Krugman v. Lucas on Fiscal Stimulus

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.


13 Responses to “Krugman v. Lucas on Fiscal Stimulus”

  1. 1 Mitch January 2, 2012 at 9:47 pm

    The part I have never understood about your monetarist argument is I don’t see how you think the government is going to dispose of the extra pieces of paper they print other than by spending them. If the claim is that they will deposit them in banks (which is essentially all the Fed can do) then the extra pieces of paper will be neutralized unless the banks are willing to lend them out – and the argument you present here (and in the post to which it refers) stalls. Since during a liquidity trap banks are already not lending out all the reserves they have, piling more in the vaults is not going to do much.

    To answer Krugman you have to explicitly deal with this point, since he has been making it repeatedly. Here

    is an example in which he presents a graph showing a trebling of the monetary base in the past 3 years, with essentially no inflation occuring. Is this graph wrong or misleading?

    As always, this goes back to the question – inevitably evaded by monetarists – of aggregate demand. We know in fact that cash is not merely piling up in the vaults of banks, but in the spreadsheets of corporations, who are retaining earnings at record levels

    (This is, of course, another way the pieces of paper get neutralized). If there were way for the companies to make money, they’d be investing this. That they aren’t is the crux of the issue, and it needs to be addressed if you want to make a dent in Keynes or Krugman.


  2. 2 Frank Restly January 2, 2012 at 10:33 pm

    What Mr. Lucas and Mr. Krugman seem to forget is that the federal government is not in the bridge building business. And so the relevance of their discussion lies primarily in the theoretical.

    A more valid description of the federal government is an insurance company with an army.

    As for this statement:

    “Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?”

    Mr. Lucas clearly does not understand the difference between nominal and real interest rates. The market failure is the inability of nominal interest rates to fall below 0% even when real interest rates are exhorbitant.


    I used AAA long term debt as a proxy for interest rates. The St. Louis federal reserve does not track the fed funds rate prior to 1956, though I believe that through the depression, that rate was about 2% nominal.

    The government is able to improve things simply because it is not affected by high real interest rates in the same way that the private sector is. Meaning, the federal government’s revenue stream (taxes) is unencumbered by the price level. The federal government does not produce anything where a fall in prices affects its ability to collect revenues.

    Like I said, an insurance company with an army.


  3. 3 Mitch January 2, 2012 at 10:43 pm

    Why do you say that the government is not in the business of building bridges? So far as I am aware, virtually all the roads and bridges were purchased (not actually built, but that’s irrelevant) by one government or another.


  4. 4 Anthony T January 2, 2012 at 11:06 pm

    “…many Keynesians, including Paul Krugman himself, like to argue that in a Depression only fiscal policy can work because of the liquidity trap.”

    Krugman has stated that conventional monetary policy does not have traction in a liquidity trap, but unconventional monetary policy could help. In fact, he advocates a higher inflation target to help the de-leveraging process along. Richard Koo has criticized Krugman for believing that monetary policy would work.


  5. 5 Frank Restly January 2, 2012 at 11:12 pm

    I should have been more clear about this.

    The federal government does not finance the construction of roads bridges with a business incentive. Meaning, they don’t do it with a profit motive in mind. This is very different from the actual bridge builder whose profit and loss determine whether the company stays in business.

    The same can be said for the other roles of government (insurance and defense of country).


  6. 6 David Glasner January 3, 2012 at 2:52 pm

    Mitch, If you have a problem with my monetarist argument, you have a problem with Keynes, too, because Keynes knew and wrote all about open market operations. The central bank buys securities from the banking system and the banking system winds up holding more reserves than they want to hold so they engage in various forms of behavior that result in a drain on their reserves until they no longer are holding more reserves than they want to hold. The result of those actions generally corresponds to an increase in income and expenditure by the rest of the economy. That is economics 102 (macrotheory) or money and banking 101. It’s not something that monetarists and Keynesians disagree about. In a liquidity trap, the simple Keynesian analysis does hold that the increase in the money supply has no effect on aggregate demand, but that is just because the simple Keynesian (IS-LM) model does not incorporate expected inflation. When you extend the model in a straightforward way, the liquidity trap is overcome. Krugman acknowledges that, in fact, I think that he has erroneously claimed to have discovered that.

    The Krugman graphs that you are citing were meant to refute hysterical claims by Austrians and some Monetarists that the increase in the monetary base was going to unleash hyperinflation. That’s a silly argument, and has nothing to do with my position, so there’s nothing for me to respond to. I am not trying to make a dent on Keynes and Krugman, because although I am coming from a different theoretical position from theirs, we are reaching similar conclusions about policy in the current situation. That’s why most of what I have been writing on this blog for the six months of its existence has been aimed at targets other than Keynes and Krugman. I like Hayek more than Keynes (whom I actually like, too), but I have written more posts critical of Hayek than of Keynes.

    Anthony, Krugman is a little tricky, because although he recognizes the possibility of unconventional monetary policy to spur a recovery even in a liquidity trap, for a long time he was arguing that only Keynesians had a way of stimulating a recovery, namely fiscal policy, as if unconventional monetary policy did not exist and as if it were not a tool in the non-Keynesian tool chest as well as the Keynesian one. So I fault Krugman for starting this sort of us versus them argument. Perhaps he anticipated that lots of anti-Keynesians would take the bait, correctly as it turned out, but he obviously was looking for a fight.


  7. 7 Chris January 5, 2012 at 9:42 am


    Sorry to be late to the table here, but I have become a regular reader of your blog precisely because Krugman mentioned it, positively, in conjunction with NGDP targeting. Even though he was looking for a fight, I think he’s come round to accepting an unconventional monetary approach as a valid alternative to a fiscal one; but I think he would (in my opinion rightly) argue that a fiscal approach is likely to have much more impact (in terms of quality of life) on the most vulnerable members of society than is a purely monetary approach. That is: I can imagine more situations under the monetary approach where aggregate real wages increase by widening inequality (so most but not all of the increase goes to the top 20-30% of earners and is diverted either by increased exports or oversea investment, or by consumption of low-cost-of-production high-cost-of-purchase “conspicuous” luxuries) rather than through translating the entire wage distribution. It could also be that I don’t yet fully understand periodic/continuous monetary expansion.


  8. 8 Unlearningecon January 5, 2012 at 11:11 am

    I’m sorry to be insulting but these economists seem to determined to prove to everyone just how stupid they are – assuming they are not arguing in bad faith, of course.

    ‘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.’

    Because investment in the U.S.’s crumbling infrastructure is not a positive thing by itself?

    ‘[A] simple Keynesian macroeconomic model implicitly assumes that the government is better than the private market at marshalling idle resources to produce useful stuff.’

    Blah blah anti-government ideology every economic issues is a battle between the government and markets. I mean, almost everyone admits that there are public goods that the government needs to provide, so why does he consider government investment to be such anathema?

    ‘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.’

    This is nothing more than an argument from personal incredulity. ‘How can this happen? It defies economics laws! Good god man, at least put forth a proper argument.

    ‘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.’

    Translation: I do not have the time or capacity to try and interpret Keynes properly, and am unable to formulate basic economic arguments alone.

    These people are best left ignored as their awful arguments have been rebutted so many times it isn’t even worth it. They have proven time and again that they lack the inclination and/or capacity to understand basic macroeconomics, or are arguing with too much ideological bias to see truth. It’s disgusting.


  9. 9 Mitch January 6, 2012 at 7:56 am

    David –

    I am aware Keynes and Keynesians in general know about open market operations and that there is little controversy about how they work. I was not claiming otherwise.

    Let’s say that the banks are overleveraged at the start of the financial crisis, hypothetically because they invested in something speculative that isn’t working out – tulips of subprime mortgages or something . The first thing the banks are going to do with the money is use it to deleverage.

    So how does the money accumulating in bank vaults and on the spreadsheets of corporations have the effect you are claiming? If they are not lending, then what are the “various forms of behavior” that will result in income going up in the rest of the economy?

    I should also say that I like this blog specifically because it comes from a different perspective. Most of what I have been seeing out of economists (especially monetarists I am afraid) just strikes me as so much climate change denial. As you pointed out in a subsequent post, all the arguments that start from the assumption that markets clear and everything is in equilibrium can’t be taken seriously since the whole point is to explain how the labor market can get stuck at less than full employment, which is a manifestly out-of-equilibrium situation.


  10. 10 David Glasner January 6, 2012 at 9:16 am

    Chris, You may be right that there are different distributional effects associated with fiscal and monetary stimulus. I haven’t really considered whether that is the case or not. Has Krugman addressed distributional effects in discussing the choice between fiscal and monetary stimulus. My impression is that distributional effects are rarely considered by economists in weighing the relative effectiveness of fiscal and monetary policy. So any references you might have to such discussions would be appreciated.

    Unlearningecon, Obviously, I share your impatience with Lucas and Barro, but just to be a bit contrarian, I don’t think that Lucas and Barro are arguing against building bridges, they are saying the decision to build or not to build should be made on a narrow cost-benefit calculation, so your comment that bridges are crumbling is not really relevant to their anti-fiscal-stimulus argument.

    Mitch, Two quick responses. First, the Fed has been subsidizing the holding of reserves by paying banks a higher interest rate on reserves than banks can earn on Treasuries with up to 2-year maturities. Under those circumstances, banks’ demand for reserves is truly unlimited, so it’s no wonder that the massive increase in reserves could has had no discernible stimulative effect. Second, if the Fed were not paying interest on reserves, so that banks’ demand for reserves was not infinite, a sufficiently large increase in reserves would lead to an excess supply of reserves which would cause banks to find ways of disposing of their reserves by increasing their lending.


  11. 11 Mitch January 6, 2012 at 1:50 pm

    What you’re saying is certainly right regarding the monetary policy of the past several years. The TARP etc has been as much as anything else a simple way to pump cash into the banks so they don’t collapse, rather than intended to be stimulative. The taxpayer is not really getting what they’re paying for.

    That being said, I think it is only fair to conclude that during a liquidity trap you may have to pump quite a bit of paper into the banks to get them to lend, and it may be quite difficult to find borrowers.


  1. 1 Why Am I Arguing with Scott Sumner « Uneasy Money Trackback on January 19, 2012 at 8:56 pm
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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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