Permanent income hypothesis

In this brief post, Krugman clearly restates his clear (and plausible) view that rule of thumb ad hoc paleo Keyensians had a lot to learn from Milton Friedman.

He mentions the Phillips curve. I think I detect a hint of Forder in this sentence “We can argue how many economists really believed in a stable tradeoff between inflation and unemployment, but that’s certainly what got taught to many students.” But, this time, I want to write about the Permanent income hypothesis.

Krugman wrote:

Conventional Keynesian consumption functions suggested that the savings rate would rise as incomes rose — and this wasn’t just the Keynesian interpreters, Keynes himself made the same claim. This, in turn, led to predictions of rising savings rates after World War II, and hence a persistent shortage of demand — hence the secular stagnation theory briefly prominent. (There was even an early Heinlein novel built in part around the secular stagnation theory. As I recall, it was pretty bad.)

In fact, however, savings rates don’t seem to follow the naive consumption function at all; they rise in booms, and are higher for the wealthy, but exhibit no secular trend. And Milton Friedman appeared to explain this paradox by arguing that people are more less rational: they base consumption on “permanent income”, a reasonable estimate of long-run income, and save temporary fluctuations in income.

I have three thoughts.

First the patterns (looks like IS-LM Hicks in the cross section and short term and looks like consumer theory Hicks in the long term) can be explained by habit formation, even if consumers are myopic. Macroeconomists who try to fit aggregate data have been forced to assume habit formation. As far as I know (not as far as I should know) once on accepts habit formation, one can’t reject Keynes’ hypothesis that shifting expectations about future *aggregate* income have negligible effects on current consumption.

There is a clear pattern based on survey data, that if people expect rapid GDP growth then there is likely to be rapid growth of consumption over the same period. Such predictable changes in consumption are inconstent with the simplest crudest models used to illustrate the PIH. They can be reconciled with utility maximization (anything can be) but they are not at all the pattern implied by the PIH. The PIH implies that if high GDP growth is expected from time t on, then consumption at time t is higher than one would guess given income at t, wealth at t and lagged consuption. The PIH implies a relationship between expected future growth and the level of consumption. Keynes’ clearly stated hypothesis was that expected future aggregate growth was negligible

The principal objective factors which influence the propensity to consume appear to be the following:


(6) Changes in expectations of the relation between the present and the future level of income. — We must catalogue this factor for the sake of formal completeness. But, whilst it may affect considerably a particular individual’s propensity to consume, it is likely to average out for the community as a whole. Moreover, it is a matter about which there is, as a rule, too much uncertainty for it to exert much influence.

As far as I know, the last sentence is a null hypothesis which hasn’t been rejected by the data. This is a bleg/challenge — links in comments to rejection of Keynes’s hypothesis will be much appreciated.

Second IS-LM if taken literally implies that there is no trend in consumption or GDP. It was introduced as a way of thinking about deviations from trends. I see no more reason to take the assumption of constant autonomous consumption literally than to take the implication of constant GDP literally.

Finally cointigration (sorry to technospeak it roughly means the same trend) of consumption and GDP can be explained by a myopic consumption rule which depends on lagged consumption, current income and current financial wealth. To avoid it, one needs to assume that consumption doesn’t rise with financial wealth. Now it is a bit tricky to reconcile paleo-Keynesianism with massive increases of the ratio household debt to GDP. But it is at least equally tricky to reconcile that increase with intertemporal optimization. 21st century US data sure seem to fit a rule of thumb involving consumption out of wealth (especially including home equity) a lot better than rational intertemporal optimization.

As far as I know, the null that the PIH glass is totally empty has not yet been rejected.