Economists Give Up on Milton Friedman's Biggest Idea

[SimpleDon]

Economists Give Up on Milton Friedman's Biggest Idea

One of the core pieces of modern macroeconomic theory, handed down to us by the great Milton Friedman, probably missed the mark. And now it might be on the way out. And this shift has big implications for how we think about economic policy and finance.

The idea is called the permanent income hypothesis (PIH). Friedman first put it on paper in 1957, and it still holds enormous sway in the econ profession. The PIH says that people’s consumption doesn’t depend on how much they earn today, but on how much they expect to earn over their lifetime. If a one-time windfall of money drops into your lap, says Friedman’s theory, you won’t rush out and spend it all -- you’ll stick it in the bank, because you know the episode won’t be repeated. But if you get a raise, you might start spending more every month, because the raise was a signal that your earning power has increased for the long term.

It goes on to say that this hypothesis forms the basis of mainstream economics' belief in the ineffectiveness of fiscal stimulus, academic theories of income leveling through swings in the economy and an important assumption in mainstream economics predictive modeling, that while left unsaid in the article, has been proven to be so poor at predicting the economy.

So it’s not much of an exaggeration to say that Friedman’s PIH is the cornerstone of modern macroeconomic theory. Unfortunately, there’s just one small problem -- it’s almost certainly wrong.

Not completely wrong, mind you, just somewhat wrong. 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.

A conclusion that anyone could have told economists, that they were foolish to believe that all consumers behave as predicted by Friedman's PIH. Much less that all consumers behave this way all of the time.

This is just one of the many parts of Friedman's body of economic theories to be disproven. He was a proponent of the idea that an excessive money supply causes inflation so that inhibiting its growth can prevent inflation. The idea that when put into practice created the Volcker recession of the early 1980's, the largest recession since the Great Depression at the time. And of course, his idea that the Fed caused the Great Depression and therefore the Fed could prevent or at very least could recover from a financial crisis induced depression like the Great Depression, suffered an ignominious defeat in the Great Recession, the largest recession since the Great Depression of the current time.

But I strongly disagree with the article about this one point, that the permanent income hypothesis was Friedman's biggest idea.

It may be Friedman's biggest economic idea that hadn't already been disproven, but it wasn't Friedman's biggest and most influential idea by far. And what this is borne out in the comments to the article. A sample,

Keynesian stimulus is an imperfect blessing, more political spoils than noble goals. Friedman said that too....

No Rtard......... Friedman's theory (which he applies to special cases) was accepted because it was the only credible alternative to explain the limitations and failure of Keynesian consumption theory.

Friedman was an advocate of free markets and less government.....Keynesians doubtlessly hate freedom and love central komissars...

Friedman's most important insight was that the government is not composed of brilliant angels, but highly fallible mortals. Hence his preference for markets -- the free interaction of self-interested individuals -- over central planners.

We don't need better models so that economic wizards employed by the government can pull the appropriate levers to manage the economy. We need the government to stop tinkering and get out of the way. ...

Bzzt, wrong. Greenspan failed to follow the rule based monetary policy that had been so successful in fixing the mess created by Keynesians in the 60's and 70's and lead to the prosperity of the 80's and 90's.

Greenspan started deviating from the taylor rule in the late 90's and produced a sequence of growing bubbles that eventually burst and destroyed the economy. ...

Standard of living is our ability to consume whatever we wish.

It is acheived (sic) by producing.
Supply may create its own demand, but demand alone does nto (sic) create supply.

My wanting something does not bring it into existance (sic). Someone else's beleif (sic) that they can benefit by providing me with what I want is what meets my demand. ...

What that means is they produced something of value others wanted and in return they were able to aquire the things of value they wanted.

That is how a free market works.
To get what you want, you must produce what others want.
That is why other forms either fail or at best work more poorly, because they either break or harm that relationship.

The more people beleive (sic) that something is theirs by right or entitlement or that it will be provided without effort the less incentive they have to produce value.

As there can be no consumption without production the less value we produce the lower our standard of living. ...

The basic principles of economics are relatively simple. What is complex is that it is massively concurrent. That actually makes it robust rather than fragile. In fact the more we try to plan the economy the more fragile we make it.
All the of the economic cycles in the past two centuries have been the consequence of government monetary games - because manipulation of money is the easiest way to nudge the economy from massively parrallel (sic) relative uncordinated (sic) actions to all or most actors moving in the same way. The economy is like a bathtub - when actors are all moving in an uncoordinated fashion there are failures and successes all the time, but failures do not occur in sync and therefore they do not cascade through the economy. While a planned economy is like controlled oscillations in a bathtub - eventually everyone ends up moving in the same direction, and then the tub overflows.
The same is true in the economy.

I have often said here that Friedman's contributions were more political than economic. These comments are examples of this. In an article that further erodes Friedman's economic ideas and theories we have people defending Friedman with his now pretty much singular contribution to public discussion and policy. The absolutely fanatical devotion to the existence of the self-regulating, self-organizing free market and that fallible people coming together to create a government are creating evil while fallible people coming together to create a corporation to stake their greed are creating a pure good because the market will be able to control their excesses without any human intervention.

It boogles the rational mind. Friedman's reputation should be based on his now largely discredited economics. But these fantasies that Friedman together with Ludwig von Mises and Friedrich August von Hayek resurrected from 19th century classical liberalism, are the persistent legacy of his career now.

Neoliberal economics, they called it, presumably shortened from neo-classical liberal economics. An economics that doesn't so much pretend to describe the economy that we have, but proposes an economy that we could have if the free market could exist. The problem with it, beyond the dependence on the fantasy of the free market, is that it would require a change in human nature, a characteristic that it shares with another 19th century economic fantasy, Marxism.

Neoliberal economics is now at the core of conservative political philosophy in all of its many variations; libertarian, movement conservative, paleoconservative, neoconservative, social conservative, theocracy conservative, etc. Conservatives wanting to return to a past that never existed, to depend on an organic free market that has never existed, independent of government.

Neoliberal economics also wormed its way into academic economics, sponsored by the wealthy who directly benefited from the policies that were generated from the adoption of the faith in the free market. The wealthy hire the economists taught by the economics departments, the wealthy fund the research and the chairs of economics in the universities. Is it any wonder that over time that academic economics bent to the will of the wealthy and adopted the faith?

It is time that we erode this legacy of Milton Friedman's. To not allow conservatives to retreat into this fantasy that the government isn't needed to define and to police the economy in the same way that government is required in society to define and police crime.

 

[Crazy Eddie]

Is there any specific reason economists feel perfectly comfortable making these very SPECIFIC predictions about human behavior without ever actually publishing research papers or behavior studies in peer-reviewed journals? I mean, even this "revelation" doesn't cite any hard evidence for Friedman being wrong, just sort of "states the obvious" like everyone should already know that.

How hard would it really be to take a sample of 500 people from 5 different income brackets and watch what they do when their income changes? Give half of each group a huge payout all at once, give the other half the same payout over ten years, and then have a control group that gets nothing and compare spending trends.

I look around, but I never seem to SEE anyone conducting that kind of research.

 

[Treedbear]

The problem with economic aphorisms is that they remain true in inverse proportion to how widely they are accepted as being true. There will always be those who will exploit an idea so that its efficacy dissipates until it is forgotten. Even this idea is not exempt ... so forget I ever said it.

 

[laughing dog]

Friedman's PIH was innovative for its day. It provided an alternative explanation for the simple Keynesian consumption function. It was an attempt to apply standard microeconomic theory to a macroeconomic issue. At the time it was published, there was scant empirical work to justify it. And, it was not formally not much different than the other competing model at the time - the life-cycle model of consumption.

I recall having to study all of those when I was in graduate school. They were not typically viewed as representing every household, but sort of a generalized "average" household. And, to be honest, at the time, very few people took them terribly seriously. The PIH was favored by "Chicago School" economists and by rational expectations theorists because it gave a tractable analytical solution in simplified macroeconomic models.

Economists have had little fortune in explaining specific consumption and saving behavior by households across countries in a consistent fashion within a generalized theoretical framework.