How true?

We should ask of economic theories not: “are they true?” but rather “how true are they?” I was reminded of this by Noah Smith’s piece pointing out that Friedman’s permanent income hypothesis is wrong – a fact which matters a lot because, as Noah says, the PIH implies that fiscal policy is ineffective.

Noah’s right. But he overstates the newness of the evidence against the PIH. In fact, we’ve known it was flawed (pdf) ever since the early 80s. He also overstates the PIH’s intellectual hegemony. The standard UK undergraduate textbook says:

One strong prediction of the simple PIH model…is that changes in income that are predictable from past information should have no effect on current consumption. But there is by now a considerable body of work on aggregate consumption data that suggests this is wrong…This is an important result for economic policy because it suggests that changes in income as a result, say, of tax changes can have a marked effect on consumption and hence on economic activity. (Carlin and Soskice, Macroeconomics: Imperfections, Institutions and Policies, p221-22)

However, Noah is absolutely right to insist that the PIH is “not completely wrong, mind you, just somewhat wrong.” There’s a big germ of truth in the PIH – that consumer spending is in part forward-looking.

Not only is this true, it is useful. As Lettau and Ludvigson (pdf) and Bank of England (pdf) research has shown, it implies that consumer spending can predict equity returns: when spending is low relative to wealth, it portends low subsequent returns.

In this sense, the question: “is the PIH true?” depends upon the context in which we are asking. As a guide to the effectiveness of fiscal policy, we should act as if it is wrong. But as a potential warning of bad times, it might well contain some truth.

It’s not just the PIH where context matters. The same is true of the efficient market theory. This is (perhaps (pdf)) false in the sense that stock markets are, in Samuelson’s phrase, “macro inefficient”: they over-react to good and bad news. It’s also not wholly true in the micro sense; the good performance (pdf) of defensive and momentum stocks is evidence against it.

However, in another context, the EMH is true and useful. If we’re asking “should we buy high-charging actively managed unit trusts?” we should act as if the EMH is true.

Here’s another example. The belief that a weaker pound post-Brexit will support the economy is partly true: it will give a boost to exports. But only partly so: statistics tell us that exports aren’t very sensitive to exchange rate changes.

Or another example. Economists believe that uncertainty usually depresses capital spending. Most post-Brexit business surveys seem to corroborate this (pdf). But this does not mean that all firms delay investment. Only some do, but as Geroski and Gregg pointed out, recessions are about what happens to a minority of firms. The fact that Glaxo has today announced a big investment is therefore wholly consistent with the claim that uncertainty will have some adverse effect on capex.

I say all this merely to reiterate what should already be well-known. For one thing, as Sarah O’Connor has said, economists need dirty shoes: it’s facts that matter, not armchair theorizing. In fact, as Noah has said, economists have taken this on board, and do more empirical work now than a few years ago.

And for another, it reinforces what Dani Rodrik has written:

Different social settings require different models. Economists are unlikely ever to uncover universal, general-purpose models. But in part because economists take the natural sciences as their example, they have a tendency to misuse models. They are prone to mistake a model for the model, relevant and applicable under all conditions. Economists must overcome this temptation. (Economics Rules, p5-6)

Comments

[Luis Enrique]

it is perhaps a minor point of intellectual history but as the intro of paper I linked to on twitter ( http://www.nber.org/papers/w8387 ) explains, Friedman's original articulation of PIH much softer than extreme version that was then shown to be flawed.

[Pablo Mira]

We are overlooking here a devastating critic made by Shefrin and Thaler (behavioral economics):
https://faculty.chicagobooth.edu/Richard.Thaler/research/pdf/The%20Behavioral%20Life-Cycle%20Hypothesis.pdf

[Ralph Musgrave]

Quite agree with Chris’s above basic point. Unsurprisingly, there’s a wealth of evidence as to what people do when their income changes (up or down). Plus there’s a wealth of evidence as to what they do when they come by windfalls.

Equally unsurprisingly is that peoples’ spending goes up / down when they experience an increase / cut in income, but not to the full extent of the increase / cut. Thus people obviously think and act TO SOME EXTENT in the “permanent income” way Friedman claimed.

[Deviation From The Mean]

"Economists are unlikely ever to uncover universal, general-purpose models."

It depends what you believe the purpose of those those models is. If it is to uncover the inner dynamics of an epoch, say the capitalist mode of production, then a universal model, of sorts, can be devised that uncovers the inner workings of the system, and what basis that system exists upon.

If we think economics is about 'moments', such as what investment decisions we should make at any particular time or what the government should do when faced with a problem then universal models are possibly inadequate. Though someone should tell that to financial advisors who seem to present graphs showing returns over say a 20 year period and assume this can be projected forward to the next 20 years etc etc

The above article seems to always assume the latter. I.e. is viewed through the spectacles of neo-classical economics.

[gastro george]

"In this sense, the question: “is the PIH true?” depends upon the context in which we are asking."

As you say, many hypotheses are only correct in certain circumstances. The problem is:

1. Individuals seeking to extend them to a generalised context.

2. Whether the truthful context is knowable in advance.

[Ken Houghton]

The Hall/Mishkin link can be made directly to NBER, where the paper is freely available.

[Ken Houghton]

http://www.nber.org/papers/w0505

[um]

If models are only correct sometimes, in some scenarios, then the models should specify what those scenarios are in advance.

"All models are wrong, but some are useful" would really be better stated as "All models are wrong. Some are useful, and some are dangerous. You'd better be damn sure you know which is which."