Fama's Fallacy V: Are There Ever Any Wrong Answers in Economics?
Montagu Norman here, back from my grave once again. This time it is Greg Mankiw whose words have summoned me...
One thing that used to give me nightmares--and that provoked several of my nervous breakdowns--was how you could never get any economist (except for John Maynard Keynes) to take a definite position. They were always "on the one hand--on the other hand." This was what led Harry Truman in later days to wish for a one-handed economist, a wish that has never been fulfilled--there is in fact a picture of Barack Obama's economic advisor Christina Duckworth Romer in Time (or is it Newsweek?) showing her with four hands...
The "on the one hand--on the other hand" nature of discourse raises the question of whether in economics--a "science" where there is enormous intellectual and ideological and political disagreement about how the world works--there can ever be any wrong answers?. I believe that there can be wrong answers in economics, because examinations in economics tend to take a particular form: instead of asking (i) "do expansionary fiscal policies increase output and employment?" we ask (ii) "in models where there are idle resources and high unemployment, do expansionary fiscal policies increase output and employment?" (ii) is a question about a particular class of models of the economy, and so has a definite right answer--"yes, in that class of models they do"--and a definite wrong answer--"no, in that class of models they don't."
Eugene Fama claimed that "when there are idle resources--unemployment" expansionary fiscal policies had no effect in models in which the NIPA savings-investment identity:
investment = (private savings) - (government deficit)
Now the NIPA savings-investment identity holds in all models--it is, after all, an identity, true by definition and construction. And every single model that has been built in which there is a possibility of high unemployment and idle resources is a model in which fiscal policy works because increases in government spending lead to unexpected declines in inventories and unexpected declines in inventories lead to firms to expand production, which leads to increases in income and saving.
I would, therefore, say that Fama's claim is "wrong". Not only does it not hold in all models in the class, it does not hold in any models in the class.
Greg Mankiw disagrees:
Greg Mankiw's Blog: Fama's arguments make sense in the context of the classical model... presented in Chapter 3 of my intermediate macro textbook.... I would go on to the Keynesian model.... But whether one leaves the classical model behind to embrace the Keynesian model is a judgment call...
Mankiw thinks that Fama is not wrong but is, rather, making a "judgment call."
But Mankiw writes in his chapter 3 that the classical model "assume[s] that the labor force is fully employed." And so Greg gets himself into Cretan Liars' Paradox territory here: Fama says that there is high unemployment and idle resources, while Mankiw says that Fama is not wrong because he makes sense as long as the labor force is fully employed and there are no idle resources.
Is Mankiw's answer here a "wrong" answer, or is he too making a "judgment call"? I seek an empirical test. I seek a Harvard undergraduate to take Greg Mankiw's course this spring, to write the following in an appropriate place:
the classical model of chapter 3 shows us that expansionary fiscal policies have no effect on output even where there are idle resources--unemployment.
and to report back on the reaction of the course instructors.