Paul Krugman on the Fiscal Multipliers

Paul Krugman writes:

A couple of weeks ago I went out to Lincoln, Nebraska (the AP graders - an institution you don't learn about until you're hawking a principles book) and they asked me to give my views on crowding out. I think my formulation is close to yours.

Here's how I explained it. Think of a standard IS-LM picture. Does that match current reality? Obviously not: the Fed doesn't target the money supply, so holding M constant is not a useful thought experiment, and actually confuses students. In fact, since the Fed actually targets the Fed funds rate rather than the money supply, you might think that the LM curve should be replaced with a horizontal FF curve. This would seem to suggest no crowding out at all.

But except in the very short run the Fed doesn't set the interest rate passively; instead, it tries to stabilize output around potential. A reasonable way to represent a Taylor rule or something like that in a simple diagram is to draw a vertical line, the BB curve (for Ben Bernanke). This gives us 100% crowding out.

And I think that's right. Except in liquidity-trap conditions or in the very short run, before the Fed has a chance to catch up, fiscal policy doesn't change aggregate demand, only the mix. The exceptions are important: we had a near-liquidity trap experience in 2003, and it was a good thing that we had some fiscal stimulus (and a bad thing that the stimulus was so poorly designed). But the normal rule is that fiscal policy is fully crowded out.

I think this is important. Fiscal prudence--budget balance--is a politically unpopular but economically important cause. The last thing we need is people claiming that budget deficits have, in our current economy, virtues they do not possess.

Comments

[Rich C]

Is this just a theoretical claim, or is it empirically supported? Does this claim depend on the sorts of assumptions that typically appear in neoclassical macro theorizing, like constant employment? And how does this view square with the empirical work of Wynne Godley and others, who show seemingly quite strong correlations between the levels of the sum of the public and private sector deficits and the external balance, along with strong correlations between the flows generating these balances and growth?

[Chris R]

I strongly disagree with the characterization that government spending has no effect on demand even if the Fed is doing its job. The intuition is as follows: Shocks to government spending are in fact real shocks to people's consumption possibilities. We're talking about output that could otherwise be consumed or invested instead going somewhere else. Imagine an RBC-style world, for the moment, without distortionary taxation. We have intertemporal substitution, labor supply and demand (maybe with real rigidities or matching instead), and a resource constraint Y(t)=C(t)+I(t)+G(t).

Think of a very persistent shock to government spending (i.e. consumption plus gross investment--the NIPA definition). This may very well raise investment as people correctly anticipate high demand throughout the future. This would probably raise hours worked and depress consumption. Monetary policy may be able to respond to this to some degree, the optimal policy of course depending on the structure of the economy and how this spending is financed. But, the optimal level of output would still be higher than it was before since the government is absorbing some of it, leaving less for consumption and investment.

If it's a temporary shock (think white noise), intertemporal substitution dictates that people initially eat some of their capital to smooth consumption. Investment initially tanks and then recovers to replenish the capital stock that's been depleted. I would expect hours worked to rise since people feel poorer, the exact shape of the response dictated by rigidities in the labor market.

Empirically, government spending shocks appear to be very, very persistent. Friedman's quip about no such thing as a temporary government program comes to mind. I'm ignoring the choice of financial instrument at this point because the effect of that isn't at all clear--we could have anything from Ricardian equivalence to supply-side effects to the fiscal theory of the price level depending how fiscal policy actually works.

That's my $0.02. Basically, for the Fed to purposefully throttle consumption in the face of a lage shock to government spending does not make sense to me.

[knzn]

This whole crowding out argument is based on a closed economy. It also works in an open economy with flexible exchange rates. But the argument doesn’t go through at all in an open economy with fixed exchange rates. This last might in some respects be a better description of the US circumstances. Although many exchange rates are flexible, I suspect others might be “worse than fixed” and might react perversely to offset the effect of flexible exchange rates.

What would happen if the US cut its budget deficit? China and Japan and various other countries would be quite unhappy with the reduction in demand coming from the US. Their response might be to undertake aggressive strong dollar policies, resulting in lower US exports and potentially nullifying the Fed’s attempt to offset the tightening of fiscal policy. This is really another way of saying that we may be closer to a liquidity trap than we think.

[knzn]

Making my previous point in a slightly different way: Imagine a 2-country model with perfect asset substitutability and in which both central banks follow Taylor rules. What happens when one country tightens its fiscal policy? For some reasonable parameter values, both nations fall quickly into a liquidity trap. If one (call it Japan) is already there, I don’t think it helps matters.

[reason]

The Krugman/DeLong's faith in the Fed is touching, but is it realistic. Do people really have such faith in the Fed? If so why is the Fed watched so carefully? Nobody really has a clue what it is up to. Hence I don't believe crowding out is as important in todays world as the academic economists are claiming. International financial flows are however I believe MORE important that they are suggesting. They need to open up their models (talk to small country economists for instance). The problem with domestic stimulus is that it flows out the external balance, not that it drives up interest rates. That creates dangerous instability because the foreign exchange market is driven by things other than trading fundamentals. Unfortunately, it seems that FX speculation is what rules the world and it is time that economists' models reflected it.

[anne]

Simply watch the bond market and understand what Federal Reserve policy is and the confidence in the policy which, from the stability and low interest rate levels of long term bonds is ample.

[anne]

http://economistsview.typepad.com/economistsview/2006/06/paul_krugman_cl.html#c18726360

June 19, 2006

Paul Krugman: Class War Politics

Paul Krugman explains how increasing income inequality has driven increased political polarization in recent decades, and he has warnings for pundits who "flock eagerly" to politicians claiming to represent the non-existent political center:

Class War Politics, by Paul Krugman, Commentary, NY Times: In case you haven't noticed, modern American politics is marked by vicious partisanship, with the great bulk of the viciousness coming from the right. It's clear that the Republican plan for the 2006 election is, once again, to question Democrats' patriotism. ... So what's our bitter partisan divide really about? In two words: class warfare. That's the lesson of an important new book, "Polarized America: The Dance of Ideology and Unequal Riches," by Nolan McCarty ..., Keith Poole..., and Howard Rosenthal...

What the book shows ... is that for the past century, political polarization and economic inequality have moved hand in hand. Politics during the Gilded Age, an era of huge income gaps, was a nasty business — as nasty as it is today. The era of bipartisanship, which lasted for roughly a generation after World War II, corresponded to the high tide of America's middle class. That high tide began receding in the late 1970's, ... and as income gaps widened, a deep partisan divide re-emerged.

Both the decline of partisanship after World War II and its return in recent decades mainly reflected the changing position of the Republican Party on economic issues.

Before the 1940's, the Republican Party relied financially on the support of a wealthy elite, and most Republican politicians firmly defended that elite's privileges. But the rich became a lot poorer during and after World War II, while the middle class prospered. And many Republicans accommodated themselves to the new situation, accepting the legitimacy and desirability of institutions that helped limit economic inequality, such as a strongly progressive tax system. (The top rate during the Eisenhower years was 91 percent.)

When the elite once again pulled away from the middle class, however, Republicans ... returned to a focus on the interests of the wealthy. Tax cuts at the top — including repeal of the estate tax — became the party's highest priority.

But if the real source of today's bitter partisanship is ... economic issues, why have the last three elections been dominated by talk of terrorism, with a bit of religion on the side? Because a party whose economic policies favor a narrow elite needs to focus the public's attention elsewhere. And there's no better way to do that than accusing the other party of being unpatriotic and godless. ...

Pre-New Deal G.O.P. operatives followed the same strategy. Republican politicians won elections by "waving the bloody shirt" — invoking the memory of the Civil War — long after the G.O.P. had ceased to be the party of Lincoln and become the party of robber barons instead. Al Smith, the 1928 Democratic presidential candidate, was defeated in part by a smear campaign — burning crosses and all — that exploited the heartland's prejudice against Catholics.

So what should we do about all this? I won't offer the Democrats advice right now, except to say that tough talk on national security and affirmations of personal faith won't help: the other side will smear you anyway.

But I would like to offer some advice to my fellow pundits: face reality. There are some commentators who long for the bipartisan days of yore, and flock eagerly to any politician who looks "centrist." But there isn't any center in modern American politics. And the center won't return until we have a new New Deal, and rebuild our middle class.

[Blissex]

"The era of bipartisanship, which lasted for roughly a generation after World War II, corresponded to the high tide of America's middle class. That high tide began receding in the late 1970's, ... and as income gaps widened, a deep partisan divide re-emerged."

Perhaps one can say that after 1945 and up to 1990 fear of Communism persuaded the wealthy to bestow on the populace a temporary stake in the system, to be taken back as soon as the need to keep the home front happy had gone away:

http://www.economist.com/images/20060617/CSF838.gif
http://www.economist.com/world/displaystory.cfm?story_id=7055911

That graph is ahem ''graphically explicit''...

[anne]

Blissex, interesting comment as usual :)

[reason]

Blissex,
I wonder what that picture looks like INCLUDING capital gains!