Revisionist historians and chardonnay socialists find their happy place throwing poo at Milton Friedman’s ideas. Friedman encompasses everything they think is wrong with economics, especially those economic ideas that have changed the world:
- “The Origin Of ‘The World’s Dumbest Idea’: Milton Friedman”, Steve Denning, Forbes
- “Milton Friedman: a study in failure”, Richard Adams, The Guardian
- “Milton Friedman Was Wrong”, Eric Posner, The Atlantic
But they miss some of the leading ideas of one of the world’s best economic thinkers.
One of the world’s best Economists: Ever.
Without a doubt one of Friedman’s best ideas was the Permanent Income Hypothesis. I’m going to give you a Econ101 primer, because in later blogs – especially around the housing market – I’m going to refer to its implications some more.
Here’s the words from the good Professor himself: https://www.nber.org/system/files/chapters/c4405/c4405.pdf
Ease in. Get yourself a beer. This post is a long one.
Permanent income and current consumption
One of Friedman’s best contribution to economics was the Permanent Income Hypothesis: what you are spending now is related to what you expect to earn (or own) over your lifetime.
Pretend everything in your life is known with certainty..
The world’s a complicated place, so lets start with something simple and obviously wrong. Pretend everything in your life is known with certainty.
You know right now – regardless of your age:
- how much money you are going to earn over your career (and when it’s going to be earnt);
- what type of assets you want to own and what will be their future value; and
- how long you’re going to live.
If you know all of these things – with certainty – then you can plan your life.
In those early days, when you’re at school or learning, you’re not earning anything, but you know the cash-tap is just about to turn on. You would be at school, and thinking about what you’re going to do after school, and what you might be earning. If you go to university, you might be thinking about what you might earn when you graduate with a degree.
You don’t really know what you’re going to do or whom might employ you.
But you do know somethings: university people tend to earn more (on average) than trade workers. Correspondingly, trade workers tend to earn more than school leavers. And you do know that the retirement age is 65: you’ll likely to be working for about 45 years.
And then you’ve got some preferences for what you want to do with your life. You might think that maybe in your 30’s you’d quite like a family.
Or maybe, you’d quite like a house.
Or maybe you’d quite like to travel.
Or maybe, you’re quite ok with staying where you are, and beating your own drum.
Whatever you actually are going to do with your life, you are looking forward into the future, thinking about everything you might quite like to do, and “planning” how you’re going to get there.
You borrow to cover the early income lows, save during the income highs, and run down your assets towards the end of your life
You sorta know how you want to live your life, and barring a medical miracle or being smacked down by a bus, you’re probably planning to life to the approximately the average life expectancy for your gender / ethnicity demographic.
In your pre-working life – before the money comes rolling in – you’re banking on your skills, and probably quite ok racking up debt: debt commensurate with what you think you’re going to earn. For example, if you’re training to be a doctor, you might be “ok” with racking up tens to a hundred thousand of dollars to the government and private financial institutions while you’re at university. If you’re a school leaver, looking for an untrained job, no way are you going to incur that debt! Likewise, if you’re at university with an Art degree that has a less certain income stream, you’ve not going to bank up that level of debt.
Permanent Income is “anticipated” lifetime income flows
But there’s something “more certain” – or in Friedman’s terms – “Permanent” – about the nature of the income flows you’re going to receive as a doctor, as a trained trade-profession, or as a dead-beat high school drop out.
You’re pretty sure its going to be very high / (high) / (very low), and you’re pretty sure your chances of being unemployed are very low / (average) / (very high), depending on which life choice you take.
And because of those pre-employment lifetime expectations, you’re quite “ok” with racking up lots of debt, some debt, or very little debt respectively.
The working life age band is about building assets
So before you’re earning, you might be living beyond your means and racking up debt which you know you’ll pay back when you’re earning. Then, as you’re earning, you’re building up assets which you know you’ll need to resell to pay for your retirement.
You may also choose to “consume” family-services through spending your money on a family and children.
And in your retirement, you’re selling the assets you’ve built up over your lifetime to pay for your retirement lifestyle.
Negative uncertainty about the future: the causes of an economic bust
So there you are – happily living the life you want, earning the amounts you expect, and paying the costs you anticipated.
Then COVID-19 hits. And then the government does something you’ve never seen before: all international travel is stopped. In fact, based on the modelling that closed down the world, and unprecedented in the history of the modern world, ALL countries close their borders.
And then the cunning investment you made a while ago in buying a business in a lovely tourist-dependent area starts to look – now – pretty frecking shaky for the immediate future. Even worse, you brought that business from the previous owner. And because both of you expected tourism to continue, you paid what was “under those circumstances” a fair-value for the existing business. But under “these circumstances” is overpriced for the income its going to generate in the near future.
And you borrowed to buy it. Because you expected everything to continue as it has since modern history. But now its not the same. And its not going to be like it was. And your certain world just got very uncertain indeed.
Those plans you made about how your “permanent” income into the future was going to change, look pretty much wrong right now. They didn’t seem dumb last year, and they might not be dumb in 5 years time, but right now your permanent consumption decisions, based on your permanent income expectations, seem pretty shaky right now.
You cut back on your spending. You downsize. You lay people off… you “transmit” your bad problems onto other people.
And now their permanent income becomes uncertain. If the “shock” to their income is perceived by them to be permanent, then they will take immediate steps to reduce their permanent consumption. The perceived decrease in someone’s permanent income right now flows into affecting someone else’s permanent income and causes economic Boom / Bust cycles associated with the Business Cycle.
Positive expectations about future permanent income create economic booms
Permanent income works on the other side: pretend in the year 2004, you decided to invest $1000 in an unknown “roughie” company called “Google”, having also stuck a lazy $1000 into a lemon IT company called “Apple” back in 1996.
Playing fast and loose with exchange rates and the specifics of the purchasing timings, that $NZ1,000 in 2004 was worth about $US890 back then, and would have brought 16.43 Google shares then. But those 16.43 Google shares now would be worth $US26,800(ish), or $NZ28,500.
Those Apple Computer shares..?
Back in 1996, they were worth about $US0.21 each, and the US/NZ exchange rate was about .6847 NZD / USD. With your lazy $NZ1000, you could have purchased 3260 shares, which are now worth $NZ398,968.
Regardless of whether you’re a tinker / tailor / soldier / sailor, rich man / poor man / beggar man or thief, if you were lucky to pick that roughie, you’re probably a millionaire just by having your money in the right place at the right time, regardless of the life choices you’ve made. And regardless of how you expected to play out your life, you’ve probably brought a MUCH BETTER house / car / wife than what you anticipated.
Permanent income and uncertainty also work in a positive way.
Rules for Good Economic Policy: keep the future as certain as possible
One of the major policy insights from the Permanent Income Hypothesis is the best thing governments could to smooth out economic booms and busts is to ensure the world is, as far as possible, quite a certain place. That doesn’t mean the world shouldn’t change – it absolutely should – but it should change in a way that allows people to adjust their income and consumption expectations smoothly over time.
No sudden movements policy lurches. No unexpected sweeping policy changes. Everything signaled in advance, and everything designed to change over a long term.
Under those conditions, people’s expectations and their choices will adjust, and they’ll choose their most preferred future life path.
Ok, that’s enough theory… taster for the housing market…
So policy needs to adjust slowly. Well signaled, well described, lots of lead time.
Here’s Labour’s housing policy: https://www.labour.org.nz/housing
Is it going to “suddenly burst” a housing bubble? Or is “..there is no silver bullet to solve the long-term challenge that is the housing crisis” and its policy is tantamount to “no chance”.
I don’t know, but it makes a difference to everyone who has treated houses like Apple shares: sure bets for future income growth for their retirement fund, or the younger generations who are thinking about where their “Apple shares” equivalent will come from.
I argue, housing policy is FAR from well signaled, and as such, it makes itself over time more risky. And large numbers of people are using it’s asset values to fund their retirements.