Permanent Income Hypothesis

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"Permanent Income Hypothesis"

By Matthew Yglesias

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Megan McArdle writes about a potential problem with stimuli:

The real question, I think, is how close the permanent income hypothesis is to being true. The basic idea is that people are forward looking, and they try to smooth their consumption over time. So if you give them a “temporary tax cut”, they save most of it, knowing that eventually they will have to give the money back.

But of course, this should also be true of “temporary government spending”–if people think the money won’t be there next year, they’ll salt as much of the money away as possible. This is a topic very underexplored in the various estimates of the stimulus multiplier, even though consumers are massively overleveraged and will presumably save as much of their new income as they can.

I think common sense tells us that the permanent income hypothesis is very far from being true. You could imagine an alien species whose psychology functioned this way. But that species wouldn’t have heavy smokers dying of cancer, problems with overreating and sedentary lifestyles. Voters belonging to that species would condemn governors who take advantage of boom times to cut taxes and hike spending—there would be massive popular pressure to sock it all away in a rainy day fund.

It’s clearly true that in the present situation people are saving more and spending less. But the reason can’t be that they’re perfectly forward-looking—the evidence for high rates of time preference and myopia is too overwhelming.

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