Saturday, October 17, 2015

Deaton vs Friedman: Is income more volatile than consumption?

Angus Deaton was awarded the 2015 Nobel Prize in economics for his "analysis of consumption, poverty and welfare."  Here you can read about his work summarized and analyzed by the Nobel committee.

One of the micro-macro issues that Deaton tackled was if income was more volatile than consumption. Milton Friedman argued that people smooth consumption over time even if they experience temporary income shock (permanent income hypothesis). In other words, consumption is not as volatile as income. However, Deaton argued that it may not be the case if people expect several bouts of income increase. In this case, consumption would not be smooth. This is the Deaton Paradox, which comes from his analysis of household's income pattern and consumption behavior. 

The Economist summarizes this:

But Mr Deaton’s work exposed this as sloppy thinking. First, he noted that the relationship between consumption and income in Friedman’s model depended on the kinds of income shocks hitting an economy. If one pay rise acts as a signal that there are more to come, then the “rational” agent in Mr Friedman’s model should anticipate future increases, and spend even more than their initial income boost. In this case, consumption should be more volatile than income, not the other way round.
So indeed it proved. Mr Deaton examined the aggregate income data more carefully, and found that it did not seem to support the idea of consumption smoothing. His microeconomic theory, allied with his empirical observations about aggregate income, together implied that income should be smoother than consumption, in contrast to what the macroeconomists had been trying to explain in the first place. This inconsistency was the Deaton paradox.

And some word of advise to economists:

As well as his specific contributions to our understanding of the world, Mr Deaton offers three lessons to aspiring economists. First, the theory should tally with the data—but if not, then do not despair. Puzzles and inconsistencies help to prompt innovation. Second, the average is rarely good enough. It is only by understanding differences between people that we can understand the whole. Finally, measurement matters. In the words of Mr Deaton, “progress cannot be coherently discussed without definitions and supporting evidence”. In the words of Mr Muellbauer, Mr Deaton’s win is “a triumph for evidence-based economics”.