Sunday, February 1, 2009

Fundamental Psychological Laws?

One of the building blocks of the Keynesian economic model is the consumption function, asserted by Keynes:
The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.
This turned out to be one of the weakest parts of the Keynesian edifice, as Modigliani and Brumberg's Life-Cycle Hypothesis and Friedman's Permanent Income Hypothesis showed in the 1950's. However, the modern view that has evolved from Friedman of rational, forward-looking agents choosing their consumption to maximize expected lifetime utility is also a bit hard to swallow.

The truth may lie somewhere in the middle, but exactly how consumption decisions are made has significant implications for the effectiveness of policies like the tax cuts in the fiscal stimulus package. The New Yorker's James Surowiecki reports on the implications of some research in behavioral economics, which is making a more serious go at uncovering the "psychological laws" that govern our behavior. Their findings imply that the stimulus will be more effective if it comes to us in small pieces, he writes:
The permanent-income hypothesis is elegant, but studies have shown that it’s not always an accurate description of the way people decide how to spend and save. A more compelling explanation for why rebates haven’t worked very well is that they have been handed out as lump sums. You might think that handing people a big chunk of change is a perfect way to get them to spend it. But it isn’t, because people don’t treat all windfalls as found money. Instead, in the words of the behavioral economist Richard Thaler, people put different windfalls in different “mental accounts,” which in turn influences what they do with the money...

The key factor in these kinds of distinctions, Thaler’s work suggests, is whether people think of a windfall as wealth or as income. If they think of it as wealth, they’re more likely to save it, and if they think of it as income they’re more likely to spend it. That’s because many people tend to base their spending not on their long-term earning potential or on their assets but on what they think of as their current income, an amount best defined by what’s in their regular paycheck. When that number goes up, so does people’s spending. In Thaler’s words, “People tend to consume from income and leave perceived ‘wealth’ alone.”

So what does this mean for making a rebate work? If you want people to spend the money, you don’t want to give them one big check, because that makes it more likely that they’ll think of it as an increase in their wealth and save it. Instead, you want to give them small amounts over time. And you want the rebate to show up as an increase in people’s take-home pay, because an increase in steady income is more likely to translate into an increase in spending. What can accomplish both of these goals? Reducing people’s withholding payments.

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