I guess I shouldn’t have been surprised. For three years conservatives have been coming over here and sneering that I was just trying to force people to spend more. Each time I patiently pointed out that I want more spending, but not more consumption.
Nevertheless, the last few days have been a real eye-opener. The comment sections contained a torrent of attacks against my novel S=I claim. Eventually people started quoted textbooks by Krugman and Mankiw, which also claimed it was an identity. But there was still a lot of grumbling, as there always is when you try to throw tautologies at people in an argument. If it’s just a tautology, what difference can it make? In this post I’d like to explain why it’s essential to think of saving as spending on capital goods, not as setting money aside. And I’ll also show that even Nobel Prize winners can make elementary errors by forgetting this identity. I’m going to rehash the Wren-Lewis/Krugman mistake, because I don’t think I explained it effectively in this post. Here’s how Simon Wren-Lewis criticized Bob Lucas and John Cochrane’s claim that when the government builds a bridge using tax money, the balanced budget multiplier might be zero:
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.
But surely very clever people cannot make simple errors of this kind?
Then Paul Krugman cited the Wren-Lewis quotation with approval:
Yes indeed. A lot of people have been clutching their pearls over my (and Brad’s) simple statement that Lucas/Cochrane made simple, fail-an-undergrad-quiz-level, errors. To say that they did what they did is a “rant.” But the truth is that they did — and have refused to admit those errors, which is worse.
Undergraduate quiz? He’s going to bitterly regret that snide remark.
First recall that C + I + G = AD = GDP = gross income in a closed economy. Because the problem involves a tax-financed increase in G, we can assume that any changes in after-tax income and C + I are identical. Checkmate in four.
Suppose that because of consumption smoothing, any reduction in after-tax income causes C to fall by 20% of the fall in after-tax income. Then by definition saving must fall by 80% of the decline in after-tax income. So far nothing controversial; just basic national income accounting. Checkmate in three.
Now let’s suppose the tax-financed bridge cost $100 million. If taxes reduced disposable income by $100 million, then Wren-Lewis is arguing that consumption would only fall by $20 million; the rest of the fall in after-tax income would show up as less saving. I agree. Checkmate in two.
But Wren-Lewis seems to forget that saving is the same thing as spending on capital goods. Thus the public might spend $20 million less on consumer goods and $80 million less on new houses. In that case private aggregate demand falls by exactly the same amount as G increases, even though we saw exactly the sort of consumption smoothing that Wren-Lewis assumed. Checkmate in one.
Those readers who agree with Brad DeLong’s assertion that Krugman is never wrong must be scratching their heads. He would never endorse such a simple error. Perhaps investment was implicitly assumed fixed; after all, it is sometimes treated as being autonomous in the Keynesian model. So maybe C fell by $20 million and investment was unchanged. Yeah, that could happen, but in that case private after-tax income fell by only $20 million and there was no consumption smoothing at all. Checkmate.
I think Wren-Lewis and Krugman both made the same mistake as those angry Austrians that complained I was trying to goose up “spending”. They momentarily forgot that saving is not money down a rat hole, but rather represents spending on capital goods. They were so overconfident that anti-Keynesian arguments are bogus that they momentarily let down their guard, and employed a bogus argument themselves.
Of course it’s very possible that investment would not fall, it’s very possible that AD would rise by the amount of the spending on the bridge. But you can’t get from here to there by employing a consumption smoothing argument against Cochrane. After all, consumption smoothing is a part of the classical model, and the multiplier is zero in many versions of the classical model. (Not all, there are classical models where wasteful expenditure makes the public poorer, and hence they work harder–Larry Sjaastad did a model like that way back in the 1970s.)
So Wren-Lewis and Krugman used the common sense notion that saving is money set aside and not “spent” and ended up making a simple error. I used the idea that saving is nothing more than spending on capital goods and got the right answer. Do you still think tautologies are useless?
Of course Nick Rowe has an even better idea, instead of obsessing over S=I, let’s drop saving completely out of business cycle theory. After all when it looks like saving is depressing the economy, the real problem is money hoarding. He’s right. Saving, income, inflation, RGDP, interest rates; Nick and I could write a textbook that stripped all the inessentials out of macro. Monetary policy controls M*V, and unexpected shocks to M*V causes fluctuations in hours worked because of sticky wages. Replace the welfare cost of inflation with the welfare cost of fast NGDP growth. Real wages become relative wages (W/NGDP per capita.) Business cycle and “inflation” theory in 2 pages. That’s not Occam’s razor, that’s Occam’s chainsaw!
There’s been a recent debate over etiquette in the blogosphere. Tyler Cowen says we should try to be civil, and try to imagine the best argument the other side might be making. Brad DeLong and Krugman insist that when the other side says something that you think looks foolish, you should call them ignorant. I can’t imagine there being any serious question over who’s right, but in case there is consider the following. Krugman recently bragged that he doesn’t read right-wing blogs. This means that on the rare occasions when he makes a mistake he doesn’t find out, but rather keeps on repeating the mistake over and over again. This allows conservatives who hate him to simply write him off.
I think conservatives are making a big mistake, as Krugman is brilliant—and you always want to be aware of the best arguments the other side has to offer. But if Krugman were a bit more humble, and occasionally said he was wrong in attacking Cochrane, he’d have a much better change of convincing the other side. So in an odd way I think both Krugman and DeLong, despite being incredibly bright and talented bloggers, are their own worst enemies.
And I think Chicago school economists made the same mistake in criticizing the Keynesian model–they simply assumed they could brush it away because for decades people had pretty much given up on fiscal stimulus. Thus they underestimated the sophistication of modern “liquidity trap” arguments for fiscal stimulus. In the end I don’t find those arguments convincing either, but I don’t think anyone reading this blog could deny that I’ve thought long and hard about the Krugman/DeLong/Thoma/Yglesias/Avent argument for stimulus. I take their arguments very seriously indeed.
Now where the hell did I leave that f****** pearl necklace I was going to wear tonight . . .
Update: I see Paul Krugman has responded to this post, and of course completely distorted my argument. I actually do understand the basic mechanical Keynesian model, believe it or not. He also completely ignores the criticism I actually did make of the Wren-Lewis quotation that he endorsed. I have a new post that responds in detail here.