Covid and the Permanent Income Hypothesis
In a rare display of political bipartisanship, Joe Biden and Donald Trump have been united by their belief that fiscal injections are the sole gospel of salvation for the Covid-19 economy. This idea is derived from the largely untested Keynesian axiom of the ‘consumption function’, that stipulates a universally positive correlation between one's disposable income and their levels of consumption (measured by their personal consumption expenditure).
This thinking flows into the idea that government injections of capital into an insolvent economy is the secret elixir to restimulation. However, many have been sceptical of the efficacy of this idea, none more so than Nobel Laureate economist - Milton Friedman.
Friedman contended that Keynes has misunderstood the relationship between levels of disposable income and consumption, and that such a faulty premise contaminates much of his work. The Chicago school economist argued instead that the true relationship lies between one’s permanent income and their level of consumption. Through this, Friedman theorised an idea called the ‘Permanent Income Hypothesis’, whereby individuals calibrate their levels of spending today by their expected earnings tomorrow; a direct assault upon Keynes’ long-held premise.
The partitions can be clearly observed: Keynes arguing a strong positive relationship between disposable income and consumption, Friedman arguing for one that is much weaker.
Despite numerous micro-experiments over the past decades to prove or disprove either man, there was not any conclusive far-reaching evidence. However, through the actions taken by the United States government of three separate fiscal injections over the past eighteen months, there has been a clear opportunity to judge this gladiatorial feud.
The period modelled in Figure 1 (January 2020 to present), presents the relationship between Disposable Personal Income (DPI) and Personal Consumption Expenditure (PCE). Through observation, the periods of fiscal injection where the US fiscal stimulus bills were enacted, DPI spikes, and correspondingly PCE is shown as largely inelastic. This theme is continued through the weak positive correlation between the two variables. This suggests the past eighteen months confirms a faulty relationship between disposable income and personal consumption, suggesting that over six decades since theorising, Friedman may just be right after all.
While the state-induced economic fallout necessitates adequate compensation, a point eloquently argued in an earlier article of ours, the sheer magnitude of the fiscal stimulus inevitably raises the question whether such money has been worthwhile. Despite spending over $5 trillion, levels of consumption have been measly affected. This futility is tantamount to the government's sheltering of Keynesian dogmatism behind a Maginot Line of state intervention. It is time this line is broken.
