Wednesday, September 23, 2009

Stimulus Package

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

This is the first of the critiques of government reactions to the current economic downturn that were promised in my previous blog.

The [tax] surcharge of 1968 … should never, on basic theoretical grounds, have been considered an effective anti-inflationary device.

Robert Eisner, “Fiscal and monetary policy reconsidered,” American Economic Review,

Dec. 1969.

The income of Americans unexpectedly surged [0.5%] in April, elevated by the economic stimulus package, while spending declined [0.1%].

Wall Street J., June 1, 2009.

1. The tax rebates and relief in the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 may be seen in the spikes in Disposable (after taxes) Personal Income in the figure.

Not seen, however, are positive responses of personal outlays (consumption expenditures and interest payments). The failure of spending to respond to obviously temporary changes in income is well known, and has been seen on several occasions, including the ineffective tax rebate of 2001 and the income-tax surcharge of 1968. The latter was a compromise by which the Johnson administration secured funding for the Vietnam War that would not be inflationary because the fall in consumption would offset the rise in government spending. Consumers’ spending was not repressed, however, as they continued to make decisions on the basis of expected future income available through the capital markets. The policy’s failure should have been anticipated, Eisner wrote (see the quotation above).

The smoothness of consumption relative to income in the figure is explained by the permanent income hypothesis (PIH), which is often associated with Milton Friedman (1957), but was well-known before him, for example by David Ricardo (1819) and Irving Fisher (1906). The hypothesis states that individuals plan consumption over time in light of their perceived wealth, which consists primarily of expected income.

The Keynesian (1936) consumption function, which still dominates the textbooks and is the theoretical basis of the stimulus packages, asserts that spending depends solely on current income. This makes sense for impoverished individuals or even societies in deep depression, but is impossible to teach with a straight face to students who are in the midst of carrying out long-term plans involving large consumption (college expenses and foregone earnings) in anticipation of future income.

Income fluctuations affect consumption under the PIH to the extent that income expectations respond to income changes. But the hypothesis implies that consumption is unresponsive to changes known to be temporary and even reversible. The apparently perverse effect of the recent stimulus packages, when consumption has actually fallen instead of being merely unresponsive, could be due to the administration’s warnings of future tax increases.

Research has qualified the PIH in light of uncertainty and psychology, but the ineffectiveness of stimulus packages implied by the simplest form of the theory continues to hold.


G. Angeletos, “The hyperbolic consumption model,” J. Economic Perspectives, Summer 2001.

Irving Fisher. The Nature of Income and Capital. Macmillan, 1906.

Milton Friedman. A Theory of the Consumption Function. Princeton Univ. Press, 1957.

J.M. Keynes. The General Theory of Employment, Interest and Money. Macmillan, 1936.

David Ricardo. The Principles of Political Economy and Taxation. John Murray, 1819.

Matthew Shapiro and Joel Slemrod. “Consumer response to tax rebates,” American Economic Rev., March 2003.