It's because crass materialism leads to a bigger Keynesian multiplier.

From Nick Rowe:

"In defence of crass materialism (temporarily)

Economists are sometimes accused of crass materialism. Normally I would plead innocent, and accuse the accuser of misunderstanding economics. But right now I am in favour of crass materialism. I want government investments which yield a monetary return. Government investments which make people happy but bring in no cash aren't as good right now. And it's not because "people are short of cash right now, and can't afford art galleries". It's because crass materialism leads to a bigger Keynesian multiplier.

Suppose we have a choice between spending $100 on building a new bridge or on building a new sculpture. The bridge will bring in money, either by charging tolls, or by increasing people's incomes. The sculpture won't bring in any money, because people will be able to see it for free, and won't increase anyone's income. But people will enjoy seeing it.

Normally, like any good economist, I would say that it makes absolutely no difference that one investment brings in money and the other doesn't. The only purpose of money is to buy things that we want (that give us utility). If we get more utility indirectly from the bridge than we get directly from the sculpture, then build the bridge. But if the sculpture brings us more utility than the bridge, build the sculpture. Money income is only a means to an end.

But right now it's different. Forget the sculpture; build the bridge. The bridge will have a bigger fiscal multiplier than the sculpture. The bridge will cause a bigger increase in aggregate demand.

Suppose the investment will be financed by increased taxes. $100 spent on construction means $100 extra demand. But $100 extra taxes will reduce disposable income by $100, and reduce consumption by (say) $80. So the immediate (first round) effect will be a net $20 increase in demand. That's correct for the sculpture, but it's incorrect for the bridge. The bridge will also increase future incomes, once it's built. When people expect an increase in their future income, they usually consume more now and save less. The increased consumption from the increased future income will offset some, or maybe all, or maybe more than all, of the drop in consumption from increased taxes.

Or suppose the investment is financed by government borrowing. Both bridge and sculpture create an immediate $100 increase in demand. But if people expect higher future taxes to pay for the government debt, they expect their future disposable incomes to be lower, so they consume less now. That drop in consumption partly offsets the $100 increase in demand, so the immediate (first round) effect will be less than $100. That's correct for the sculpture, but incorrect for the bridge. If the government collects tolls from the bridge, it won't have to increase taxes as much. If the tolls pay the full borrowing costs, taxes won't need to increase at all, so consumption won't decrease now.

It's about the same if the government doesn't collect tolls, but the bridge increases people's incomes. The increase in future income from the bridge will offset the increased future taxes at least partly, maybe fully, or more than fully. So future disposable income won't fall as much, and might even rise. So current consumption won't fall as much, and might even rise.

Either way, whether financed by taxes or by borrowing, $100 spent on building the bridge will have a bigger effect on aggregate demand than $100 spent on building the sculpture. And that's what we need, in these abnormal times. Once the abnormal times are over, and aggregate demand is no longer the problem, we economists can renounce crass materialism, and return to our good old spiritual natures.

[If you are uneasy about this conclusion, because you see the sculpture as giving "psychic income", think of it this way: is the psychic income from the statue a perfect substitute for the material goods you buy with money income? If it is, so that $1 equivalent of psychic income causes the marginal utility of consumption to fall by the same amount as $1 of money income, then $1 of psychic income will have exactly the same effect on current savings as $1 of money income. In this case, the bridge and the sculpture are the same. But it seems much more plausible that the sculpture would be a very imperfect substitute for the consumption goods that money can buy, and would have little or no effect on the marginal utility of future consumption.]

Posted by Nick Rowe on January 28, 2009 in Fiscal policy, Macro, The current recession | Permalink"

And me:

Nick,

I don't credit the saving for future taxes argument as well. Everyday we make decisions and plans based on any number of conflicting desires, needs, etc. Some people might save for a tax, or they might save for other reasons. Whether you follow Quine or Wittgenstein you will have problems separating out motives and causes. I'm not saying it doesn't make some sense, but I don't see a straight line of cause and effect.

One argument put forth for infrastructure spending now, in a downturn, is that we are likely to get better terms on our infrastructure contracts at present. I'm a bit bothered by trumpeting this argument because it makes it sound as if we need recessions to improve the efficiency of government spending.

I completely agree with the point about infrastructure investment needing to be just that. However, as I said in your last post, I would market it differently. I'm a fan of the new Trust Index approach( I'd like your views Nick ):

http://blogs.wsj.com/economics/2009/01/28/trust-troubles/

Right now, trust in government is actually falling. In the US, it's hard to sell government spending as competent. Consequently, I'd use different arguments, like trust in our future.Trust in doing things together with our taxes.This can help overcome doubts about competence. However, even if they'll make a pig's breakfast of the spending, it has to also be sold, truthfully, as an attempt to invest in our future. Just telling people we're handing out money for whatever, as if the money acts mechanically, isn't a way to inspire trust. It signals insincerity.

Also, I might note the following:

http://www.nytimes.com/2008/12/27/opinion/27lyubomirsky.html?_r=2&ref=opinion

I feel that, in a downturn, selling communal projects as just that is an easier task.

Posted by: Don the libertarian Democrat | January 29, 2009 at 10:51 AM

it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship.

From Paul Krugman:

"A Dark Age of macroeconomics (wonkish)

Brad DeLong is upset about the stuff coming out of Chicago these days — and understandably so. First Eugene Fama, now John Cochrane, have made the claim that debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity.

There has been a tendency, on the part of other economists, to try to provide cover — to claim that Fama and Cochrane said something more sophisticated than they did. But if you read the original essays, there’s no ambiguity — it’s pure Say’s Law, pure “Treasury view”, in each case. Here’s Fama:

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

And here’s Cochrane:

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.1 This is just accounting, and does not need a complex argument about “crowding out.”

Second, investment is “spending” every bit as much as consumption. Fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.

There’s no ambiguity in either case: both Fama and Cochrane are asserting that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment — period.

What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line.

It’s like the fact that the capital account and the current account of the balance of payment have to sum to zero: that’s true, but it does not mean that an increase in capital inflows magically translates into a trade deficit, without anything else changing (what John Williamson used to call the doctrine of immaculate transfer). A capital inflow produces a trade deficit by causing the exchange rate to appreciate, the price level to rise, or some other change in the real economy that affects trade flows.

Similarly, after a change in desired savings or investment something happens to make the accounting identity hold. And if interest rates are fixed, what happens is that GDP changes to make S and I equal.

That’s actually the point of one of the ways multiplier analysis is often presented to freshmen. Here’s the diagram:

A case of mistaken identity

In this picture savings plus taxes equal investment plus government spending, the accounting identity that both Fama and Cochrane think vitiates fiscal policy — but it doesn’t. An increase in G doesn’t reduce I one for one, it increases GDP, which leads to higher S and T.

Now, you don’t have to accept this model as a picture of how the world works. But you do have to accept that it shows the fallacy of arguing that the savings-investment identity proves anything about the effectiveness of fiscal policy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did."

Here's my reply:

I think that many of these deniers actually believe that a stimulus by government spending can influence behavior, but they’re worried that accepting that fact will commit them to a stimulus by government spending. Although their use of equations seems simplistic and mechanistic, so does picking an amount for the stimulus as you do. You make it sound as if we’re changing the oil. As well, I feel that infrastructure spending should be efficient and necessary. Just picking a number makes it sound like we’ll spend a lot of money foolishly.

I agree that a stimulus can effect behavior as we wish. I believe it because my political economy is a lot like Shiller’s. I read that he advocates a massive stimulus. And here’s my problem. I’m with Shiller on the stimulus. In order to work well, it needs to be very large. However, I’m also with Buiter, in believing that this spending carries serious risk for us going forward. Consequently, I end up with a plan much like the administration’s.

I also don’t consider social safety net spending a stimulus. It’s what we should do in order to help our citizens get through this crisis. By calling it a stimulus, I’m not sure if these government spending critics are saying that we shouldn’t spend on the social safety net, or simply that they don’t think that infrastructure spending works as a stimulus. As I said, I do, when it’s very large.

— Don the libertarian Democrat

"These efforts, akin to avoiding bank runs in prior periods"

Robert Barro in the WSJ:

"Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called "multiplier" effect of government spending on economic output is greater than one -- Team Obama is reportedly using a number around 1.5.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment.

The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.( THIS IS TRUE )

What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff( ONLY IN AN ECONOMIC CRISIS ). Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out( THE FEAR AND AVERSION TO RISK IS NOT RATIONAL ). In other words, there is something wrong with the price system.( THERE IS. FEAR AND AVERSION TO RISK. )

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall( WE SHOULD DO THIS ). So, something deeper must be involved -- but economists have not come up with explanations, such as incomplete information, for multipliers above one.

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports( NOT IN A CALLING AND PROACTIVITY RUN ). In other words, the social cost of one unit of additional government purchases is one.

This approach is the one usually applied to cost-benefit analyses of public projects. In particular, the value of the project (counting, say, the whole flow of future benefits from a bridge or a road) has to justify the social cost. I think this perspective, not the supposed macroeconomic benefits from fiscal stimulus, is the right one to apply to the many new and expanded government programs that we are likely to see this year and next.( HERE I COMPLETELY AGREE )

What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.

I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.( ONE COULD ARGUE THAT THE WAR, BEING A WAR, EFFECTED PEOPLE'S ATTITUDES IN ANY NUMBER OF WAYS. )

We can consider similarly three other U.S. wartime experiences -- World War I, the Korean War, and the Vietnam War -- although the magnitudes of the added defense expenditures were much smaller in comparison to GDP. Combining the evidence with that of World War II (which gets a lot of the weight because the added government spending is so large in that case) yields an overall estimate of the multiplier of 0.8 -- the same value as before. (These estimates were published last year in my book, "Macroeconomics, a Modern Approach.")

There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases. For one thing, people would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot( THAT DOESN'T FOLLOW. A WAR COULD IN FACT DAMPEN DEMAND BY EFFECTING HUMAN BEHAVIOR. ). Second, the use of the military draft in wartime has a direct, coercive effect on total employment. Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. In any event, when I attempted to estimate( THAT'S ALL YOU DID ) directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.

As we all know, we are in the middle of what will likely be the worst U.S. economic contraction since the 1930s. In this context and from the history of the Great Depression, I can understand various attempts( YES ) to prop up the financial system. These efforts, akin to avoiding bank runs in prior periods( YES. THAT'S WHY I CALL THEM A CALLING RUN AND A PROACTIVITY RUN. ), recognize that the social consequences of credit-market decisions extend well beyond the individuals and businesses making the decisions.

But, in terms of fiscal-stimulus proposals, it would be unfortunate if the best Team Obama can offer is an unvarnished version of Keynes's 1936 "General Theory of Employment, Interest and Money." The financial crisis and possible depression do not invalidate everything we have learned about macroeconomics since 1936.

Much more focus should be on incentives for people and businesses to invest, produce and work. On the tax side, we should avoid programs that throw money at people and emphasize instead reductions in marginal income-tax rates -- especially where these rates are already high and fall on capital income. Eliminating the federal corporate income tax would be brilliant( TARGETED TOWARDS INVESTMENT. ). On the spending side, the main point is that we should not be considering massive public-works programs that do not pass muster from the perspective of cost-benefit analysis( I AGREE ). Just as in the 1980s, when extreme supply-side views on tax cuts were unjustified, it is wrong now to think that added government spending is free."

I'm beginning to realize that economists are using preposterous views of Human Agency as a matter of course. Wars can have a myriad of effects, and simply assuming that, if they don't last long, consumption will remain the same, seems totally unjustified to me. Much depends on the nature and context of the war. Barro sees people as robots. I don't. One reason economics is so useless to us is its use of and reliance on Mechanistic Explanations.

Still, his recommendations are like mine. One reason is that I believe that the focus on the amount of the stimulus is also a mechanistic explanation. Tax incentives are a Human Agency approach. Spending money on a cost-benefit basis is more like common sense and fiscal prudence. There is some sense in government spending when investors are frozen by the fear and aversion to risk. However, the spending should still be prudent and wise. It should not mechanistically be spent in order to hit an artificial target.

"*It is the Minsky effect that is the real kicker here."

Arnold Kling also lines up with the Payroll Tax Cut:

"Mark Zandi says

A payroll tax holiday and a permanent payroll tax credit would be effective tax cuts, particularly if designed to help harder-pressed lower- and middle-income households and smaller businesses.

Tyler Cowen also favors payroll tax cuts. I like the idea because there is minimal time lag, it lowers the price of labor, and it keeps the government out of picking winners and losers in terms of industries.

I have zero faith in econometric estimates of the Keynesian multiplier. I think that today's asset-deflation economy is too different from most of what we have observed over the past fifty years for econometrics to be of any help."

I tend to agree that history is not much help here at all, except as a narrative to help us get through this mess. I'm fine with the Payroll Tax Cut, but I'm still stubbornly pushing my Sales Tax Cut Idea.

"Logic suggests that the multiplier today is large. It more likely to be closer to 3 (or above) than to 1.

1. Interest rates on Treasuries are so low that printing Treasuries is tantamount to printing money. ( True )

2. Unless the fiscal stimulus is really stupidly targeted, there should be few supply bottlenecks. The demand increase will go mostly to output and hardly at all to prices. ( Agree )

3. Investment is more likely to be "crowded in" by stronger demand than crowded out by higher interest rates. ( Agree )

4. We are likely to see a strong "Minsky effect." That is, higher income should increase wealth and improve balance sheets. This will stimulate spending by both businesses and consumers.*" ( Agree )

Logic=It makes sense to me.

"Having said all that, it is still a bit strange to think of a larger government deficit as a stimulus. If I wrote myself a check for $5000, obviously that would not be a stimulus. If I wrote my daughter a check for $5000 and said that it was coming out of her inheritance, we are saying that would be a stimulus. At a national level, what we are doing is writing checks to our children and taking it out of their inheritance. And, yes, I do think that under present circumstances that will be a net stimulus."

I'm glad he agrees.

Let's look at "stimulus":

1. Something causing or regarded as causing a response.
2. An agent, action, or condition that elicits or accelerates a physiological or psychological activity or response.
3. Something that incites or rouses to action; an incentive: "Works which were in themselves poor have often proved a stimulus to the imagination" (W.H. Auden).

[Latin, goad.]

I don't know, it does seem to be a stimulus, in that it is intended to incite or rouse spending. Where the money comes from seems secondary to the purpose.

"*It is the Minsky effect that is the real kicker here.

Let E be expenditure and let Y be income or GDP. Suppose that without the Minsky effect, we have:

E = $100 + 0.5Y
E = Y

The multiplier is 2, and Y = $100/(1-0.5) = $200.

Now, introduce a Minsky effect, where wealth is denoted by W.

E = Y
W = 5Y
E = $100 + 0.5Y + 0.08W

Now, E = $100 + 0.5Y + 0.08(5Y)

= $100 + 0.9Y

and the multiplier is 10, so that Y = $1000"

Can we introduce the Minsky Effect into my bank account?

"The installation of infrastructure increases economic growth in the future"

Mark Thoma answers some of my questions about Woodward and Hall's post:

"Romer and Romer do not look at government spending multipliers, so we don't know if the government spending multiplier is smaller/larger than the tax multiplier if they are estimated in the same model (note, though, the the confidence band for Romer and Romer's tax multiplier is 1.3 to 4.7, so a multiplier smaller than Ramey's estimated value of 1.4 for government spending - though not strictly comparable since it comes from a different model - is within the confidence bounds of these estimates; confidence bounds for Ramey's estimates are not reported). I should also note that Romer and Romer isolate different types of tax cuts, the multiplier of 3.0 (plus or minus about 1.7) is for exogenous tax changes intended to promote economic growth, not tax changes intended to stabilize the economy. Their results for tax cuts used for stabilization purposes are not encouraging:

The behavior of output following countercyclical tax changes ... suggests that policymakers' efforts to adjust taxes to offset anticipated changes in private economic activity have been largely unsuccessful.

Finally, many estimates of the Keynesian government spending multiplier can be criticized on the same grounds that the tax cut advocates like to cite. The installation of infrastructure increases economic growth in the future, but these dynamic effects are missing from the standard Keynesian analysis (and using history as a guide is not very helpful since we have had very few surges in government spending devoted to infrastructure spending, and we have little data on the effects of fiscal policy - or any policy - in severe downturns since they are so unusual). If the dynamic effects were to be included in the infrastructure spending mulitplier, the multiplier would be larger."

This would explain my belief that infrastructure spending does have positive benefits, and that tax cuts don't necessarily do a great job as a stimulus.

But he doesn't discuss targeted tax cuts in order to help move the fear and aversion to risk in investment. I still think that's an obvious move, and don't understand what's so controversial about them.