Update: Continue reading, but then go to my next post to find out how it all turns out in the end.
Signs of fatigue are clearly evident and multiplying rapidly, so we had all better figure out and start executing our exit strategies from this convoluted, and at times acrimonious, debate about consumption smoothing. Things got started (two whole weeks ago!) when Simon Wren-Lewis picked on Robert Lucas for the following statement:
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.
and on John Cochrane for this statement:
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 off.
Wren-Lewis made the following accusation:
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.
Paul Krugman followed up with a blast of his own at both Cochrane and Lucas, and John Cochrane weighed in, defending himself and Lucas. The battles among the principals were accompanied by various interventions on either (or neither) side by Brad DeLong, Scott Sumner, Nick Rowe, Karl Smith (to name just a few) and by responses and rejoinders by Cochrane, Wren-Lewis and Krugman. I got involved mainly because I was upset that my friend Scott Sumner seemed to be making arguments invoking accounting identities in ways that I thought were illegitimate and even nonsensical. Scott, though apparently intervening on the side of Lucas and Cochrane, denied that he was supporting their substantive position, a denial that I, though apparently intervening on the side of Wren-Lewis and Krugman, also made.
I am not going to repeat my previous arguments against Scott, which mostly involved denials that any useful implication can be inferred from an accounting identity. I will merely reiterate that I hate – despise — all accounting identities, and deny that they can ever have any substantive implications about anything, serving only one function, namely, to force us to obey the laws of arithmetic. OK, I got that out of my system, and now I feel well enough to go on.
The key passage that we have all been arguing was this one from Wren-Lewis’s original post:
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? Perhaps there is some way to re-interpret such statements so that they make sense. They would make sense, for example, if the extra government spending was permanent. The only trouble is that both statements were made about a temporary fiscal stimulus package.
My next step is a bit tricky because I am going to have to refer to Scott’s criticism of Wren-Lewis, which, I must admit, I still do not fully understand. But the gist of at least part of what Scott was trying to say — and he, as well as Karl Smith, has repeated it in responding to me several times — is that Wren-Lewis was trying to force Lucas and Cochrane to accept the validity of the Keynesian model, when they simply don’t accept the model. My basic response to that has been that you can’t have a discussion about the effects of a policy unless you have some (at least implicit) model from which you are deriving your conclusions. It is not enough to invoke an accounting identity from which no conclusions (as Scott agrees) can be deduced. My first attempt to specify some model from which we could deduce the position adopted by Lucas and Cochrane was not too successful. I suggested that what they had in mind was some sort of crowding-out effect, the increase in government spending and taxes causing private investment to fall. I then combined this effect with a consumption-smoothing effect to produce a small short-term increase in Y as a result of building the bridge. This was unsatisfactory, because it was ad hoc, and because, as commenter John Hall pointed out, the change in consumption ought to (and could) have been derived rather than just assumed as I had done.
But I realized when responding to Scott’s comment on my previous post, that there is a simple way to reconcile what Lucas and Cochrane are saying with the basic Keynesian model, which, after all, is just a tool of analysis compatible with a variety of substantive assertions about the real world. So it is not correct to say that it is an unfair imposition on Lucas and Cochrane to require their position to be expressed in terms of a Keynesian model that they obviously reject. The Keynesian model is pretty flexible, and, by appropriate assumptions, you can get almost any substantive implication you want. So how does one interpret Lucas and Cochrane? Simple. They believe that households are rational maximizers basin their consumption decisions on their expected future income stream and expected future tax liabilities. They therefore engage in consumption smoothing, so that current consumption is fixed and independent of variations in current income, such variations being capitalized into their expected future income streams. Thus, the MPC out of current income in such a model is 0.
In terms of the Keynesian cross, you have an aggregate expenditure line that is horizontal (reflecting a 0 MPC). The multiplier with respect to a change in autonomous expenditure is one. However, since all government spending must be financed eventually by taxes, Ricardian equivalence implies that the increase in G is offset by an equal reduction in C, reflecting the effect on consumption of expected future taxes. That is precisely what Lucas and Cochrane were saying in the quotations above. Wren-Lewis, in his criticism, accepted that position. His point was that if the increase in government spending is temporary, the increase in government spending in the current period will rise by more than the fall in consumption this period due to the effect of expected future taxes (or borrowing this period to pay part of the current tax bill). This is not necessarily the end of the story (though, with a bit of luck, perhaps it will be), but this is the framework within which the argument must be carried out. It has nothing to do with accounting identities.
PS By the way Nick Rowe apparently had this all figured out almost two weeks ago. He could have saved us all this agony. But the truth is we loved every minute of it.