America's Two Economies: Wal-Mart And Wall Street

Weakness in retail sales is being reported across the board. However, while car sales are not back to their 2005 highs, plants are operating with record capacity utilization. There are two theories of consumption, based on "permanent" income and "transitory" or temporary income.

Posted 09/11/2013 06:22 PM ET

Successive economic reports on consumer behavior have sown confusion among analysts. For instance, a recent newspaper headline read: "Wal-Mart Deepens Gloom as Retailers Feel Left Behind."

It's not just the Bentonville giant that's feeling pain; both Macy's (M) and Kohl's (KSS) reported disappointing results as well. Weakness in retail sales is across the board, hitting even cosmetics and beauty products.

Meanwhile, another recent headline read: "U.S. Car Plants to Shift to Top Gear." While car sales are not back to their 2005 peaks, plants are operating with record capacity utilization. Additionally, the housing market is improving.

In what kind of world do cars sell and cosmetics don't?

It turns out that it is in a world that Milton Friedman explained to us almost 60 years ago in a work titled "A Theory of the Consumption Function." In writing it, he grappled with the deficiencies of then-standard macroeconomics.

Textbooks treated consumption as mechanistically linked to current, measured income. As soon as one thinks seriously about it, it is an absurd proposition. Wage earners do not spend their entire paycheck on the day it is received — certainly not if they have a family. Consumption is spread out over the period between paychecks. Workers, whose income fluctuates in a known or expected way with the season, adjust their spending over the entire year. Windfalls, like inheritances, are not, on average, spent the day after their receipt.

Permanent Vs. Temporary

Friedman reasoned to a new theory of consumption, which was based on a distinction between "permanent" income and "transitory" or temporary income. Consumers behave differently depending on whether an inflow of money is viewed as signaling a new, higher permanent income or merely a transitory event. An increase in a consumer's expected permanent income funds an increase in permanent consumption. An increase in income not viewed as permanent is largely saved.

His analysis has profound implications for current policy efforts at fiscal and monetary stimulus. To anticipate the conclusion, if Friedman was right, all efforts at using temporary measures to effect permanent change are bound to fail.

Why Autos Are In Demand

Temporary fluctuations in income are absorbed by a buffer stock of savings. Shortfalls are met by a drawdown of savings, and windfalls can add to liquid assets. Importantly for the current situation, Friedman considered another form of consumer saving from temporarily higher income. He suggested that "the timing of the replacement of durable goods and of additions to the stock of such goods (is) likely to some extent to be adjusted so as to coincide with windfalls." Purchases of durable goods, which yield their services over time, are one vehicle for storing temporary additions to income.

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