Why aren't Americans spending? What would Friedman say now?

The Bush administration's plan to get Americans to spend their way out of the economic doldrums appears to have hit problems, according to a survey of US householders conducted for CNN/ Opinion research Corp.

Only last month, the U.S congress voted through a $170 billion package to boost the economy, with $120 billion of this set to be put straight into consumers pockets in the form of tax rebates, with payments of $600 to most individual taxpayers who earn less than $75,000, and $1,200 for married taxpayers filing joint returns who together earn less than $150,000. There is also a $300-per-child tax credit.

But a survey pulished today reveals that only one in five U.S consumers are planning to spend the money. Instead 41% of those surveyed plan to use their rebates to pay off bills, and 32% will put the money in savings. A further 3% said they will donate the extra money to charity.

The survey indicates that only $24 billion of the $120 billion being handed out will actually contribute to stimulating the U.S economy.

The results are ironic, given the long standing commitment of the U.S to monetarist economics. Monetarism's rise dates back to the 1970's when nations were grappling with the failure of Keynesian economics to stimulate domestic demand in the face of the oil crisis, and inflation and unemployment were both rising.

One of the key theoretical explanations for Keynesian economics failure was contained in Milton Friedman's 'Permanent Income Hypothesis' first published in the 1950's. This stated that, rather than modify their consumption patterns in line with temporary increases or decreases in income, people would use credit to smooth out these fluctuations over their lifetime and attempt to maintain a constant level of consumption. Short term attempts to boost the economy - for example increased welfare payments or tax rebates - Friedman argued, would be largely ineffectual. Only changes in household's long term expectations would have an impact.

For neo-liberal administrations like those of Thatcher and Reagan, Friedman's theory - and other life cycle theories of credit that followed it in the 1960's - provided the theoretical justification for policies that deregulated credit markets, promoted home ownership, and boosted demand. Expanding credit markets meant not having to resort to the old Keynesian mechanisms of state spending, but instead relying on individual households to borrow and spend. The consequent surge in house values shifted household expectations sufficiently to encourage a cycle of increasing indebtedness and, for limited periods, economic growth.

It also provided a good basis on which to reduce traditional welfare provision throughout this period under slogans of "self-reliance", and "individual responsibility". In this sense, credit was the tool of choice for those administrations looking for a mechanism to undermine the welfare state.

But this cannot last forever. Just as this process resulted in mass repossessions in the UK in the late 1980's, so it must come to an end this time around also. At some point, as the economists Godley & Izurieta pointed out in 2003, (Coasting on the Lending Bubble Both in the U.K and U.S. Paper presented at the Annual Meeting of the Society of Business Economists, London, June 25th, 2003) household expectations begin to flatten out - they balance their debt burdens against a prognosis for the economy more broadly. Once this happens, spending slows and the cycle begins to reverse. Consumers repay debts or save rather than spend, demand slows, and asset values including house prices fall.

The evidence from the US survey indicates that consumer expectations have now been firmly realigned downwards. According to Friedman's theory, tax breaks are not going to be enough to save the US economy now.

What might help? Firstly, if Friedman's theory is right then measures must be taken that will help manage household expectations for the longer term. Short term measures are unlikely to be successful. Instead, emphasis should be placed on preventing house prices from collapsing further - putting in solid protections against repossession would be a good start.

Secondly, there has to be both liquidity of credit, and responsibility in its provision - this means ways must be found to continue to lend to households that require re-financing, but that this must be done in ways that help households in the longer term rather than simply seek to profiteer on their desperate positions. Rescue loan funds, that genuinely work with consumers to provide sustainable long term solutions would be useful. Given that so much central bank funding is now flowing into private banks, some insistence that this be used to assist households in difficulty doesn't appear to be too much to ask.

For the longer term, there needs to be a reassessment of the regulatory framework governing credit provision and a debate involving government, consumers, and the industry to determine accepted principles of responsible lending and the required rules to ensure this.