Emily Skarbek  

Noah Smith on Milton Friedman

Jeff Bezos on innovation... Tyler Cowen on low interest ra...

In commenting on Milton Friedman's contributions to economics, it was once remarked that "attempting to portray the work of Milton Friedman . . . is like trying to catch the Niagara Falls in a pint pot." In yesterday's Bloomberg View, however, Noah Smith argues that it is time economists give up on Milton Friedman's biggest idea - the Permanent Income Hypothesis (PIH).

It seems to me that Smith has chosen to take one of the many contributions of Milton Friedman - far from his biggest or most important idea, I would argue - and give some examples of why it may not hold in particular cases. Smith then uses this to suggest that Friedman's contributions are passé and economists and the general public should not invest further in learning or caring about these insights.

If this were true, what would the public be missing? Here are just a few:

1. Friedman's theory concerning the positive relationship between economic freedom and political freedom. Friedman long argued that political freedoms are inextricably related to economic freedom. In today's political climate, I would argue the public discussion desperately requires a renewed understanding of this relationship and what it means for questions of immigration, civil liberty, healthcare, security, war on terror, etc. Political campaigns in the UK and the US capitalise on the ability to decouple questions of political freedoms from their related economic freedoms.

2. Friedman ended the military draft in the United States. A topic David Henderson has written on extensively - for example, see here, here, and here.

3. Friedman and Schwartz showed that the Federal Reserve's monetary policies were largely to blame for the severity of the Great Depression. An important contribution with which even Ben Bernanke agrees. More generally, Friedman brought renewed understanding to the dangers of inflation and central banks as a source of macro -instability.

4. Friedman argued for ending the war on drugs. A policy long overdue.

5. Friedman argued for how markets work to weed out discrimination and provide opportunities for discriminated groups to overcome bias. These ideas are under-explored when it comes to understanding processes of social change. When minority groups face political discrimination, markets and civil society can provide in-routes to positive change. For an illustration, consider the case of the Green Book.

4. Occupational licencing - for contemporary relevance see the recent CEA report; the costs of government-supplied public schooling; negative-income tax (or its political manifestation, the Earned Income Tax Credit).

Finally, to go back to Noah Smith's examples of how the PIH doesn't hold, it is curious that each of his examples involves relatively small windfall gains, not investment decisions. Smith looks at evidence relating to things like a bonus at work, or a tax refund, or a government stimulus check. It seems to me that the PIH is a useful way to understand personal investments decisions over one's lifetime. For example, why young people who expect (even if inaccurately in many cases) to have high earnings after college incur student loans instead of directly entering the workforce. Or why people take out 30 year mortgages to buy homes. It doesn't seem surprising that in some instances people's behavior does't conform to the exact predictions of consumption smoothing at any given point in time (for possibly many reasons - individual time preference, cognitive biases, etc). But that also doesn't mean it isn't a useful way to understand a general life cycle pattern of lower consumption/higher borrowing when young ; high consumption/higher savings or debt repayment when older; and lower consumption/dis-savings during retirement.

You don't have to believe that markets are always efficient to see that many people think Friedman's arguments are worth taking seriously. Just look at his citations.

Comments and Sharing

COMMENTS (9 to date)
ThaomasH writes:

I did not read read Smith so broadly, but to some extent his "oversights" may be because most of the other points -- War on Drugs, EITC, occupational licensing, the draft, the importance of monetary policy to stimulate the economy in recession -- are so mainstream among "Liberals" (and that's who is mainly likely to read Smith) as to no longer be associated with Friedman.

Now if "Conservatives" would just read Freadman for a change.... :)

Dallas Wood writes:

I think it is also important to realize that the empirical evidence on the Permanent Income Hypothesis isn't as clear as Noah Smith makes it out to be.

He mentions several studies that don't find evidence for PIH, but a simple google search would reveal just as many that do. NCSU's John Seater has published a number of papers on this topic, trying to answer the question using different data sets and testing different theoretical predictions of PIH.

This 2004 paper I really liked because I thought the test was pretty clever.

Now, I'm not saying Seater and others that find evidence for PIH are absolutely right. However, the empirical waters are a lot muddier than Smith lets on.

Daniel Kuehn writes:

I agree with Thomas and Dallas - I didn't read Noah as claiming anything nearly as broad as what you're suggesting here. PIH isn't completely dismissed empirically but it's been heavily questioned for decades now. This isn't something Noah is pulling out of thin air. And there's nothing really scandalous about how it's been questioned - some people budget and consume on much shorter time horizons than others. The idea that we've probably got a semi-permanent income hypothesis instead of a permanent income hypothesis seems pretty reasonable to me. I doubt Friedman would disagree with it that simple point, in fact. The remaining question is, do the empirical departures merit a different modeling approach or is the strong version good enough.

Dallas Wood writes:


"The remaining question is, do the empirical departures merit a different modeling approach or is the strong version good enough."

If Noah had approached the issue as an open question of empirical science, then I probably wouldn't be so annoyed by this piece. Instead, he thinks the issue is pretty much settled. He cites a few papers that are at odds at PIH, then jumps straight to suggesting that economists should go back to the drawing board.

Not only does he not mention other work that supports the PIH, he also doesn't even consider alternative hypotheses that may explain why some results fail to conform with the PIH. Liquidity constraints seem like an obvious candidate.

In the end, I don't think this column was an attempt to start a serious discussion among economists. Instead, it is perfectly designed, econo-nerd click-bait.

Ramon writes:

Almost every theory in economics is "false" if interpreted unconditionally. Just think in the Modigliani-Miller Theorem, Ricardian Equivalence, Comparative Advantage.

In physics a false theory: "bodies fall at the same speed regardless of weight".

Handle writes:

Smith writes:

The equation says that when interest rates are high, people save more and consume less -- this is the way they smooth their consumption, as Friedman predicted. But Canzoneri et al. found that the opposite is true -- for whatever reason, the fact is that people tend to consume more when rates are high.


Uh, no. Oops for Smith. If an agent works from year 0 to R, and is retired from year R to D living off accumulated savings, the equation for consumption is proportional to the average working-age wage multiplied by:

(e^iD - e^i(D-R)) / (e^iD - 1)

For the numerate, it's clear that as the interest rate goes up, consumption under a smoothing assumption also goes up. This is the PIH result that is consistent with all kinds of studies of real behavior, and Michael Pettis has pointed out repeatedly that it is particularly true in China.

Friedman was so hugely influential because his critics then were no better than Smith is now in critiquing his ideas.

James writes:

I will guess that Smith didn't get to title his piece. I doubt that anyone, Smith included, thinks of PIH as Friedman's biggest idea.

Nevertheless, his article is part of an interesting trend on the left which involves rejecting various principles in economics. What economic principles do liberals still believe in? Downward sloping demand curves (for labor)? The quantity theory of money? Opportunity cost?

Daniel Kuehn writes:

Dallas - yes evidence is stronger than he implies and it's obviously not an attempt to start a serious discussion among economists - it's a Bloomberg article! But I think it's a fair ways above click-bait. If you think of the typical non-economist Bloomberg reader he's got a lot of good stuff for them to consider on a technical topic in economics.

Dallas writes:

So you're saying that he is overstating his case for a non-technical audience that wont know how unserious hes being? That sounds like a bad thing to me. But then again my salary isnt linked to page views.

Comments for this entry have been closed
Return to top