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April 28, 2013

Slate: A better way to manage your household budget

CHICAGO — When I meet people on airplanes and they find out I'm an economist, they usually ask about stock tips. When I explain I'm not that kind of economist, they next ask why we couldn't predict the crisis. I'm not that kind of economist, either. Sometimes, they end with something about household budgeting — how do I know if I'm overspending on rent? I'm not really that kind of economist either — no academics are. But in this case, I think I might know more than the usual experts.

Most people who want to know about household budgeting turn to someone like personal finance guru Dave Ramsey, who has a carefully crafted household budgeting system. His, like many others, relies on a simple idea — sometimes called the "envelope system" — where you put your gas money in one envelope, your grocery money in another, etc., and spend only within a category.

This idea is clear and elegant — even if you don't actually use an envelope, it seems like it could be easy to stick to, and it has a nice old-timey feel. There is a problem, though: It is in violation of basic economic principles.

The principle in question here is that "money is fungible." In reality, all dollars are the same. There is no such thing as a gas dollar, a grocery dollar, a "fun" dollar. The Ramseys of the world argue you should just apportion them into the envelopes depending on what you think you might spend. But doing it this way is not actually the best way to dole out your money; you are not optimizing. Your money is just not working as hard as it should.

The system works great, as long as nothing ever changes. But the minute that some price changes, you're in trouble. Here's an extreme example. Imagine you drive to work, and your "gas money" envelope contains enough money to get you to work for the month, and maybe a little cushion. But then gas gets more expensive. You may first react by switching to a worse grade — say, from premium to regular (research shows many people do this). But if gas prices go up even more you simply will run out of money in the gas envelope. And then you won't be able to get to work. Strictly following the envelope system here would be much, much worse than "cheating": It's certainly bad for your household budget if you miss work.

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