Archive for January, 2012



Why Am I Arguing with Scott Sumner?

This is going to be my third consecutive post about Scott Sumner (well, not only about Scott), and we seem to be arguing about something, but it may not be exactly clear what the argument is about. Some people, based on comments on this and other blogs, apparently think that I am defending the Keynesian model against Scott’s attacks. Others even accuse me of advocating – horrors! – tax and spend policies as the way to stimulate the economy. In fact, Scott himself seems to think that what I am trying to do is defend what he calls the hydraulic Keynesian model. That’s a misunderstanding; I am simply trying to enforce some basic standards of good grammar in arguing about economic models, in this case the hydraulic Keynesian model. I am not a fan of the hydraulic Keynesian model, but most economists, even anti-Keynesians like Hayek (see here), have acknowledged that in a severe recession or depression, when there is substantial unemployment of nearly all factors of production, the model does provide some insight. I have also explained (here and here) that it is possible to translate the simple Keynesian model of a depression and a liquidity trap into the language of the supply of and demand for money. So at some level of generality, the propositions of the Keynesian model can be treated as fairly trivial and non-controversial.

So what do I mean when I say that I am just trying to enforce basic standards of good grammar? I mean that good grammar is not about what you choose to say; it is about how you say it. Using good grammar doesn’t prevent you from saying anything you want to; it just prevents you from saying it in certain not very comprehensible ways. If you use good grammar, you enhance your chances of saying what you want to say coherently and avoiding needless confusion. Sure some grammatical rules are purely conventional or nitpicks, but good writers and speakers know which grammatical rules can be safely ignored and which can’t. Using bad grammar leads you make statements that are confusing or ambiguous or otherwise incoherent even though the point that you are trying to make may be perfectly clear to you. Making the point clear to someone else requires you to follow certain semantic rules that help others to follow what you are saying. It is also possible that when you make an ungrammatical statement, you are disguising (and at the same time revealing) some confusion that you yourself may not be aware of, and had you made the statement grammatically you might have become aware that you had not fully thought through what you were trying to say. So in a discussion about the Keynesian model, I regard myself as a neutral observer; I don’t care if you are making a statement for or against the model. But I want you to make the statement grammatically.

That’s right; my problem with Scott is that he is using bad grammar. When Scott says he can derive a substantive result about the magnitude of the balanced-budget multiplier from an accounting identity between savings and investment, he is making a theoretically ungrammatical statement. My problem is not with whatever value he wants to assign to the balanced-budget multiplier. My problem is that he thinks that he can draw any empirically meaningful conclusion — about anything — from an accounting identity. Scott defends himself by citing Mankiw and Krugman and others who assert that savings and investment are identically equal. I don’t have a copy of any of Krugman’s textbooks, so I don’t know what he says about savings and investment being identically equal, but I was able to find the statement in Mankiw’s text. And yes, he does say it, and he was speaking incoherently when he said it. Now, it is one thing to make a nonsense statement, which Mankiw obviously did, and it is another to use it as a step – in fact a critical step — in a logical proof, which is what Scott did.

The unfortunate fact is that the vast majority of economics textbooks starting with Samuelson’s classic text (though not until the fourth edition) have been infected by this identity virus, even including the greatest economics textbook ever written. The virus was introduced into economics by none other than Keynes himself in his General Theory. He was properly chastised for doing so by Robertson, Hawtrey, Haberler, and Lutz among others. Perhaps because the identity between savings and investment in the national income accounts reinforced the misunderstanding and misconception that the Keynesian model is somehow based on an accounting identity between investment and savings, the virus withstood apparently conclusive refutation and has clearly become highly entrenched as a feature of the Keynesian model.

The confusion was exacerbated because, in the most common form of the Keynesian model, the timeless, lagless form with the instantaneous multiplier, the model has meaning only in equilibrium for which the equality of savings and investment is a necessary and sufficient condition. This misunderstanding has led to completely illegitimate attempts to identify points on the Keynesian cross diagram away from the point of intersection as disequilibria characterized by a difference between planned (ex ante) and realized (ex post) savings or planned and realized investment. It is legitimate to refer to the equality of savings and investment in equilibrium, but you can’t extrapolate from a change in one or the other to determine how the equilibrium changes as a result of the specified change in savings or investment, which is what Scott tried to do. So, yes, the mistaken identification of savings and investment is distressingly widespread, but unfortunately Scott has compounded the confusion, taking it to an even higher level. Let me again cite as the key source identifying and tracking down all the confusions and misconceptions associated with treating savings and investment (or expenditure and income) as identically equal the classic paper by Richard Lipsey, “The Foundations of the Theory of National Income,” originally published in 1972 in Essays in Honour of Lord Robbins and reprinted in Lipsey Macroeconomic Theory and Policy: The Selected Essays of Richard G. Lipsey, vol. 2.

That’s all for now. I still need to respond to some of Scott’s arguments in detail, clear up a mistake in my previous post and say some more about the savings is identically equal to investment virus.

I Figured Out What Scott Sumner Is Talking About

I won’t bother with another encomium to Scott Sumner. But how many other bloggers are there who could touch off the sort of cyberspace fireworks triggered by his series of posts (this, this, this, this, this and this) about Paul Krugman and Simon Wren-Lewis and their criticism of Bob Lucas and John Cochrane? In my previous post, after heaping well-deserved, not at all overstated, praise upon Scott, I registered my own perplexity at what Scott was saying. Thanks to an email from Scott replying to my post (owing to some technical difficulties about which I am clueless, his comment, and possibly others, to that post weren’t being accepted last Friday) and, after reading more of the back and forth between Scott and Wren-Lewis, I now think that I finally understand what Scott was trying to say. Unfortunately, I’m still not happy with him.

Excuse me for reviewing this complicated multi-sided debate, but I don’t know how else to get started. It all began with assertions by Lucas and Cochrane that that old mainstay of the Keynesian model, the balanced-budget multiplier theorem, is an absurd result because increased government spending financed by taxes simply transfers spending from the private sector to the public sector, without increasing spending in total. Lucas and Cochrane supported their assertions by invoking the principle of Ricardian equivalence, the notion that the effect of taxation on present consumption is independent of when the taxes are actually collected, because the expectation of future tax liability reduces consumption immediately (consumption smoothing). Paul Krugman and Simon Wren-Lewis pounced on this assertion, arguing that Ricardian equivalence actually reinforces the stimulative effect of government spending financed by taxes, because consumption smoothing implies that a temporary increase in taxation would cause current consumption to fall by less than would a permanent increase in taxation. Thus, the full stimulative effect of a temporary increase in government spending is felt right away, but the contractionary effect of a temporary increase in taxes is partially deferred to the future, implying that a temporary increase in both government spending and taxes has a net positive immediate effect.

[See update below] Now this response by Krugman and Wren-Lewis was just a bit opportunistic and disingenuous, the standard explanation for a balanced-budget multiplier equal to one having nothing to do with the deferred effect of temporary taxation. Rather, it seems to me that Krugman and Wren-Lewis were trying to show that they could turn Ricardian equivalence to their own advantage. It’s always nice to turn a favorite argument of your opponent against him and show that it really supports your position not his. But in this case the gambit seems too clever by a half.

Enter Scott Sumner. Responding to Krugman and Wren-Lewis, Scott tried to show that the consumption-smoothing argument is wrong, and the attempt to turn Ricardian equivalence into a Keynesian argument a failure. I don’t know about others, but it did not occur to me on first reading that Scott’s criticism of Krugman and Wren-Lewis was so narrowly focused. The other problem that I had with Scott’s criticism was that he was also deploying some very strange arguments about the alleged significance of accounting identities, which led me in my previous post to make some controversial assertions of my own denying Scott’s assertion that savings and investment are identically equal as well as the equivalent one that income and expenditure are identically equal.

So what Scott was trying to do was to show that consumption smoothing cannot be an independent explanation of why an equal temporary increase in government spending and in taxes increases equilibrium income.  Krugman and Wren-Lewis were suggesting that it is precisely the consumption-smoothing effect that produces the balanced-budget multiplier. Here’s Wren-Lewis:

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.

This is not your parent’s proof of the balanced-budget multiplier, in which consumption decisions are based only on current income without consideration of future income or expected tax liability. It’s a new proof. And it drove Scott bonkers. So what he did was to say, let’s see if Wren-Lewis’s proof can work on its own. In other words, let’s assume that the standard argument for the balanced-budget theorem — that all government spending on goods and services is spent, but part of a tax cut is spent and part is saved, so that an equal increase in government spending and taxes generates a net increase in expenditure, leading in turn to a corresponding increase in income — is somehow false.  Could consumption smoothing rescue an otherwise disabled balanced-budget multiplier

This was a clever idea on Scott’s part. But implementing it is not so simple, because if you are working with the simple Keynesian model, you can’t help but get the balanced-budget multiplier automatically. (A balanced-budget multiplier of 1 is implied by the Keynesian cross. In the world of IS-LM, you must be in a liquidity trap to get a multiplier of 1. Otherwise the multiplier is between 0 and 1.) At this point, the way to proceed would have been for Scott to say, well, let’s assume that something in the Keynesian model changes simultaneously along with the temporary increase in both government spending and taxes that exactly offsets the expansionary effect of the increase in spending and taxes, so that in the new equilibrium, income is exactly where is started. So, let’s say that initially Y = 400, and G and T then increase by 100. The balanced-budget multiplier says that Y would rise to 500. But let’s say that something else also changed, so that the two changes together just offset one another, resulting in a new equilibrium with Y = 400, just as it was previously. At this point, Scott could have introduced consumption smoothing and determined how consumption smoothing would alter the equilibrium.

But that is not what Scott did.  Instead, he relied on arguments from irrelevant accounting identities, as if an accounting identity can be used to predict (even conditionally) the response of an economic variable to an exogenous parameter change. Let’s now go back to a more recent restatement of his argument against Wren-Lewis (a restatement with the really bad title “It’s tough to argue against an identity”). Here’s Scott responding to Paul Krugman’s jab that Lucas and Cochrane had committed “simple fail-an-undergraduate-level-quiz errors.”

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.

By after-tax income, Scott means C + S, because in equilibrium, E (expenditure) ≡ C + I + G = Y (income) ≡ C + S + T. So if G = T, then C + S = C + I. Scott continues:

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.

It is not clear what accounting identity Scott is referring to; the accounting identities of national income accounting do not match up with the equilibrium conditions of the Keynesian model. But the argument is getting confused, because there are two equilibria that Scott is talking about (the equilibrium without consumption smoothing and the one with smoothing), and he doesn’t keep track of the difference between them. In the equilibrium without consumption smoothing, Y is unchanged from the initial equilibrium. Because after-tax income must be less in the new equilibrium than in the old one, taxes having risen with no change in Y, private consumption must be less in the new equilibrium than the old one. By how much consumption fell Scott doesn’t say; it would depend on the assumptions of the model. But he assumes that in the equilibrium with consumption smoothing, consumption falls by 20%. Presumably, without consumption smoothing, consumption would have fallen by more than 20%. But here’s the problem. Instead of analyzing the implications of consumption smoothing for an increase in government spending and taxes that would otherwise fail to increase equilibrium income, while reducing disposable income by the amount of taxes, Scott simply assumes that consumption smoothing leaves Y unchanged. Let’s follow Scott to the next step.

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.

Again, Scott is assuming a solution to a model without paying attention to what the model implies. The solution of a model must be derived, not assumed. The only assumption that Scott can legitimately make is that Wren-Lewis would agree that without consumption smoothing the $100 million bridge financed by $100 million in taxes would not change Y. The effect on Y (and implicitly on C and S) of consumption smoothing must be derived, not assumed. Next step.

But Wren-Lewis seems to forget that saving is the same thing as spending on capital goods.

I interrupt here to protest emphatically. There is simply no basis for saying that saving is the same thing as spending on capital goods, just as there is no basis for saying that eggs are chickens, or that chickens are eggs. Eggs give rise to chickens, and chickens give rise to eggs, but eggs are not the same as chickens. Even I can tell the difference between an egg and a chicken, and I venture to say that Scott Sumner can, too. Now back to Scott:

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. 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.

Scott has illegitimately assumed a solution to a model after introducing a change in the consumption function to accommodate consumption smoothing, rather than derive the solution from the model. His numerical assumptions are therefore irrelevant even for illustrative purposes. Even worse, by illegitimately asserting an identity where none exists, he infers a reduction in investment that contradicts the assumptions of the very model he purports to analyze. To say “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” is simply wrong. It is wrong precisely because saving is not “the same thing as spending on capital goods.” I know this is painful, but let’s keep going.

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.

What Scott is saying is that if you were to assume that savings is not the same as investment, so that investment remains at its original level, then C + I goes down by only $20. Then in equilibrium, given that G = T, C + S, private after-tax income also went down by $20 million, in which case consumption accounted for the entire reduction in Y, which, if I understand Scott’s point correctly, contradicts the very idea of consumption smoothing. But the problem with Scott’s discussion is that he is just picking numbers out of thin air without showing the numbers to be consistent with the solution of a well-specified model.

Let’s now go through the exercise the way it should have been done. Start with our initial equilibrium with no government spending or taxes. Let C (consumption) = .5Y and let I (investment) = 200.

Equilibrium is a situation in which expenditure (E) equals income (Y).  Thus, E ≡ C + I = .5Y + 200 = Y. The condition is satisfied when E = Y = 400. Solving for C, we find that consumption equals 200. Income is disposed of by households either by spending on consumption or by saving (additional holdings of cash or bonds). Thus, Y ≡ C + S. Solving for S, we find that savings equals 200. Call this Equilibrium 1.

Now let’s add government spending (G) = 100 and taxes (T) = 100. Consumption is now given by C = .5(Y – T) = .5(Y – 100). Our equilibrium condition can be rewritten E ≡ C + I + G = .5(Y – 100) + 200 + 100 = .5Y + 250 = Y. The equilibrium condition is satisfied when E = Y = 500. So an increase in government spending and taxes of 100 generates an increase in Y of 100. The balanced budget multiplier is 1. Consumption and saving are unchanged at 200. Call this Equilibrium 2.

Now to carry out Scott’s thought experiment in which the balanced-budget multiplier is 0, we have to assume that something else is going on to keep income and expenditure from rising to 500, but to be held at 400 instead. What could be happening? Perhaps the increase in government spending causes businesses to reduce their planned investment spending either because the government spending somehow reduces the expected profits of business, by reducing business expectations of future sales. At any rate to reduce equilibrium income by 100 from the level it would otherwise have reached after the increase in G and T, private investment would have to fall by 50. Thus in our revised model we have E ≡ C + I + G = .5(Y – 100) + 150 + 100 = .5Y + 200 = Y. The equilibrium condition is satisfied when E = Y = 400. The increase in government spending and in taxes of 100 causes a reduction in investment of 50, and therefore generates no increase in Y. The balanced budget multiplier is 0. Consumption and savings both fall by 50 to 150. Call this Equilibrium 2′.

Now we can evaluate the effect of consumption smoothing. Let’s assume that households, expecting the tax to expire in the future, borrow money (or draw down their accumulated holdings of cash or bonds) by 10 to finance consumption expenditures, planning to replenish their assets or repay the loans in the future after the tax expires. The new consumption function can be written as C = 10 + .5(Y – T). The revised model can now be solved in terms of the following equilibrium condition: E ≡ C + I + G = 10 + .5(Y – 100) + 150 + 100 = .5Y + 210 = Y. The equilibrium condition is satisfied when E = Y = 420.  Call this equilibrium 3.  Relative to equilibrium 1, consumption and savings in equilibrium 3 fall by 30 to 170, and the balanced budget multiplier is .2.  The difference between equilibrium 2′ with a zero multiplier and equilibrium 3 witha multiplier of .2 is entirely attributable to the effect of consumption smoothing.  However, the multiplier is well under the traditional Keynesian balanced-budget multiplier of 1.

Scott could have avoided all this confusion if he had followed his own good advice: never reason from a price change. In this situation, we’re not dealing with a price change, but we are dealing with a change in some variable in a model. You can’t just assume that a variable in a model changes. If it changes, it’s because some parameter in the model has changed, which means that other variables of the model have probably changed. Reasoning in terms of accounting identities just won’t do.

Update (1/17/12):  Brad DeLong emailed me last night, pointing out that I was misreading what Krugman and Wren-Lewis were trying to do, which was pretty much what I was trying to do, namely to assume that for whatever reason the balanced-budget multiplier without consumption smoothing is zero, so that an equal increase in G and T leads to a new equilibrium in which Y is unchanged, and then introduce consumption smoothing.  Consumption smoothing leads to an increase in Y relative to both the original equilibrium and the equilibrium after G and T increase by an equal amount.  So I withdraw my (I thought) mild rebuke of Krugman and Wren-Lewis for being slightly opportunistic and disingenuous in their debating tactics.  I see that Krugman also chastises me in his blog today for not checking my facts first.  My apologies for casting unwarranted aspersions, though my rebuke was meant to be more facetious than condemnatory.

Scott Sumner Goes Too Far

As I have said many times, Scott Sumner is the world’s greatest economics blogger. What makes him such a great blogger is not just that he is smart and witty, a terrific writer and a superb economist, but he is totally passionate about economics and is driven to explain to anyone who will listen why our economy unnecessarily fell into the deepest downturn since 1937 and has been needlessly stuck in the weakest recovery from any downturn on record. Scott loves economics so much, you might even think that he studied economics at UCLA. So the reason Scott is the greatest economics blogger in the world is that no one puts more thought, more effort, more of everything that he’s got into his blog than Scott does. So, Scott, for your sake, I hope that you get a life; for our sake, I hope that you don’t.

The only downside from our point of view about Scott’s obsession with blogging is that sometimes his enthusiasm gets the better of him. One of the more recent ideas that he has been obsessing about is the insight that fiscal policy is useless, because the Fed is committed to keeping inflation under 2%, which means that any fiscal stimulus would be offset by a monetary tightening if the stimulus raised the rate of inflation above 2%, as it would certainly do if it were effective. This insight about the interaction between fiscal and monetary policy allows Scott to conclude that the fiscal multiplier is zero, thereby allowing him to tweak Keynesians of all stripes, and especially his nemesis and role model, Paul Krugman, by demonstrating that fiscal policy is useless even at the dreaded zero lower bound. Scott’s insight is both clever and profound, and if Kydland and Prescott could win a Nobel Prize for writing a paper on time inconsistency, it’s not that big of a stretch to imagine that a few years down the road Scott could be in the running for the Nobel.

Okay, so having said all these nice things about Scott, why am I about to criticize him? Just this: it’s fine to say that the Fed has adopted a policy which renders the fiscal multiplier zero; it’s also correct to make a further point, which is that any estimate of the fiscal multiplier must be conditional on an (explicit or implicit) assumption about the stance of monetary policy or about the monetary authority’s reaction function to changes in fiscal policy. However, Scott in a post today has gone further, accusing Keynesians of confusion about how fiscal policy works unless they accept that all fiscal policy is monetary policy. Not only that, but Scott does this in a post in which he defends (in a manner of speaking) Bob Lucas and John Cochrane against a charge of economic illiteracy for believing that fiscal stimulus is never effective notwithstanding the results of the simple Keynesian model. Scott correctly says that it is possible to make a coherent argument that the fiscal multiplier implied by the Keynesian model will turn out to be zero in practice. But Scott then goes on to say that the textbook understanding of the Keynesian model is incoherent, and the only way to derive a positive fiscal multiplier is to assume that monetary policy is operating to make it so. Sorry, Scott, but that’s going too far.

For those of you who haven’t been paying attention, this whole dust-up started when Paul Krugman approvingly quoted Simon Wren-Lewis’s attempt to refute Bob Lucas and John Cochrane for denying that fiscal stimulus would be effective. Scott provides a reasonable defense of Lucas and Cochrane against the charge that they are economically illiterate, a defense I have no problem with. Here’s where Scott gets into trouble:

Wren-Lewis seems to be . . . 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.

Scott, where is savings “defined as the resources put into investment projects?”  Savings is not identically equal to investment, the equality of savings and investment is an equilibrium condition. Savings is defined as that portion of income not consumed. Investment is that portion of expenditure not consumed. Income and expenditure are not identically equal to each other; they are equal in equilibrium. One way to see this is to recognize that there is a lag between income and expenditure.  A tax on consumers causes their saving to fall, because they finance their tax payments by reducing consumption and their savings. Investments are undertaken by businesses and are not immediately affected by the tax payments imposed on consumers. Scott continues:

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.

Consider what Scott is saying here: assume that Wren-Lewis is wrong about the fiscal stimulus, so that the fiscal stimulus fails. Given that assumption, Scott is able to prove the very surprising result that “Wren-Lewis’s example would be wrong.” Amazing! If we assume that Wren-Lewis is wrong, then he is wrong. Now back to Scott:

I’m pretty sure my Keynesian readers won’t like the previous example.

What’s not to like?

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 [we?] have a “free lunch” where the private sector would not reduce consumption at all.

I don’t know what this means. Does calling the increase in national income a free lunch qualify as a refutation?

Either way Wren-Lewis’s example is wrong.

There is no “either way.” If you assume that the example is wrong, there is no way for it not to be 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.

Viewing anything as accounting doesn’t allow you to prove anything. Accounting is just a system of definitions with no explanatory power, regardless of whether saving and investment are ignored or taken into account. As for the behavioral explanation, the assumption that consumption falls is made with respect to the pre-stimulus income. When the stimulus raises income enough to make post-stimulus disposable income equal to pre-stimulus disposable income, post-stimulus consumption is equal to pre-stimulus consumption.

Scott continues with only a trace of condescension:

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.

Scott may be right about this assertion, but he is not talking about the standard Keynesian model. Scott doesn’t like it when Keynesians insist that non-Keynesians accept their reasoning or be dismissed as ignoramuses, why does Scott insist that Keynesians accept his view of the world or be dismissed as not “even know[ing] 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.

The Keynesian assumption is that there is absolute liquidity preference, so the savings going down the rate hole is pure hoarding. As I pointed out in my post criticizing Robert Barro for his over the top dichotomy in a Wall Street Journal op-ed between Keynesian economics and regular economics, Keynesian fiscal stimulus works by transferring idle money balances in exchange for bonds at liquidity trap interest rate and using the proceeds to finance expenditure that goes into the pockets of people with finite (rather than infinite) money demand.  In that sense, Scott is right that there is a deep connection between the monetary side and the fiscal side in the Keynesian model, but it’s different from the one he stipulates.

The point of all this is not to be critical of Scott. Why would I want to be critical of one of my heroes and a potential Nobel laureate? The point is just that sometimes it pays to take a deep breath before flying off the handle, even if the target is Paul Krugman.

The Fog of Inflation

Blogger Jonathan Catalan seems like a pretty pleasant and sensible fellow, and he is certainly persistent. But I think he is a bit too much attached to the Austrian story of inflation in which inflation is the product of banks reducing their lending rates thereby inducing borrowers to undertake projects at interest rates below the “natural rate of interest.” In the Austrian view of inflation, the problem with inflation is not so much that the value of money is reduced (though Austrians are perfectly happy to throw populist red meat to the masses by inveighing against currency debasement and the expropriation of savings), but that the newly created money distorts relative prices misleading entrepreneurs and workers into activities and investments that will turn out to be unprofitable when interest rates are inevitably raised, leading to liquidation and abandonment, causing a waste of resources and unemployment of labor complementary to no longer usable fixed capital.

That story has just enough truth in it to be plausible; it may even be relevant in explaining particular business-cycle episodes. But despite the characteristic (and really annoying) Austrian posturing and hyperbole about the apodictic certainty of its a priori praxeological theorems (non-Austrian translation:  assertions and conjectures), to the exclusion of every other explanation of inflation and business cycles, Austrian business cycle theory simply offers a theoretically possible account of how banks might simultaneously cause an increase in prices generally and a particular kind of distortion in relative prices. In fact, not every inflation and not every business cycle expansion has to conform to the Austrian paradigm, and Austrian assertions that they possess the only valid account of inflation and business cycles are pure self-promotion, which is why most of the reputable economists that ever subscribed to ABCT (partial list:  Gottfried Haberler, Fritz Machlup, Lionel Robbins, J. R. Hicks, Abba Lerner, Nicholas Kaldor, G. L. S. Shackle, Ludwig Lachmann, and F. A. Hayek) eventually renounced it entirely or acknowledged its less than complete generality as an explanation of business cycles.

So when in a recent post, I chided Jon Hilsenrath, a reporter for the Wall Street Journal, for making a blatant logical error in asserting that inflation necessarily entails a reduction in real income, Catalan responded, a tad defensively I thought, by claiming that inflation does indeed necessarily reduce the real income of some people. Inasmuch as I did not deny that there can be gainers and losers from inflation, it has been difficult for Catalan to articulate the exact point on which he is taking issue with me, but I suspect that the reason he feels uncomfortable with my formulation is that I rather self-consciously and deliberately formulated my characterization of the effects of inflation in a way that left open the possibility that inflation would not conform to the Austrian inflation paradigm, without, by the way, denying that inflation might conform to that paradigm.

In his latest attempt to explain why my account of inflation is wrong, Catalan writes that all inflation must occur over a finite period of time and that some prices must rise before others, presumably meaning that those raising their prices earlier gain at the expense of those who raise their prices later. I don’t think that that is a useful way to think about inflation, because, as I have already explained, if inflation is a process that takes place through time, it is arbitrary to single out a particular time as the starting point for measuring its effects. Catalan now tries to make his point using the following example.

[If] Glasner were correct then it would not make sense to reduce the value of currency to stimulate exports.  If the intertemporal aspect of the money circulation was absent, then exchange ratios between different currencies (all suffering from continuous tempering) would remain constant.  This is not the case, though: a continuous devaluation of currency is necessary to continuously artificially stimulate exports, because at some point relative prices (the price of one currency to another) fall back into place —, reality is the exact opposite of what Glasner proposes.  The example is imperfect and very simple (it does not have anything to do with the prices between different goods amongst different international markets), but I think it illustrates my point convincingly.

Actually, devaluations frequently do not stimulate exports. When they do stimulate exports, it is usually because real wages in the devaluing country are too high, making the tradable goods sector of the country uncompetitive, and it is easier to reduce real wages via inflation and devaluation than through forcing workers to accept nominal wage cuts. This was precisely the argument against England rejoining the gold standard in 1925 at the prewar dollar/sterling parity, an argument accepted by von Mises and Hayek. Under these circumstances does inflation reduce real wages? Yes. But the reason that it does so is not that inflation necessarily entails a reduction in real wages; the reason is that in those particular instances the real wage was too high (i.e., the actual real wage was above the equilibrium real wage) and devaluation (inflation) was the mechanism by which an equilibrating reduction in real wages could be most easily achieved. In this regard I would refer readers to the classic study of the proposition that inflation necessarily reduces real wages, the paper by Kessel and Alchian “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices” reprinted in The Collected Works of Armen A. Alchian.

Whether inflation reduces or increases real wages, either in general or in particular instances, depends on too many factors to allow one to reach any unambiguous conclusion. The real world is actually more complicated than Austrian business cycle theory seems prepared to admit. Funny that Austrians would have to be reminded of that by neo-classical economists.

Just How Scary Is the Gold Standard?

With at least one upper-tier Republican candidate for President openly advocating the gold standard and pledging to re-establish it if he is elected President, more and more people are trying to figure out what going back on a gold standard would mean.

Tyler Cowen wrote about the gold standard on his blog the week before last, explaining why restoring the gold standard is a dangerous idea.

The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment.  There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.

Why put your economy at the mercy of these essentially random forces?  I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time.  When it comes to the next twenty years, who knows?

Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold.  A gold standard, by the way, is still compatible with plenty of state intervention.

Tyler’s short comment seems basically right to me, but some commenters were very critical.

Lars Christensen, commenting favorably on Tyler’s criticism of the gold standard, opened up his blog to a debate about the merits of the gold standard, and Blake Johnson, who registered sharp disagreement with Tyler’s take on the gold standard in a comment on Tyler’s post, submitted a more detailed criticism which Lars posted on his blog. Johnson makes some interesting arguments against Tyler, showing considerably more sophistication than your average gold bug, so I thought that it would be worthwhile to analyze Blake’s defense of the gold standard.

Blake begins by quibbling with Tyler’s statement that if the relative price of gold rises under a gold standard, the appreciation of gold is expressed in falling prices, reducing output and employment. Johnson points out that when prices are falling in proportion to increases in productivity deflation is not necessarily bad. That’s valid (but not necessarily conclusive) point, but I suspect that that is not the scenario that Tyler had in mind when he made his comment, as Johnson himself recognizes:

Cowen’s claim likely refers to the deflation that turned what may have been a very mild recession in the late 1920’s into the Great Depression. The question then is whether or not this deflation was a necessary result of the gold standard. Douglas Irwin’s recent paper “Did France cause the Great Depression” suggests that the deflation from 1928-1932 was largely the result of the actions of the US and French central banks, namely that they sterilized gold inflows and allowed their cover ratios to balloon to ludicrous levels. Thus, central bankers were not “playing by the rules” of the gold standard.

The plot thickens. The problem with Johnson’s comment is that he is presuming that there ever were any clearly articulated rules of the gold standard. The most ardent supporters of the gold standard at the time, people like von Mises and Hayek, Lionel Robbins, Jacques Rueff and Charles Rist in France, Benjamin Anderson in America, were all defending the Bank of France against criticism for its actions. (See this post about Hayek’s defense of the Bank of France.)  I don’t think that they were correct in their interpretation of what the rules of the gold standard required, but it is clearly not possible to look up the relevant rules of how to play the gold-standard game, as one could look up, say, the rules of playing baseball. Central bankers were not playing by the rules of the gold standard, because the existence of such rules was a convenient myth, covering up the fact that central banks, especially the Bank of England, ran the gold standard in the late 19th and early 20th centuries and exercised considerable discretion in doing so. The gold standard was never a fully automatic self-regulating system.

Johnson continues:

Personally, I see this more as an indictment of central bank policy than of the gold standard. Peter Temin has claimed that the asymmetry in the ability of central banks to interfere with the price specie flow mechanism was the fundamental flaw in the inter-war gold standard. Central banks that wanted to inflate were eventually constrained by the process of adverse clearings when they attempted to cause the supply of their particular currency [to] exceed the demand for that currency. However, because they were funded via taxpayer money, they were insulated from the profit motive that generally caused private banks to economize on gold reserves, and refrain from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did.

Unfortunately, I cannot make any sense out of this. “Central banks that wanted to inflate” presumably refers to central banks keeping their lending rate at a level below the rates in other countries, thereby issuing an excess supply of banknotes that financed a balance of payments deficit and causing an outflow of gold (adverse clearings). Somehow Johnson transitions from the assumption of inflationary bias to the opposite one of deflationary bias in which, “funded via taxpayer money,” central banks were insulated from the profit motive that generally caused private banks to economize on gold reserves, thus refraining from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did. Sorry, but I don’t see how we get from point A to point B.

At any rate, Johnson seems to be suggesting — though this is just a guess – that central banks are more likely than private banks to hoard gold reserves. That may perhaps be true, but it might not be true if there are significant economies of scale in holding reserves. Under a gold standard with no central banks and no lender of last resort, the precautionary demand for gold reserves by individual banks might be so great that the aggregate monetary demand for gold by the banking system could be greater than the monetary demand of central banks for gold. We just don’t know. And the only way to find out is to make ourselves guinea pigs and see how a gold standard would work itself out with or without central banks. I personally am curious to see how it would turn out, but not curious enough to actually want to live through the experiment.

Johnson goes on:

I would further point out that if you believe Scott Sumner’s claim that the Fed has failed to supply enough currency, and that there is a monetary disequilibrium at the root of the Great Recession, it seems even more clear that central bankers don’t need the gold standard to help them fail to reach a state of monetary equilibrium. While we obviously haven’t seen anything like the kind of deflation that occurred in the Great Depression, this is partially due to the drastically different inflation expectations between the 1920’s and the 2000’s. The Fed still allowed NGDP to fall well below trend, which I firmly believe has exacerbated the current crisis.

What Johnson fails to consider is that inflation expectations are not totally arbitrary; inflation expectations in the 1930s plunged, because people understood that gold was appreciating toward its pre-World War I level. The only way to avoid that result for an individual country on the gold standard was to get off the gold standard, because the price level of any country on the gold standard is determined by the value of gold. That’s why FDR was able to initiate a recovery in March 1933 with the stroke of a pen by suspending the convertibility of the dollar into gold, allowing the dollar to depreciate against gold and gold-standard currencies, causing prices in dollar terms to start rising, thereby stimulating increased output and employment practically over night. The critical difference that Johnson is ignoring is that no country under a gold standard could stop deflating until it got off the gold standard. The FOMC is doing a terrible job, but all they have to do is figure out what needs to be done. They don’t have to get permission to do what is right from anyone else.

So how scary is the gold standard? Scarier than you think.

Is Joblessness a Skills Problem or an FOMC Problem?

Jeffrey Lacker, President of the Richmond Federal Reserve Bank, is joining the Federal Open Market Committee (FOMC), the body within the Federal Reserve with the final say on monetary policy. The presidents of the 12 regional banks occupy five of the seats on the FOMC on a rotating basis (except that the President of the New York Fed is always on the FOMC), Presidents of the Richmond, Philadelphia, and Boston Banks occupying one of the seats on the FOMC, each president serving every third year. Dr. Lacker is replacing Dr. Charles Plosser, President of the Philadelphia Fed, for the 2012 calendar year.

Among Lacker’s duties as President of Richmond Federal Reserve Bank is writing a message in the bank’s quarterly publication Region Focus, the third quarter edition of which I found in my mailbox yesterday. Knowing that Lacker has just become one of the most important people on the planet, I was curious to find out his thoughts at the start of his year on the FOMC. My reading of Lacker’s message in the second quarter Region Focus was not exactly an uplifting experience (see this post from October), but I try to look for glimmers of hope wherever I can find them. Sadly, Dr. Lacker’s message, entitled “Is Joblessness Now a Skills Problem?” offers nothing hopeful.

Lacker begins by painting a bleak picture of the plight of the long-term unemployed.

Today long-term unemployment – that is, unemployment lasting six months or longer – is at a record high. The share of unemployed Americans whose job searches have lasted this agonizingly long is 43.1 percent, a figure that is unprecedented since the Bureau of Labor Statistics began keeping records in 1948.

His explanation?

A growing number of observers have argued that this state of affairs is caused in significant part by a mismatch between available jobs and available workers, especially a mismatch in skills.

I agree that the long-term component of unemployment has structural origins, including a substantial degree of skills mismatch. I hear a fair number of stories from around our District of hard-to-fill job vacancies in certain specialties. Looking at the world around us, it is reasonable to assume that employers need higher skill levels from their workers today, on average, than they did a generation ago. . . . Economic research indicates that the relationship between unemployment and the job vacancy rate changed during the recession; we’re seeing more unemployment for a given rate of job vacancies – which suggests matching problems.

Lacker acknowledges that the skill-mismatch story has been criticized because the empirical evidence suggests that skill-mismatch accounts for only 0.6 to 1.7 percentage points of current unemployment. In turn, Lacker doubts the relevance of the data on which critics of the skill-mismatch story calculate its contribution to current high rates of unemployment. And even if the critics are right, “a percentage point, or 1.5 percentage points, is significant even within the context of today’s unemployment rate of roughly 9 percent.” Lacker concludes:

In short, I think it is quite plausible that skills mismatch is an important factor holding back improvements in the labor market. The question is how important – and that’s an issue that economists are working to answer as precisely as possible.

OK, so what does this all mean for policy? First, Lacker goes out on a limb and announces that he is actually in favor of – hold on to your hats – job training!

Finally, Lacker gets to the point, monetary policy:

Another, more immediate, implication is the extent to which monetary policy can make a difference in getting more Americans into jobs. To the extent that skills mismatch is identified as a significant portion of the long-term unemployment problem, monetary policy will have difficulty making meaningful inroads into the jobs problem without increasing inflation. Monetary policy, after all, doesn’t train people.

This is hugely depressing. Lacker is telling us that because, on the basis of some stories he has heard from around his district (Maryland, Virginia, West Virginia, North Carolina, South Carolina), and because the ratio of unemployed workers to job vacancies has been increasing, he thinks that our unemployment problem is largely the result of skills mismatches, mismatches impervious to monetary policy.

I won’t even bother asking how all these skills matches suddenly appeared out of nowhere in 2008, so let’s just assume that some percentage of the currently unemployed are unemployed because they don’t have the skills to take the jobs that employers are trying so hard to fill, but can’t. But if there is this huge unsatisfied demand for workers out there (of which Lacker claims to have, if not direct personal knowledge, at least hearsay evidence), wouldn’t one expect to observe employers bidding up wages for those desirable employees with those coveted skills?

I mean Lacker can’t have it both ways. Either there are lot of unfilled vacancies that employers are trying to fill, and wages are being bid up to attract the highly prized workers that can fill them, or there are not that many unfilled vacancies and wages are not being driven up by desperate employers trying to fill those vacancies. If Lacker is right about the magnitude of unsatisfied demand for labor, there should be some evidence for it showing up in the wages actually being paid.

So what do the data show? Well, the Bureau Labor Statistics has published since 2001 an employment cost index of wages and salaries for workers in private industry. The chart below shows the quarterly year-on-year change in the index since 2002. As you can see the year-on-year change has come down steadily since 2002, bottoming out at a rate of increase well below anything observed in the 2002-2008 period. If Lacker is right that job mismatch accounts for a significant fraction of currently observed unemployment, why is the rate of wage inflation nearly a percentage point below the lowest observed rate of wage inflation in the 2002 to 2008 period?

Of course, some people regard the 2002-2008 period as one of wild inflationary excess. So I also looked at a similar, but slightly different, index that goes back further than the employment cost index, the labor cost index which takes into account changes in both wages and productivity. The next chart shows the quarterly year on year change in unit labor costs since 1983 (the beginning of the recovery from the 1981-82 recession). The rate of increase in unit labor costs since 2008 is clearly well below the rates of increase for almost the entire period.

And, at the armchair level of analysis at which Lacker is comfortably operating in making his assessments about the role of skills mismatch in the labor market, it is not at all clear that skill deficiencies are the only, or chief, reason for the increasing number of unemployed per vacancy. It would be at least as plausible to suggest that employers are becoming increasingly choosy in selecting job applicants for the few available vacancies that they are trying to fill. Because they are not trying hard to increase output, employers can afford to wait a little longer to find the perfect employee than they would wait if they were trying to expand output. There are two sides to every matching problem, and Lacker seems interested in just one side.

Finally, it is just astonishing that, at a time when inflation is at its lowest rate in a half century, Lacker could offer as an implied rationale for his opposition to using monetary policy to reduce unemployment: “monetary policy will have difficulty making meaningful inroads into the job problem without increasing inflation,” as if any policy option that would increase inflation above its current historically low rate is not even worthy of consideration.

On Multipliers, Ricardian Equivalence and Functioning Well

In my post yesterday, I explained why if one believes, as do Robert Lucas and Robert Barro, that monetary policy can stimulate an economy in an economic downturn, it is easy to construct an argument that fiscal policy would do so as well. I hope that my post won’t cause anyone to conclude that real-business-cycle theory must be right that monetary policy is no more effective than fiscal policy. I suppose that there is that risk, but I can’t worry about every weird idea floating around in the blogosphere. Instead, I want to think out loud a bit about fiscal multipliers and Ricardian equivalence.

I am inspired to do so by something that John Cochrane wrote on his blog defending Robert Lucas from Paul Krugman’s charge that Lucas didn’t understand Ricardian equivalence. Here’s what Cochrane, explaining what Ricardian equivalence means, had to say:

So, according to Paul [Krugman], “Ricardian Equivalence,” which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.

Cochrane was a little careless in defining Ricardian equivalance as a theorem about stimulus, when it’s really a theorem about the equivalence of the effects of present and future taxes on spending. But that’s just a minor slip. What I found striking about Cochrane’s statement was something else: that little qualifying phrase “in a well-functioning economy,” which Cochrane seems to have inserted as a kind of throat-clearing remark, the sort of aside that people are just supposed to hear but not really pay much attention to, that sometimes can be quite revealing, usually unintentionally, in its own way.

What is so striking about those five little words “in a well-functioning economy?” Well, just this. Why, in a well-functioning economy, would anyone care whether a stimulus works or not? A well-functioning economy doesn’t need any stimulus, so why would you even care whether it works or not, much less prove a theorem to show that it doesn’t? (I apologize for the implicit Philistinism of that rhetorical question, I’m just engaging in a little rhetorical excess to make my point a little bit more colorfully.)

So if a well-functioning economy doesn’t require any stimulus, and if a stimulus wouldn’t work in a well-functioning economy, what does that tell us about whether a stimulus works (or would work) in an economy that is not functioning well? Not a whole lot. Thus, the bread and butter models that economists use, models of how an economy functions when there are no frictions, expectations are rational, and markets clear, are guaranteed to imply that there are no multipliers and that Ricardian equivalence holds. This is the world of a single, unique, and stable equilibrium. If you exogenously change any variable in the system, the system will snap back to a new equilibrium in which all variables have optimally adjusted to whatever exogenous change you have subjected the system to. All conventional economic analysis, comparative statics or dynamic adjustment, are built on the assumption of a unique and stable equilibrium to which all economic variables inevitably return when subjected to any exogenous shock. This is the indispensable core of economic theory, but it is not the whole of economic theory.

Keynes had a vision of what could go wrong with an economy: entrepreneurial pessimism — a dampening of animal spirits — would cause investment to flag; the rate of interest would not (or could not) fall enough to revive investment; people would try to shift out of assets into cash, causing a cumulative contraction of income, expenditure and output. In such circumstances, spending by government could replace the investment spending no longer being undertaken by discouraged entrepreneurs, at least until entrepreneurial expectations recovered. This is a vision not of a well-functioning economy, but of a dysfunctional one, but Keynes was able to describe it in terms of a simplified model, essentially what has come down to us as the Keynesian cross. In this little model, you can easily calculate a multiplier as the reciprocal of the marginal propensity to save out of disposable income.

But packaging Keynes’s larger vision into the four corners of the Keynesian cross diagram, or even the slightly more realistic IS-LM diagram, misses the essence of Keynes’s vision — the volatility of entrepreneurial expectations and their susceptibility to unpredictable mood swings that overwhelm any conceivable equilibrating movements in interest rates. A numerical calculation of the multiplier in the simplified Keynesian models is not particularly relevant, because the real goal is not to reach an equilibrium within a system of depressed entrepreneurial expectations, but to create conditions in which entrepreneurial expectations bounce back from their depressed state. As I like to say, expectations are fundamental.

Unlike a well-functioning economy with a unique equilibrium, a not-so-well functioning economy may have multiple equilibria corresponding to different sets of expectations. The point of increased government spending is then not to increase the size of government, but to restore entrepreneurial confidence by providing assurance that if they increase production, they will have customers willing and able to buy the output at prices sufficient to cover their costs.

Ricardian equivalence assumes that expectations of future income are independent of tax and spending decisions in the present, because, in a well-functioning economy, there is but one equilibrium path for future output and income. But if, because the economy not functioning well, expectations of future income, and therefore actual future income, may depend on current decisions about spending and taxation. No matter what Ricardian equivalence says, a stimulus may work by shifting the economy to a different higher path of future output and income than the one it now happens to be on, in which case present taxes may not be equivalent to future taxes, after all.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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