The blogosphere has been buzzing recently over the recent confrontation between Nobelists Paul Krugman and Robert Lucas, Krugman charging Lucas with not understanding Ricardian equivalence. The controversy has already gone on too long with too many contributions from too many sources to even attempt to summarize it, so if you have been asleep for the last week and haven’t yet heard about this minor internet conflagration, I suggest that you do a google search on Krugman + Lucas + Ricardian equivalence.
I am not even going to try to comment on Krugman’s criticism of Lucas or on criticisms of Krugman’s criticism by Andolfatto and Williamson and Cochrane. But I do want to go back to the statement that Lucas made in his talk that got Krugman all bent out of shape, because it reminded me of a piece that Robert Barro wrote a while back in the Wall Street Journal, a piece I commented on here. First, here’s what Lucas said in his talk.
We had some lively sessions this morning about fiscal stimulus. Now, would a fiscal stimulus somehow get us out of this bind, or add another weapon that would help in this problem? I’ve already said I think what the Fed is now doing is going to be enough to get a reasonably quick recovery committed. But, could we do even better with fiscal stimulus?
I just don’t see this at all. 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.
So Lucas remains enough of a Monetarist to agree that printing money can provide a stimulus to an ailing economy. However, he denies that government spending can provide any stimulus if there is no money printing.
Last August, Robert Barro had a take similar to Lucas on the ineffectiveness of fiscal policy.
If [the Keynesian multiplier were] valid, this result would be truly miraculous. The recipients of food stamps get, say, $1 billion but they are not the only ones who benefit. Another $1 billion appears that can make the rest of society better off. Unlike the trade-off in regular economics, that extra $1 billion is the ultimate free lunch.
How can it be right? Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people? Keynes in his “General Theory” (1936), was not so good at explaining why this worked, and subsequent generations of Keynesian economists (including my own youthful efforts) have not been more successful.
I also pointed out that Barro had written an earlier piece in the Journal in which he explicitly stated that a business downturn and high unemployment could be prevented by monetary expansion (printing money).
[A] simple Keynesian macroeconomic model implicitly assumes that the government is better than the private market at marshalling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.
John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.
I then suggested that if monetary policy is indeed effective in providing stimulus to an economy in recession, it is not that hard to construct an argument that fiscal policy can also be effective in providing stimulus, fiscal stimulus being a method of transferring cash from those indifferent between holding cash and holding bonds to those who would spend cash.
[H]ow is it that monetary expansion works according to regular economics? People get additional pieces of paper; they have already been holding pieces of paper, and don’t want to hold any more paper. Instead they start spending to get rid of the the extra pieces of paper, but what one person spends another person receives, so in the aggregate they cannot reduce their holdings of paper as intended until the total amount of spending has increased sufficiently to raise prices or incomes to the point where everyone is content to hold the amount of paper in existence. So the mechanism by which monetary expansion works is by creating an excess supply of money over the demand.
Well, let’s now think about how government spending works. What happens when the government spends money in a depression? It borrows money from people who are holding a lot money but are willing to part with it for a bond promising a very low interest rate. When the interest rate is that low, people with a lot cash are essentially indifferent between holding cash and holding government bonds. The government turns around and spends the money buying stuff from or just giving it to people. As opposed to the people from whom the government borrowed the money, a lot of the people who now receive the money will not want to just hold the money. So the government borrowing and spending can be thought of as a way to take cash from people who were willing to hold all the money that they held (or more) giving the money to people already holding as much money as they want and would spend any additional money that they received. In other words, i.e., in terms of the demand to hold money versus the supply of money, the government is cleverly shifting money away from people who are indifferent between holding money and bonds and giving the money to people who are already holding as much money as they want to. So without actually printing additional money, the government is creating an excess supply of money, thereby increasing spending, a process that continues until income and spending rise to a level at which the public is once again willing to hold the amount of money in existence.
Now I happen to think that there are solid reasons to prefer monetary over fiscal policy as a method of stimulus, but there is no reason to treat this issue as if some deep principle of economic theory depended on it. But that seems to be the way it is treated by Lucas and Barro. And, just to show that I can be even-handed in my assessments, many Keynesians, including Paul Krugman himself, like to argue that in a Depression only fiscal policy can work because of the liquidity trap. However, at least Krugman displays the unfairly maligned virtue of inconsistency.