Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 4 January 2017

Reactionary Keynesianism revisited

I wrote my original post on this to counter the idea that the size of any increase in the deficit was at least as important as its composition, with particular reference to any fiscal expansion likely to come from Donald Trump. To put it very simply, I argued that any fiscal expansion that focused on tax cuts for the very rich and extremely dubious mechanisms designed to increase infrastructure investment should not be welcomed by those who think (as I do) there is still spare capacity in the US economy. Some subsequent helpful feedback suggests that in making this argument I should have said some things a little better.

I started my discussion with an example of how a tax cut for the rich could, in theory at least, be deflationary. The idea was that the rich would immediately consume very little of any tax cut, but if the non-rich thought that in the future their taxes might rise because of the higher deficit they might decrease current consumption. [1]

Talking about the rich and non-rich was very imprecise of me. I actually had in mind people who were income rich. The distinction between income and asset rich could matter, following an Econometrica paper by Kaplan and Violante that Narayana Kocherlakota pointed me to. This paper argues that there is an important group that they call the ‘hand-to-mouth wealthy’. These are asset rich individuals that hold their wealth in non-liquid form (e.g a pension), and because of the non-liquid nature of the wealth they might have a high marginal propensity to consume out of current income. It is an interesting idea with some empirical backing, but which I think only emphasises the importance of thinking about the composition of any tax cut when calculating the degree of stimulus.

In retrospect it might have been simpler to give a better known example of the potential disconnect between the aggregate deficit and a stimulus, which is the balanced budget multiplier. To the extent that fiscal policy under Trump may involve cuts in government consumption, that example could be very relevant, as Paul Krugman notes.

In the case of public investment, I again argued that the nature of this investment mattered. If the mechanism used to increase public investment (see this piece by Stiglitz for example) meant that a good proportion of this investment involved projects with a low social return (white elephants), then once again people on average would not be better off. This point depends on something which I took for granted but which I should have been spelt out: monetary offset.

Because the US economy is no longer at the zero lower bound, then an increase in GDP caused by building lots of white elephants would almost certainly lead to an increase in interest rates. [2] As a result, GDP might not actually increase, and useful private investment would be crowded out by useless public investment.

Once interest rates start rising from their zero lower bound, then those who argue that demand should be increased in the US (see here or here) are really complaining about monetary policy, not fiscal policy. An expansionary fiscal policy that is crowded out by the Fed might have some indirect advantages, in raising the natural interest rate for example, but the famous ‘digging holes’ argument used by Keynes no longer applies.

Once we leave the zero lower bound, tax cuts for the rich amount to a regressive redistribution of income. People should not be fooled into thinking that the tax cuts will somehow pay for themselves, through Keynesian or any other means. There is an extremely strong case for a large expansion in public investment financed by additional public borrowing, but this investment needs to go where it is needed, rather than to schemes that will generate a quick return to private sector financiers. There is a strong case for using additional demand to expand the US economy, but it will not happen as long as the Fed believes otherwise.

[1] I confusingly talked about the wealthy as acting as if Ricardian Equivalence held, when I should have simply said that because they were wealthy they would focus on lifetime rather than current income, and so would have a low MPC from a temporary tax cut. Assuming a tax cut for the rich is permanent is equivalent to assuming the Republicans never lose power.

[2] Assuming, of course, that the Fed remains independent, but Krugman argues that even if it did not we might still see higher interest rates.


  1. Why would a bad Trumpian expansipbary fiscal stimulus be crowded out by the Fed, whereas a good Keynsian stimulus would not be. And how does this relate to your view that there is currently spare capacity in the US economy? Thanks.

    1. I hope I'm not speaking out of turn and that Simon will correct me if I misrepresent his argument here, but this is my understanding of the difference between good and bad stimulus:

      It's not that good stimulus wouldn't be crowded out, but that it would still have a positive or at worst roughly neutral effect even if it *is* completely crowded out so there is no downside.

      Needed infrastructure or social welfare increasing redistribution are things that can have a positive effect on their own even if they didn't expand the economy

      The point of doing "good" stimulus is that it will be better or at worst nearly as good for overall social welfare, or structurally for the economy as whatever marginal private investment gets crowded out.

      OTOH, if we do a "bad" stimulus -- something that's basically a boondoggle to enrich private interests, but that those private interests would not consider worth financing on their own without the government largesse under any circumstances -- then we *know* it's going to be less valuable than whatever it crowds out, and possibly *much* less valuable. Similarly, tax cuts for the rich, will have a known negative social welfare effect, since income and wealth have declining marginal utility. These will have a known large negative effect if offset, and a potential positive effect *only* if they aren't offset.

      This post is very interesting to me, because it addresses what I see as the heart of the main disagreement between Keynesians and MMTs during our great recession. Scott Sumner, at least, was arguing that the fed was not actually out of ammunition even at the zero bound, and that their failure to do more possibly represented an intention to offset potential stimulus even though everyone but the RBC maniacs believed we were still *clearly* below full output in 2009-2013. If Scott was right, then "bad" stimulus would have been pointless or worse even then. To be fair to Scott, even he admitted that fiscal stimulus was worth trying back then, because he wasn't certain about the fed's stance, and that it was basically insane to put off obvious "goods" like infrastructure maintenance due to "austerity" when interest rates were near zero.

      It seems as though the MMTs and Keynesians (that I read) are closer to agreement about policy at this point, now that the Fed's intentions are very clear, and the liquidity trap seems to be behind us, though time and the revised 2017Q1 economic reports due in 6 months or so will tell for sure.

    2. Both good questions, and I'll be interested in Prof. Wren-Lewis's response.

      My take is this: I think a "bad Trumpian" fiscal stimulus might not be crowded out by the Fed simply because it might not be expansionary---just the opposite, if Krugman is right. The Fed would get involved if it looked as though inflation were increasing, but tax cuts to people who won't spend the money combined with decreased government spending may end up being contractionary instead. On the "good Keynesian" stimulus side, now that we are off the zero-lower-bound floor the Fed could feel the need to counter it, and drive private investment out to make room for the public investment---so we'd better make the public investment in productive places (infrastructure) instead of digging holes and filling them in.

    3. " . . . there is currently spare capacity in the US economy?"

      Not according to J.Y.?

      '"The economy is operating relatively close to full employment at this point," she said, "so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state." '

  2. Tax cuts for the wealthy can stimulate an economy if the money goes to stimulate demands for goods and services in that economy.
    Tax cuts for the wealthy in a global economy can be spent on building offshore production facilities.
    Absent good investment opportunities, the wealthy may buy and drive up real estate or park their money in places that creates little new demand for lack of better options.
    The wealthy may use the tax cuts to replace labor with capital. Automation is often taxed as property, and tax cuts to business are often tax reduction on machine purchases.
    The wealthy may spend the money in a way that displaces more labor rather than create new jobs.
    Expanding Medicaid gives more people the ability to spend on medical services and creates medical service jobs.
    Expanding TANF (food stamps) creates more demand at grocery stores who need more paid clerks and fewer unpaid volunteers are needed at food pantries
    Tax cuts and spending that apply directly to short term demand will be the most stimulative

  3. "Because the US economy is no longer at the zero lower bound, then an increase in GDP caused by building lots of white elephants would almost certainly lead to an increase in interest rates. [2] As a result, GDP might not actually increase, and useful private investment would be crowded out by useless public investment."

    What is this about?
    'GDP will not increase but interest rates would increase'? By what logic or mechanism? Obviously, it doesn't involve CB methodology. Maybe by bond vigilanties against whose existence you succesfully argued?
    'crowding out'? Why are you again adopting neoliberal excuse (better called Austrian Economics)? Is it because you are guessing that you are getting nicked from Corbyn's economic councel and aiming for a batter paid position at conservative think thank?

    There is no crowding out, only crowding in. Ah, you explained that by imagined increased interest rates caused by no GDP growth.
    Only ricardian equivalence comes from later reduction in government purchases after tax cuts enlarged the debt. There is no rational homoeconomicus as you presuppose. Such person would be an idiot sawant who thinks that he/she should balance its spending over many budget years where tax is increased and lowered. It would be as if someone is believeing that tax increase on their income is retrogard, that income received under tax cuts would be back taxed after tax increased.
    Income is yearly and tax on income is for that year, only economists can believe that such ricardian person can exist.

    Stupidity of Ricardian human is hiding the fact that debt from tax cuts for the rich are later used as excuse to slash government purchases thus creating an effect of Ricardian equivalence.

    Tax cuts for the rich create bubbles and nominal GDP growth, but not income growth and no core inflation, hence it can't increase interest rates.

    1. Thanks to B. Mitchell.
      “It was opportune that about that time the US Congress gave out large tax cuts (in August 1981) and this provided the first real world experiment possible of the Barro conjecture. The US was mired in recession and it was decided to introduce a stimulus. The tax cuts were legislated to be operational over 1982-84 to provide such a stimulus to aggregate demand.
      Barro’s adherents, consistent with the Ricardian Equivalence models, all predicted there would be no change in consumption and saving should have risen to “pay for the future tax burden” which was implied by the rise in public debt at the time.
      What happened? If you examine the US data you will see categorically that the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84).
      In other words, Ricardian Equivalence models got it exactly wrong. There was no predictive capacity irrespective of the problem with the assumptions.”

  4. "Because the US economy is no longer at the zero lower bound,"

    By what criteria? By FED increasing the rate by 0.25%? That would say that earlier rate of 0.25% wasn't ZLB because it wasn't 0%.
    What is the consequence of ZLB? that LOW interest rates do not affect investment increase trough borrowing. Will this increase of official interest rates affect unofficial interest rate and decrease investements?
    Off course not. Why? because decrease of interest rates did not increase investmants from borrowing since unofficial interest rate did not decrease.
    Again back to basics. Monetary policy works through influencing unofficial interest rate by change in official interst rate. Unofficial interest rate is rate that economy can acces funds with. Official rate is the one that states and corporations acces funds with.
    When did official interst rate became ineffective in influencing unofficial IR? Around 2%.
    I argue that ZLB is around 2% because that is when banks stop or start following officialy set interest rates in offering it to private sector. Or, in other words, monetary policy gets tracktion.

    Forgetting the basics just shows how modeling can sidetrack the logic if it is so abstract as not to model the real world.

    USA is still in ZLB because monetary policy have no tracktion on unofficial interest rate. And raising official interest rate up to 1,5% will cause no effect on economy, real economy and capital investment. It has some infuence on bubbles, asset bubbles. That's it.

  5. One should note that infrastructure investment in the US is likely to produce very little economic benefit because of land use regulations at the local level. New light rail systems have been built that have created next to zero new jobs or housing, because no additional floor area was ever permitted in the zoning around the station areas. Infrastructure spending without land use reform is going to create your white elephants.


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