[Many times, I've asked macroeconomists about why Duesenberry's ideas
have been lost. I've never received a satisfactory answer.]
June 9, 2005/New York TIMES
The Mysterious Disappearance of James Duesenberry
By ROBERT H. FRANK
UNLESS you are a professional economist nearing retirement, the name
James S. Duesenberry is probably unfamiliar. By itself, that is
unsurprising, because he wrote primarily for academic audiences while
on the Harvard economics faculty from 1946 to 1989. The real surprise
is that most academic economists under 50 have also never heard of Mr.
Duesenberry.
This is puzzling because his theory of consumer behavior clearly
outperforms the alternative theories that displaced it in the 1950's -
a striking reversal of the usual pattern in which theories are
displaced by alternatives that better explain the evidence. His
disappearance from modern economics textbooks is an intriguing
cautionary tale in the sociology of knowledge.
But it also has important practical implications. Unless we understand
what drives consumption, which makes up two-thirds of total economic
activity, we cannot predict how people will respond to policy changes
like tax cuts or Social Security privatization.
Any successful consumption theory must accommodate three basic
patterns: the rich save at higher rates than the poor; national
savings rates remain roughly constant as income grows; and national
consumption is more stable than national income over short periods.
The first two patterns appear contradictory: If the rich save at
higher rates, savings rates should rise over time as everyone becomes
richer. Yet this does not happen.
Mr. Duesenberry's explanation of the discrepancy is that poverty is
relative. The poor save at lower rates, he argued, because the higher
spending of others kindles aspirations they find difficult to meet.
This difficulty persists no matter how much national income grows, and
hence the failure of national savings rates to rise over time.
To explain the short-run rigidity of consumption, Mr. Duesenberry
argued that families look not only to the living standards of others,
but also to their own past experience. The high standard enjoyed by a
formerly prosperous family thus constitutes a frame of reference that
makes cutbacks difficult, which helps explain why consumption levels
change little during recessions.
Despite Mr. Duesenberry's apparent success, many economists felt
uncomfortable with his relative-income hypothesis, which to them
seemed more like sociology or psychology than economics. The
profession was therefore immediately receptive to alternative theories
that sidestepped those disciplines. Foremost among them was Milton
Friedman's permanent-income hypothesis, which still dominates research
on spending.
Mr. Friedman argued that a family's current spending depends not on
its current income, but rather on its long-run average, or permanent,
income. Because economic theory predicts that people prefer steady
consumption paths to highly variable ones, Mr. Friedman argued that
people would smooth their spending - saving windfall income gains and
drawing down savings to cover windfall losses. Consumption should thus
be more stable than income over short periods.
Mr. Friedman also argued that a family's savings rate should be
independent of its income, leading him to predict the long-run
stability of national savings rates.
Mr. Friedman dismissed the high savings rates of the rich as a
statistical artifact. Because many of those with high measured incomes
in any given year will have enjoyed positive windfalls, their
permanent incomes will be lower, on average, than their measured
incomes for that year. So if they save windfall gains, they will save
a higher proportion of their measured incomes than of their permanent
incomes. The converse holds for those with low measured incomes in any
given year, who will have experienced a preponderance of windfall
losses that year.
Although it is a tidy story, its fundamental premises are contradicted
by the data. As numerous careful studies have shown, for example,
savings rates rise sharply with permanent income. Mr. Friedman's
defenders responded by arguing that rich consumers want to bequeath
money to their children. But why should the poor lack this motive?
Another problem is that people consume windfall income at almost the
same rate as permanent income. To this, Mr. Friedman responded that
consumers appear to have unexpectedly short planning horizons. But if
so, then consumption does not really depend primarily on permanent
income.
Strangest of all, Mr. Friedman's theory assumes that context has
absolutely no effect on judgments about living standards. It predicts,
for example, that an investment banker will remain equally satisfied
with his twin-engine Cessna, even after discovering that his new
summer neighbor commutes to Nantucket in an intercontinental
Gulfstream jet.
In light of abundant evidence that context matters, it seems fair to
say that Mr. Duesenberry's theory rests on a more realistic model of
human nature than Mr. Friedman's. It has also been more successful in
tracking actual spending. And yet, as noted, it is no longer even
mentioned in leading textbooks.
What is going on here? The psychologist Tom Gilovich has suggested
that someone who wants to accept a hypothesis tends to ask, "Can I
believe it?" In contrast, someone who wants to reject it tends to ask,
"Must I believe it?" Most economists, it appears, just never wanted to
believe the relative-income hypothesis - perhaps because it suggests
the possibility of wasteful spending races.
But whatever the original reason for Mr. Duesenberry's disappearance,
the profession's mood seems to be changing. As evidenced by the Nobel
Prize in economics having been awarded to a psychologist, Daniel
Kahneman, in 2002, economists are showing new receptiveness to
insights from other social sciences.
Professor Duesenberry, now 86, is alive and well in Cambridge, Mass.
His theory is ripe for a second look.
Robert H. Frank, an economist at the Johnson School of Management at
Cornell University, is the author of "Luxury Fever."