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The Permanent Income Hypothesis

from Lars Syll

150514006_4Milton Friedman’s Permanent Income Hypothesis (PIH) says that people’s consumption is not affected by short-term fluctuations in incomes since people only spend more money when they think that their lifetime incomes change. Believing Friedman is right, mainstream economists have for decades argued that Keynesian fiscal policies, therefore, are ineffectual.

As shown over and over again for the last three decades, empirical facts totally disconfirm Friedman’s hypothesis. The final nail in the coffin is recent research from Harvard:

We compare the path of spending during unemployment in the data to three benchmark models and find that the buffer stock model fits better than a permanent income model or a hand-to-mouth model …

Using rich category-level expenditure data, we find that work-related expenses explain only a modest portion of the spending drop during unemployment. The overall path of spending for a seven-month unemployment spell is consistent with a buffer stock model where agents hold assets equal to less than one month of income at the onset of unemployment. Because unemployment is such a large shock to income, our finding that spending is highly sensitive to income overcomes the near-rationality critique applied to prior work. Finally, we document a puzzling drop in spending of 11% in the month UI benefits exhaust, suggesting that families do not prepare for benefit exhaustion.

Peter Ganong & Pascal Noel

So — now we know that consumer behaviour is influenced by short-term fluctuations in incomes and that this is true even if consumers know that their situation may well change in the future. 

Since almost all modern mainstream macroeconomic theories are based on PIH –standardly used in formulating the consumption Euler equations that make up a vital part of ‘modern’ New Classical and New Keynesian macro models — these devastating findings are extremely problematic.main-qimg-1b106c1df117b1c788bd8f4089d394e3-c

In many modern macroeconomics textbooks, one explicitly adopt a ‘New Keynesian’ framework, adding price rigidities and a financial system to the usual neoclassical macroeconomic set-up. Elaborating on these macromodels, one soon arrives at specifying the demand side with the help of the Friedmanian Permanent Income Hypothesis and its Euler equations.

But if people — not the representative agent — at least sometimes cannot help being off their labour supply curve — as in the real world — then what are these hordes of Euler equations that you find ad nauseam in these ‘New Keynesian’ macromodels gonna help us?

My doubts regarding macroeconomic modellers’ obsession with Euler equations is basically that, as with so many other assumptions in ‘modern’ macroeconomics, Euler equations, and the PIH that they build on, don’t fit reality.

In the standard neoclassical consumption model, people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? The Euler equation used implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Further, in the Euler equation, we only have one interest rate, equated to the money market rate as set by the central bank. The crux is, however, that — given almost any specification of the utility function – the two rates are actually often found to be strongly negatively correlated in the empirical literature!

From a methodological pespective, yours truly has to conclude that these kind microfounded macroeconomic models are a rather unimpressive attempt at legitimizing using fictitious idealizations — such as PIH and Euler equations — for reasons more to do with model tractability than with a genuine interest of understanding and explaining features of real economies. Mainstream economists usually do not want to get hung up on the assumptions that their models build on. But it is still an undeniable fact that theoretical models building on piles of known to be false assumptions — such as PIH and the Euler equations that build on it — in no way even get close to being scientific explanations. On the contrary. They are untestable and hence totally worthless from the point of view of scientific relevance.

Ganong’s and Noel’s research finally shows that mainstream macroeconomics, building on the standard neoclassical consumption model with its Permanent Income Hypothesis and Euler equations, has to be replaced with something else. Preferably with something that is both real and relevant, and not only chosen for reasons of mathematical tractability or for more or less openly market fundamentalist ideological reasons.

  1. June 17, 2018 at 8:19 pm

    The Permanent Income Hypothesis requires perfect present and future knowledge not to mention an utter disregard of use-values which can and do alter through time. When ‘utility’ excludes use-values, it is completely empty of useful content.

    It’s pure Chicago School nonsense meant to undermine the judicious use of fiscal policy.

  2. June 17, 2018 at 8:28 pm

    Meant to add that since the “Euler equation used implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow”, then the ‘representative’ agent is indifferent to meeting basic needs now versus next year.

    As I have pointed out, this means that such representative agents cannot be life-forms, much less human beings.

    And, as I have also pointed out before, the ‘firm’ is also a consumer of goods and services to obtain a benefit from doing so. No ‘firm’ could be as indifferent to their ‘whens’ as consumers as a Permanent Income/Profits Hypothesis requires or their activities as consumers.

  3. Jan Milch
    June 18, 2018 at 12:42 am
  4. Helen Sakho
    June 18, 2018 at 1:23 am

    A match made in heaven.

  5. Craig
    June 18, 2018 at 2:59 am

    Heard this all before. What are the policies of the new heterodox alternatives?

  6. Helen Sakho
    June 18, 2018 at 12:47 pm

    None

    • Craig
      June 18, 2018 at 8:51 pm

      Actually Helen they do have some half baked and not thoroughly informed policies as enumerated in this blog post:

      Upon Viewing my 203rd Steve Keen Video
      So far as economics is concerned you can’t get any more basic than the point of exchange itself, and any more integrative than the infrastructure upon which all exchange takes place and is accounted for than double entry bookkeeping…..and economists do not look/do not go there….and so do not discern the monetary and economic significances to be found at these points in time and with that discipline.

      Keen, who is the best of the heterodox economists and from whom I have learned much so far as correct macro-economics is concerned….still has not crashed through the haze of the monopolistic and parasitic paradigm of Debt Only by looking where I have been suggesting he look for like 4-5 years.

      He also hasn’t taken my advice and started a mass movement by and for the individual and the small to medium sized business community because they are both who the policies I suggest will benefit from the most and also the constituencies big enough to herd the politicians toward implementation of them. He’s still trying to convince a very small constituency of academics who are egocentrically opposed to him….despite continually quoting Max Planck about how “science advances one funeral at a time.” I don’t get it.

      Then he suggests debt write downs/debt jubilee as a policy despite it being only of a one off STATIC nature, the character of which he has long opposed in his correct de-bunking of DSGE.

      He also advocates UBI/universal dividend even though he apparently has no idea from where and when it originated, and also has none but orthodox ideas about how to finance it so that it would be effective instead of an eventual opportunity for regressive thinkers to critique and reverse it….because despite liberal orthodoxy it would inevitably cause inflation….because money itself is not the operant factor in “monetary inflation.

      Finally, he has absolutely no idea of how to synergize the positive effects of a universal dividend with discount/rebate policies throughout the entire economic process and at its terminal ending point.

      I’m tired of otherwise smart guys being such blinkered and shallow thinking mere theorists and reformers when if they took the closer look, had paradigm perception and had the guts and intelligence to step out and oppose Finance in a politically savvy way they’d actually change the world.

      wisdomicsblog.com

  7. June 18, 2018 at 10:22 pm

    The utility of wealth should be modeled as purchasing security, social rank, and the like. Not as temporally displaced consumption. From this a surprising amount follows: Inequality is a gigantic inefficiency. Pensions based on savings are wrong. Inflation is good.

  8. Helen Sakho
    June 19, 2018 at 12:49 am

    And so it is intended to be.

  9. David Harold Chester
    June 19, 2018 at 9:21 am

    Strictly, social justice (expressed as capitalism) demands that the funding a person saves during his/her working life should be used to more than cover the person’s eventual pension needs. (More, because the life span is an unknown.) Obviously many workers have such low earnings that they cannot achieve this reserve funding, and rather than see them starve or become homeless or both, the better-paid part of our society should support them as well as using the “left-overs” from the pensioners.

    Consequently true social justice combines monetary strictness with the care for human dignity and life support, which might be termed a necessary and charitable form of socialism. As good human beings, we have no choice but to embrace these opposing trends and live ethical lives regardless of the capitalistic trends.

  10. Helen Sakho
    June 19, 2018 at 11:44 am

    Please be mindful of the extremely visible boot as it turns left and right and back again at extraordinary speed, particularly targeting the weak and the vulnerable of all ages, pleading ignorance and promising never-ending state inquiries into perfectly visible disasters.

  11. June 26, 2018 at 10:38 am

    This sort of BS is like the carnival huckster who promises a show with lions, and tigers, and bears that he doesn’t have and never presents, but after the show tells you how lucky you are to have seen his lions, and tigers, and bears. Friedman obviously dreamed up the Permanent Income Hypothesis sitting in an easy chair in some rich guy’s parlor. Friedman also obviously has no experience of working, being laid off, or managing limited money during the layoff. This should be the minimum experience required before offering such a rubbish theory. That this guy is considered by some as a major economic thinker and won a Nobel Prize (even a fake one) shows us just how useless and dangerous economics as an academic discipline is.

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