Laura Rowley Money & Happiness

Many financial pundits recommend you start putting away money in your early 20s if possible, because the power of compounding is formidable over time. But lately, a number of economists have been recommending the opposite.

Consider a post from University of Chicago economist Stephen Levitt on his "New York Times" Freakonomics blog last week. It was headlined: When It Comes to Saving, Who Would You Listen to: My Wife or Milton Friedman?

Levitt says that when he was a first-year assistant professor, department chair Jose Scheinkman shared some advice that Nobel Laureate Milton Friedman had given him when he started out: Don't save too much.

Theoretically, Levitt would be able to make it up in later years when his income was higher. Since the purpose of saving is to smooth out your consumption over time, Levitt writes, you should "borrow when times are bad and save when times are good." Levitt says he didn't follow the advice as fully as he should have, because his wife insisted they save.

Milton Friedman may have been an economic genius, but Levitt's wife has a better handle on real-world money issues. If you're trying to figure out whether to save or splurge in your early working years, go beyond theory and consider these five issues:

"In academia, you may have a stable salary and pension -- but that's not how the rest of the world works," says attorney and financial planner Charles Farrell of Northstar Investment Advisors in Denver. "People change jobs and careers, move across the country. Maybe they were making $100,000 and the new job pays $75,000. Or workers in the Midwest go from manufacturing jobs where they made $80,000 a year with overtime into the service industry to find out they're worth $40,000."

Jacob Hacker, Yale professor of political science and author of "The Great Risk Shift", has found that short-term family income volatility doubled between 1969 and 2004. Ten percent of working-age Americans experienced a drop of 50 percent or more in their family income in the early 2000s -- up from 4 percent in the early 1970s.

The instability increased more for Americans with at least four years of college than for those with only a high school education. Moreover, if you plan to have children, or have parents who will be elderly when you hit your late 30s and 40s, you may find your income disappears for some period of time. Women spend an average of 11 years outside the workforce caring for children or aging parents.

The risks of an income drop "hit us hardest when we have extended ourselves financially to achieve our dreams," writes Hacker, adding that, if you face unexpected expenses, "setting aside even a small share of your income for retirement [is] a safety valve you can release by postponing your contributions for a while."

"Being in debt can be extremely nerve-racking, whereas saving regularly and having some sort of nest egg gives you a wonderful sense of control," says Jonathan Clements, director of financial guidance for MiFy -- a new advisory service from Citigroup -- and former "Wall Street Journal" columnist. "There's a real psychic value in having a small pot of money."

In a paper published in the "Journal of Economic Psychology", researchers Peter Lunt and Sonia Livingstone found a psychic payoff from saving even among people who had debt (something no economist would recommend given the typical interest-rate arbitrage).

"Those who save up out of their income at the same time as paying off debts (rather, say, than paying off their debts faster) felt more in control of their finances and more optimistic about their future than those who did not or could not save while having debts," they wrote, adding that regular savers worried less about "unpredictable changes in economic conditions."

Roy Baumeister, author and social psychologist at Florida State University, studies how people resist temptation and change bad habits.

"Dr. Levitt's suggestion may make sound financial and economic sense," Baumeister wrote in an email from a writing retreat in Aruba. "But self control works like a muscle, and developing good habits of self control when one is young provides an important psychological foundation for later life." (Baumeister says his retreat was made possible, in part, by an early savings habit.)

New York financial planner Gary Schatsky agrees. "I understand at age 21 if you're earning $25,000 and you don't have the ability to save," he says. "But if you don't start early, you'll forever defer saving until some future period of time when your salary is higher, and allow spending to rise faster than it would have otherwise."

In recent months, revolving credit card use has increased at its sharpest rate in seven years, as consumers who were using home equity to "smooth their consumption" find that the spigot has run dry. At the same time, the rules of the game are moving against debtors, as lenders begin to reduce credit card limits and damage credit scores.

Meanwhile, the shorter your time horizon, the lower the likelihood of getting the investment returns you anticipate. "Performance over a long period is better," says Schatsky. "There are many more poor 10-year [return] numbers than 20-year numbers or 30-year numbers."

Buying more stuff in your 20s offers temporary joy and lots of inventory to sell on eBay in your 30s. A host of research -- see this, this, and this column - has found that material goods don't buy happiness.

"You lust after the new car, but three months after you purchase it the thrill is gone and it's just another thing you drive around town," says Clements. "Hedonic adaptation is something we cannot escape. The idea that consuming more is going to make us happy is a piece of financial foolishness."

Meanwhile, running up debt to consume in your 20s may come back to haunt you in your 40s. "If you're 22, you are wildly enthusiastic about your career and imagine working at it for the rest of your life," says Clements. "By the time you're 45, the world doesn't seem quite so exciting -- you start to think about changing careers, downshifting, working part-time. If you started saving diligently when you got into the workforce, all of those are options. But if you spent your 20s accumulating debt, you may have a totally secure job and no option but to go to the office in the morning."

Finally, as Farrell points out, nobody knows if the consumption-smoothing advice panned out for the great Nobel Prize winner himself: "All I know is Milton Friedman was working when he was 90 -- so who knows if he did well or not?"