Imagine a Nobel Prize winner in physics, who in public debate makes elementary errors that would embarrass a good undergraduate. Now imagine other academic colleagues, from one of the best faculties in the world, making the same errors. It could not happen. However that is exactly what has happened in macro over the last few years. Where is my evidence for such an outlandish claim? Well here is Nobel prize winner Robert Lucas:
“But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge.”
I’m not sure if Wren-Lewis knows this, but Nobel Prizes are frequently awarded to people who don’t believe accept the Keynesian model (Lucas, Prescott, Friedman, Hayek, etc.) So if this is the right analogy, then Wren-Lewis (and Krugman?) is suggesting that the academy in Sweden is continually awarding Nobel Prizes for the economic equivalent of alchemy. In that case the Nobel Prize is a joke, and Wren-Lewis was wrong to use it as an indicator of academic prestige.
Lots of people believe the fiscal multiplier is roughly zero, including Lucas, Friedman and me. That doesn’t mean one is ignorant of basic economics.
Wren-Lewis makes the same complaint about John Cochrane. Here’s Cochrane:
Before we spend a trillion dollars or so, it’s important to understand how it’s supposed to work. Spending supported by taxes pretty obviously won’t work: If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off2.
“Stimulus” supposes that if the government borrows $1 from A and gives it to B we get a fundamentally different result, and we all are $1.50 better off.
But here’s the catch: to borrow today, the government must raise taxes tomorrow to repay that debt. If we borrow $1 from A, but tell him his taxes will be $1 higher (with interest) tomorrow, he reduces spending exactly as if we had taxed him today! If we tell both A and B that C (“the rich”) will pay the taxes, C will spend $1 less today.
. . .
2 Yes, I’m aware that old Keynesian models do give a multiplier to tax financed spending. Also, some new Keynesian models such as Christiano, Eichenbaum and Rebelo (2009) predict huge government spending multipliers whether financed by taxes or by borrowing. However, tax-financed spending is usually thought to have a weaker (if any) effect, which is why the current policy debate is only about borrowing to spend.
3 Advocates will go nuts here, and complain that A might be putting money in the bank, and “banks aren’t lending,” or stuffing the money in mattresses. As you can tell, this line of argument leads us into “something’s wrong” with the banking system, and confusion between fiscal and monetary policy.
So Cochrane is dividing debt-financed government spending into two components, a tax-financed spending increase and a deficit-financed tax cut. I don’t see any problem with that thought experiment, but maybe I’m missing something. Then he argues the debt-financed tax cut will do nothing, because of Ricardian equivalence. I don’t entirely agree, but it’s certainly a respectable argument. Then he suggests that the balanced budget multiplier is zero. Obviously the Keynesian model says it’s not, but why assume that model is correct? Do we have lots of empirical evidence of tax financed expansions of the state boosting RGDP? Cochrane clearly indicates that he understands that the old Keynesian model implies a positive balanced budget multiplier, so it’s not a question of Chicago economists not having studied Keynesian economics. He simply doesn’t agree. (BTW, I learned the Keynesian model in Lucas’s macro class.)
Why did Wren-Lewis think this argument is silly?
Both make the same simple error. If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.
Even worse, Krugman quoted this passage with approval! Wren-Lewis seems to be the one making a simple logical error (which is common among Keynesians.) He equates “spending” with “consumption.” But the part of income not “spent” is saved, which means it’s spent on investment projects. Remember that S=I, indeed saving is defined as the resources put into investment projects. So the tax on consumers will reduce their ability to save and invest.
So now let’s consider two possibilities. In the first, the fiscal stimulus fails, and the increase in G is offset by a fall of $100 in after-tax income and private spending. In that case, consumption might fall by $10 and saving would have to fall by about $90. That’s just accounting. But since S=I, the fall in saving will reduce investment by $100 $90. So the Wren-Lewis’s example would be wrong, the $100 in taxes would reduce private spending by exactly $100.
I’m pretty sure my Keynesian readers won’t like the previous example. So let’s assume the bridge building is a success, and national income rises by $100. In that case private after-tax income will be unchanged. But in that case with have a “free lunch” where the private sector would not reduce consumption at all.
Either way Wren-Lewis’s example is wrong. If viewed as accounting it’s wrong because he ignores saving and investment. If viewed as a behavioral explanation it’s wrong because he assumes consumption will fall, but that’s only true if the fiscal stimulus failed.
Now that doesn’t mean the balanced budget multiplier is necessarily zero. Here’s the criticism that Wren-Lewis should have made:
Cochrane ignores the fact that tax-financed bridge building will reduce private saving and hence boost interest rates. This will increase the velocity of circulation, which will boost AD.
Those who read my blog know I don’t think much of this argument, because the Fed doesn’t tend to keep the monetary base fixed. Rather they tend to adjust the base to offset changes in base velocity. But at least it’s a respectable criticism of Lucas and Cochrane. As it is, Wren-Lewis and Krugman are showing they don’t understand that not everyone agrees with the Keynesian model, and also that they don’t even know how to defend their own model. It does no good to “refute” Cochrane with an example that implicitly accepts the crude Keynesian assumption that savings simply disappear down a rat-hole, and cause the economy to shrink. Non-Keynesians aren’t likely to be impressed with that sort of argument, especially when presented with arrogant assertions that anyone who doesn’t buy into the Keynesian approach is some sort of ignoramus.
Again, the point is not that Wren-Lewis and Krugman are necessarily wrong about fiscal stimulus, but rather that the argument they present is incredibly weak. I also find Cochrane’s critique of Keynesianism to be very weak (and equally arrogant), because he has no model of NGDP determination. Indeed at times he seems to imply that if NGDP is the problem, then we are talking about monetary policy, not fiscal policy. That’s my view as well, but if you plan to persuade Keynesians you need to do so with an explicit model of NGDP determination. He needs to explain why fiscal stimulus won’t boost velocity, or why any boost would be offset by a lower money supply. Cochrane doesn’t do that.
HT: Marcus Nunes