Managing a family’s budget can be similar, in many ways, to running a small business. There are sources of income, often diverse, and multiple expenses. Some appear incompressible while others can constitute adjustment variables. It may also appear necessary to save according to future objectives, but also to implement more or less offensive investment strategies depending on the problems we must face. Thinking about financing your children’s studies when they are still in elementary school is also a good way to show foresight and anticipation. These are also qualities required when it comes to running a business.
The question, as for the State currently, is also that of fair debt. When is it appropriate to take on debt in a household? Is this only a possibility when investing in housing? Or can we resort to borrowing in other situations? It is generally said that you should not resort to loans to cover operating expenses. But, in other cases, resorting to a loan, using specialized establishments like here, is a common practice. This ranges from the car to be financed to the children’s studies when it comes to particularly selective courses, for example. We can be sure of having a return on investment, which justifies the significant expense.
Milton Friedman and the theory of permanent income
To manage your finances effectively, it is always relevant to know some of the major economic theories presented in recent years and which have given rise to the publication of works that have enjoyed significant success. We can thus call on the ideas developed by Milton Friedman, and in particular his concept of permanent income. This theory postulates that consumers base their consumption not on their current income, but on their permanent income, that is to say the average of their past and future income. Thus, to adopt healthy management of its finances, a household should take into account its long-term income prospects and smooth its consumption over time.
Born in 1912 in the United States, Milton Friedman has had a strong impact on the recent history of economics, notably by publishing Capitalism and freedom in 1962, then appearing on television in a series of programs entitled Free to choose. Friedman’s liberal thought had a very significant impact from the 1980s, in the United States, by advising American President Richard Nixon, but also, in a much more controversial way, in Chile, with the famous Chicago Boys. This term ended up referring to Chilean students who came to train in Chicago in the 1970s, notably with Friedman.
Franco Modigliani and the life cycle
A theory that can complement Friedman’s theory is that of the life cycle. According to this principle, individuals seek to distribute their consumption optimally throughout their lives. During their working lives, they save for retirement, then spend their savings once they retire. To apply this theory, households must anticipate their future needs and adapt their savings accordingly. Midigliani’s works are mainly available in English, as well as Capital Marketshis most famous title.
Developed by the Italian-American economist Franco Modigliani (who died in 2003), this theory highlights the wealth situation of individuals according to their age. Thus, the child, although he does not have means as such, nevertheless contributes to influencing certain purchases made by his parents. As a teenager, he develops needs of his own, and often seeks to follow fashions. When we enter working life, we can consume, in particular by contracting debts, but also build up savings, which can be used later. Finally, when you reach retirement, you often seek to hold more liquid assets, to ensure financing needs which may be more or less significant, depending on the situation of your children, but also depending on your health.
Household finances and Keynesian theory:
John Maynard Keynes argued that consumption is primarily determined by disposable income. Thus, to improve their financial situation, households should seek to increase their income, for example by investing in their training or by negotiating a salary increase. Ultimately, Keynes’ vision is quite simple: if you consider that you need more funds to ensure your daily life, but also your investments, it is necessary to implement strategies to earn a better living.
Entering a training course to raise your level of qualification, and therefore your value on the job market, is a principle that often pays off. When you are a public employee, you can, for example, prepare for competitions to move into a higher pay category. A final solution remains to try to keep your job, but to develop the practice of overtime, or, more radically, to take a second job, as is often done in the United States. To get into the work of Keynes, you can take a look at the Ellipses editions, with Introduction to Keynes’ thought (2019, 336 pages) by Giuseppe Pagano, or directly seize his General theory of employment, interest and money (Payot, 2017, 496 pages, €26.40).
The theory of relative income:
This theory, developed by James Duesenberry, states that individuals compare their level of consumption to that of their peers. Thus, households may be encouraged to spend more to maintain their social status. To avoid this trap, it is important to set personal consumption goals and resist social pressure. The American economist went to theorize a principle that we have seen in the past strongly contribute to ruining the French nobility, caught in a frenzy of spending on representation in the 17th and 18th centuries. If one did not have the latest carriage, or the latest ceremonial outfit, one was perfectly “has-been”. As a result, crazy amounts of money can go up in smoke.
Sometimes called in French “demonstration effect”, or even “imitation effect”, the principles established by Duesenberry are in reality as old as time. We particularly tend to feel very strongly the discrepancies in resources with regard to the people close to us, whether friends, family or neighbors. That there are very rich people, from the moment we rarely cross their path, the problem exists quite weakly in our minds.
If the neighbor builds a swimming pool, keep in mind that it is your freedom not to want to build one a little bigger, just to show him that the lawn is decidedly greener on the other side of the fence! The same goes when he decides to change car to a more premium range. No point in selling your old car to try to compete in such ostentatious spending. Instead, just invest in a new rose bush. It will certainly last longer than the neighbor’s last car…
The Liquidity Preference Theory:
Keynes also developed this theory, which states that individuals prefer to hold liquid assets (like money) rather than less liquid assets (like stocks or real estate). To effectively manage their finances, households must therefore find a balance between holding liquid assets to cope with unforeseen events, and investing in less liquid but potentially more profitable assets. In particular, we can go for a walk near his Treatise on Currency which is recently available in French.
We must also take into account the fact that this return on assets varies greatly depending on when we invest, depending on where the assets are held, and depending on how we finance these investments. It is undoubtedly for all these reasons that it is important to do in-depth research before taking action on personal finances. And the major economic theories may have their interest in the management of sums which may nevertheless seem insignificant at first glance.
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