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Fama's Fallacy, Take I: Eugene Fama Rederives the "Treasury View"

A Guestpost from Montagu Norman, former Governor of the Bank of England:

Back in the 1920s and 1930s--in the days that overly-clever bisexual academic dilettante John Maynard Keynes was trying to persuade us that if only we got the government to spend more money the unemployment rate might go down--by far the silliest argument against his position was the one put forward by the staff of the Chancellor of the Exchequer: the so-called "Treasury View."

The Treasury View was that nothing could boost employment: not government spending, not tax cuts, not private business decisions to expand their capacity, not irrational exuberance on the part of entrepreneurs--for the level of output was what it was and the unemployment rate was what it was and no fiscal policies or private investment decisions could change it, for all they could do was move resources from one use to another without affecting the total flow of economic activity.

Back on Christmas Eve Paul Krugman whacked Caroline Baum of Bloomberg on the nose for rediscovering the Treasury View. Now Eugene Fama of the University of Chicago has rederived it from scratch (apparently without knowing anything of its history), claiming that the savings-investment national income identity proves that fiscal policy cannot have any effect on output and employment.

This is a howler of such magnitude that it has pulled me from my grave to speak--because we went over and over this in the 1920s starting with R.G. Hawtrey (1925), "Public Expenditure and the Demand for Labour," Economica 5, pp. 38-48, and with F.W. Leith-Ross's various Treasury memos to P.J. Grigg, and thrashed this out to a conclusion that Fama appears not to know. It is very strange: the argument Fama wants to make--that government deficits completely crowd out private investment so that fiscal policy has no effect on output or employment--is, depending on circumstances, sometimes true and usually false, depending on circumstances. But the premise from which Fama attempts to derive complete crowding-out is the savings-investment accounting identity in the National Income and Product Accounts--and an accounting identity is something that must be true by construction, no matter what. The fact that savings equals investment in the NIPA is logically independent of whether the complete crowding-out doctrine is true or false.

Here is Fama:

Bailouts and Stimulus Plans: There is an identity in macroeconomics... private investment [PI] must equal the sum of private savings [PS], corporate savings (retained earnings) [CS], and government savings [GS]....

(1) PI = PS + CS + GS....

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt.... The added debt absorbs savings that would otherwise go to private investment.... [S]timulus plans do not add to current resources in use. They just move resources from one use to another.... I come back to these fundamental points several times below....

The Sad Logic of a Fiscal Stimulus

In a "fiscal stimulus," the government borrows and spends the money on investment projects or gives it away as transfer payments to people or states. The hope is that government spending will put people to work.... Unfortunately, there is a fly in the ointment.... [G]overnment infrastructure investments must be financed -- more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount....

Suppose the stimulus plan takes the form of lower taxes... we can't get something for nothing this way either... lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes...

Fama's reasoning is that fiscal policies don't change private saving, but fiscal policies do change the government deficit, thus investment must change in an amount equal and opposite to the change in the government deficit. Fama's reasoning is dead wrong. Fama's reasoning is dead wrong for an elementary reason. The accounting identity that savings are equal to investment is true only under a particular definition of investment--one that counts unwanted growth in inventories as part of investment--and under a particular valuation of unexpected inventory accumulation--that which values unwanted inventory accumulation at its cost.

In general, the value of unwanted inventory accumulation can't be equal to its cost--the inventory accumulation is unwanted and unexpected, meaning that they tried to sell it at a normal price and failed, and it is now sitting in a corner of a warehouse somewhere. When Fama writes "bailouts and stimulus plans... absorbs savings that would otherwise go to private investment" he does not think that the rise in public spending is truly useful stuff while the fall in private investment is a decline in unwanted inventory accumulation--a decline in the amount of stuff made at high cost that firms could not sell and then must mark down in value.

This matters a lot because whenever unwanted inventories accumulate the next thing that happens is that incomes and savings drop. (i) NIPA-defined investment is equal to (ii) private savings minus the (iii) government deficit, so if (iii) changes and (ii) doesn't then (i) must change. But if that change in NIPA-defined investment is driven by unwanted inventory accumulation or unexpected inventory declines then private savings do change, and do change quickly and substantially.

Let's tell the story of how:

Suppose that it is Friday, January 2, 2009, and all of a sudden the federal government borrows some money--reducing savings--and buys some extra stuff. Savings is still equal to investment on January 2: savings went down because the government ran a bigger deficit but investment also went down because firms sold extra and so their inventories dropped.

What happens on Monday, January 5? Over the weekend the firms mark the value of the goods in their remaining inventory up: inventories are now scarce. They revisit their production plans. Sunday night they call some extra workers and tell them to show up on Monday--that they are expanding production because they are now short of inventories. So when Monday rolls around more people are at work. Thus incomes are higher on Monday than they were on Friday. And in all likelihood savings will be higher as well, for consumers on Monday probably won't raise their consumption spending by as much as their incomes rose. Maybe on Monday purchases will be back in balance with production, and there will be no more unwanted inventory changes. Maybe it will take until Monday January 12 before the change in inventories is back to its desired level. Maybe it will take until the third quarter of 2009, or perhaps 2010. But when the change in inventories does come back to its wanted level, production, employment, income, savings, and investment will all be higher than they were on January 1: the stimulus will have worked.

Yet at every point--on every single day--savings are equal to investment according to the accounting conventions of the National Income and Product Accounts. Fama's premise holds. His conclusion--that stimulus programs cannot work--doesn't. How can this be? The reason is that his conclusion has nothing at all to do with his premise. Whether there is complete crowding-out depends on circumstances--on how much of offsetting investment changes are unwanted and unexpected changes in inventories, and what the consequences of those unwanted and unexpected changes in inventories are for private savings. But whether there is complete crowding-out or not, savings always equals investment in the NIPA framework by construction, by definition.

Thus Fama's claim that "'stimulus spending must be financed which means it displaces other current uses of the same funds..." rests on Fama's implicitly making one of two assumptions: either that stimulus spending does not lead to any surprise reduction in inventories, or that a surprise fall in inventories does not lead to any change in the flow of saving. Make either of these assumptions, and Fama's argument goes through--but it is those ancillary assumptions taht Fama does not explicitly own up to that drive his conclusion, not his stated premise of the truth of the NIPA savings-investment identity.

But why should you make either assumption? Why would you ever assume that there can't be unwanted growth in inventories? Why would you ever assume that household incomes and saving do not change whenever firms' stocks of unwanted inventories grow ever larger?

The answer is that you never would--but that Fama does not know enough national income accounting to know that that he is making these two ancillary assumptions. He does not understand the identity he deploys as equation (1). He thinks that "investment" means "growth in the value of the capital stock." He simply does not understand what the NIPA investment concept is, or that what he thinks of as "investment" is not in general equal to savings.

All of this is part of the undergraduate sophomore economics curriculum. It is gone over again very quickly in graduate school--for example, David Romer (2006), Advanced Macroeconomics 3e, p. 224:

If one treats goods that a firm produces and then holds as inventories as purchased by the firm, then all output is purchased by someone. Thus actual expenditure equals the economy's output, Y. In equilibrium, planned and actual expenditure must be equal. If planned expenditure falls short of actual expenditure, for example, firms are accumulating unwanted inventories; they will respond by cutting their production...

These mistakes are, literally, elementary ones.

They were elementary when R.G. Hawtrey and the other staffers of the British Treasury made them in the 1920s.

They carry the implication not just that government cannot stimulate or depress the economy, but that no set of private investment or savings decisions can stimulate or depress the economy either, and thus that there can be no business cycle fluctuations from any source whatsoever--because every action that shifts savings or investment simply moves resources from one use to another.

What is extraordinary is that these mistakes are being rederived today, at the end of the 2000s--without any consciousness of their past or of the refutations of them made by past theory and history.

I think it is time to draw a line in the sand: no more economists who know nothing about the economic history of the world or the history of economic thought.

I, the ghost of Montagu Norman, have risen from my grave to say this.

Jeebus save us...