The Deaton Paradox
By David Henderson
Yesterday I was busy writing the piece on Nobel Prize winner Angus Deaton for the Wall Street Journal. Here’s the link, although realize that it’s gated. The good news: Hoover asked me to do a longer piece, which will be out soon. I’ll post when it’s out.
My word count for the WSJ piece was restricted to 550. A 550-word article is much harder to write than an 800-word article. The Hoover piece is just over 1500 words. But even in that, I didn’t get a chance to handle one technical point about Angus Deaton’s work. So here goes here.
Mike Bird, at the Business Insider, wrote a good article on Deaton, especially given how little time he wrote it in. He highlighted something that the Nobel Committee highlighted. Here’s the relevant paragraph:
Deaton’s 1980s studies, including one called “Why is consumption so smooth?” gave birth to a concept called the Deaton Paradox — in short, sharp shocks to income didn’t seem to cause similarly large shocks to consumption. That was an important development in understanding the actions of consumers, causing economists to rethink the “permanent income hypothesis” developed by Milton Friedman, which suggested that people spend based on their lifetime income.
Why do I find that interesting? Because even though those findings do undercut Friedman’s permanent income hypothesis, they don’t undercut the main thing that Friedman’s PIH was used for. Indeed, they strengthen it.
Recall that one of the big issues in Keynesian economics was and is what percent of additional income people spend on consumption. If Keynesian fiscal policy gives people temporarily higher incomes and if the percent of that higher income spent on consumption is high, then the Keynesian multiplier is at work. People, including Friedman, used the PIH to say that when incomes go up temporarily people will spend only a small percent of that income on consumption. The smaller the percent they spend, the smaller is the Keynesian multiplier and the less effective is fiscal policy. Deaton’s findings show that the percent of additional income that people spend when they get an “income shock” is even lower than Friedman thought. The result: the Keynesian multiplier is even lower and Keynesian fiscal policy is even less effective than Friedman and others thought.
HT to Harry Watson.