Permanent and Transitory Components of Real GDP
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Notes for U.C. Davis Debate on the Stimulus Package

I. Spending Can Boost Employment and Production:

The argument that Fama, Prescott, Cochrane, Barro, Poole, and company are making is what historians of economic thought call "Say's Law." It is the claim that decisions to increase spending from the government cannot spur the economy and raise employment and production because if the government spends, somebody else must cut back on their spending in order to finance it.

Now anyone who can use their eyes can see that "Say's Law" is in general false. Recall 2003-2006, when capital inflows from Asia, easy money by the Federal Reserve, and promises that financial engineering would cheaply diversify risk spurred homebuilders to spend money building houses. The American unemployment rate fell from 6.0% to 4.8%. Recall 1996-2000, when the assembled investors of America discovered the internet and in response businesses spent money like water on computers and telephones. The American unemployment rate fell 5.6% to 4.3%. In general, spending works to spur the economy, and the government's money when spent is as good as anybody else's.

Even though Say's Law is not true in general, could it possibly be true in this particular case? Could it happen that as the government starts its spending that the spending is, in Fama's words, "funded by issuing more government debt.... The added debt absorbs savings that would otherwise go to private investment... [and] just move[s] resources from one use [private investment] to another [government purchases]..."? Yes, it can happen. When government deficit spending triggers a sharp rise in interest rates, that rise in interest rates will discourage and crowd-out private investment spending. Back in 1993 I carried spears for Larry Summers, Bob Rubin, and Lloyd Bentsen when they argued that Clinton did not dare let the deficit increase but rather had to reduce it for that reason. But you have to have that rise in interest rates, and we don't have it now: the ten-year Treasury rate last Friday was 3.02% per year, down from 4.01% back before Obama's election victory.

II. Milton Friedman Agrees that Spending Can Boost Employment and Production:

How fiscal stimulus works (with signs reversed), from Milton Friedman (1972), "Comments on the Critics of 'Milton Friedman's Monetary Framework'":

If [extra] government spending... [is not] financed by higher taxes... the government would have to borrow [more]. The individuals... from whom the government... borrowed now have [less] left to spend or lend themselves.... To find any net effect on... spending, one must look farther beneath the surface. [As the government borrows more, interest rates rise]... make it [more] expensive for people to hold cash. Hence some of the funds... borrowed by the Federal government... [are subtracted from] idle cash balances rather than [taken from money] spent or loaned...

Now Friedman said that fiscal stimulus was a weak tool--that its effects were "certain to be temporary and likely to be minor" and that policies "to have a significant impact on the economy... must somehow affect monetary policy--the quantity of money and its rate of growth"...

The answer to the question "why not do monetary policy?" is "we are." We are doing expansionary monetary policy--but that we have done all the expansionary monetary policy that we can, and we do not think that it is enough to keep us out of a depression. Milton Friedman quoted his old teacher Jacob Viner's advice as to what to do in the Great Depression:

[G]overnment and Federal Reserve [expansionary] bank operations have not nearly sufficed to countervail the contraction of credit on the part of the member and non-member banks.... There has been... a fairly continuous and unprecedentedly great contraction of credit during this entire period.... Assuming for the moment that a deliberate policy of [credit] inflation should be adopted, the simplest and least objectionable procedure would be for the federal government to increase its expenditures or to decrease its taxes, and to finance the resultant excess of expenditures over tax revenues either by the issue of legal tender greenbacks or by borrowing from the banks...

Milton Friedman on the We-Must-Suffer Caucus:

From Milton Friedman (1972), "Comments on the Critics of 'Milton Friedman's Monetary Framework'":

[Abba] Lerner was trained at the London School of Economics [in the 1930s], where the dominant view was that the depression was an inevitable result of the prior [speculative] boom, that it was deepened by the attempts to prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by "easy money" policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate weak and unsound firms.... It was [this] London School (really Austrian) view that I referred to in my "Restatement" when I spoke of "the atrophied and rigid caricature [of the quantity theory] that is so frequently described by the proponents of the new income-expenditure approach and with some justice, to judge by much of the literature on policy that was spawned by the quantity theorists" (Friedman 1969, p. 51).

The intellectual climate at Chicago had been wholly different. My teachers... blamed the monetary and fiscal authorities for permitting banks to fail and the quantity of deposits to decline. Far from preaching the need to let deflation and bankruptcy run their course, they issued repeated pronunciamentos calling for governmental action to stem the deflation-as J. Rennie Davis put it, "Frank H. Knight, Henry Simons, Jacob Viner, and their Chicago colleagues argued throughout the early 1930's for the use of large and continuous deficit budgets to combat the mass unemployment and deflation of the times" (Davis 1968, p. 476). They recommended also "that the Federal Reserve banks systematically pursue open-market operations with the double aim of facilitating necessary government financing aind increasing the liquidity of the banking structure" (Wright 1932, p. 162).... Keynes had nothing to offer those of us who had sat at the feet of Simons, Mints, Knight, and Viner.

It was this view of the quantity theory that I referred to in my "Restatement" as "a more subtle and relevant version, one in which the quantity theory was connected and integrated with general price theory and became a flexible and sensitive tool for interpreting movements in aggregate economic activity and for developing relevant policy prescriptions" (Friedman 1969, p. 52). I do not claim that this more hopeful and "relevant" view was restricted to Chicago. The manifesto from which I have quoted the recommendation for open-market operations was issued at the Harris Foundation lectures held at the University of Chicago in January 1932 and was signed by twelve University of Chicago economists. But there were twelve other signers (including Irving Fisher of Yale, Alvin Hansen of Minnesota, and John H. Williams of Harvard) from nine other institutions.'...

[W]e do know that the London School view, really the Austrian view of Ludwig von Mises, had many adherents including Gottfried Haberler...