Taking a step back in history for a moment, John Maynard Keynes outlined in his 1936 The General Theory of Employment, Interest and Money<\/em> a view that household consumption was dependent on disposable income, and, that in times of economic downturn, the government could stimulate employment and income growth using fiscal policy, which would boost consumption.<\/p>\n In Chapter 3 The Principle of Effective Demand<\/em>, Keynes wrote:<\/p>\n \nWhen employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income …<\/p>\n The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.\n<\/p><\/blockquote>\n Keynes later (in Chapter 6 The Definition of Income, Saving and Investment<\/em>) considered factors that might influence the decision to consume and talked about “how much windfall gain or loss he is making on capital account”.<\/p>\n He elaborated further in Chapter 8 The Propensity to Consume …<\/em> and wrote:<\/p>\n \nThe amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them (which may suffer modification as output is increased).\n<\/p><\/blockquote>\n And concluded that:<\/p>\n 1. An increase in the real wage (and hence real income at each employment level) will “change in the same proportion”.<\/p>\n 2. A rise in the difference between income and net income will influence consumption spending.<\/p>\n 3. “Windfall changes in capital-values not allowed for in calculating net income. These are of much more importance in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.” So, wealth changes will impact positively on consumption (up and down).<\/p>\n Later, as he was reflecting in Chapter 24 on the “Social Philosophy towards which the General Theory might lead” he wrote:<\/p>\n \n… therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.<\/p>\n For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him …\n<\/p><\/blockquote>\n It was thus clear – that active fiscal policy was the “only practicable means of avoiding the destruction” of recession brought about by shifts in consumption and\/or investment.<\/p>\n That view dominated macroeconomics for several decades.<\/p>\n In 1957, Milton Friedman, who had been chipping away at the view that fiscal policy interventions were crucial for the maintenance of prosperity, published his book – A Theory of the Consumption Function<\/a> – in which he outlined (in Chapter III) what became known as the Permanent Income Hypothesis<\/a>.<\/p>\n It provided him with a basis for refuting any notions that active fiscal policy could stimulate household consumption, a major contention of the then dominant Keynesian policy consensus that had sustained full employment and strong real GDP growth in the peace time after the end of World War 2.<\/p>\n The idea of a propensity to consume, which had been formalised in textbooks as the Marginal propensity to consume<\/a> (MPC) – which described the extra consumption that would follow a $ of extra disposable income, was thrown out by Friedman.<\/p>\n The MPC concept – that households consume only a proportion of each extra $1 in disposable income received – formed the basis of the expenditure multiplier.<\/p>\n Please read my blog – Spending multipliers<\/a> – for more discussion on this point.<\/p>\n Accordingly, if government deficit spending of, say $100 million, was introduced into a recessed economy, firms would respond by increasing output and incomes by that same amount $100 million.<\/p>\n But the extra incomes paid out ($100 m) would stimulate ‘induced consumption’ spending equal to the MPC times $100m. If the MPC was, say, 0.80 (meaning 80 cents of each extra dollar received as disposable income would be spent) then the ‘second-round’ effect of the stimulus would be an additional $80 million in consumption spending (assuming that disposable and total income were the same – that is, assuming away the tax effect for simplicity).<\/p>\n In turn, firms would respond and produce an additional $80 million in output and incomes, which would then create further induced consumption effects.<\/p>\n Each additional increment, smaller than the last, because the MPC of 0.80 would mean some of the extra disposable income was being lost to saving.<\/p>\n But it was argued that the higher the MPC, the greater the overall impact of the stimulus would be.<\/p>\n Instead, Friedman claimed that consumption was not driven by current income (or changes in it) but, rather by expected permanent income<\/strong>.<\/p>\n Permanent income becomes an unobservable concept driven by expectations. It also leads to claims that households smooth out their consumption over their lifetimes even though current incomes can fluctuate.<\/p>\n So when individuals are facing major declines in their current income – perhaps due to unemployment – they can borrow short-term to maintain the smooth pattern of spending and pay the credit back later, when their current income is in excess of some average expectation.<\/p>\n The idea led to a torrent of articles mostly mathematical in origin trying to formalise the notion of a permanent income. They were all the same – GIGO – garbage in, garbage out. An exercise in mathematical chess although in search of the wrong solution.<\/p>\n This period of theoretical development was rife when I was in graduate school and so I, along with my colleagues, waded through hours of tedium in our studies.<\/p>\n We learned (or whatever you might call it) that consumption smoothing occurs in perfect capital markets – that is, where anybody can access credit no matter what.<\/p>\n We learned that relative assessment of how consumption patterns in our neighbourhoods or social groups were irrelevant in determining an individual’s lifetime consumption.<\/p>\n The so-called https:\/\/en.wikipedia.org\/wiki\/Relative income hypothesis<\/a> developed by James Duesenberry, which stated that individuals were not robustly independent (as in Friedman’s story) but linked in social groups and neighbourhoods was rejected.<\/p>\n Duesenberry had argued that “an individual’s attitude to consumption and saving is dictated more by his income in relation to others than by abstract standard of living”.<\/p>\n It was the “keeping up with the Jones” theory.<\/p>\n But Friedman was not one to embrace interdependence. In the ‘free market’ tradition, all decision makers were rational and independent who sought to maximise their lifetime utility.<\/p>\n Accordingly, they would borrow when young (to have more consumption than their current income would permit) and save over their lifetimes to compensate when they were old and without incomes. Consumption was strictly determined by this notion of a lifetime income.<\/p>\n Only some major event that altered that projection would lead to changes in consumption.<\/p>\n The Permanent Income Hypothesis is still a core component of the major DSGE macro models that central banks and other forecasting agencies deploy to make statements about the effectiveness of fiscal and monetary policy.<\/p>\n So it matters whether it is a valid theory or not. It is not just one of those academic contests that stoke or deflate egos but have very little consequence for the well-being of the people in general.<\/p>\n It turns out that the theory is moribund to say the least.<\/p>\n
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