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.