Here’s Paul Krugman:
Menzie Chinn has some fun pointing out that if the doctrine Heritage was pushing to oppose fiscal stimulus were true — namely, that government borrowing always crowds out an equal amount of private spending — then the fiscal cliff could not be a problem.
. . .
But what Menzie doesn’t mention is that the very same doctrine was propounded by distinguished economists at the University of Chicago — John Cochrane and Gene Fama made exactly the same argument that Brian Riedl was making at Heritage, while Robert Lucas fell into a somewhat different but equally misleading fallacy.
So if you think the fiscal cliff matters, you also, whether you know it or not, believe that a whole school of macroeconomics responded to the greatest economic crisis since the Great Depression with ludicrous conceptual errors, of a kind nobody has had a right to make since 1936 at the latest.
Or perhaps one should take a deep breath, and spend a minute or two recalling that conservatives think the supply-side effects of taxes are very important.
PS. In the post on Lucas that Krugman links to, he quotes Lucas as saying:
If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.
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.
Since Lucas was my adviser I won’t call this ludicrous, but it is wrong. He’s saying that it has no effect holding M constant, when he should say holding M*V constant. Or it would have no effect if the central bank were targeting inflation, or the Taylor Rule, or whatever. What he’s really saying is it makes no sense to do fiscal stimulus if the monetary authority is targeting some sort of nominal aggregate like M*V. And that if fiscal stimulus works, it’s just a backdoor way of doing monetary stimulus (i.e. more M*V.) That’s all true.
Here’s Krugman’s response:
I’ve tried to explain why Lucas and those with similar views are all wrong several times, for example here. But it just occurred to me that there may be an even more intuitive way to see just how wrong this is: think about what happens when a family buys a house with a 30-year mortgage.
Suppose that the family takes out a $100,000 home loan (I know, it’s hard to find houses that cheap, but I just want a round number). If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.
But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.
Now notice that this family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like Lucas’s bridge; in this case the household really does know that today’s spending will reduce its future disposable income. And even so, its reaction involves very little offset to the initial spending.
How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong? And yet as far as I can tell almost everyone on the freshwater side of this divide did get it wrong, and has yet to acknowledge the error.
I won’t call this ludicrous, but it’s a very strange argument. Krugman should have said that Lucas forgot that fiscal stimulus can impact V. But instead he makes a completely different argument that doesn’t seem to depend on V rising; one that opens the door to deflationary stimulus, i.e. real GDP going up without any rise in either M or V. That’s possible, but not much of a refutation of Lucas.
I also don’t understand the representative household argument. If the stimulus is to work, it must raise the quantity of labor supplied by the representative household. If Krugman had made the standard Keynesian argument that more fiscal stimulus boosts NGDP, then he’d just need to assume sticky wages to get more hours worked. But here he seems to be making an optimal consumption smoothing argument that requires people to work more hours, but doesn’t explain why they would want to work more hours. Is it because the bridge makes them poorer? It’s obvious to me that the representative household that buys a $100,000 house will not reduce consumption by an equal amount. But it’s not obvious that they would avoid that drop in consumption by choosing to work more.
So what’s the Keynesian model all about? Is it about nominal shocks combined with sticky wages and prices, or is it about inter-temporal consumption allocation decisions when the government decides to build bridges?
And if it’s “obvious” the bridge will make real GDP rise, is it equally obvious it will work if the central bank targets NGDP, or does it only work if the central bank targets M? If it’s the latter, then Krugman should have just claimed that bridges boost velocity, and left it at that. If the former, then he’s claiming bridges can provide deflationary growth. Maybe, but that’s not the Keynesian argument, is it?
I wish Keynesians and freshwater economists could agree on a common language:
1. There are nominal shocks when NGDP changes, and they may have real effects if wages and prices are sticky.
2. There are all sorts of real shocks that can also impact RGDP.
Instead freshwater economists spend so little time thinking about nominal shocks that they forget it’s M*V that matters, not M. And Keynesians spend so little time thinking about real shocks that they don’t see how fiscal policy could affect anything beyond AD.
Update: Marcus Nunes got there first.