The commentary on Mitlon Friedman's passing reminded me of the permanent income hypothesis, one of his most important theoretical contributions. The basic argument is that people will plan their annual consumption based on their expected income over their lifetime, not their income at a point in time. There is a simple logic in this. If someone has a temporary falloff in income, for example if they lose their job, we don't expect their consumption to fall by the same amount. Similarly, if someone has an especially good year (lots of overtime or big gains in the stock market) we don't expect them to spend all this money at once. So the idea that consumption would not respond to transitory changes in income in the same way as permanent changes in income seems intuitively reasonable. However, there is a stronger version of this story that Friedman and some of his followers sought to promulgate. This was the view that consumption was largely unresponsive to temporary changes in disposable income, like temporary tax cuts. Therefore, there is no point in using temporary tax cuts as a way to boost the economy out of a recession. In this view, only permanent changes in the country's tax code have an impact on consumption. I will admit to not being up-to-date on the latest research on the topic, but I recall in grad school reading an article by Stanford University Professor Robert Hall that sought to support Friedman's case. Professor Hall regressed changes in consumption against changes in disposable income. In support of the permanent income hypothesis, he found that only permanent changes in income had a significant impact. Temporary changes in taxes did not affect consumption. Unfortunately, there was a big problem in Professor Hall's test that was pointed out by one of the students in the class. Professor Hall excluded durable goods like cars and dishwashers from his analysis because these items provide a flow of services over a period of time. They are not consumed in a single quarter or year. While this move may be reasonable on conceptual grounds, it completely undermined the policy conclusion that Hall drew from his evidence. If consumers rush out and buy durable goods in response to a temporary tax cut, it will give a boost to demand just as the Keynesians would argue. In other words, if we don't know how purchases of durable goods respond to temporary tax cuts, we have no basis for assessing the impact of temporary tax cuts on the economy. Again, I can't speak for the subsequent research, but the policy conclusions drawn from article would appear to be a case of irrational exuberance by one of Mr. Friedman's followers.
--Dean Baker