Monday, 29 November 2010

Hard Times?

It is the beginning of term and you might quickly become miserable about the important expenditures to be made on big nights and new outfits. Once university fees are paid there seems so little money left and every penny spent is just more that you owe the government. A little economic analysis, however, reveals that a student's finances are no nightmare. In fact, they make a lot of sense. 

The starting salary of an Oxford graduate is on average £24,000 which builds up to £40,000 within just 5 years and it is these longer term statistics, according to Nobel prize-winning economist Milton Friedman, that you should focus on when making spending decisions. The central idea of his Permanent Income Hypothesis is that people spend according to what they think is their average income. It is common sense that on pay day you know not to spend all of your wages because they have to last until the next one. Friedman simply extends this idea over a larger time frame. He thinks that people should not only divide their income equally from month to month, but from year to year in order to achieve a constant standard of living over their lifetimes. Any fluctuations in income can be smoothed by saving in periods of unusually high income, and borrowing in times of financial woe. 
This is what students do; the moderate amount of debt they take on today increases their future expected income which will more than cover the cost of their loan. And the loan provided by the government is in fact a good deal. The cost of borrowing from a private bank starts at around 8%, exceeding the upper end estimates (4.4%) of the government's rates this year. This is the best loan of your life!

If you take Friedman's reasoning further, then you find that students are conservative in their spending patterns. This is because the education that you are paying for now significantly raises your lifetime income. Those of you who are very optimistic about your future earnings (I'm talking to the business and engineering students out there, sorry arts students) can afford to spend much more now! Unfortunately, you are, as they say in the parlance of economics, 'credit constrained', because no bank is willing to lend you a significant amount of money (at least, not at a decent rate). If you could borrow relative to your expected income (more) oxford students would be driving sports cars and holidaying in the Bahamas. Since you are credit constrained the next best thing to do is what your parents probably advised - divide your funds evenly across the period of constraint. 

From experience, I doubt that many of you will behave in line with homo economicus and keep to a strict weekly budget. Humans exhibit strong tendencies to be myopic and spendthrift at the expense of their future selves. With this in mind, when making spending decisions today, you might want to take into account the number of meals that you will be eating out of a can come the end of term. Apart from this, you should feel confident about your financial situation.

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