The big issues in macroeconomics: the fiscal multiplier

by John Quiggin on January 4, 2013

The biggest theoretical issue in macroeconomics is “what causes unemployment”. As discussed in the last post, the classical answer, that unemployment is caused by problems in labor markets, is obviously wrong as an explanation of the simultaneous emergence of sustained high unemployment in many different countries. Unemployment is a macroeconomic problem.

The central macroeconomic policy issue, then, is “what, if anything, can macroeconomic policy do to move the economy back to full employment”. If you accept that, under current conditions of zero interest rates, there’s not much positive that can be done with monetary policy[1], and you stay within the bounds of mainstream policy debate, this question can be restated as “how effective is expansionary fiscal policy” or, in Keynesian terms, “how large is the fiscal multiplier in a depression”.

To restate this in more neutral terms, if the government spends more, say by employing and equipping more firefighters, what happens in the rest of the economy? The answer given by classical economics is that the newly-employed firefighters must be drawn from elsewhere in the economy, presumably in the private sector. Similarly, the production of extra firetrucks means less vehicles can be produced for other purposes. Although the exact way in which resources are reallocated can’t easily be predicted, the classical model gives the clear answer that the overall level of employment and economic activity won’t change[2]

Keynes gave a different answer. The classical solution, he said, was applicable in a situation of full employment, but that was a special case. In general, the economy might be in an equilibrium with high unemployment, with plenty of idle workers who could be hired as firefighters, and factories to produce their equipment. Not only that, but the firefighters would spend at least some of their increased incomes, leading to further growth in demand. So, aggregate employment and production would expand by more than the amount of the initial increase, leading to a ‘multiplier’ effect.

More precisely, the fiscal multiplier is the ratio of the final change in aggregate output (and therefore in employment) to the initial change in government expenditure. The traditional “Old Keynesian” view (implied by the multiplier terminology) is that, provided there are plenty of unemployed resources, the multiplier is greater than 1 (among other things the value depends on the kind of expenditure – low income households are more responsive to income changes, so expenditure that benefits them will have a higher multiplier). That view seems consistent with the evidence of, for example, Romer and Romer and, more recently, the IMF World Economic Outlook (PDF), which concluded

Research reported in previous issues of the WEO finds that fiscal multipliers have been close to 1 in a world in which many countries adjust together; the analysis here suggests that multipliers may recently have been larger than 1

The classical position may be restated as saying that the fiscal multiplier is zero. The core of New Classical economics is the reassertion of this claim. If workers are unemployed it was either because they are unwilling to work at the going wage or because some artificial barrier (unions or minimum wages) stops wages from adjusting to their equilibrium level. To the extent that Keynesian policies worked, New Classical economists like Lucas argued, it was by generating unanticipated inflation and tricking workers into accepting wages that were higher in nominal terms but lower in real terms.

Before the current crisis, New Keynesians conceded a fair bit of ground to the classical view, but argued for a positive multiplier, though not necessarily greater than 1. One way of putting this is that public expenditure partially “crowds out” private spending. But most NK advocates thought fiscal policy unnecessary, since monetary policy had the same effects and was easier to manage.

I criticized the New Classical view last time, but the dominant idea in European and many US policy circles is even worse. It’s, the theory of expansionary austerity put forward by Alesina and various co-authors that the fiscal multiplier is substantial and negative. That is, cutting public expenditure will increase output.

This claim has no real theoretical basis and almost no empirical support, being based largely on anecdotal evidence and on a few studies that have not stood up to criticism. I took it apart in the paperback edition of Zombie Economics – the relevant section was published here

To sum up, despite the thousands of papers published every year in the field, macroeconomic theory is incapable of giving even a qualitative answer to the most basic questions about fiscal policy[3]; at least, not one that would not elicit dissent from a substantial, and well-credentialled group of leading experts. Worse, public policy decisions to impose austerity policies are being made on the basis of a magical theory, with almost no empirical support.

This is an appalling situation, made worse by the complacency of (the dominant group of) academic macroeconomic specialists, who seem to think that everything in the garden is rosy, or would be if outsiders like Krugman would just shut up. It really is hard for me to see how the economics profession can recover from its current rotten state, at least as regards macro (and, even worse, finance).

fn1. Some advocates of nominal GDP targeting, such as Scott Sumner say that monetary policy could work if central banks showed sufficient resolve to convince people they would tolerate inflation. I disagree, but I’ll have to leave this for another time.

fn2. On this view, welfare would decline, because governments would use resources less efficiently.

fn3. While writing this, I wondered what would happen if you put this question to a group of DSGE theorists as a pop quiz. I suspect most would give some variant of “the question is ill-posed” and the rest would be all over the place. But, if any DSGE theorists are reading, I’d be keen to get their views.

{ 59 comments }

1

southofthe49th 01.04.13 at 5:48 am

I think it would be better if the profession conceptualized macroeconomics as two separate disciplines. One looking at at business cycles and basically studying recessions, and the other focusing on long term growth and economic development. More simply: 1) how do we operate at full capicity, 2) how do we raise that capacity.

The popular discourse often confuses these two areas; discussing our current economic problems, without acknowledging that we aren’t operating at full capacity.

2

Ramanan 01.04.13 at 5:52 am

Nice piece!

Economists sadly try very hard to prove that the use of fiscal policy is immoral and bad for society as a whole. It is as if it is the aim of the subject.

3

hix 01.04.13 at 7:02 am

When the tide is down, we see who has no pants. Greece will not grow an export industry by hireing another useless soldier to fight scary Turks, if they manage to hire some local to stand arround in the first place. More likely they will buy some submarine and later spread rumours that they were forced to do so.

4

Nahim 01.04.13 at 7:23 am

“…macroeconomic theory is incapable of giving even a qualitative answer to the most basic questions about fiscal policy.”

I wonder. Is it that there is a right answer and macroeconomists have failed to spot it (in part because of their ideological inclinations towards one position or the other)? Or is it that there is no universal answer and the value of the multiplier depends (as with so many other economic variables) on the economic and policy context. In which macroeconomists might be making quite a different kind of bloomer: searching for the correct answer when the question should be posed as: what is the likely value of the fiscal multiplier given the economic context and the fiscal policy strategies available to governments? And with that expectation in mind, what extent of fiscal policy is justified?

In other words, specifics rather than absolutes. Won’t win a Nobel Prize but might lead to slightly better policy-making until the next ambitious idiot comes along to ruin it all.

5

ponce 01.04.13 at 7:34 am

The right seems to spend an awful lot of time and effort to hide how fast the U.S. economy expanded under FDR in the 1930s and 40s.

It’s practically a wingnut industry.

6

isomorphismes 01.04.13 at 8:57 am

How can Krugman be considered an outsider?

7

isomorphismes 01.04.13 at 9:00 am

I’m reminded of what Carolyn Sissoko said here: http://syntheticassets.wordpress.com/2012/02/27/what-is-capital/

the K from economists’ models, working to constrain our ability to think about what capital is.

Seems apposite to many things. In my opinion abetted by the fact that these people who are trying to tell us how commerce works have, to a first approximation, zero commercial experience.

8

reason 01.04.13 at 9:10 am

southofthe49th @1
Isn’t what you are saying just another way of saying that economics should abandon the equilibrium assumption.

It is also a dirty secret that economics doesn’t have a clue about growth – it only concerns itself with questions of efficiency within the production frontier.

9

reason 01.04.13 at 9:16 am

John,
It may be obvious – but it seems almost never said – that the propensity to import and the rate of tax have substantial influence on the multiplier. Hence for a country like Luxembourg (to take an extreme example), the domestic multiplier is almost always very close to zero.

This is why I tend to agree with Wolfgang Münchau when he identifies the Eurozone’s policy problem as coming from a “small country mindset”.

http://www.ft.com/cms/s/0/91ea6aaa-7720-11df-ba79-00144feabdc0.html

The domestic multiplier and the Eurozone multiplier are two different things – and it becomes hard to sell policies to Germans whose main benefits accrue to Greeks and Spaniards (on the one hand) and banks on the other.

10

John Quiggin 01.04.13 at 9:32 am

@Reason That’s a good point. Because the eurozone was created under the assumption that monetary policy was all-powerful, there was no serious thinking about fiscal policy (not just the absence of fiscal union, but even the need for co-ordination).

11

To 01.04.13 at 11:04 am

@southofthe49th (1): I think it would be better if the profession conceptualized macroeconomics as two separate disciplines. One looking at at business cycles and basically studying recessions, and the other focusing on long term growth and economic development. More simply: 1) how do we operate at full capicity, 2) how do we raise that capacity.

Isn’t the problem that a large fraction of the profession can’t imagine there is a distinction at all ?

12

ivansml 01.04.13 at 11:59 am

if any DSGE theorists are reading, I’d be keen to get their views.

Not really a DSGE theorist here, but there are papers showing that you can get large multipliers in New-Keynesian DSGE models when ZLB binds, see e.g. Christiano, Eichenbaum & Rebelo (2011) or Woodford (2011).

13

Simon Wren-Lewis 01.04.13 at 12:20 pm

As someone who has written DSGE papers on fiscal policy, I have an answer, but as its a bit long I have written a post as a reply: http://mainlymacro.blogspot.co.uk/2013/01/macroeconomic-theory-and-multiplier.html

14

The Raven 01.04.13 at 12:26 pm

@isomorphismes: “no true Scotsman…” I like Sissoko’s argument, too.

It strikes me that the neo-classical school is once again arguing with the data, which is unproductive in science. No, not just unproductive. Unethical. OK, sure, maybe if the discussion of multipliers was a new thing there might be reasons to argue for measurement error. But there is decades, perhaps even centuries, of data, and to deny well-substantiated data is unethical in science—it strikes at the very heart of the scientific enterprise.

A year and a half before I wrote the article which Krugman quoted, I wrote: “This is ideological, rather than rational, opposition. […] The field of economics, I think, needs ethics to keep it track, so that it is a scholarly discipline rather than one that produces extensively rationalized propaganda. […] Yet it seems to me that without ethics, scientific research is not possible. Without basic honesty, without the ability to admit error, without the tools of criticism and review, there is no way to arrive at scientific truth. I believe that economics went off-track partly because of highly-rewarded status-seeking behavior on the part of many economists.”

Say I, read the whole thing. :-)

It is wholly unscientific to argue that multipliers are zero or less, just as it was unscientific for Wegener’s critics to reject his case for continental drift, despite the well-organized evidence he presented. There is another parallel with Wegener: his data was rejected because geologists of his times could not see a mechanism by which the data were possible. This is parallel to the demand for microfoundations. It would be much easier to make the case for Keynesian economics if a clear explanation for the behavior of labor markets could be found in economic data. But that is not required for it to be true; thermodynamics, the understanding of heat in bulk materials, began to emerge centuries before statistical mechanics, the understanding of energy of molecules in large numbers, was invented to explain it.

Perhaps economists have been looking to the wrong physical sciences for their models.

Valid microfoundations, it seems to me, would require the ability to take models and measurements of individual psychology and translate them into valid explanations of macro-economic behavior, and so far, the effort to do this has not been successful on any large scale. Molecules, it has emerged, obey simple physical laws, and no-one expects a molecule to suddenly decide that, oh, instead of going this way, it will go that way. But people produce unexpected behavior all the time. The only time human economic behavior is strongly constrained is when basic needs are involved: we expect hungry people to want to eat, for instance. Even then, we can be surprised: people do sometimes fast, cannot eat due to health difficulties, or even die, which is another thing that molecules do not do.

It is only in subsistence economies that microfoundations are so far accessible. In the economies people prefer, they are not constrained by basic needs; people eat to live rather than live to eat. We understand some of human needs, but valid microfoundations, it seems to me, require an understanding of human desire, and this so far does not exist.

15

Phil 01.04.13 at 12:44 pm

Expansionary austerity is a curious beast. If anyone sincerely believed in a negative multiplier – that cutting X government jobs would create X+1 private sector jobs – they would surely be committed to believing the inverse, i.e. that government job creation leads unemployment to rise. This would be so easy to disprove that it makes me wonder if anyone does hold that belief – or if it’s just a bit of theoretical decoration for the bosses’ party governing in the bosses’ (short-term) interests.

16

Barry 01.04.13 at 1:58 pm

southofthe49th: “I think it would be better if the profession conceptualized macroeconomics as two separate disciplines. One looking at at business cycles and basically studying recessions, and the other focusing on long term growth and economic development. More simply: 1) how do we operate at full capicity, 2) how do we raise that capacity.”

Since the freshwater people would be involved, they’d still muck it up.

17

Trader Joe 01.04.13 at 2:44 pm

Expansionary austerity is ultimately a discussion of whether crowding out it true or not. Empirical assertions of this are at best flimsy and at worst distrortion of fact (as others have referenced including Zombie Economics).

“In the lab” expansionary austerity coupled with near zero interest rates and a reduction in regulatory constraints might produce at least short-run growth on the premise that markets allocate capital better than government. The trick would be finding the right size petri dish.

As someone mentioned, in a petri dish the size of Luxembourg, it might be plausible although perhaps a state like Haiti might provide the relevant counter example….in petri dishes the size of the US or EU it would be hard to justify the experiment and as last week’s fiscal cliff discussion proved, certainly no one in any position to enact such a policy is even leaning the slightest bit that way.

18

P O'Neill 01.04.13 at 3:02 pm

The IMF has published the working paper giving all the technical background and responses to criticisms of the finding cited by JQ above.

The fact that attacks on the original finding were concentrated from central banks, finance ministries, and even the FT shows how deep the fiscal orthodoxy was running — well beyond standard domains of “new classical economics.”

19

CJ 01.04.13 at 4:00 pm

I’m no economist, so if these questions are too basic feel free to direct me elsewhere.

I can understand that there is a link between output and employment, of course, but I don’t understand why it should be so strong. For instance, could you explain why you can write “… in aggregate output (and therefore in employment)…”?

Is it not feasible to maintain a similar economy to the existing one and employ everyone even while output shrinks? (And if it is, when would that be a reasonable trade-off?)

I am also confused by the following quote: “… newly-employed firefighters must be drawn from elsewhere in the economy, presumably in the private sector. Similarly, the production of extra firetrucks means less vehicles can be produced for other purposes. Although the exact way in which resources are reallocated can’t easily be predicted, the classical model gives the clear answer that the overall level of employment and economic activity won’t change.” Is this intended to apply to new private investment also? If not, what is the difference? And if so, then how does growth occur (in the economy as a whole, or at any lower level) according to the classical model? Perhaps private investors are meant to be better at it on average? Or perhaps growth only occurs when new resources are introduced, or when existing ones are used more efficiently?

20

Vivek Jacob 01.04.13 at 4:12 pm

I have read many arguments, but this is propaganda. It is unfortunately a very nice piece of writing which encourages people to think along simplistic and jingoistic lines. A true argumentation should be about cause and effect, and to create a logical framework.

First of all this crisis has occurred because Consumers and Governments overspent and financed their spending using debt. The debt was placed on the books of banks, creating a huge increase in the assets owned by the banks. All of a sudden the central bank questioned the levels of assets to capital, and decided to dramatically decrease money supply. The decision was to invade the balance sheets of the banks, without having an a post-invasion strategy.

What did the Central Banks do? They reduced the price of money. Great! We have reduced the price of money, but have not made money available at the designated price. Just like in communist regimes, the price of bread is fixed but there is no bread. This piece of writing says that the solution to the problem of a lack of bread is to ensure that Governments create more demand for bread.

Please stop this reasoning. This is not a debate. We have a situation where the problems created by a lack of the growth of bank balance sheets was to implement a highly restrictive monetary policy with low interest rates and a low velocity of money. We have to wake up to the reality that in a global economy liquidity risk is the demon, and that demon can be killed only by using a monetary policy focused on the velocity of money and money supply.

21

shah8 01.04.13 at 4:36 pm

/me shrugs

Fiscal multipliers are not about macroeconomics. It’s fundamentally a political economy problem. People keep thinking macro, and thinking about governments or big businesses doing input and extraction, when people are (supposedly) autonomous units that can still add up. I mean, lots of people could just hire each other, right? Right?

Look, like with that whole phase when Hernando De Soto was a bigtime pundit, and people thought poor people needed assets and clear registries, and forget wholesale that the elites prevent that sort of thing–fiscal multipliers are fundamentally about the political economy of the economically distinct region in the “who’s *supposed* to get what” sense, like farmer subsidies that goes to well off and connected farmers and corporations in the US and France. But it’s also about people not having real economic rights. Bankruptcy is highly constrained for both legal and costs reasons, for example. We have licenses for barbershops, taxi medallions, and invidious zoning regulations as per Yglesias droning. Small companies have a hard time growing to big companies, not only because the original owners are happy with the size, but because owners of capital only does angel investing for tiny segments of industry, and there is very little genuine assistance for any mom & pop shop beyond the sort that keeps them in their place.

Lastly, many economies treat the immiseration (yeah, meaning Marxist dialect) of certain groups of people as a public good, like prison complexes and war on drugs in the US, get tough policies on Palestinians and Roma. There are propaganda campaigns and general management of the social idea that worker should suffer for the long term benefit of companies/sports league/government/society. Macroeconomics fundamentally cannot model that simply by looking at flows of currency, goods, and services. At least not without incorporating a great deal of political economics.

–comments powered by high grade Jingmai puerh tea. The drink of intellectuals.

22

Don Geddis 01.04.13 at 4:43 pm

@Quiggin: as grudgingly as you made it, I really really appreciate footnote 1. So thank you.

@Nahim: I think you’ve hit the nail on the head. Sumner would say that the #1 most important “economic context”, is the reaction function of the central bank. Monetary policy “moves last”, and is vastly more powerful than any possible fiscal policy. (And without the side effects, like increased debt!) Discussing the fiscal multiplier, in terms of its effect on aggregate demand, without consider what the monetary authority is doing, is nonsensical. No wonder the data doesn’t show any clear results for “the” fiscal multiplier.

23

JRHulls 01.04.13 at 5:10 pm

Seems to me that if one were to look at specific fiscal projects, it becomes clear that the nature of the project is what determines the multiplier. For instance, take the Hoover Dam

From ‘Dam the Economists’ at http://somewhatlogically.com/?p=523

“Thanks to a 1933 Fortune article, we have an excellent historical perspective on such a project along with some interesting statistics. http://www.usbr.gov/lc/hooverdam/History/articles/fortune1933.html

The Hoover Dam and its associated power and irrigation projects cost $165 million in 1933 dollars and created 16,000 jobs at the height of the Depression. Interest charges during construction were $17 million. Total cost was $1.25 for every man, woman and child in America, which Dr. Cochrane would dismiss as interfering with free enterprise and stealing jobs and capital from the private sector. In reality, the dam cost citizens nothing: the $1.25 actually represents a collective (oops…nasty socialist word) investment by the entire citizenry. In less than 50 years, the dam paid itself off by selling water and power with a 100% profit and continues to generate over $400 million a year from selling electricity.”

The multiplier effects will range from Keynes stuffing abandoned mine shafts with money and paying people to dig it up to Hoover Dam type projects, and I don’t understand why more attention is not paid to the analysis of such projects. If one looks at the economic impacts of infrastructure lag, there are plenty of similar projects available today.

(For further comments on government investment and a link to the American Society of Civil Engineers infrastructure report card, which is a gateway to lots of data on infrastructure and efficiency, please see “The Light in Rand Paul’s Bathroom” at http://somewhatlogically.com/?p=489 and “Republicans raise taxes, increase spending and create thousands of jobs” at http://somewhatlogically.com/?p=505

24

Bruce Wilder 01.04.13 at 5:12 pm

I think I would have framed this differently. The original post says, “what causes unemployment” is the big issue and then goes directly to an operationalization of that issue: the fiscal multiplier. That’s a big leap to make from paragraph one to paragraph two.

The “problem” of unemployment for economists is not just a behavioral one, of calculating in quantitative terms, a policy response. It is not, at base, just a matter of spend $1, get an increase of national income of $1.20 in the first year, which is the kind of answer the fiscal multiplier purports to give us.

All the problems of economics, for economists, are both normative and positive, meaning that they are about what is an objectively “good thing”, as well as about what is, as a factual matter. Economists are interested in how the economy performs, not just how the economy behaves. The former includes an evaluation.

The concern with unemployment is performative.

Keynes had one killer argument, and it wasn’t about about any of the arcane topics introduced in the General Theory. It was simply the observation that unemployment of resources in the economy is a waste. The observation of unemployment, as a fact, combined with the evaluation of unemployment as a waste is the argument, which killed the classical model.

Waste is inefficient. In the formal terms of Pareto-efficiency, employment of resources to some productive purpose would result in goods, which could improve welfare for some, without necessarily making anyone else worse. In the best of all possible worlds, where the classical model of the market economy operates, efficient market operation would fully and efficiently employ all resources in production. If that’s not happening, if there’s unemployment, if the classical model is wrong, then there’s scope for a Pareto-improving government policy intervention.

The division in mainstream macro theory, between the New Keynesians on the one hand, and the New Classicals and Real Business Cycle folks on the other, is a division over behavior v. performance. The New Keynesians are chiefly pre-occupied with adapting their models to reflect how the economy behaves quantitatively. To get the models to behave in ways that seem to roughly correspond with the response of the actual economy to policy changes seems to require, for example, the famous “sticky prices”.

The New Classicals and Real Business Cycle folks are chiefly pre-occupied with proving that unemployment is not the waste it appears to be, and that government policy interventions to reduce it, will prove to be not welfare-enhancing. Ignoring the reactionary conservative’s black-hearted tenderness for the welfare of plutocrats and corporate chieftains (named Anderson, especially*), the underlying moral instinct might be summarized as a conviction in favor of “free to choose”. If the government chooses to build a bridge, it must be impinging, to some extent, on the ability of individuals to choose a flat-screen tv, or something. The free market economy is gloriously welfare-enhancing, indeed welfare-optimizing, because individuals are free to choose to satisfy their individual wants and desires in markets, where price allocates resources. Collective choice, mediated by the corrupt political process, by contrast, must be regarded as diminishing welfare, by its very nature; even if there is some improvement observable, the tainted nature of corrupt political choice at least partially offsets that improvement, which you can see, if you just look hard enough.

This division of opinion in mainstream macro is essentially incommensurable. There is nothing measureable, which they could agree upon. For a New Keynesian, a fiscal multiplier is literally a quantitative estimate: how much does a dollar of expenditure increase national income (and by entailment, employment)? For NC and RBC, it is a completely different question: does the fiscal stimulus actually improve welfare? does the fiscal stimulus impair the ability of the sacred free market economy to make its own optimal choices in the fullness of time? For someone like Barro, it makes perfect sense to discount any fiscal multiplier by several tenths, to account for the inherent inefficiency and corruption of political choices and government administration. It is a small step from focusing on normative assessment to affirming broad moral judgments. I think if you look closely at, say, Cochrane’s rants against Krugman over Obama’s stimulus in 2009, you will find that all Cochrane wants to do is to affirm his favored moral imperatives. The economy as a system of quantitative flows is lost to him.

25

Alex 01.04.13 at 5:24 pm

If anyone sincerely believed in a negative multiplier – that cutting X government jobs would create X+1 private sector jobs – they would surely be committed to believing the inverse, i.e. that government job creation leads unemployment to rise.

They do.

26

SusanC 01.04.13 at 5:29 pm

Very nice post!

In my experience, the US and Canadian governments do believe in a fiscal multiplier > 0, at least when handing out research grants to Universities. For example, DARPA can be quite explicit that they are prepared to fund institutions outside the US, but US institutions get a degree of priority because of the stimulus effect . (If the grant money is mostly spent in the US, the US government will get some of it back via taxes etc., and so US government grants to US universities are cheaper than they look on paper).

I’ve heard it said (but this is second hand hearsay, so possibly not too reliable) that some years back the Japanese government was acting as though the fiscal multiplier was > 1: pretty much any research proposal, no matter what it is was about, could get funded, because the allowance for the Keynsian stimulus the funding body was making made pretty much anything look like a net gain for the government.

In Europe, it is widely rumoured that when awarding research contracts, the EU gives preference to bids with Greek partners, for the obvious stimulus reasons. However, I have never heard anyone from the European Commission publically say that this is what they are doing. It may be harder for the European Commission to publically admit this; while if the US government says says they prefer to spend the US taxpayers money in ways thay go to Americans, hardly anyone is going to accuse them of doing something wrong.

Our governments are perhaps, not entirely consistent in how they do this — welfare payments to unemployed and/or homeless people probably have a good fiscal multiplier too.

27

Bruce Wilder 01.04.13 at 5:57 pm

Nahim @ 4

The correct specification of many theses in economics would seem to be necessarily conditional on context. Getting the context right would seem critical, to common-sense reasoning.

Ex: Is a minimum wage a good policy? It would seem to depend on how high the minimum was set relative to the main tendency of wages (average or median).

I can certainly imagine contexts in which austerity would be an appropriate policy and could be counted on to call forth private investment in force. The transition from a wartime to a peacetime economy, especially one in which private indebtedness was low, a large stock of public debt was in private hands, and the government was, by austerity, releasing resources and controls no longer needed for the war effort, might be such a context.

It is a measure of the degeneracy of economics that its collegial debates are so embittered and stupid that propositions, rather than being enhanced in their subtlety and nuance by intelligent discussion, are reduced to indefensible simplicities, asserted with fanatical and unfounded conviction.

28

Anderson 01.04.13 at 6:06 pm

I’m confused. A mulitiplier of zero would yield a zero answer, which can’t be what anyone predicts.

Isn’t the issue whether the mulitplier is greater than one (Keynes) or equal to one (classical)? If you multiply by one, things stay the same.

29

js. 01.04.13 at 6:16 pm

Just wanted to say: this series of posts has been very helpful to this non-economist. Thanks.

30

Patrick 01.04.13 at 6:19 pm

Perhaps the biggest problem in macroeconomics is creating theories that can be messaged persuasively to the public?

It seems that many politicians are happier making policy on theories that are false but can be persuasively explained in 15 seconds than theories that would yield better results but take more than 15 seconds to explain.

Fiscal multiplier is one example of an idea that takes longer than 15 seconds.

31

Bruce Wilder 01.04.13 at 6:21 pm

The multiplier is the ratio of the incremental government expenditure to the expected or resulting increase in national income. If the government borrows an additional $1 from me, private citizen, and I spend $1 less (since I lent it to the government), at the same time as the government spends the additional $1 it borrowed, national income (the total expenditure on production in the economy) hasn’t changed. Hence, a multiplier of zero.

32

Trader Joe 01.04.13 at 6:25 pm

Wilder @19
Bravo!

33

Bruce Wilder 01.04.13 at 6:51 pm

If the government spends a $1 that would not otherwise be spent — if the government borrows a $1 from me, private citizen, and I take that $1 out of my mattress not out of my household budget — then national income has gone up by $1. Now, someone received that $1 as additional income — maybe that was me, I sold the government a widget for its dollar — and having $1 more in income, I stuff 20¢ in my mattress, but spend 80¢ at the grocery. National income has now gone up by $1.80. The grocery spends 60¢ out of its additional 80¢ in income on wages. National income has increased by $2.40. And, so on.

Demand for goods and services is only effective, if you have the cash in hand to make it effective. And, in some circumstances, some people and other resources can fall out of the circular flow of currency and credit in the money economy. And, they may have no practical way to get back in.

The classical model invokes Says’ Law, which is to assert that resources outside the circular flow can bid their way back in to the money economy, lowering price for their product sufficiently to allow the existing flow of money to employ all resources. Even if you accept the thesis that resources, which have fallen out of the circular flow of the money economy, can bid their way back in, in the event of a financial shock, which has exogenously reduced the money flow substantially, it may make more sense to simply increase the money flow back to the point at which all resources can be employed at existing prices, than to wait for a long, painful and wasteful process of price adjustment.

If you choose, by policy, fiscal or monetary, to expand the money flow, as a means to bring resources into production in the money economy, and you overdo it, some say, the worst that will happen is that prices will be bid up, to absorb the additional money flow, aka a general inflation. Others say, the worst that will happen is that the government borrowing will crowd out private investment. Resources that could have been employed by private investors to accumulate capital and add to future production, will have been bid up in price by demand from government expenditures, while funds, which might have been borrowed to finance private investment, will have been lent instead to the profligate government.

34

Bruce Wilder 01.04.13 at 7:04 pm

Ultimately, the struggle over fiscal and monetary policy, like all political struggles, is a struggle over power, income and wealth distribution.

As a matter of political polemic, I am not sure I quite understand why those on the Left in these debates will claim that austerity is stupid, when austerity is clearly smart, cruel and greedy.

At some point, one has to recognize that one’s opponents are not competitors, but opponents, because they do not share one’s goals, and, in fact, are pursuing contrary or opposite goals. Not just in degree or style, but in substance and form. Maybe, acknowledging such a reality would make the struggle seem too desperate, even too hopeless.

35

Bruce Wilder 01.04.13 at 7:19 pm

My comment above @ 31 is a statement of conditions of Ricardian Equivalence. The equivalence in question is the supposed equivalence of government taxes and government borrowing. Robert Barro recast Ricardian Equivalence as the assertion when the government borrowed to finance a fiscal stimulus, people with rational expectations would reduce their expenditures, saving up what they expected to pay in future taxes to repay the borrowing. So, it was said, cancelling out the effect of the additional spending with their rational expectations and resulting savings. This was treated as some great fundamental insight on the Right, and the Left immediately began great and hoary attacks on the heroic assumptions of, for example, infinitely lived agents, said to be required by this argument.

As an old institutionalist, I would just like to point out that of course people “save” exactly the expected future taxes. Not because they have infinite lives or are brainiacs rationally calculating their expectations. But, because the government hands them in exchange a bond, which is . . . wait for it . . . exactly equal to the future taxes to repay the borrowing.

A large part of academic macroeconomics is a bunch of smart people with way too much time on their hands overthinking these issues.

36

The Raven 01.04.13 at 7:38 pm

Bruce Wilder @34: “As a matter of political polemic, I am not sure I quite understand why those on the Left in these debates will claim that austerity is stupid, when austerity is clearly smart, cruel and greedy.”

I think there are very few people who would actually enjoy being filthy rich in an impoverished world. The idea is attractive to some people, but the reality would be attractive to far fewer. Who actually wants a world returned to a subsistence economy?

I am constantly pleading with people to see past the fantasies of power to its realities.

37

Martin Bento 01.04.13 at 7:39 pm

Surely it makes a difference whether we are talking about government spending that is a) paid out of revenues, b) paid with financed debt, or c) monetized? Since the US sells a lot of treasuries to foreign entities, it seems that would provide some expansion right there, although this is obviously not something that can hold simultaneously for all nations. I don’t see how anyone could dispute an expansionary effect to c, but that is the one that is veboten, and one can obviously get out of hand with it, but I’ve yet to see an account of why it is any more inflationary than increasing the money supply by other means, and that seems to be acceptable in circumstances like ours.

Meanwhile, the Repubs are threatening to bring the whole house down over a debt ceiling, while the Fed is now buying treasuries. The Fed hasn’t gone for full monetization in that they are not burning the treasuries, so it is still, on paper, debt, and they still presumably plan to resell them at some point. But that money is supposed to go back to the Treasury anyway, so the Fed could just write it off, which, ISTM (someone please tell me if there is some reason this is not true), would reduce the outstanding federal debt and keep us below the ceiling. I realize policy is a bit of a tangent here, but this seems the way out. Should we not be agitating for this? This is how I would expect the confrontation solved, though it would cost us a taboo.

38

William Timberman 01.04.13 at 7:52 pm

Why do we call them (the advocates of austerity, not austerity itself) stupid? It’s not because we believe it to be true in any narrowly technical sense, but because we think that the kind of world their advocacy creates is a terrible place. We call them stupid because, in the long run, that world will be a terrible place not only for us, but for them as well, and because they can’t imagine themselves having to live in it.

Looked at from the left’s end of the telescope, moral stupidity is pretty much the worst kind of stupidity there is, even though it has nothing to do with IQ measurements.

39

Barry 01.04.13 at 8:04 pm

Raven: “I think there are very few people who would actually enjoy being filthy rich in an impoverished world. The idea is attractive to some people, but the reality would be attractive to far fewer. Who actually wants a world returned to a subsistence economy?”

If there’s a limit to the greed of our elites, we haven’t seen it yet.

40

Alex 01.04.13 at 9:00 pm

Barry: we have a natural experiment. the wealthy elites of poor countries spend a lot of their money in London, Zurich, Miami, and Dubai.

Admittedly the latter hardly counts as civilisation, but you see my point.

41

Main Street Muse 01.04.13 at 10:08 pm

From JQ: “This is an appalling situation, made worse by the complacency of (the dominant group of) academic macroeconomic specialists, who seem to think that everything in the garden is rosy…”

Is this true? The dominant group of academic macroeconomic specialists feel that all is right with the world today? I don’t understand how any thinking person could believe this. Especially an academic macroeconomic specialist. If true, then macro is truly making itself irrelevant.

To Raven, I’d say there are plenty of people happy and content being “filthy rich in an impoverished world.”

42

Anderson 01.04.13 at 10:23 pm

31: “The multiplier is the ratio of the incremental government expenditure to the expected or resulting increase in national income. If the government borrows an additional $1 from me, private citizen, and I spend $1 less (since I lent it to the government), at the same time as the government spends the additional $1 it borrowed, national income (the total expenditure on production in the economy) hasn’t changed. Hence, a multiplier of zero.”

So your ratio is the expenditure of $1 to the zero increase? 1/0?

Economists don’t do math like the rest of us, it seems.

43

Chris Mealy 01.04.13 at 10:39 pm

There’s a great line in Bicycling Science, “science has learned more from the steam engine than the steam engine has learned from science.” I think economic theory will be in much better shape when economic management techniques improve. The toolkit we have is pretty bad. Monetary policy is mainly good for controlling inflation by laying off construction workers. What kind of technique is that? I’d love the Fed chair to come on tv and say, “We’re going to lower prices by putting carpenters out of work. Sorry, losers.” Scott Sumner has written a zillion words on NGDP targeting but as far as I can tell has never explained in plain english what would actually happen if he was running things. I doubt that he knows.

Sufficient fiscal policy only seems possible in one party states (1930’s America and Germany, China today). Why that is I don’t know.

I don’t have any great ideas about what should go in the toolkit, but I’d like to see somebody try demurrage. Kurzarbeit looks alright too. Automatic countercyclical public works seems like a great idea (here’s a plan from 1921). MMT’s employer of last resort sounds completely terrible.

I don’t know for sure that better policy options would improve economic theory, but at least we’d have better policies.

44

Bruce Wilder 01.04.13 at 10:40 pm

$1 * 0 = $0
is how I do math. ymmv

45

Bruce Wilder 01.04.13 at 11:39 pm

Chris Mealy @ 43
The kind of highly abstract and analytic debate of the models, which mainstream economics engages in, has narrowed the focus of policy analysis to a very abstract control model of one interest rate.

Things have loosened up a lot post-GFC, but before 2008, suggesting such a small variation as having the Fed buy or sell long-term bonds with an eye to affecting long rates relative to short, was treated as heresy. Banking regulation was completely neglected, of course, though that is the largest part of what a central bank traditionally does. Capital controls? Forget about it!

It is past obvious that the world needs to hold a Bretton Woods Redux conference and devise some kind of multipolar currency and managed trade system, but, instead, we’ll probably ride the U.S. dollar and U.S. hegemony right into oblivion for both, but none of our priestly experts know their jobs. (Can you imagine hiring any of the imbeciles, who gave the world the Euro, to devise a post-dollar global regime? No one else is credentialed, though.)

46

Peter T 01.05.13 at 1:42 am

I don’t have any good analogy for economics. Many of the people engaged in it seem both skilled and intelligent, and there is lots of interesting data that would bear on the problems they engage. But they don’t seem very interested in the data – the kinds of aggregates discussed here would just be the starting point in any other intellectual endeavour. Still less would the debate be continued for decades in high abstraction, with occasional anecdotes about mattresses or corner stores thrown in for light relief. Surely what kind of stimulus, in what context, matters. Is it Hoover dam? Tiger tanks? Clean water for those who have none? Or better helicopters for CEOs?

Others disciplines looking at complex, path-dependent systems take the history of those systems seriously. People get prizes in climate science for making better guesses about the climate of the Jurassic, because the answer further constrains the field of possible answers to current questions. Likewise biologists take evolution seriously enough to study what evolved, where, how. Economists seem to think the answers lie in some platonic void, or in the application of some grand universal to some tiny patch of behaviour – an essentially amateur approach.

I don’t know what might bring the discipline back into some more relevant frame – I am not sure that there is any path forward starting from where it is.

47

AM 01.05.13 at 6:56 am

@anderson: my understanding is:

multiplier = (aggregate benefit)/(gov’t stimulus)

this is >1 if AB>GS, 1 if AB=GS, and <1 if AB<GS.

now, if the economy gets WORSE as a result of the government spending, then AB is negative, so the multiplier would indeed be negative

48

PGD 01.05.13 at 8:01 am

Nahim @4 goes well with Peter @36 — a fundamental issue here is economists refusal to admit the narrative / historical dimension of their discipline, the fact that it should be about the particular effects of particular actions understood in a particular context, with the output being not universal scientific laws but better informed decisionmaking. There is no contradiction in using quantitative analysis or modeling in such an effort.

Meanwhile, the Repubs are threatening to bring the whole house down over a debt ceiling, while the Fed is now buying treasuries. The Fed hasn’t gone for full monetization in that they are not burning the treasuries, so it is still, on paper, debt, and they still presumably plan to resell them at some point. But that money is supposed to go back to the Treasury anyway, so the Fed could just write it off, which, ISTM (someone please tell me if there is some reason this is not true), would reduce the outstanding federal debt and keep us below the ceiling.

Two issues here, a technical one and a political one. The technical one is that like any bank, the Fed has to maintain a balance sheet that equates assets and liabilities (or has traditionally maintained one, not sure if it is a legal requirement). If the Fed simply cancels debt or writes it off assets will fall below liabilities, making the Fed technically insolvent. The political issue is that if the Fed tries to use its monetary powers to take sides in a key fiscal controversy and empower one political side over another then it will likely lose its political independence, or at least create great danger of such. At the least Congress would eventually restrict its powers.

49

Martin Bento 01.05.13 at 10:47 am

PGD,

On the technical issue, the Fed is purchasing these treasuries by printing money. It has been purchasing MBS’s in the same way for years now. Meanwhile, whatever money it has left over after paying its bills and the guaranteed return to the member banks is supposed to be given to Treasury anyway. I think any balancing of assets and liabilities at an institution that has unlimited ability to manufacture assets from thin air, but also a perpetual blanket liability that can expand or contract arbitrarily, has to be considered accounting kabuki ™.

On the political issue, first of all, loss of Fed independence is from my standpoint a feature. I don’t think an institution with the degree of power that is held at the Fed by commercial entities has any business running the economy in a democracy. Of course, the Fed will not see it this way.

Second, there is a real problem with regard deliberate default on the debt as a “fiscal controversy”. The fiscal controversy was settled when Congress passed the budget. The question here is whether the government can deliberately choose to disobey its own laws, since the debt we are discussing is a legal obligation. Whether the government has to obey its own laws should not be considered a normal political controversy. If the government steps deliberately and non-trivially outside its own law, it has become a fundamentally different kind of government. Therefore, the existence of such a controversy constitutes a Constitutional crisis, since the legislative branch is simultaneously requiring and prohibiting that the executive spend money. This is particularly so since there is no external force compelling this action. The crisis is being deliberately engineered.

50

Gyan Sinha 01.05.13 at 12:51 pm

You left out one major reason why the debate about fiscal policy goes nowhere – it’s because one side has an ideological bias against any kind of “collective” expenditure in the face of a liquidity trap where monetary policy has lower potency.
If government is really the only means to bring about the increase in AD (since, at the individual level, it is rational to save more given the negative shock to income and the increase in its volatility) but you believe that it is a road to (a) waste, fraud and abuse and (b) the slippery slope to serfdom, then the economics doesn’t really matter, does it? The Classicals are solving an entirely different optimization problem than the rest of us. All their arguments are elaborate contraptions to work back from the conclusion – government spending is bad, and how better to convince others of the merits of your case than to conclude that it simply doesn’t work, so why even bother?

The reason this debate is barren is because it is not about how society can create a program of higher AD effectively It’s especially hard when the policy makers on the classical side rely on shibboleths about the evils of “collectivism” and government spending. I am sorry to say the track record of the current US administration is not that much better in this regard.

Until government spending becomes ” respectable” again, there will never be enough traction to drive the academic debate on fiscal multipliers forward, in my opinion.

51

Barry 01.05.13 at 4:26 pm

Peter @46: ” But they don’t seem very interested in the data “

Please read Krugman for a start, and then read those to whom he links approvingly. Lots and lots of uses of the data, and lots and lots of consideration on the nature of the stimulus.

The two sides are not the same; that’s the first lesson from the Crash.

52

Martin Bento 01.05.13 at 6:40 pm

BTW, prior to 1951 the Fed not only routinely monetized the national debt, it did so effectively under orders from the Treasury. The 1951 accord that gave it the right (not obligation) to refuse to monetize government debt was largely motivated by concern with excessive increase in private credit and inflation. The inflation rate of such concern was around 3%. Meanwhile, we are in the aftermath of an utterly irresponsible expansion of private credit that the Fed enabled and explicitly encouraged (Greenspan directly told people who stayed in old-fashioned fixed mortgages that they were being irrational). As argued in the other thread, even the great inflation taming of the 80s and 90s can be seen at least in part as inflation diversion from consumer goods and wages to assets. Given all this, it’s not clear to me that the case for Fed independence made at the time was all that good.

53

Anderson 01.05.13 at 10:43 pm

47: that makes sense, but not a zero multiplier.

54

Peter T 01.06.13 at 12:16 am

Barry

By “not interested in the data” I don’t mean no appeal to empirical evidence – Krugman and those he cites do this a lot. I mean that economics seems averse to actually getting into and assimilating the enormous amounts of information about behaviour over time, the relations of economic movements to particular social formations, what actually happens inside families or corporations and so on. There is some very good economic history, but it seems distant from the main run of professional argument. Marx set a standard here which has been very much neglected since.

55

Ricardo Amateur 01.06.13 at 12:41 am

The question of unemployment is answered in ECO 1, in the production function:
People stay unemployed because demand is satisfied with a mix of capital and labor that leaves people redundant.
Why the cost of labor does not drop to recover balance, is the matter of sufficient studies.
But Monetary stimulus clearly works against employment, as it makes capital cheaper.
Even with a neutral monetary policy, capital tends to become ever cheaper, because of the accumulation of long lasting capital goods and technological progress.

Demand stimulus? Little if any additional demand is created by monetary stimulus, after rates get close to zero.
So the tools are only two:
Measures to reduce cost of labor (highly impolitical and with backloaded, small effect), and
Fiscal spending financed without crowding out, that is, with Central Bank printing. There are plenty of public goods in short supply, from education to environment, from subways to hospitals, from urban development to safety.

56

Peter T 01.07.13 at 4:16 am

57

Nathanael 01.08.13 at 12:45 am

I would describe the situation in much simpler terms.

Unemployment can be caused by:
(1) Lack of (unconstrained) demand for work product. This would be the world of Star Trek: The Next Generation and its replicators. This has probably never happened.
(2) Lack of demand for the work product produceable by the people who are unemployed; in other words, skills mismatch. This happens sometimes but is clearly not happening during recessions, as this would involve massive overdemand for another group of workers, which isn’t happening in recessions.
(3) Missing cofactors of production. For instance, suppose every product requires oil as well as labor to manufacture, and there’s an oil shortage. The manufacturers raise their prices due to the oil shortage, and keep doing so until demand drops to meet supply — but at that point there are lots of unemployed people, because there just isn’t enough oil to keep them busy. This may have happened during the ’70s in the US but also seems rare. It would be associated with inflation.
(4) Shortage of money in the hands of average people. Recall that most goods and services are bought by poor to middle class people; one very rich person is almost never capable of making up for a drop in purchasing by thousands of poor people. This means that demand is constrained by the poverty of the general population. This happens when businesses are not following Ford’s rule (“I pay my workers enough to buy a Ford”). The solution is to put wealth in the hands of the population, by one means or another: when done by government, this is always called “fiscal policy”. This is the *most common* sort of recession and is associated with deflation.

“Monetary policy” does sort of involve putting money into the hands of the population, but involves forcing them to take on “debt” in exchange for getting the money — and only under certain circumstances will they be able to pay back that debt; eventually they will be unable to take on more debt due to the interest costs and monetary policy will be useless. Monetary policy has no virtues over fiscal policy except that contraction can be done quickly. (Is this actually a virtue?) It does consistently transfer money from the poor to the rich, which rather explains its political popularity.

58

Nathanael 01.08.13 at 12:47 am

Martin Bento @51: important points. It seems to me that Fed independence has been a complete, unmitigated failure. We need to go back to monetizing the debt like we did in previous administrations.

59

reason 01.09.13 at 10:52 am

Nathanael @57
you got it just about right up the last sentence:
“It does consistently transfer money from the poor to the rich, which rather explains its political popularity.”

No it doesn’t transfer money from the poor to the rich (the act of borrowing does PRECISELY the opposite). What it does is transfer WEALTH from the poor to the rich.

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