A lot of people have been getting all worked up about Paul Krugman’s acerbic takedown of Robert Barro for suggesting in a Wall Street Journal op-ed in 2011 that increased government spending would not stimulate the economy. Barro’s target was a claim by Agriculture Secretary Tom Vilsack that every additional dollar spent on food stamps would actually result in a net increase of $1.84 in total spending. This statement so annoyed Barro that, in a fit of pique, he wrote the following.
Keynesian economics argues that incentives and other forces in regular economics are overwhelmed, at least in recessions, by effects involving “aggregate demand.” Recipients of food stamps use their transfers to consume more. Compared to this urge, the negative effects on consumption and investment by taxpayers are viewed as weaker in magnitude, particularly when the transfers are deficit-financed.
Thus, the aggregate demand for goods rises, and businesses respond by selling more goods and then by raising production and employment. The additional wage and profit income leads to further expansions of demand and, hence, to more production and employment. As per Mr. Vilsack, the administration believes that the cumulative effect is a multiplier around two.
If 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.
Sorry to brag, but it was actually none other than moi that (via Mark Thoma) brought this little gem to Krugman’s attention. In what is still my third most visited blog post, I expressed incredulity that Barro could ask where Is the market failure about a situation in which unemployment suddenly rises to more than double its pre-recession level. I also pointed out that Barro had himself previously acknowledged in a Wall Street Journal op-ed that monetary expansion could alleviate a cyclical increase in unemployment. If monetary policy (printing money on worthless pieces of paper) can miraculously reduce unemployment, why is out of the question that government spending could also reduce unemployment, especially when it is possible to view government spending as a means of transferring cash from people with unlimited demand for money to those unwilling to increase their holdings of cash? So, given Barro’s own explicit statement that monetary policy could be stimulative, it seemed odd for him to suggest, without clarification, that it would be a miracle if fiscal policy were effective.
Apparently, Krugman felt compelled to revisit this argument of Barro’s because of the recent controversy about extending unemployment insurance, an issue to which Barro made only passing reference in his 2011 piece. Krugman again ridiculed the idea that just because regular economics says that a policy will have adverse effects under “normal” conditions, the policy must be wrongheaded even in a recession.
But if you follow right-wing talk — by which I mean not Rush Limbaugh but the Wall Street Journal and famous economists like Robert Barro — you see the notion that aid to the unemployed can create jobs dismissed as self-evidently absurd. You think that you can reduce unemployment by paying people not to work? Hahahaha!
Quite aside from the fact that this ridicule is dead wrong, and has had a malign effect on policy, think about what it represents: it amounts to casually trashing one of the most important discoveries economists have ever made, one of my profession’s main claims to be useful to humanity.
Krugman was subsequently accused of bad faith in making this argument because he, like other Keynesians, has acknowledged that unemployment insurance tends to increase the unemployment rate. Therefore, his critics argue, it was hypocritical of Krugman to criticize Barro and the Wall Street Journal for making precisely the same argument that he himself has made. Well, you can perhaps accuse Krugman of being a bit artful in his argument by not acknowledging explicitly that a full policy assessment might in fact legitimately place some limit on UI benefits, but Krugman’s main point is obviously not to assert that “regular economics” is necessarily wrong, just that Barro and the Wall Street Journal are refusing to acknowledge that countercyclical policy of some type could ever, under any circumstances, be effective. Or, to put it another way, Krugman could (and did) easily agree that increasing UI will increases the natural rate of unemployment, but, in a recession, actual unemployment is above the natural rate, and UI can cause the actual rate to fall even as it causes the natural rate to rise.
Now Barro might respond that all he was really saying in his 2011 piece was that the existence of a government spending multiplier significantly greater than zero is not supported by the empirical evidenc. But there are two problems with that response. First, it would still not resolve the theoretical inconsistency in Barro’s argument that monetary policy does have magical properties in a recession with his position that fiscal policy has no such magical powers. Second, and perhaps less obviously, the empirical evidence on which Barro relies does not necessarily distinguish between periods of severe recession or depression and periods when the economy is close to full employment. If so, the empirical estimates of government spending multipliers are subject to the Lucas critique. Parameter estimates may not be stable over time, because those parameters may change depending on the cyclical phase of the economy. The multiplier at the trough of a deep business cycle may be much greater than the multiplier at close to full employment. The empirical estimates for the multiplier cited by Barro make no real allowance for different cyclical phases in estimating the multiplier.
PS Scott Sumner also comes away from reading Barro’s 2011 piece perplexed by what Barro is really saying and why, and does an excellent job of trying in vain to find some coherent conceptual framework within which to understand Barro. The problem is that there is none. That’s why Barro deserves the rough treatment he got from Krugman.
Uneasy Money 
The first time paper money was issued in America was in 1690, when Massachusetts issued its own paper shillings as emergency pay for its soldiers. The spending was stimulative, and the reason was that a new and super-efficient money had been introduced into a cash-starved economy, thus facilitating trade. A Keynesian would look at this result and think that it was the spending multiplier at work. But that explanation runs afoul of the common economic sense that Barro and others have been trying to explain. The monetary view gives a good explanation of how recessions happen, and how they end. There’s no need for us to descend into the Keynesian neverland of multipliers, free lunches, wealth from thin air, and economic quantities that don’t add up.
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Seems like the appropriate way for Barro to respond to the Lucas critique is to break down his WW2 multiplier by year. The first year would still be in the depths of the Depression.
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David, it’s good to see you address this subject. I already read Sumner’s take (both posts), and Bob Murphy’s. So far I like yours best.
Mike Sproul, have you seen the IOU post at JP Koning’s?
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Tom:
Yes, I just posted a comment over at JP’s blog.
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Mike, We agree that too little money can be prevent an economy from functioning properly. What if some people want to hoard money so badly that there is not enough left for everyone else? That’s a Keynesian liquidity trap, and, under that premise, the analysis is similar to the situation in Massachusetts in 1690 that you describe. I wrote a post awhile ago (“Counterfeiting and American Monetary History”) that discussed this episode. My point about Barro is that he simply dismissed the possibility that fiscal policy could be a way of reallocating cash balances to promote increased economic activity. I am not saying that Keynesian economics is the right way to understand that situation, but Barro seems to say that there is no problem that has to be addressed.
Wonks Anonymous, That sounds right to me. However, a strong recovery, largely driven by exports to Europe which is busy rearming and then fighting World War II, had already started in 1939. By 1941-42, when military spending exploded, unemployment had already dropped considerably from its 1938 peak.
Tom, Thanks.
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I have a different take.
Are the food stamps just printed and given to people?
Or, does the US government borrow money from people, and then print the food stamps to an amount equal that being borrowed?
If the former, it would seem to me that food stamps could be wonderfully stimulative in the macroeconomic sense.
In this case, the Fed would not even have to “accommodate,” as the USDA is essentially printing money (since everyone eats, food stamps are pretty close to money, and surely leave more cash in consumers’ hands to spend another goods).
The more I think about it, in times of recession, having the USDA just print food stamps is a good idea, macroeconomically speaking.
I asked this food stamp question 40 years ago in an undergrad class at Berkeley, and I was snubbed then by the prof, who didn’t really answer but acted annoyed.
I still think I am on to something.
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Barro’s own empirical evidence doesn’t show a multiplier of 0; it shows a multiplier of like 0.7.
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Benjamin, Your point sounds right to me. If there is any problem with injecting money into the economy because of the zero lower bound, increasing spending on food stamps would seem to be a good and handy solution.
rhmurphy, Can you provide a citation for that number?
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Wonks Anonymous January 24, 2014 at 11:21 am
“Seems like the appropriate way for Barro to respond to the Lucas critique is to break down his WW2 multiplier by year. The first year would still be in the depths of the Depression.”
You might want to consult a book about the Great Depression which shows a timeline of economic/employment shrinkage and growth.
Then again, you might not.
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I take issue with Agriculture Secretary Tom Vilsack ‘s remark that “every additional dollar spent on food stamps would actually result in a net increase of $1.84 in total spending.” If he is referring to the Keynesian multiplier, then from my analysis that cannot be correct. I believe the Keynesian formula is misinterpreted – the multiplier can never be more than one.
This does not mean that deficit spending and food stamps are not beneficial and cannot stimulate the economy; it only means that one dollar of stimulus cannot yield more than one dollar to the money supply nor add more than one dollar to GDP.
This sentence, which appears in the article, tells it all – why the Keynesian multiplier is misinterpreted.
“Thus, the aggregate demand for goods rises, and businesses respond by selling more goods and then by raising production and employment. The additional wage and profit income leads to further expansions of demand and, hence, to more production and employment. As per Mr. Vilsack, the administration believes that the cumulative effect is a multiplier around two.”
Is it correct that “additional wage and profit income leads to further expansions of demand,” or does it only lead to reproduction of the same demand. It seems consumers are only passing the same money, reducing supply and eventually allowing demand (the added stimulus) to be more than the supply.
Let me explain:
Let us start with four supply units and an equal four demand units – a normal situation in a balanced economy. Government deficit spending (investment) of one unit purchases trucks and so a trucking company adds an additional production facility for another supply unit…
The company hires workers, makes no profit and pays them the total of one demand unit, which is equal to the value of the produced supply unit. The government receives the trucks and there is an additional one demand unit in the economy. The company has no added assets to its books and cannot repeat the production process unless someone else invests a unit for producing more supply.
Four demand units can purchase the available four supply units, which allows for re-production of another four units of supply. The government has the other supply unit. So, we are left with one demand unit in the economy with no supply for it, Either one of two occurrences can follow.
(1) The unused demand unit can be invested in production of another supply unit. We then have five supply units and four demand units plus the workers wages from the new supply unit creating another demand unit, which gives five supply and five demand units. If all five supply units are consumed by the five demand units, then the five units of supply can be repeated.
Result – The original government investment has increased the economy’s demand and supply by only the equivalent of the original investment. The multiplier is one.
(2) The unused demand unit is partially invested and partially used to purchase available supply.
Result – The multiplying factor is less than one and because demand is greater than supply, some increase in prices may occur in order to equalize supply price and demand.
The Keynesian formula may actually state that if total investments are consistently not totally consumed and reinvested, then less than all of the original investment is available for new production, and with time the value of this investment to the economy will fade to nil. The economy will return to four supply units and four demand units.
How can there be a Keynesian multiplier greater than one?
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