• Charles Bromley-Davenport

What Washington is Forgetting About Stimulus Bills

Washington bureaucrats and policymakers left scratching their heads following the most recent stimulus package – yet their mistake was warned of over sixty years ago

A fundamental premise behind the Keynesian view of ‘demand-management’ is the assumption that consumer spending is positively correlated to levels of income. This dictum came to dominate macroeconomic policy during the 20th century through the simple belief that the way to therefore stimulate consumer spending is to thus increase their levels of income. This also serves as the logical premise behind the topic all A-Level economists are introduced to in their first year – the Keynesian ‘Multiplier Effect’.

Suppose this hypothetical situation involving two people: Amanda and Steve. Amanda earns an extra pound than Steve each year, and on average out spends him around 90 pence. On first inspection many would conclude that Amanda’s higher earnings are the consequence of why she outspends Steve on average, and the logic behind this simple idea appears to be rationale. However, an observation that was later awarded with a Nobel Prize in 1976 explains otherwise.

The Permanent Income Hypothesis (PIH) is an economic theory first developed by Milton Friedman in the mid-20th century, and served as a distinct break from the orthodox Keynesian school of thought. The theory dictates that consumer spending habits are consistent with their long-term average income level, as oppose to being a fixed percentage that would thus cause an increase or decrease dependent on their income for an individual year.

Supposing the previous hypothetical situation, Friedman’s theory would state that the reason why Amanda outspends Steve is not as a result of her higher earnings directly – but as a derived result of her higher permanent earnings. What this means is that she expects to out-earn Steve this time next year, the year after, the year after that, and so on – and therefore her spending this year is calibrated at a higher relative amount. This logic therefore flows into the argument that transitory ‘windfall gains’, more often than not, have a minimal impact on consumer spending, unless such gains are made permanent (such as from receiving a job promotion).

Such a theory is supported by a thorough range of empirical data, including a study of 2000 households by Hall and Mishkin, who concluded that the PIH is compatible with 80% of those tested - as well as a conclusion by former Chair of the Federal Reserve, Ben Bernanke, who found “no evidence against the permanent income hypothesis” in regard to the tested automobile industry.[1][2]

This logic can be used to explain the futility of Washington in dealing with the current economic situation. Since President Biden’s inauguration last January, a $1.9 trillion stimulus bill parachuted $1400 into the pockets of most Americans, in the hope of stimulating economic recovery and levels of confidence through allowing the pent-up demand of the previous year to be released in a tirade of economic activity. Despite initial signs of the bill’s success – the Friedmanian dictum has proven correct once again.

Following a modest increase in consumer sentiment during March 2021 as a result of the stimulus bill being passed, economists predicted the level to increase further from 88.3 to 90.4 between the months of April and May 2021. In reality – consumer sentiment reduced to 82.8, a rate not that dissimilar to a few months ago when the US were $1.9 trillion wealthier.[3] A similar theme was seen in regard to US retail spending, which stalled in April 2021 at a 0% difference. [4]

Many in Washington over the past few days have likely been confused about how ineffective a bill of a magnitude just less than 1/10 their total GDP has been. However, such people are forgetting the aforementioned lesson Freidman taught us over sixty years ago - that income is made up of two parameters: permanent income and transitory income. With the enforcement of coronavirus restrictions in many states, household’s perspectives over the past year towards their ‘immediate’ permanent income is likely to be highly pessimistic.

This idea suggests that households eager to return to a level of equilibrium after a year of such uncertainty are therefore likely to have a higher marginal propensity to save their recently provided transitory income gains. This point is further supported through considering a study conducted by the University of Pennsylvania, which estimated that instead of directing the economy towards recovery, 73% of the most recent stimulus bill will be directed straight into household saving.[5] From this, it can be argued that stimulus packages ultimately fail in their single purpose - to stimulate economic activity and begin the course out of recession. The overall ineffectiveness of the stimulus package is therefore levied on the incidence of the bill being distorted towards saving as oppose to consuming – a judgement shared with Nobel Laurate Eugene Famas.[6]

With rumours of a fourth stimulus bill being drafted shortly, clearly Washington are reluctant to shift from their ineffective dogmatism that the multiplier effect would be the saviour of their economy. The question this raises is the price the US are willing to pay in order to continue adhering to thinking dispelled over six decades previously.


[1] Hall, Robert E. & Mishkin, Frederic S. (1982): "The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households" [2] Bernanke, Ben S. (1984): "Permanent Income, Liquidity, and Expenditure on Automobiles: Evidence From Panel Data" [3] https://tradingeconomics.com/united-states/consumer-confidence [4] https://tradingeconomics.com/united-states/retail-sales [5] https://budgetmodel.wharton.upenn.edu/issues/2021/2/3/background-mpc-in-2021-economy [6] Fama, Eugene F. (2021): "Stimulus and the Permanent Income Hypothesis" Available At: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3790543