Economists giving pp on Milton Friedman’s biggest idea – Permanent Income Hypothesis

Today is perhaps a Friedman day on Mostly Economics.

Noah Smith the usually good economist turned columnist has a piece. He says how more and more empirical evidence is coming against Friedman’s biggest idea – Permanent Income Hypothesis:

One of the core pieces of modern macroeconomic theory, handed down to us by the great Milton Friedman, probably missed the mark. And now it might be on the way out. And this shift has big implications for how we think about economic policy and finance.

The idea is called the permanent income hypothesis (PIH). Friedman first put it on paper in 1957, and it still holds enormous sway in the econ profession. The PIH says that people’s consumption doesn’t depend on how much they earn today, but on how much they expect to earn over their lifetime. If a one-time windfall of money drops into your lap, says Friedman’s theory, you won’t rush out and spend it all — you’ll stick it in the bank, because you know the episode won’t be repeated. But if you get a raise, you might start spending more every month, because the raise was a signal that your earning power has increased for the long term.

That assumption about human behavior has huge implications for policy. If true, the PIH means that the effectiveness of a fiscal stimulus is likely to be a lot lower than economists thought in the 1960s. If the government tries to goose spending by mailing people checks, people will just deposit the money in the bank, instead of going out and consuming.

It’s also important for finance. Lots of academic theories are based on the PIH. Friedman’s idea says that consumers want to smooth out their consumption — they don’t like dips. So in theory people will spend a lot for financial assets that pay off during recessions, allowing them to avoid tightening their belts.

PIH is so dominant that almost all modern macroeconomic theories are based on it. They enshrine the idea with a formula called a “consumption Euler equation,” which has appeared in the vast majority of academic macro models during the past few decades. Those are the models that many central bankers use to set interest rates.

So it’s not much of an exaggeration to say that Friedman’s PIH is the cornerstone of modern macroeconomic theory. Unfortunately, there’s just one small problem — it’s almost certainly wrong.

Not completely wrong, mind you, just somewhat wrong. There probably are a lot of consumers out there who do behave just the way that Friedman imagined. But the problem is, there are a lot of others who act very differently. Slowly, economists have been building up evidence that the latter group is important and sizable

He points to several studies which show PIH does not stand true. People tend to spend money as soon as they receive it no matter how temporary the inflow:

The mounting evidence against the PIH — the papers I cited are only a small sampling — is causing economists to cast around for an alternative. My Bloomberg View colleague Narayana Kocherlakota recently blogged that:

The choices made 25-40 years ago – made then for a number of excellent reasons – should not be treated as written in stone or even in pen. By doing so, we are choking off paths for understanding the macroeconomy.

Kocherlakota thinks macroeconomists should set aside their big, complex formal models of the economy, since these elaborate constructions are built on a foundation that probably doesn’t describe reality all that well. He recommends that economists go back to the drawing board, and look around for new, more accurate kernels of insight with which to build the theories of tomorrow.

In the meantime, we should all recognize that Milton Friedman’s ideas might have been too influential. His impact on economics was deep and lasting, but this theory, at least, hasn’t stood the test of time.



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