by claiming that “this book began as a critique of the Keynesian consumption function. This critique is based on a demonstration that two fundamental assumptions of aggregated demand theory are invalid. These assumptions are (1) that every individual’s consumption behavior is independent of that of every other individual, and (2) that consumption relations are reversible in time (1).” His critique revolves around the idea that “a real understanding of the problem of consumer behavior must begin with a full recognition of the social character of consumption patterns. From the viewpoint of preference theory or marginal utility theory, human desires are desires for specific goods; but nothing is said about how these desires arise or how they are changed. That, however, is the essence of the consumption problem when preferences are interdependent (19).”

One of the first attempts to model the effect of social elements, such as status or relative rank on consumption, was James Duesenberry’s Income, Saving, and the Theory of Consumer

Behavior. Unfortunately, “Duesenberry’s belief in the social significance of consumption….failed to find a sympathetic audience even in those areas of research that held no brief to protect the orthodoxies of traditional economic thought and that took a more catholic, interdisciplinary view of consumer preference formation and consumer demand

(Mason 2000).” Likewise, the failure of the economics field to embrace a socio-economic consumption function may have been because “Duesenberry’s emphasis on interdependent preferences had, in fact, always posed a threat to consumer theory – a theory that held that preferences were independent and that aggregated demand could therefore be derived from the simple summation of individual demand schedules (Mason

2000).”

If emulation, or what Duesenberry calls the “demonstration effect” is behind the U.S. savings paradox, then interdependent preferences play an important role in explaining consumption behavior on the individual and aggregate levels. Duesenberry incorporated interdependent preferences into individual consumption behavior by making an individual’s utility dependent on a 11

weighted average of the consumption expenditures of others. By doing so, an individual’s

consumption decision is influenced by his: current income, current assets, expected future income,

expected future interest rates, and the current consumption of other people.

While Veblen presented a theoretical treatment of the causes of conspicuous consumption,

Duesenberry presented his own framework and came to the following a priori beliefs (45).

1. The aggregate savings ratio is independent of the absolute level of aggregate income.

2. The aggregate savings ratio is dependent on: interest rates, the relation between current and

expected future incomes, the distribution of income, the age distribution of the population,

and the rate of growth of income.

3. Because of the discontinuity in preference functions (at lower levels of income desires for

current consumption are so strong that they overcome all considerations of the future) the

aggregate savings ratio will be rather insensitive to changes in interest rates, expectations, and

preference parameters. Large changes in these factors will be required to produce

substantial changes in the savings ratio.

4. Ceteris paribus, the propensity to save of an individual can be regarded as a rising function

of his percentile position in the income distribution. The parameters of that function will

change with changes in the shape of the income distribution.

These conclusions are important and they will be tested with an expanded set of data. Hopefully, the testing will shed light on the validity of his arguments, especially in regard to the aggregate consumption behavior of the United States.

SIMILARITIES BETWEEN VEBLEN AND DUESENBERRY

Duesenberry and Veblen share a common approach to consumption behavior. While

Veblen described a society driven by the pursuit of pecuniary emulation, Duesenberry focused his

arguments on the demonstration effect. Since both are methods of displaying or trying to attain

status, they will be closely related throughout this paper. However, as Duesenberry noted, “this effect need not depend at all on consideration of emulation or conspicuous consumption (28).” In addition to sharing the belief that individual consumption decisions are influenced by the consumption of others,

Veblen and Duesenberry held similar beliefs with regard to emulation and the demonstration effect are relevant for explaining consumption behavior.

This similarity involves the idea of habit formation. According to Duesenberry, “the mechanism which connects consumption decisions is not that of rational planning but of learning and habit formation

(24).” Likewise, Veblen alludes to habit formation by stating that:

“the question is therefore, not whether, under the existing circumstances of individual habit and social custom,

a given expenditure conduces to the particular consumer’s gratification or peace of mind; but whether, aside

from acquired tastes and from the canons of usage and conventional decency, its result is a net gain in the

comfort in the fullness of life (61).”

Habit formation is an essential element of both pecuniary emulation and the demonstration effect.

In a habit-forming society, it is reasonable to predict that the individual need to maintain a reputable standard of living would lead to greater income inequality and a lower aggregate savings rate. For that reason, the analysis in this paper is directed at answering the following questions. 1.) Is there an intrinsic need to keep up with the Joneses in the American lifestyle? 2.) Has status-seeking led to a lower savings rate? 3.) Do the rich save a larger proportion than the poor? 4.) And if relative status matters, would a lower savings rate cause higher income inequality, or vice versa?

TO CONSUME OR NOT CONSUME, THAT IS THE QUESTION

The continued evolution of institutions and conventions leads one to routinely “modernize”

his way of life in order to maintain a given level of reputability. Given the assumption that

individual preferences arise as an adaptation to the social, political, and economic environments and

that agents are rational decision makers, then such modernizing leads economic agents collectively

into an endless Prisoner’s Dilemma. Veblen sees aggregate economic advancement as transforming

the society with “the result being that the members of each stratum accept as their ideal of decency the scheme of life

in vogue in the next higher stratum, and bend their energies to live up to that ideal (52).” Likewise, Duesenberry

asserts that “in a fundamental sense the basic source of the drive toward higher consumption is to be found in the

character of our culture. A rising standard of living is one of the major goals of our society (26).”

The following table represents a simplified model of an agent’s trade-off of whether to

consume and maintain status, or save and risk demerit for not consuming with the expected

standard of decency. In this case, two individuals compare their gains as predetermined by society in

terms of conspicuous consumption or a demonstration effect.

Agent 2 Consume Save

Agent 1 Consume δ, δ α, λ Save λ, α β, β

Accordingly, the following string of equalities must hold: α > β > δ > λ. Since society is

always in a process of change and refinement, we assume that through iterated elimination of

dominated strategies, uncoordinated action will yield the payoff of δ for each agent. Although this is

the equilibrium, it is Pareto inferior (both agents could be made better off if both saved, since β >

δ). Veblen recognizes this when he wrote that “the collective interest is best served by honesty, diligence, peacefulness, good-will, an absence of self-seeking, and a habitual recognition and apprehension of causal sequence….” 14

Instead, agents become caught up in keeping up with the Joneses and increase consumption in order

to gain reputability.

The potential consequence of a society engaging in the prisoner’s dilemma above is over-

consumption at the disregard of the aggregate personal savings rate. Veblen considers this

consequence by stating that “considered by itself simply – taken in the first degree- this added provocation to

which the artisan and the urban laboring classes are exposed may not very seriously decrease the amount of savings; but

in its cumulative action, through raising the standard of decent expenditure, its deterrent effect on the tendency to save

cannot but be very great (55).” In fact, he says “if the canon of conspicuous consumption were not offset to a

considerable extent by other features of human nature, alien to it, any saving should logically be impossible for a population situated as the artisan and laboring classes of the cities are at present, however high their wages or their income might be (56).”

As history has shown, social and economic advancement has led to efficiency gains that have increased the average standard of living. These advances taken alongside society’s preferences for consuming with a certain standard of decency is evidenced when Duesenberry declares “our social goal of a high standard of living, then, converts the drive for self-esteem into a drive to get high quality goods. The possibility of social mobility and recognition of upward mobility as a social goal converts the drive for self-esteem into a desire for high social status (31).” Unfortunately, although the average standard of living has increased, so has the income inequality.

The United States is not alone in this respect. With the collapse of the Soviet Union, Russia and many satellite nations simultaneously experienced income growth and income inequality.

Intuitively, one could claim that the embrace of a market system contributed to the increased income inequality as the top one or five percent of the population experienced income growth far greater than the remaining population. Nevertheless, many countries in Europe have averted this

problem by creating social barriers to limit the inequality consequences of increasing living 15 standards. Such social barriers include the implementation of a welfare state, value added taxes on consumption goods, higher marginal tax rates on income and greater regulation of industries.

When the cycle of emulation deepens, agents increase their consumption expenditures and thus decrease their personal savings. Duesenberry makes reference to this outcome when he stated that “since high social status requires the maintenance of a high consumption standard, the drive is again converted into a drive to obtain high quality goods (31).” The effort expended trying to maintain or increase reputability leads to a socially inefficient outcome. Veblen notes the dissatisfaction that results:

“if, as is sometimes assumed, the incentive to accumulation were the want of subsistence or of physical comfort,

then the aggregate economic wants of a community might conceivably be satisfied at some point in the advance

of industrial efficiency; but since the struggle is substantially a race for reputability on the basis of an invidious

comparison, no approach to a definitive attainment is possible.”

Veblen’s theory may help explain the U.S. savings paradox. If it is true that individuals are reluctant to scale back their conspicuous consumption, but rather to increase it in light of the race for reputability, then it seems that social phenomena play an important role in explaining consumption behavior.

SAVINGS IN LIGHT OF THE RACE FOR REPUTABILITY

So far, there has been no mention of self-checks that signal an agent is living beyond his means. The lack of self-checks is due to the fact that the social component of consumption behavior suggests that on the aggregate, society will be stuck in a herd mentality that embraces consumption at all costs. The negative consequences of such behavior can best be thought of as irrational exuberance, ultimately leading to poor decisions from individuals, firms, and the government. This race for reputability has everyone increasing their indebtedness via credit cards, credit lines, loans, and the issuance of treasuries in remarkable volumes. Debt no longer becomes a vice, but a virtue and a way of achieving the sought after means. Thus, the heightened sense of euphoria experienced under the cycle of emulation reduces savings until the marginal propensity to consume approaches one.

If in fact the need for emulation has given society an increased euphoric need to consume, then testing whether or not the marginal propensity to consume has approached one will be a relatively simple task. First, the aggregate time series data will be tested for cointegration in order to unveil the long-run and short-run dynamics of the marginal propensity to consume. Then, the data

will be tested for a structural break to see whether or not the marginal propensity to save has been statistically stable over the tested time period.

The remainder of the paper will review recent literature as well as discuss the methodology for empirically testing whether or not relative status is behind the savings paradox. The testing will be directed at interpreting the 2004 Survey of Consumer Finances in order to test for emulation, to test whether or not a long-term equilibrium exists between consumption and income, and to determine whether or not the savings paradox is a result of a structural break, as well as whether the race for status leads to higher income inequality and lower savings (and if so, which way does the causation run). 17

RESEARCH RELATING TO THE SAVINGS PARADOX

Recent literature has focused on effects of consumption externalities on the savings rate.

In a two period model, Direr (2001) found that consumption inequality is positively correlated to

income inequality. He also noted that consumption is higher in the period in which the distribution

of consumption is relatively more concentrated and that aggregate saving is therefore negatively

correlated with a rise in consumption inequalities (Direr 2001). In another study, Dynan, Skinner

and Zeldes (2004) challenge Schmidt-Hebbel and Serven’s (2000) cross-country study that found no

evidence of a statistically significant link between measures of income inequality and aggregate

saving rates. Furthermore, they claim the link between income and saving rates influences how

changes in income inequality alter saving and possibly aggregate growth (Dynan, Skinner and Zeldes

2004). “Then a high degree of inequality in the distribution of income and wealth may reinforce the

tendency to save little as the distance between consumption levels is greater. And a further increase

in inequality would put more pressure on individuals to consume yet more to attain their status

targets, thereby saving less (Wisman 2008).” In his critique of the Permanent Income Hypothesis,

Mayer (1972) claimed “both the absolute and relative income theories assert that the rich are saving

a larger percent of their income than the poor.” And “if so, as time goes by, the rich should receive

an increasing share of property income, and hence of total income (61).”

In regards to their study on the long-run relationship between consumer sentiment and the

personal savings rate, Ewing and Payne (1998) found that as expected, a higher interest rate is

associated with higher personal savings rates. Using cointegration techniques, they found the

contemporaneous correlation between the index of consumer sentiment and the personal savings

rate is consistent with Carroll, et al. (1994) who found that the index of consumer sentiment was

positively correlated with spending. This result does not refute traditional life-cycle or permanent- income models of consumption. Their finding that “the savings rate is non-stationary is particularly 18

interesting for practitioners. For example, economic shocks such as the increase in access to

financial markets through the Internet would permanently impact the savings rate. Similarly, a one-

time unanticipated change in consumer sentiment would have permanent effects. This finding also

indicates that the personal savings rate follows a random walk (Ewing and Payne 1998).”

Furthermore, they claim that “while a long run equilibrium relation between the personal savings

rate and consumer sentiment exists, there may be a short run lag before households adjust their

savings rate to be in line once again with consumer sentiment (Ewing and Payne 1998).”

In his pioneering work on the permanent income hypothesis, Friedman (1957) argued that the positive correlation between income and saving rates observed in cross-sectional data reflected

individuals changing their saving in order to keep consumption smooth in the face of temporarily

high or low income. He presented empirical evidence consistent with the proportionality hypothesis

that individuals with high permanent income consume the same fraction of income as individuals

with low permanent income (Dynan, Skinner and Zeldes 2004). In their paper, Dynan, Skinner and

Zeldes (2004) find “that the rich do save more; more broadly, we find that saving rates increase

across the entire income distribution. In addition, we present evidence suggesting that the marginal

propensity to save is greater for higher-income households than for lower-income households.”

Besides consumption externalities, some research has been directed at work hours and

income inequality. In their attempt to explain “Veblen effects in the determination of work hours,

namely the manner in which a desire to emulate the consumption standard of the rich may influence

an individual’s allocation of time between labour and leisure,” Bowles and Park (2005) find “that

work hours are increasing in the degree of income inequality.” They also show “that increased

inequality induces people to work longer hours and provide evidence that the underlying cause is the

Veblen effect of the consumption of the rich on the behavior of those less well off (Bowles and

Park 2005).” Robert H. Frank also makes this point. He writes that “a related distortion is present 19

when individuals make decisions about how much leisure to consume. To the extent that extra

income is valued not only for its own sake, but also for the relative advantages, it affords, the option

of working an additional hour will appear misleadingly attractive to individuals (Frank, 1985).”

In his classic critique of the Permanent Income Hypothesis, Mayer (1972) asserts “the two

main differences between the relative income theory and the permanent income theory are: (1) the

validity of proportionality hypothesis in a cross-section context, and (2) the underlying mechanism

responsible for the lag, that is, habit persistence vs. rational utility maximization” He claims that “the

relative income theory equation fits the data somewhat better than the permanent income theory.

While the permanent income equation explains 60 percent of the variance not accounted for by

common trend, the relative income equation explains 80 percent (78).” Furthermore, he finds that

“none of the tests support the full permanent income theory in the sense of showing that the

income elasticity of consumption is zero for transitory income and unity for permanent income

(89).” This in itself should be evidence of the importance of incorporating social elements such as

habit persistence into individual consumer behavior.

Robert H. Frank argues for the unfounded neglect of Duesenberry’s work. He notes “in view of the empirical evidence, the extent to which these theories have supplanted Duesenberry’s relative income hypothesis in modern textbooks seems yet another testament to the power of the a priori beliefs held by most economists. This outcome is not without irony, since we have seen that concerns about relative standing may well be fully compatible with the pursuit of self-interest, and therefore presumably not at all in conflict with economists’ important prior beliefs. If this view wins acceptance, it suggests that greater attention be accorded to Duesenberry’s explanation of the

savings rate paradox, at least until some new empirical evidence is uncovered that proves it faulty

(Frank, 1985).” 20

The approach to explaining U.S. savings paradox often involves looking at the aggregate personal savings rate. As Dynan, Skinner and Zeldes (2004) claim, “there seems to be considerable support for the hypothesis that the low rate of household saving in the U.S. is related to Americans’ strong belief that vertical mobility in the U.S. is readily possible and hence their relatively weak sense of class identity.” The link between income and saving rates bears on a number of specific issues.

First, differences across income groups in saving rates and marginal propensities to save imply that the effects on aggregate consumption of shocks to aggregate income or wealth depend on the distribution of the shock across income groups (Dynan, Skinner and Zeldes 2004). Moreover, one can point to several stylized facts that do not seem to support a positive correlation between saving rates and income. First, there has been no time-series increase in the aggregate saving rate during the past century despite dramatic growth in real per capita income (Dynan, Skinner and Zeldes 2004).

The same conclusions are drawn by Ewing and Payne (1998) when they state “the results of the expanded cointegration test further revealed that the personal savings rate is negatively associated with increases in real disposable personal income. This suggests that, at least initially, households may increase their propensity to spend rather than save when they experience current increases in real disposable income.”

Without question, the bulk of the literature aimed at explaining the savings paradox revolves around the quest for status or relative rank. Status is important because “individuals experience happiness by doing well relative to some reference group (consume more than others) or to a benchmark level (Garriga 2006).” As Duesenberry pointed out, “introducing status directly into an agent’s utility function seems to require a psychological theory to underpin the preference assumptions. The plausibility of the model is then tied to the plausibility of the psychological preference theory (Cole, Mailath and Postlewaite 1992).” In their paper, Cole, Mailath and

Postlewaite (1992), “interpret an agent’s status as a ranking device that determines how well he or 21

she fares with respect to the allocation of nonmarket goods. The existence of nonmarket decisions can endogenously generate a concern for relative position in, for example, the income distribution so that higher income implies higher status.”

“For many years economists struggled to resolve the apparent paradox implicit in the observation that the average propensity to consume falls with income in cross-section data, but is constant in time-series data. Duesenberry’s proposed solution to this puzzle in 1949 was essentially the same as the one stated in Proposition 3` above, namely, that demonstration effects weigh relatively more heavily on people with lower incomes, causing them to consume higher fractions of their incomes than do people with higher incomes (Frank, 1985).” Frank’s PROPOSITION 3` claims that “Noncooperative budget shares for savings are an increasing function of the individual’s rank in the income hierarchy of the population of which he is a member.”

In regards to reference groups, Bowles and Park (2005) find their “result is consistent with the hypothesis that social comparisons are upwards to a richer reference group and is inconsistent with the alternative hypothesis that social comparisons are downward-looking, people’s consumption and work choices reflecting a desire to distance themselves from a poorer reference group.” Similarly, Fuhrer (2000) claims that “habit formation may be modeled by assuming that consumers’ current utility is determined by current consumption relative to a reference level of consumption. The notion that consumers form habits in their expenditure patterns certainly has intuitive appeal.”

METHODOLOGY FOR CAPTURING EMULATION

In estimating the aggregate personal savings rate of the United States, it is important to keep

in mind the problems of: using time series regressions of aggregate data to tell how households

behave, single equation bias, autocorrelation and stochastic trends, measurement error; and ex post data revisions. Since the focus is on estimating the degree to which emulation plays in reducing the aggregate personal savings rate, it is necessary to establish a microeconomic framework before addressing the aggregate dynamics of the personal savings rate. To reduce the likelihood of misinterpreting the results, the aggregate and individual data will each be tested with the appropriate techniques.

Under the hypothesis that individual consumption behavior is driven by the need to emulate others, it is necessary to bridge the gap between theoretical and empirical methods with a proxy of emulation. One method of incorporating emulation into consumer theory is by assuming that individuals have a time invariant, additive consumption function. Assuming the consumption function resembles the form proposed by Frank and Levine (Expenditure Cascades) it is easy to see how the need to keep up would strengthen an individual’s degree of emulation. As the individual’s degree of emulation strengthens, it is easy to see how changing social and institutional stimuli will further escalate the cycle of emulation within society. Such a consumption function is where1:

Ci = αYi + θCi+1 where 0 ≤ α ≤ 1 and 0 ≤ θ ≤ 1

As the cycle of emulation deepens, individuals experience growing wants to consume in a manner that satisfies the need to keep up or maintain status. Although data are readily available to estimate α, a measure of θ is harder to find. The difficulty in finding an appropriate measure of emulative consumption points to the need for an appropriate proxy.

1 Where Ci and Yi are the current consumption and permanent income of individual i in the consumption function. Ci+1 could be thought of as the reference group consumption which individual i wishes to emulate. The parameter α could be thought of as the marginal propensity to consume while θ can be viewed as degree of emulation. 23

With regards to the individual data, a reasonable proxy of emulative consumption is an individual’s amount of consumer debt. It is my belief that the amount of consumer debt is directly related to the degree to which one emulates others. However, consumer debt in itself is a very broad proxy as it contains amounts owed on credit cards, lines of credit, education loans, home improvement loans, vehicle loans, and other loans. Clearly, it is difficult to separate an individual’s debt into needs and wants, but nonetheless, it is the proxy most suitable for testing the role emulation plays in an individual’s savings decisions.

It is necessary to understand the importance of consumer debt in order to see how this proxy for emulation can explain the U.S. savings paradox. In its purest form, consumer debt is a measure of credit extended by the original owners on a good or service to the final consumers. For that reason, for consumer debt to exist, credit must exist. Thus, consumer credit and consumer debt coexist and neither can survive without the other. For the analysis of the Survey of Consumer

Finances as well as the aggregate data, it is assumed that greater access to credit has increased an individual’s ability to emulate others. Thus, it believed that the increased ability to emulate is behind the U.S. Savings Paradox.

IS EMULATION EVIDENT IN THE SURVEY OF CONSUMER FINANCES?

Since the primary focus of using consumer debt is to see whether emulation has an impact on savings at the individual level, the Federal Reserve Board Survey of Consumer Finances for 2004 was used in analyzing the individual’s saving behavior. The Survey of Consumer Finances (SCF)2 is

a triennial survey of the balance sheet, pension, income, and other demographic characteristics of

U.S. families. The SCF is sponsored by the Board of Governors of the Federal Reserve System in

cooperation with the Statistics of Income Division of the Internal Revenue Service. Data for the

2004 SCF were collected by NORC, a national organization for research and computing at the

University of Chicago.

Although the analysis is directed at seeing what effect emulation has on an individual’s

amount of savings, emulation in itself cannot explain the savings behavior of individuals. For that

reason, it is necessary to construct an econometric model that includes variables of interest to the

savings decision. The econometric model will focus on the savings motives previously mentioned in

the introduction. Therefore, the model takes the following form where the dependent variable is an

individual’s total savings and depends on the respondent’s quantitative and qualitative responses.

Total Savings = β1 + β2(Consumer Debt) + β3(Value Investments) + β4(Value Home/Property) + β5(Expected Inheritance) + β6(Precautionary Savings) +

β7(Household Size) + β8(Income Expectations) + β9(Saver) + β10(Financial Risk) + µi

The dependent and independent variables are defined in Table and the economic reasoning or intuition behind each variable’s importance to the model follows.

2 http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html 25

Table 1

Dependent Variable Definitions Total value of savings accounts, checking accounts, Total Savings certificate of deposits, and savings bonds (very safe and liquid measure of savings). Independent Variables Consumer Debt Consumer debt is computed as the outstanding balance on credit cards, education loans, mortgages, lines of credit, home improvement loans, property loans, vehicle loans, and other loans.

Value of Investments This variable includes the total market value of the respondent’s cash account, government bonds, other bonds, stocks, mutual funds, and other miscellaneous investments.

Value of Home/Property This variable lists the value of the home/property as listed by the respondent.

Expected Inheritance Listed by the respondent as the total amount of inheritance expected to receive.

Precautionary Savings Listed by the respondent as the amount of savings needed for emergencies or other unanticipated events.

Household Size Number of people in the household.

Income Expectations Dummy variable where 1 means the respondent believes his (family) income will increase more than or about the same as prices over the next year and 0 otherwise.

Saver Dummy variable where 1 means the respondent is more likely to be a Saver and 0 if he is more likely to be a Spender. The likeliness of being a saver or spender depends on whether or not the respondent’s answers regarding his saving habits outweigh his answers regarding his spending habits.

Financial Risk Dummy variable that is a measure of how much financial risk the respondent is willing to take. 1 if the respondent is willing to take above average or substantial financial risks and 0 if the respondent is willing to take no financial risks or average risks.

Income the respondent (family) received in 2003 Total Income from all sources, before taxes and other deductions were made. 26

Economic theory suggests that consumer debt lowers the amount of total savings.

Intuitively, this makes sense as individuals would have to borrow more money if they had insufficient savings when purchasing a large ticket item. With respect to the individual’s value of investments, I expect a positive coefficient because rational individuals would retain some of the investment gains in the form of savings. However, if individuals were irrational and always assumed that the value of their investments would forever increase, then I would expect a negative sign as individuals would consume today (less savings) in anticipation of future investment gains.

For the value of home/property variable, I expect a negative coefficient because house or land prices have historically risen over time. This expectation should influence an individual to save less in anticipation of benefitting from higher house or property values in the future.

I anticipate a respondent to have less total savings if they expect to receive a higher inheritance than a respondent expecting to receive little to no inheritance. Thus I expect a negative coefficient on expected inheritance. Here the idea is that individuals foreseeing an expected future inheritance might borrow against that inheritance and spend more money today.

It is my belief that a respondent with a higher precautionary savings motive would have

more total savings than respondents with a lower precautionary savings. Clearly, if an individual felt

that he needed a higher savings to offset future expenditures or unforeseen circumstances, then it is

reasonable to expect a positive coefficient on precautionary savings.

Since the survey takes into account family dynamics, I am unsure whether larger households

would save more or less than smaller ones. I can imagine the need for higher savings (education,

health care, and etcetera) but I also understand that larger families imply higher consumption

expenditures.

The income expectations dummy variable is a good qualitative measure of an individual’s

time preference in regards to his savings decision. If over the next year, the respondent anticipates 27 income growth exceeding or equal to the change in the level of prices, then I expect him to have more total savings than a respondent experiencing a lower real standard of living. Like total income, the idea is that higher income individuals would save a greater proportion of their income than lower income individuals.

A qualitative variable targeting an individual’s habit formation is the Saver dummy variable.

Based on the respondent’s questions regarding their saving and spending habits, I would expect a saver to have more total savings than a non-saver. If the individual possesses habits making him more inclined to save rather than spend, then the coefficient should have a positive sign. Finally, it is my belief that more risky people, as measured by financial risk, would have less total savings than an individual willing to take less financial risk because that respondent would prefer to have more liquid (cash) assets.

Estimating the economic and statistical significance of each savings motive cannot be done via ordinary least squares (OLS). Due to the nature of the survey data, OLS results would not be efficient due to heteroskedasticity. When analyzing cross-section data such as the Survey of

Consumer Finances, heteroskedasticity often arises from the skewed distribution of income. Since complex weighing techniques are beyond the scope of this paper, the data was weighted by

1/√ to achieve efficient estimates of the coefficients. The descriptive statistics and weighted least squares (WLS) results are reported in Table 2 and Table 3 on the following page.

Table 2. Dependent Variable Table 3. (Total Savings) Results from 2004 Survey of Consumer Descriptive Statistics of the Variables Finances Independent Variables Variables Mean Median Std. Constant 16,184 Total Savings 239,514 8,650 1,190,633 (1.45)

Consumer Debt 373,657 22,300 2,908,729 Consumer Debt -0.0076** (-2.16) Value Investments 2,151,624 0 13,657,460

Value of Investments 0.0357*** Value Home/Property 622,633 150,000 1,622,601 (20.45)

Expected Inheritance 456,404 0 13,946,955 Value of Home/Property 0.0677*** (6.54) Precautionary Savings 199,648 8,000 1,449,187

Expected Inheritance 0.0041*** Number in Household 2.62 2 1.41 (9.36)

Income Expectations 0.73 1 0.44 Precautionary Savings 0.0144*** (3.59) Saver 0.70 1 0.45

Number in Household -5,884* Financial Risk 0.25 0 0.43 (-1.85)

Total Income 768,760 60,000 3,810,566 Income Expectations -224.86 (-0.02)

Saver 20,668** (2.19)

Financial Risk 18,530 (1.58)

F-value 149.13***

Adjusted R2 0.2278

Number of Observations 4,519 Data Source: 2004 SCF. Statistical significance as follows: *** → α = .01, **→ α = .05, *→ α = .10. t -statistics in parentheses. Results are WLS estimates using the weight 1/√ .

The WLS results of the 2004 Survey of Consumer Finances are economically and statistically

significant as the proposed econometric model explains roughly 23% of the variation in an

individual’s total savings and all but two explanatory variables are statistically significant at the five

percent level. For a sample as large as the Survey of Consumer Finances to have a lower than

anticipated explanatory ability shows the difficulty in trying to estimate an individual’s stock of total

savings in cross-section data. Such a lack of explanatory power also displays the difficulty in

addressing the social phenomena affecting an individual’s saving behavior. However, it is important

to remember that the Survey of Consumer Finances tends to oversample the wealthy (Kennickell).

Clearly, the results might have been aided by a more accurate proxy of emulation as well as

the inclusion of demographic and geographic variables. The results are still economically and

statistically significant and bring to light many factors influencing an individual’s amount of savings.

The a priori beliefs regarding the savings motives were validated by the results. Therefore the results

indicate that the saving motives and corresponding economic intuition remain an important driver for estimating an individual’s total amount of savings. Although precautionary savings was economically important it lacked statistical significance and was the only savings motive to be rejected at the five percent level.

As expected consumer debt was economically and statistically significant. The estimate reveals that on average, holding all else constant, a $1,000 increase in an individual’s consumer debt would decrease his total savings by $7.60. Although this estimate validates the underlying theory, the size of the coefficient seems rather small. The lack of a larger coefficient could be the result of using consumer debt as the proxy for emulation. Perhaps a more accurate measure of the degree in which an individual emulates the consumption of others would be better suited. Unfortunately, a better proxy would require the separation of an individual’s needs from wants. 30

The results reaffirm the prior belief that individuals would be inclined to save an increase in

investment gains, as on average, holding all else constant, a $1,000 increase in the value of an

individual’s investments will increase an individual’s total savings by $35.70. Again, this coefficient

is relatively small and suggests that the bulk of investment gains remained unrealized. For individuals this seems to be alright as long as they experience investment gains over their lifetime.

However, it becomes problematic if the individual is heavily invested in high-risk high-reward investments and experiences one or multiple market downturns. If in fact most of the unrealized gains remain invested, then such a market downturn would greatly diminish unrealized gains and place downward pressure on the aggregate savings.

From the estimated model, on average, holding all else constant, a $1,000 increase in the home/property value will increase an individual’s total savings by $67.70. Although this result is statistically significant, it lacks economic significance. The idea that individuals would increase their savings when their home/property values increase seems unlikely. First, economic intuition would argue that people would reduce savings today if they expected to make up for the lost savings with the proceeds from selling the home or property at a higher value. Second, it seems highly unlikely that individuals can extract equity from their house/property value and transfer the sum into a checking or savings account. The only plausible way for this to happen is voodoo accounting.

When expecting to receive an inheritance, the model found that on average, holding all else constant, a $1,000 increase in expected inheritance will increase an individual’s total savings by $4.10.

This estimate is statistically significant and economically significant depending on one’s prior beliefs regarding inheritance monies. For example, if the belief is that individuals expecting to receive an inheritance would forgo a certain level of current savings to be offset by the inheritance, then the result would lack economic significance. However, if the prior belief was that individuals would 31 increase their current savings in anticipation of spending the expected inheritance, then the estimate would be economically significant.

The precautionary savings variable was economically and statistically significant as the results found that on average, holding all else constant, a respondent would have $14.40 in total savings for every $1,000 needed in case of emergencies or unanticipated events. This estimate validates one of

Keynes’s savings motives and emphasizes that respondents are forward-looking.

Although it could be argued that larger families are prone to save more than smaller families for the sake of unforeseen circumstances, larger family vacations, or the costs of higher education, the model found that on average, holding all else constant, a one person increase in the number of people in the household will decrease total savings by $5,884. This estimate is economically and statistically significant as it implies that if in fact families are active participants in emulating others, then the cost of increasing or maintaining relative status would be via a lower level of total savings.

Another important qualitative variable classifying individuals by their saving and spending habits was Saver. The results found that on average, holding all else constant, an individual labeled a saver will save $20,668 more than an individual deemed a spender. This is economically and statistically significant and points to the need for having qualitative variables to distinguish the underlying thriftiness of the individual. It also shows the importance that socio-economic variables have when attempting to estimate an individual’s personal savings.

Finally, the results estimated that on average, holding all else constant, an individual who considers himself to take above average or substantial financial risk will save $18,530 more than an individual who listed himself as willing to take average or less than average financial risk. This result lacks economic and statistical significance. Usually, economics would consider a risk averse (willing to take average or less than average financial risk) individual to have a higher level of savings than a risk lover (one who loves taking financial risk), not vice versa. 32

Given that the results have been individually analyzed, to see how the model predicts an individual’s amount of savings, the estimates will be evaluated at the median of the independent variables. Since the data are heavily skewed, evaluating at the median will give a better view of how much an average individual has in savings. When evaluated at the median values listed in the descriptive variables table, that individual would have roughly $34,844 in total savings. Again, total savings is defined as the sum of checking and savings accounts. If one were to use the rule of thumb that people should save roughly six months of their income, then according to the 2004

Survey of Consumer Finances3, where median household income is $60,000, an individual should have roughly $30,000 in savings. Interestingly enough, the estimated savings according to the model is not much different from the rule.

One more interesting analysis the 2004 Survey of Consumer Finances provides is to see the degree in which savings rises with income. As seen in figure 3 below, when the natural log of total savings is plotted again the natural log of total income, total savings is an increasing function of total income. Whereas Friedman (1957) claimed that individuals would save the same proportion regardless of income, this plot is a contradiction of his argument. Clearly, the underlying convexity of the savings schedule confirms that the rich do in fact save a greater proportion of their income than the poor. Therefore, visual analysis reaffirms the results obtained by Dynan, Skinner and

Zeldes (2004).

3 Once again, oversampling of wealthy individuals is evident as the respondent’s median income is greater than the median income of the U.S. population. http://quickfacts.census.gov/qfd/states/00000.html 33

LNIncome 19

0123456789101112131415161718 LNSavi ngs

Figure 3

COINTEGRATION RESULTS

In the attempt to understand the dynamics of the marginal propensity to save, I have

followed Damodar Gujarati’s procedures for estimating the long-run and short-run marginal

propensities to consume. The long-run and short-run marginal propensities to consume were

estimated using quarterly data from the St. Louis Federal Reserve Economic Database. The data

covers 1947:1 to 2008:4 and are seasonally adjusted annual rates. The variables of interest were real

personal disposable income (DPI) and real personal consumption expenditures (PCE) in Billions of

chained 2000 dollars. Variables were adjusted for the price level and taxes to allow for a better

estimation of the aggregative dynamics of the economy’s consumption behavior. According to

Gujarati, “although PCE and DPI individually have stochastic trends, their linear combination is stationary.”

Since savings, which is the remainder from subtracting personal consumption expenditures from

personal disposable income, is stationary “the two variables (PCE and DPI) are cointegrated (822).” Thus,

in order to get the long-run equilibrium marginal propensity to consume, real personal consumption

expenditures is regressed on real disposable personal income. Therefore, the model is estimated to

PCEt = β1 + β2DPIt + ut .

Like Gujarati’s example, a unit root test was performed on the residuals.

Δut = β1ut -1

The Engle-Granger 1 percent critical τ250 value is -2.58 and the 5 percent level is -1.95. Since the

computed value is more negative than both critical values, the residuals from the regression are stationary. Therefore, the estimated equation reveals the long-run, or equilibrium, marginal propensity to consume to be 0.949. As Gujarati notes, “since there is a long-term relationship between PCE

and DPI, we can use the error term to tie the short-run behavior of PCE to its long-run value (824).” Hence, the 35

following Error-Correction Model (ECM) can be used to estimate the short-run marginal propensity

to consume.

Δ PCEt = α0+ α1ΔDPIt + α2ut-1 + εt

Table 4. Dependent Variables

Independent Variables PCEt Δut Δ PCEt Constant -154.473 20.639 (-10.373) (-10.319)

DPIt 0.949 (-294.26)

ut -1 -0.067 -0.033 (-2.978) (-2.294)

ΔDPIt 0.270 (-7.47)

Adjusted R2 0.997 0.035 0.191 Durbin-Watson 0.129 2.741 1.522

Using the ECM, the results indicate that the short-run marginal propensity to consume is

0.270. On average, holding all else constant, a $1 million increase in aggregate real personal disposable income will result in a $270,000 increase in aggregate real personal consumption expenditures. These estimates are in line with Duesenberry’s claim that holding all else constant, on

average, “we should expect people to split the increase between increased spending and increased saving. Moreover, we

should expect savings to increase as a percentage of income….At (relatively) low incomes the desires for present

consumption outweigh considerations of the future to such an extent that little or no saving occurs (37).”

TESTING FOR A STRUCTURAL BREAK

As previously mentioned, increased access to credit could increase the ability to emulate and lead to irrational exuberance and a marginal propensity to consume approaching one. One method of testing whether the need for emulation has increased the marginal propensity to consume is to see whether a structural break exists in the marginal propensity to save. If in fact access to credit has eased over the years, then it is reasonable to expect consumer debt to lead to a structural break. As seen in Figure 2, aggregate household financial obligations as a percent of disposable personal income has steadily increased since 1980.

Figure 2. Household Financial Obligations as a percent of Disposable Personal Income 20% 19% 18% 17% 16% 15% 1980 1984 1988 1992 1996 2000 2004 2008

Household Financial Obligations as a percent of Disposable Personal Income

The liberalization and de-regulation of the financial industry during the Reagan administration appears to have increased access to credit as the household financial obligations ratio increased two full percentage points between 1984 and 1987. If a structural break exists, then it is fair to assume that the increased access to credit could be behind the U.S. savings paradox.

A quite glance back at the Quarterly Personal Savings Rate in Figure 1 suggests a structural break is more than likely. Unfortunately, to make inferences from the visual decline is hardly scientific. Thus, it is necessary to test the existence of a structural break via Chow’s Test and a recursive residuals test. Although one or another is necessary, both are sufficient in order to pin 37

down the break. Both tests were conducted with the Bureau of Economic Analysis’s quarterly

national income product accounts on disposable personal income and personal savings. The data

are expressed in Billions of chained 2000 dollars at a seasonally adjusted rate.

The recursive residuals test4 of the disposable personal income coefficient reveals a

structural break around observations 125 to 135. In other words, there appears to be a structural

break in the marginal propensity to save between the first quarter of 1983 to the third quarter of

1985 (1983:1 – 1985:2). Since any break around 1983 could be attributed to a short-run change in

the economic environment, the second quarter of 1985 (1985:2) will be viewed as the structural break for the purpose of the Chow Test. In Figure 4, the recursive estimates show the existence of a

structural break.

.11 .10 .09 .08 .07 .06 .05 .04 .03 .02 25 50 75 100 125 150 175 200 225

Recursive C(1) Estimates ± 2 S.E.

Figure 4

4 Figure 4. 38

Since the recursive residuals test validates the prior assumption about a structural break, the following analysis will test the significance of the structural break with a Chow Test. With the Chow

Test, the full sample (1951:1 – 2008:3) will be divided into two time-periods (1952:1 – 1985:2 and

1985:3 – 2008:3) to test whether the coefficients on disposable personal income are statistically equivalent.

The regression equation was modeled as the following:

St = κ1 + κ 2DPIt + μ1t (1) Time Period 1952:1 – 1985:2

St = γ1 + γ 2DPIt + μ2t (2) Time Period 1985:3 – 2008:3

St = α1 + α2DPIt + μt (3) Time Period 1952:1 – 2008:3

Given that the recursive residuals test revealed a structural break in the marginal propensity to save

estimate, my a priori belief is that κ 1 ≠ γ 1 and κ 2 ≠ γ 2 and the marginal propensity to save will be different for the two time periods. The results in Table 55 indicate that equations (1) and (2) have different intercepts as well as different marginal propensity to save coefficients. Furthermore, the

Chow Test reports an F value of 592, much greater than the 5 % critical value of 3.07. Thus, one can reject the null hypothesis of parameter stability and conclude that statistical evidence verifies the existence of a structural break.

5 The associated t-statistics are in parentheses. 39

Table 5. Dependent Variable (Savings) 1952:1 - 2008:3 1952:1 - 1985:2 1985:3 - 2008:3 Constant 97.9611 -8.9000 417.6667 (10.582) (-4.917) (22.603)

DPI 0.0142 0.1047 -0.0325 (6.696) (72.927) (-11.696)

F Value 44.8366 5318.3349 136.8037 Adjusted R2 0.1625 0.9756 0.5961 Durbin-Watson 0.171 0.624 1.178 No. Observations 227 134 93

The above results indicate that for the full time period (1952:1 – 2008:3) the marginal propensity to save was 0.0142. Thus, on average, holding all else constant, a $1 million increase in aggregate disposable personal income would increase aggregate personal savings by $14,200.

However, this measure of marginal propensity to save is irrelevant since a structural break was found. For that reason, the time period before the structural break (1952:1 – 1985:2) estimates that on average, holding all else constant, a $1 million increase in aggregate disposable personal income would increase aggregate personal savings by $104,700. Likewise, the time period after the break

(1985:3 – 2008:3) estimates that on average, holding all else constant, a $1 million increase in aggregate disposable personal income would decrease aggregate personal savings by $32,500. This result is quite remarkable as it reveals a post-structural break marginal propensity to consume greater than one.

If Milton Friedman’s theory of consumption were valid, especially the part that disregards social elements and assumes a constant savings rate across all incomes, then the aggregate personal savings should also grow at the same rate as income. To see where the savings constancy fails, you can compare the actual aggregate savings with an estimated aggregate savings. The estimated 40 aggregate savings were obtained by using the estimates of the pre-structural break. As Figure 5 reveals, the estimated aggregate savings accurately described the actual aggregate savings until the occurrence of the structural break. Furthermore, when the estimated aggregate savings was extrapolated to the full time frame (Figure 6) the estimated savings greatly differed from the actual aggregate savings.

Figure 5. Actual versus Estimated Figure 6. Extrapolated Estimated Savings versus Actual $400 $1,200

$350 $1,000 $300 $800 $250 $600 $200 $400

Savings ($B) $150 Savings ($B) $200 $100

$50 $0

$0 -$200

Savings Estimated Savings Actual Estimated

Likewise, Figure 7 plots the actual aggregate savings versus the corresponding aggregate disposable personal income. In terms of aggregate savings in relation to aggregate disposable personal income, a linear relationship between savings and disposable personal income exists.

Again, this seems to validate Friedman’s claim that savings is constant across all incomes.

Unfortunately, further introspection reveals a break in the linear trend around the $5 Trillion disposable personal income level. 41

Figure 7. Aggregate Savings vs Disposable Personal Income $500 $400 $300 $200 $100 $0 ‐$100 $0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 Aggreate Disposable Personal Income Personal Savings ($Billions) Savings

When Figures 5 and 6 are viewed in regards to pre (Figure 8) or post (Figure 9) structural break,

their respective positive and negative trends are easily distinguishable across aggregate disposable

personal income levels.

Figure 8. Aggregate Savings Figure 9. Aggregate Personal $400 Savings Rate (1985:3 - 2008:3) 10% $350 $300 8%

$250 6% $200 4% $150 2% $100 Aggregate Savings ($B) 0% $50 Aggregate Personal Rate Savings $0 -2% $0 $1,000 $2,000 $3,000 $4,000 $0 $5,000 $10,000 $15,000 Aggregate Disposable Personal Aggregate Disposable Personal Income ($B) Income

Savings Linear (Savings) Savings Rate Linear (Savings Rate)

Together, the recursive residuals test and the Chow Test statistically validate the existence of parameter instability in the marginal propensity to save. Duesenberry alludes to the possibility of a structural break when he stated that “if, over a long period of rising income, the net influence of the factors just 42 listed is small we can predict an approximately constant savings ratio. On the other hand, if those factors operate in such a way as to discourage saving we should predict a falling ratio (57).” Apparently those factors discouraged savings in light of rising aggregate income.

These results coincide with the previously stated idea that, holding all else constant, emulation would lead society to a euphoric need to consume and ultimately, result in the marginal propensity to consume around one. In light of that fact, the results are impressive as they statistically validate parameter instability in the marginal propensity to save, estimate a negative marginal propensity to save post structural break, and invalidate Friedman’s argument that savings rate should be constant across all incomes.

SAVINGS RATE AND INCOME INEQUALITY

If consumer debt is the means which enables individuals to emulate the consumption of

others, then the ensuing consumption externalities should constrain the emulators and increase the

relative income inequality6 within each reference group. The rise in aggregate income inequality

over the years is evidenced by Figure 10.

Income Inequality

0.48 0.46 0.44 0.42 0.4 Gini Coefficient 0.38 1967 1972 1977 1982 1987 1992 1997 2002 2007 Year GINI

Figure 10

Linking the decline in the savings rate to rising income inequality has been demonstrated by

Frank and Levine (Expenditure Cascades) as they claim that “a simple model incorporating context

dependence predicts a clear link between income inequality and observed savings rates.” They also assert that “such a model predicts, for example, that the savings rate of any reference group will decline when income inequality within that group rises.” Additionally, they argue “the observed patterns in the savings data should mirror the corresponding patterns in the inequality data.”

Furthermore, this corresponds with Duesenberry’s belief that “when the Lorenz curve is given, the savings ratio depends on position in the income distribution rather than upon absolute income (39).”

6 Throughout the analysis the Gini coefficient is used as the measure of income inequality. The data are taken from the U.S. Census Bureau. 44

A simple OLS regression shows that the first difference of the personal savings rate is

negatively related to the first difference of the Gini coefficient and the first difference of the

household financial obligations ratio7. The results are economically and statistically significant.

However, the direction of causation is unclear. Table 6 shows that on average, holding all else constant, a 1 point change in the Gini coefficient will reduce the personal savings ratio by .802 percentage points. Also, on average, holding all else constant, a percent change in the household financial obligations ratio will reduce the personal savings ratio by 1.196 percentage points. This result is significant and brings to light the consequences of increasing consumption externalities.

Unfortunately, there could be contemporaneous effects where a decline in the savings rate increases the income inequality, which leads to a further decrease in the savings rate as individuals’ consumption externalities increase.

Table 6. Dependent Variable (∆Personal Savings Rate) t-statistics in parentheses Constant -.009 (-0.049)

∆Gini -.802** (-2.505)

-1.196** ∆HFO (-2.671)

F Value 6.150*** Adjusted R2 0.284 No. Observations 27 Sample period is from 1981 – 2007. Statistical significance at the 5% level is implied by ** while *** implies significance at the 1% level.

7 This ratio is expressed as household financial obligations as a percent of disposable personal income and is provided by Board of Governors of Federal Reserve System. 45

As Figure 11 indicates, the aggregate personal savings rate8 is a declining function of income inequality. Although it is unclear which direction the causation runs, the relationship between income inequality and the personal savings rate should not be overlooked. If in fact the rising income inequality and the declining savings rate are due to consumption externalities, then emulation or the demonstration effect could go a long way in explaining an individual’s consumption behavior.

To get at the causation, Granger Causality Tests were performed on the following variables: the aggregate savings ratio, Gini coefficient, Consumer Sentiment9 (CS), Spread10, and the household financial obligations (HFO) ratio. The corresponding relationships between the aggregate personal savings rate and the other variables are displayed in figures 11-14.

Figure 11. Savings Rate vs. Gini Figure 12. Personal Savings Coefficient Rate vs. Household Financial 12% Obligations % DPI 12% 10% 10% 8% 8% 6% 6%

4% 4%

2% Personal Savings Rate 2% Personal Savings Rate

0% 0% 0.35 0.40 0.45 0.50 15% 16% 17% 18% 19% 20% Gini Coefficient HFO % DPI

8 Aggregate Savings Rate is taken from annual NIPA. 9 University of Michigan Consumer Sentiment. Survey Research Center, University of Michigan. 10Annual average. Interest Rate Spread between the 10 year Treasury constant maturity and the effective Fed Funds rate. 46

Figure 13. Savings Rate vs. Figure 14. Househould Financial Interest Rate Obligations % DPI vs. Gini 12% 20%

10% 19%

8% 18% 6% 17% 4% HFO % DPI

2% 16% Personal Savings Rate

0% 15% 0% 5% 10% 15% 0.38 0.4 0.42 0.44 0.46 0.48 10 Year Constant Maturity Interest Rate Gini Coefficient

Clearly, a distinguishable relationship exists between the savings rate and Gini coefficient as well as the percent of HFO to DPI and the Gini coefficient. Given that the individual data show consumer debt (the degree of emulation) to be a significant variable reducing an individual’s amount of savings, the following Granger Causality Tests reveal whether these variables are behind the U.S. savings paradox. The testing is important as it could answer whether or not the paradox is a result of consumption externalities that arise in theoretical models and empirical testing. All variables except the interest rate spread were made stationary by taking the first difference and the Akaike information criterion suggested a lag length of one year. In each case, the null hypothesis is that the variable does not granger cause the other variable. The sample covers the time period 1978 – 2007 and a summary of the results are listed above in Table 7.

The fact that most of the results are statistically insignificant suggests that the variables are independent of each other. However, the results do establish the causation for four relationships.

Intuitively, the one making the most economic sense is that the interest rate spread granger causes the savings rate. This is appealing given that the spread typically widens during sluggish or 47 recessionary economic environments. This often results in an increased incentive to save due to the higher degree of uncertainty surrounding the future economic environment.

Table 7. Granger Causality Results

Null Hypothesis Obs. F-Stat P-value Decision

Savings Rate → Gini 28 1.052 0.314 Do not reject

Gini → Savings Rate 28 3.206 0.085 Reject*

Savings Rate → HFO 26 0.595 0.448 Do not reject

HFO → Savings Rate 26 0.030 0.862 Do not reject

Savings Rate → Spread 28 1.881 0.182 Do not reject

Spread → Savings Rate 28 5.809 0.023 Reject**

Savings Rate → CS 28 1.146 0.294 Do not reject

CS → Savings Rate 28 0.487 0.491 Do not reject

HFO → Spread 26 0.908 0.350 Do not reject

Spread → HFO 26 1.201 0.284 Do not reject

HFO → Gini 26 4.821 0.038 Reject**

Gini → HFO 26 0.373 0.547 Do not reject

HFO → CS 26 0.041 0.840 Do not reject

CS → HFO 26 6.242 0.002 Reject***

Statistical significance at the 1% level is implied by ***, at the 5% level by **

and significance at the 10% level is implied by *. Ho: variable A does not

Granger Cause Variable B. Ha: Variable A Granger Causes variable B.

More importantly the results indicate that the aggregate savings rate is dependent on social factors. This can be seen given that consumer sentiment (CS) granger causes household financial obligations (HFO), which in turn granger causes the Gini coefficient, which granger causes the aggregate personal savings rate. Under this string of causalities, an argument could be put forth that 48

the consumption externalities resulting from a society taking on more debt in its attempt to emulate

or demonstrate the consumption of a particular reference group increases income inequality. It

should be noted that a small minority of people, particularly the wealthiest individuals in society, will not have to worry about emulating a higher reference group as they gain reputability via an invidious comparison.

Since there is no pressure on the rich to ratchet up their consumption, they focus their attention on increasing their earnings potential in order to gain a favorable comparison. However,

they only account for a small portion of society and cannot control the consumption behavior of

others. Hence, the income inequality would rise as a result of a society fixated on current

consumption rather than earnings potential. Therefore, the rising income inequality decreases the

aggregate personal savings rate and explains the U.S. savings paradox.

CONCLUSIONS

Mainstream economics continues to approach consumer theory in the neoclassical manner of maximizing utility under independent preferences and financial constraints. In terms of consumption behavior, the field overwhelmingly embraces the idea the individuals have time variant consumption functions that are independent of others. Unfortunately, this approach is misleading as it fails to account for the impact that social phenomena have on consumption decisions. While the first attempts to incorporate social elements in consumer theory were originally rejected, empirical evidence continues to support the importance that social phenomena have on consumption.

With regard to the U.S. savings paradox, the individual and aggregate evidence suggests that individuals and society are caught up in a consumption race which has led to many unintended consequences. With such consequences being an increasingly leveraged society (household financial obligations as a percent of disposable personal income), increased income inequality, and the lowest savings rate in the developed world. The results conducted at the individual and aggregate levels were economically and statistically significant and raise the question of whether or not policy should be directed at today’s consumption arms race. Nevertheless, one thing is certain, if the economics field is to further understand consumer theory, then it must accept the fact that social variables are important in explaining consumption behavior.

Bibliography Alessie, Rob, and Annamaria Lusardi. "Consumption, savings and habit formation." Economics Letters, 1997: 103-108.

Alpizar, Francisco, Fredrik Carlsson, and Olof Johansson-Stenman. "How much do we care about absolute versus." Journal of Economic Behavior and Organization, 2005: 405-421.

Alvarez-Cuadrado, Francisco. "Envy, leisure, and restrictions on working hours." Canadian Journal of Economics, 2007: 1286-1310.

Alvarez-Cuadrado, Francisco, and Ngo Van Long. "A Permanent Income Version of the Relative Income Hypothesis." CESifo Working Paper No. 2361, 2008.

Arrow, Kenneth J., and Partha Dasgupta. "Conspicuous Consumption, Inconspicuous Leisure." James Meade Centenary meeting. London, 2007.

Bagwell, Laurie Simon, and B. Douglas Bernheim. "Veblen Effects in a Theory of Conspicuous Consumption." The American Economic Review, 1996: 349-373.

Basmann, Robert L, David J. Molina, and Daniel J Slottje. "A Note on Measuring Veblen's Theory of Conspicuous Consumption." The Review of Economics and Statistics, 1988: 531-535.

Bowles, Samuel, and Yongjin Park. "Emulation, Inequality, and Work Hours: Was Thorstein Veblen Right?" The Economic Journal, 2005: 397-412.

Campbell, John Y., and N. Gregory Mankiw. "Permanent Income, Current Income, and Consumption." Journal of Business and Economic Statistics, 1990: 265-279.

Carroll, Christopher D., Jeffrey C. Fuhrer, and David W. Wilcox. "Does Consumer Sentiment Forecast Household Spending? If So, Why?" The American Economic Review, 1994: 1397-1408.

Cole, Harold L., J. George Mailath, and Andrew Postlewaite. "Social Norms, Savings Behavior, and Growth." The Journal of Political Economy, 1992: 1092-1125.

Corneo, Giacomo, and Olivier Jeanne. "Pecuniary emulation, inequality and growth." European Economic Review, 1999: 1665-1678.

Corneo, Giacomo, and Olivier Jeanne. "Social organization, status, and savings behavior." Journal of Public Economics, 1998: 37-51.

Cuervo-Cazurra, Alvaro. "Better the Devil You Don't Know; Types of Corruption and FDI in Transition Economies'." Journal of International Management, 2007.

Direr, Alexis. "Interdependent Preferences and Aggregate Saving." Social Interactions and Economic Behavior, 2001: 297-308. 51

Duesenberry, James S. Income, Saving, and the Theory of Consumer Behavior. Cambridge: Harvard University Press, 1949.

Dupor, Bill, and Wen-Fang Liu. "Jealousy and Equilibrium Overconsumption." 2002.

Dynan, Karen E., Jonathan Skinner, and Stephen P Zeldes. "Do the Rich Save More?" Journal of Political Economy, 2004: 397-444.

Ewing, Bradley T., and James E. Payne. "The Long-Run Relation Between The Personal Savings Rate and Consumer Sentiment." Financial Counseling and Planning, 1998: 89-96.

Frank, Robert H. Choosing the Right Pond; Human behavior and the quest for status. New York: Oxford University Press, 1986.

—. Luxury Fever. New York : The Free Press, 1999.

Frank, Robert H. "The Demand for Unobservable and Other Nonpositional Goods." The American Economic Review, 1985: 101-116.

Frank, Robert H., and Adam Seth Levine. "Expenditure Cascades."

Friedman, Milton. A Theory of the Consumption Function . Princeton University Press, 1957.

Fuhrer, Jeffrey C. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models." The American Economic Review, 2000: 367-390.

Garriga, Carlos. "Overconsumption, reference groups, and equilibrium efficiency." Economics Letters, 2006: 420-424.

Gujarati, Damodar N. Basic Econometrics. New York: McGraw-Hill , 2003.

Harbaugh, Richmond. "Falling Behind the Joneses: Relative Consumption and the Growth-Savings Paradox." Economics Letters, 1996: 297-304.

Kawamoto, Koichi. "Status-Seeking Behavior, the Evolution of Income Inequality, and Growth." 2007.

Kennickell, Arthur B. The Role of Over-sampling of the Wealthy in the Survey of Consumer Finances. Washington, DC: Federal Reserve Board, 2007.

Keynes, John Maynard. The General Theory of Employment, Interest and Money. New York: Harcourt, Brace & World, 1936.

Mason, Roger S. The economics of conspicuous consumption : theory and thought since 1700. Cheltenham, UK: Edward Elgar, 1998. 52

Mason, Roger. "The Social Significane of Consumption: James Duesenberry's Contribution to Consumer Theory." Journal of Economic Issues, 2000: 553-572.

Maurer, Jurgen, and Andre Meier. Do The "Joneses" Really Matter? Peer-Group Versus Correlated Effects In Intertemporal Consumption Choice. The Institute For Fiscal Studies, 2005.

Mayer, Thomas. Permanent income, wealth, and consumption: a critique of the permanent income theory, the life- cycle hypothesis, and related theories. University of California Berkely Press, 1972.

Peng, Baochun. "A Model of Veblenian Growth." Topics in Macroeconomics, 2006.

Veblen, Thorstein. The Theory of the Leisure Class. London: Unwin Books, 1899; reprinted New York: Cosimo, 2007.

Wärneryd, Karl-Erik. The psychology of saving : a study on economic psychology. Northhampton: E. Elgar, 1999.

Wisman, Jon D. Household Saving, Class Identity, And Conspicuous Consumption. Working Paper No. 2008-19, Washington, D.C.: American University, 2008.