Mainstream Crap-o-nomics and Milton Friedman

An article published on Bloomberg.com yesterday by Noah Smith (Milton Friedman's Cherished Theory is Laid to Rest) brought back memories of my early endeavor and research in economics. Smith discusses some recent research on consumption theory that "proves" Milton Friedman's theory was wrong.  If these people who live in ivory towers simply read some of the real world heterodox research, it wouldn't have taken this long to figure it out!

One of the reasons I was attracted to what we call heterodox economics was because I found too many instances where traditional, or mainstream, economics seemed so unrealistic.  My original area of research was on US wealth distribution and related theories used to explain household consumption and saving, the source of wealth.  Mainstream theory was dominated by Milton Friedman's Permanent Income Hypothesis (PIH) and Franco Modigliani's (and Brumberg) Life-Cycle Hypothesis.  Both of these theories argued that we base our consumption (and therefore savings) on our permanent or life-time income.  That is, we are so smart that we base our consumption today on what our income will be over our lifetimes.

As a champion of limited government, Friedman's theory conveniently suggested that temporary government policies used to stimulate the economy during recessions will have no additional impact (the multiplier is zero) because we consumers will view the income as temporary, not permanent. According to Friedman, since the income generated from a stimulus would be viewed as temporary, most of it would be saved; and, therefore, there would be no impact from expansionary fiscal policy.

Having grown up in a middle class household and worked in the hotel industry for some six years, I couldn't think of anyone who acted this way.  The people I hung out with, middle class and poor, spent most of their income--and it certainly didn't matter if it came from our weekly paychecks or winning $500 in the Super Bowl pool!

In studying heterodox economics I was introduced to alternative explanations.  For example, Ed Wolff, probably the premier researcher on US wealth inequality, showed that the consumption-income relation depended on what income or wealth class one belonged to.  Using data on US wealth distribution, he suggested four "class types": the richest 1% (who own 35-40% of all wealth), whose consumption was more closely tied to changes in the value of their wealth rather than changes in income; a professional class (doctors, lawyers, college professors, et al) who followed the PIH/Life-Cycle model because their income was more certain and stable; the working class who spent most of their income; and an underclass, dependent on government programs, who tended to spend even more than any income they earned or were provided.

The policy conclusion is straight-forward: if your aim is to provide a stimulus to the economy by raising consumption demand, then increased spending or tax cuts should be targeted at the bottom two classes (representing approximately the lower 80% of the income distribution) because they will spend almost all of the increase in income, whether or not you call it permanent or temporary.  While this may be obvious to those who live in the real world, it's astonishing and frustrating that it has taken so long for the mainstream economics discipline to reject the PIH theory.

One of the lessons to learn from this is there are many in the economics discipline who claim to be objective but, in fact, have an ideological bias.  Friedman's theory was constructed to support his personal/political bias against government intervention.  In his original article he provided "supporting" evidence, but he had to fudge the data to get that support.  He did so by assuming spending on consumer durables--refrigerators, microwave ovens, and color TVs--was not consumption, rather it was a form of savings.  In other words, once he took out that big chunk of consumption spending (and counted it as savings), then--voila!--he "found statistical support" for his theory.

So, next time you are lucky enough to win a few hundred bucks from a football pool or lottery and you use it to buy a new iPad or Sous Vide, comfort yourself knowing you are not engaging in frivolous spending, rather you are padding your savings account...