Milton Friedman’s permanent income hypothesis — so wrong, so wrong

7 September, 2017 at 14:52 | Posted in Economics | 4 Comments

150514006_4Milton Friedman’s Permanent Income Hypothesis (PIH) says that people’s consumption isn’t affected by short-term fluctuations in incomes since people only spend more money when they think that their life-time 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 new research from Harvard:

Unemployment is a particularly good setting for testing alternative models of consumption because it causes such a large change in family income. A literature starting with Akerlof and Yellen (1985), Mankiw (1985) and Cochrane (1989) has argued that because ignoring small price changes has a second-order impact on utility, a rule of thumb such as setting spending changes equal to income changes may be “near-rational.” More recently, many researchers have documented evidence of an immediate increase in spending in response to tax rebates and similar one-time payments …

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 …

To summarize, we find that families do relatively little self-insurance when unemployed as spending is quite sensitive to current monthly income. We built a new dataset to study the spending of unemployed families using anonymized bank account records from JPMCI. 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 can’t 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 macro economic modelers’ 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 perspective​ yours truly has to conclude that these kind of 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 in​ 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.

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4 Comments

  1. Excuse me Lars i have to repeat it! About the Overlyclever professors Friedman,on his methods to prove his points on PI ,wich he partly got his “Nobel Award” for, for all interested,,read , “Paul Diesing, “Hypothesis Testing and Data Interpretation: The Case of Milton Friedman,” Research in the History of Economic Thought and Methodology, 1985, vol. 3, pp. 61-69 Paul Diesing was a great philosopher of the social sciences.Diesing published six important books during his career,but became not particularly famous.
    Until his retirement,Diesing taught in the State University of New York at Buffalo.Diesing was enrolled at the University of Chicago philosophy (social ethics) Professor from 1950 ,he worked with and was closely familiar with Friedman and his work.In latter year, Diesing took a position in the Philosophy Department of the University of Illinois.

  2. The PI has been a key tenet of economic theory since its inception, and Friedman won the Nobel Memorial Prize for it in 1976.

    When discussing Friedman’s in-depth empirical treatment of the PI, Paul Diesing listed six ways Friedman manipulated the data:

    “1. If raw or adjusted data are consistent with PI, he reports them as confirmation of PI
    2. If the fit with expectations is moderate, he exaggerates the fit.
    3. If particular data points or groups differ from the predicted regression, he invents ad hoc explanations for the divergence.
    4. If a whole set of data disagree with predictions, adjust them until they do agree.
    5. If no plausible adjustment suggests itself, reject the data as unreliable.
    6. If data adjustment or rejection are not feasible, express puzzlement. ‘I have not been able to construct any plausible explanation for the discrepancy’…”

  3. Conclusion:
    “Milton Friedman’s academic contributions do not stand up to scrutiny. Friedman seemed to be prepared to conjure up neat, ad hoc explanations for certain phenomena, simply asserting facts and leaving it for others to see if they were true or not, which they usually weren’t. He selectively interpreted his own data, exaggerating or plain misrepresenting it in order to make his point. Furthermore, his methods should be unsurprising given his incoherent methodology, which allowed him to dodge empirical evidence on the grounds of an ill-defined ‘predictive success’, something which sadly never materialised. In almost any other discipline, Friedman’s attempts at ‘science’ would have been laughed out of the room. Serious economists should distance themselves from both him and his contributions.” https://unlearningeconomics.wordpress.com/2013/07/12/milton-friedmans-distortions-part-ii/

  4. “In August 1972, a case study of the methodology of neoclassical economics by Imre Lakatos’s London School of Economics colleague Spiro Latsis published in The British Journal for the Philosophy of Science found Milton Friedman’s methodology to be ‘pseudo-scientific’ in terms of Lakatos’s evaluative philosophy of science, according to which the demarcation between scientific and pseudo-scientific theories consists of their at least predicting testable empirical novel facts or not. -in Situational Determinism in Economics S.J Latsis The British Journal for the Philosophy of Science, 23, p 207-45.”
    Three years later, in 1976, Friedman was awarded the “Nobel Prize” for Economicsprofessor Edward Herman,writes in Triumph of the Market (1995), p. 36. that “Friedman’s methodology in attempting to prove his models have set a new standard in opportunism, manipulation, and the abuse of scientific method.” In July 1970 Nicholas Kaldor wrote an article in the Lloyd’s Bank Review in which he questioned Friedman’s empirical assertions. Friedman replied — in the same journal in October — that:
    “Asking how Professor Kaldor would explain the existence of essentially the same relation between money and income… for the UK as for the US, Yugoslavia, Greece, Israel, India, Japan, Korea, Chile and Brazil?”
    The problem with this? Friedman just made it up. No such relation existed. went back and crunched the numbers. Kaldor is his responded in his ‘The Scourge of Monetarism’:
    “The simple answer to this is that Friedman’s assertions lack any factual foundation whatsoever. They have no basis in fact, and he seems to me to have invented them on the spur of the moment. I had the relevant figures extracted from the IMF statistics for 1958 and for each of the years 1968 to 1979, for every country mentioned by Friedman and a few others besides… Though there are some countries (among which the US is conspicuous) where in terms of the M3 the ratio has been fairly stable over the period of observation, this was not true of the majority of others.” Kaldor, N. 1982. The Scourge of Monetarism. Oxford University Press, Oxford and New York.
    Kaldor summed this up well in a speech to the House of Lords regarding this little ‘blunder’ on the 16th April 1980. There he said:
    “Professor Friedman, as on some other WELL-KNOWN OCCASIONS, invented the facts to clinch the argument, and relied on his reputation as an expert for being taken on trust without anyone bothering to check the figures.”
    source: The UK Forum for Post Keynesian Economics
    Keynes Seminar in Cambridge
    Professor Richard Kahn on The Scourge of Monetarism (11 December 1987).


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