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Milton Friedman's Permanent Income Hypothesis

Written by:
CameronDaniels

Milton Friedman is the most influential economist of the last fifty years. He is, with John Maynard Keynes, perhaps even the most influential of the entire 20th century.  His theories and research continue to shape public policy debates even until today.  One of his most important and lasting is the Permanent Income Hypothesis.

The Permanent Income Hypothesis

One of Friedman’s most influential and revolutionary theories was his challenge to the traditional Keynesian consumption function, which includes simple after-tax income as a variable in the consumption.

Friedman countered, that those who consume today take future taxes, price increases, salary increases, and other factors into account. This is summarized in his Permanent Income Hypothesis.

Defining the Permanent Income Hypothesis

More specifically, the Permanent Income Hypothesis argues that people consume based off of their overall estimation of future income. Economic thought at the time assumed people consumed only based on their current after-tax income.

For a simple example, consider a college student.

A college student borrows a lot of money to go into a (hopefully) moderate amount of debt. She does this expecting that her debt now will be easily covered by her increased earning power.

In this way, she "smoothes" her consumption, consuming only slightly less during college than immediately after. This is even after the huge increase in income.

Smoothing Consumption and Peak Earnings

Milton Friedman, creator of the Permanent Income Hypothesis - from Wikipedia

Milton Friedman, who created the Permanent Income Hypothesis ( Wikipedia)

Let's look at it another way. A person is going to earn a certain amount of money in his lifetime.

In the framework  of the Permanent Income Hypothesis, he'll smooth his spending over a career based off of his expectations, as opposed to bouncing wildly around as raises and salary increases come.

On the other side of the scale is a near-retiree. Near-retirees are usually at a relative high point in their income. With kids out of the house, they usually save quite a bit in the expectation that their future "income" will decrease significantly to their level of Social Security payments). A cautious near-retiree carefully saves money to avoid an income shock when he is no longer earning active income.

These anecdotal examples are pretty strong examples of Milton Friedman’s hypothesis.

One clarifying remark before we move onto modern research on the topic:

All  consumption smoothing decisions are based only on readily available information. Obviously, you can't predict lottery winnings or stock market luck, so the Permanent Income Hypothesis doesn't account for these types of windfalls.

Why Does the Permanent Income Hypothesis Matter to the Economy?

The Permanent Income Hypothesis has significant implications for government entitlement programs. It is especially relevant for those who will continue working for quite a while, say a decade or more.

Let's say you're under the age of 45. If the government increases spending today, you might expect them to match it with an equal tax increase at some point in the near future. This means that the government's new spending will not in spur you to increase your short term spending – in fact, you might increase your savings rate in anticipation of higher taxes. This effect might go a long way – or the full way – towards cancelling out the effects of some government policies or lending programs.

Milton Friedman is known for this counter-example and counter-hypothesis to Keynes’ deficit-fueled recession-fighting formula. Friedman believed that monetary policy is the appropriate tool to fight recessions. Friedman stated lower rates in the near term eventually lead to an increase in short-term output at the cost of long-term inflation.

Problems and Tests for the Permanent Income Hypothesis

A major problem for the hypothesis hypothesis is the amount and quality of known information.

If you're 35 today, can you actually know how government spending now will lead to an increase in taxes for yourself later in your life?

Even if you do realize there will be a tax increase, will you change your consumption patterns perfectly to match?

Probably not, and further the effect will be different across the population. Perhaps the way citizens react to spending increases is really a blend between Keynes’ and Friedman’s hypotheses.

Testing the Hypothesis

One of the best papers testing the hypothesis is David Wilcox's “Social Security Benefits, Consumption Expenditure, and the Life Cycle Hypothesis” from the Journal of Political Economy in April, 1989. It looks at Social Security benefit increases in between 1974 and 1982.

Before 1974, increases in Social Security benefits for recipients were random and varied wildly. In 1974, however, a law was passed to link SS payment increases to increase in CPI.

Over the next eight years (and continuing today), the increase in Social Security benefits were announced around 2.5 months before they occurred.

This clearly directly tests the hypothesis. These are known increases in a Social Security recipient’s income. The Permenent Income Hypothesis predicts that retirees would increase consumption even before payments increase, effectively borrowing from future payments. Thus, there'd be a negligible, statistically insignificant change in spending habits before and after the actual payment increase.

There are a number of nuances in the paper, but suffice to say there was a rather large percentage increase in spending among retirees immediately after payment increases took place. Thus, you can conclude that the Permanent Income Effect, if it exists, was small in that population.

The Permanent Income Hypothesis Today

Obviously, we'll continue debating the proper policy response to help spur the economy during difficult times. Expect the Keynes versus Friedman debate of Monetary versus Fiscal policy to continue for quite some time.

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