At the heart of the economic theory of Milton Friedman, a giant in the field of eocnomics, is the idea that people do not spend based on what they earn today, but rather on what they expect to earn in a lifetime. This permanent income hypothesis (PIH) is still central to economic theory.<\/p>\n
Noah Smith writes:\u00a0\u00a0 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.<\/p>\n
It\u2019s also important for finance. Lots of academic theories are based on the PIH. Friedman\u2019s idea says that consumers want to smooth out their consumption — they don\u2019t 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.<\/p>\n
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.<\/p>\n
A blow to the mathematical version of the theory came in 2006, when Georgetown economists Matthew Canzoneri, Robert Cumby and Behzad Diba wrote a paper testing the consumption Euler equation directly against real financial data — something that, for reasons that escape me, no economist seems to have actually tried before. The equation says that when interest rates are high, people save more and consume less — this is the way they smooth their consumption, as Friedman predicted. But Canzoneri et al. found that the opposite is true — for whatever reason, the fact is that people tend to consume more when rates are high.<\/p>\n","protected":false},"excerpt":{"rendered":"
At the heart of the economic theory of Milton Friedman, a giant in the field of eocnomics, is the idea that people do not spend based on what they earn today, but rather on what they expect to earn in … Continue reading