Friday, July 2, 2010

Much ado about austerity

There’s been a lot of talk recently about austerity as a spur for growth. Much of it has revolved around the work of Alberto Alesina, a Harvard economist. Bloomberg summarizes his position this way:


“Alesina argues that austerity can stimulate economic growth by calming bond markets, which lowers interest rates and promotes investment. In addition, he says, deficit-cutting reassures taxpayers that more wrenching fiscal adjustments won't be needed later. That revives their animal spirits and their spending. Alesina says that as a way to shrink deficits, spending cuts are better for growth than raising taxes.”
Bruce Bartlett highlights other work in this vein in The Fiscal Times.

Like so many arguments made by respectable economists, on one level this logic is perfectly fine. I have no doubt that fiscal conservatism can spur growth. I would be surprised to find anything else, in fact. But there is an important difference between:

(1.) Increasing GDP growth rates and spurring recovery, and
(2.) Spurring recovery in an economy with depressed aggregate demand and spurring a recovery in an economy suffering from other problems

For some reason, time after time, people act as if all downturns are created equal. If an economy is suffering from a demand shortfall, removing more demand exacerbates the problem. What isn’t a particular concern in an economy that doesn’t exhibit a notable shortfall in demand (say, the American economy of the early 1920s) becomes a major problem in an economy where demand is already quite weak.

The primary mechanism through which austerity operates for Alesina is the bond market. Austerity calms the bond markets, “which lowers interest rates and promotes investment”. No Keynesian would quibble with the importance of this mechanism. The point they raise (highlighted in the Bloomberg article) is that interest rates are already quite low. If nothing else, this suggests that bond markets aren’t concerned about government debt (removing the primary “confidence” argument that Alesina utilizes). So, perhaps cutting spending would lower rates somewhat more – but who honestly believes that government borrowing is propping up interest rates right now? If interest rates are a problem, the source is either (1.) a zero lower bound on interest rates, or (2.) lack of investment demand.

To believe Alesina you have to believe that fear of the U.S. government’s ability to pay back its debt is a bigger factor than unwillingness to make investments, and you have to believe that a zero lower bound on interest rates is not a serious constraint right now (perhaps because you think inflation will make that zero lower bound non-binding as a constraint on real interest rates). Both of those cases seem untenable to me, which is why I really don’t think this argument makes sense at a time like this, at least (it would certainly hold true under different conditions). The primary problem is investment demand. Cutting demand further doesn't address this primary problem. If there were another primary problem, I probably wouldn't have these sorts of doubts.

The other version of the Alesina argument is not a bond-market story but a taxpayer story, and it’s known as “Ricardian Equivalence”. Robert Barro suggested that taxpayers would recognize that increasing deficits would be mean higher taxes down the road, leading them to curtail spending in anticipation. To a certain extent this amounts to assuming his own conclusions. The only reason why they would anticipate higher taxes down the road (as opposed to the same taxes imposed on a larger economic pie) is if they expected deficits not to increase output. In other words, Ricardian Equivalence essentially says “deficit spending cannot stimulate the economy if it does not stimulate the economy” (because if it did stimulate the economy, taxpayers would expect that the government could pay off the debt with lower taxes on a broader tax base). So it’s somewhat nonsensical (or at least tautological) on that point alone. But Paul Krugman points out another problem. He writes:


“If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.”

This gets back to my initial point that the impact of deficits on GDP growth rates is different from the impact of deficits on recovery. Even if you believe in Ricardian Equivalence, even if you believe there is exactly zero stimulus effect of government spending (i.e. – a multiplier of 1). Hell – even if you believe there is a multiplier of less than one, you still have the consumption smoothing effect of counter-cyclical deficits! They may do nothing for the net present value of wealth, but they can help out with the roller coaster ride that is the modern industrial economy.
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So if we’re thinking in terms of interest rates and bond markets, Alesina’s point doesn’t seem to apply to this particular downturn very well at all. If we’re thinking in terms of tax payers and public debt, Alesina’s point doesn’t seem to apply to any downturn. After those two, distinct critiques what we’re left with is that keeping a lid on public debt can improve long-term secular growth.
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Big whoop – you don’t need a Harvard economist to figure that one out.

Note: If you're a fan of George Mason economics, you might be interested in James Buchanan's critique of Robert Barro's argument here (sorry, can't find an ungated version). His concerns are along somewhat different lines.

29 comments:

  1. I had to use a textbook written by Barro last year for a macro class I was taking. It wasn't particularly enlightening.

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  2. :) A point on which Austrians and Keynesians can agree.

    He's a smart guy, but I think he doesn't seem to think hard enough about the implications of his work. Ricardian Equivalence, for example, has childish assumptions to begin with - but even if you grant that it doesn't change the case for counter-cyclical policy (see the Krugman point).

    Same with his multiplier evidence - he estimates multipliers outside of depression conditions in a really brilliant way - but then he tries to apply them to depressionary conditions.

    A very creative mind, but not a very reflective one - at least not in the two things you hear his name most for these days.

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  3. I don't know how much original work went into the text, but the way he taught Solow Growth Model, RBCT, household budget constraints... None of them made sense and he was frankly not great at explaining them.

    Obviously, I would have enjoyed a few chapters on capital-based macro, but no professor would teach it! haha

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  4. perhaps if you could find of assessing the extent to which it is important for the operation of the actual economy, they would :)

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  5. As if the models I was taught are totally applicable? The Cobb-Douglas and RBCT are not realistic at all.

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  6. But they can be tested, Mattheus.

    Cobb-Douglas is just a functional form, it's not an explanation of anything. It's empirically flexible (and can be made even more flexible - actual work will use something like a trans-log function or CES function). It has no real theoretical implications. Austrians that don't particularly care about cardinal/ordinal utility can use it too.

    RBCT I would agree - but again - we know that because we have tested it.

    RBCT I think is as plausible as ABCT. Why wouldn't it be? The question is - has it been practically an important explanation? The data seem to suggest "no" for RBCT. We haven't even really tested ABCT.

    Which once again leads me back to the question of why you're so confident about that figure you quoted in the other post about it explaining 100% of the boom-bust cycle. I'm still quite confused about the source of your confidence.

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  7. "If an economy is suffering from a demand shortfall, removing more demand exacerbates the problem."

    Sort of begging the question, isn't it? What if a demand shortfall (say for labor) is the result of bad investment that needs some time to sort out? It takes time, and more investment, for bad investments to be turned into something profitable. If I build a steel mill but it turns out there are too many steel mills already, it's going to take some time money and effort to figure out how to take that steel mill and put it to another use. Is govt. spending going to make that whole process go faster or slower? Crowding out effects?

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  8. The functional form of Cobb-Douglas doesn't make any sense. It implies mathematically constant relations (constant returns to scale, etc.) where there are none in economics. The entire application of mathematics as a language is misguided; its like trying to describe music with colors. The form of the language is wrong.

    We know RBCT is unrealistic for many reasons. Economics is about much more than simple falsifiability. "Testing it" is not the ultimate end to whether a model is predictive or not. RBCT is unrealistic because exogenous shocks do not cause business cycles. Credit expansion does. The very nature of the boom/bust cycle cannot be created by things like tax structure or institutional reforms.

    The source of my confidence is the fact that I understand causality. Once credit expansion is embarked upon, there follows a predestined sequence of events that ends in boom/bust. It is a causal connection.

    Do you disagree with my treatment of business cycles? What do you think I left out? What did I mistake?

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  9. It doesn't imply constant returns to scale unless the exponents sum to one. And it doesn't imply constant relations if you let the exponents vary over time.

    As for mathematics - I'm not sure why it's any worse than describing it with logical language. The two seem to be more or less the same with me - except mathematical statements are more precise and less at risk of confusion over meaning. Are you simply arguing that it is imperfect? Sure, I'll agree with that. What precisely were you expecting?

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  10. Robert -
    Certainly - these are the questions we have to ask. What are your reasons for believing it is simply a readjustment that you describe? Why do we see an increase in money demand if it is this sort of adjustment (I'm honestly curious - I'm not sure what ABCT would predict in this regard)?

    My concern with the Alesina story is precisely that it seems to only work given certain assumptions about demand that don't seem to be in force right now. We need to inquire "what is the nature of the demand shortfall?".

    What are your reasons for thinking it is a massive, global, readjustment of the sort you describe?

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  11. "Do you disagree with my treatment of business cycles? What do you think I left out? What did I mistake?"

    Well for one thing you never explain why exogenous shocks can't cause busts.

    You don't address the inventory cycle.

    You don't explain how shifts in aggregate demand and the demand for money influence the system.

    You don't address what you think of "bubble psychology" a la Minsky (although presumably this could easily be incorporated into the sort of credit expansion story you provide).

    You don't address changes in the money supply at all (although again - perhaps related).

    You just seem to find one plausible story that you like a lot and declare it the answer. You don't have to repeatedly explain why you find it plausible. I find it plausible too. What you need to explain is why you exalt it - I still don't understand that.

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  12. You don't talk about nominal wage rigidity either.

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  13. I'm not saying they're imperfect. A machine running at 95% efficiency is imperfect.

    I'm saying these models get it wrong like the Catholic Church got geocentricity wrong. I wrote a long piece on Solow's Long Run Growth Model on Economic Thought that explains what I mean by wrong.

    "The two seem to be more or less the same with me - except mathematical statements are more precise and less at risk of confusion over meaning. "

    Mathematical symbols express quantities. Rarely do I ever see algebraic symbols expressing a sequence of events linked by causal connection. The expression "A = A" is mathematically the same as the logical equivalent "I am me." But the eloquence of mathematics to explain further than simple tautologies is short indeed.

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  14. "Well for one thing you never explain why exogenous shocks can't cause busts."

    Exogenous shocks (like the oil spill) lead to general impoverishment and capital decumulation. They can lead to a lower standard of living. They cannot explain the effects of the business cycle in terms of increased consumption and investment, and a bust of consumption and investment.

    "You don't address the inventory cycle."

    I don't believe in price rigidity.

    "You don't explain how shifts in aggregate demand and the demand for money influence the system."

    Not directly I don't, but the heart of ABCT deals with the demand for loanable funds and the effects that has on investment.

    "You don't address what you think of "bubble psychology" a la Minsky (although presumably this could easily be incorporated into the sort of credit expansion story you provide)."

    I'm not familiar with Misky, but I don't buy into a lot of rational expectations theory (ie, that everyone knows they are in a bubble)

    "You don't address changes in the money supply at all (although again - perhaps related)."

    Of course I do. That's what credit expansion IS.

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  15. "Mathematical symbols express quantities. Rarely do I ever see algebraic symbols expressing a sequence of events linked by causal connection. The expression "A = A" is mathematically the same as the logical equivalent "I am me." But the eloquence of mathematics to explain further than simple tautologies is short indeed."

    This is a joke, right? Didn't you just say you learned the Solow Growth Model? Do you think if you expressed the causality in words rather than equations the result of that model would be any different?

    Now - whether it's accurate or not is a different question entirely.

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  16. So...

    - RBCT: "they cannot explain..."
    - Inventory cycle: "I don't believe in..."
    - Minsky: "I don't buy into a lot of..." [by the way - Minsky says PRECISELY THE OPPOSITE of what you are saying about rational expectations here]


    I think I need to refer you back to that post I did on religion as a self-authorized belief.

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  17. "This is a joke, right? Didn't you just say you learned the Solow Growth Model? Do you think if you expressed the causality in words rather than equations the result of that model would be any different?"

    No, it wouldn't be different. But explaining the theory in words would immediately showcase all the problems with it.

    If I were to tell you I had a theory that one day we will stop increasing capital per worker (k*) because capital becomes less productive over time.. that sounds like nonsense right?

    "- RBCT: "they cannot explain...""

    It doesn't. Just like sunspots don't explain the emergence of hurricanes. Failure to have any causal connection is grounds to eliminate a theory.

    "- Inventory cycle: "I don't believe in...""

    Why *should* prices be rigid? What accounts for it? The entrepreneurs that remain flexible are the ones whose inventories clear in a depression.

    "- Minsky: "I don't buy into a lot of...""

    I don't know anything about Minsky. But it is my understanding that we generally don't see the bubble until after it's passed. Or is that highly contested?

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  18. "If I were to tell you I had a theory that one day we will stop increasing capital per worker (k*) because capital becomes less productive over time.. that sounds like nonsense right?"

    I think you are confusing convergence on an equilibrium which may change as parameters (namely, technological knowledge) change over time with an actual time path of capital. Convergence to an equilibrium k* is not the same as a predicted time path of k*.

    It doesn't. Just like sunspots don't explain the emergence of hurricanes. Failure to have any causal connection is grounds to eliminate a theory.

    So a quantity shock to one input (money) can cause a recession, but a quantity shock to another input (oil) won't? That makes no sense, Mattheus. I suppose I could rephrase by asking on what basis you say that this is "just like" sunspots and hurricanes.

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  19. "I think you are confusing convergence on an equilibrium which may change as parameters (namely, technological knowledge) change over time with an actual time path of capital. Convergence to an equilibrium k* is not the same as a predicted time path of k*."

    But the model does not link the technology level with existing capital. There's no connection. It's assumed parameter A is a constant (or at least unknown) and K climbs until it's not worthwhile anymore.

    "So a quantity shock to one input (money) can cause a recession, but a quantity shock to another input (oil) won't?"

    Precisely. A quantity shock of oil makes the world wealthier because we have just that much more oil to use. A quantity shock of money disrupts prices, thus frustrating rational economic calculation. In this instance, the input of money to commercial banks has the effect of masquerading as savings and distorting production decisions.

    Money and oil are not the same type of goods.

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  20. OK - now we're getting into nuts and bolts, but the "solow residual" (A) is multifactor productivity, while the coefficient on lnK is capital productivity.

    Once again, this is why just relying on language is dangerous. Technology as in the solow residual is not the same as "technology" as it is used in every day language.

    RE: "A quantity shock of oil makes the world wealthier because we have just that much more oil to use."

    So a negative shock to oil will make us less wealthy? Is that right? Correct me if I'm wrong, but this is sounding a hell of a lot like RBCT.

    My only beef with RBCT is that it only explains certain circumstances - I don't think all downturns are due to real shocks. It is necessary but not sufficient, in that sense.

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  21. "So a negative shock to oil will make us less wealthy? Is that right? Correct me if I'm wrong, but this is sounding a hell of a lot like RBCT."

    A negative shock to oil will make us less wealthy, but it will not create business cycles. There is a difference. You're talking about impoverishment, or a declining standard of living. I'm on something totally different.


    "My only beef with RBCT is that it only explains certain circumstances - I don't think all downturns are due to real shocks. It is necessary but not sufficient, in that sense. "

    I have the same opinion as you on this.

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  22. "A negative shock to oil will make us less wealthy, but it will not create business cycles. There is a difference. You're talking about impoverishment, or a declining standard of living. I'm on something totally different."

    Well "cycle" is just a word we use to describe downturns we see every once in a while. It does describe what we choose to label a "cycle" if we are misidentifying sporadic downturns as cycles.

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  23. I posit that business cycles are not just "downturns we see every once in a while." A business cycle is, specifically, the whole period of time in which an economy experiences a boom and then a bust in quick succession.

    The Dust Bowl, the oil spill, a high progressive tax, and heavy war expenditure may create "downturns" - or in other words, lead to impoverishment/capital consumption - but they cannot lead to the unique characteristics of a business cycle. I am very sorry if we've been arguing semantics this whole time.

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  24. Mattheus -

    No, I don't think there's a misunderstanding there. Much of what I've cited has been "cyclical" in the sense that you're using it.

    My point is simply that what we're really talking about is chronological downturns. You may assume downturns are "cyclical" but you have no proof of that in a given case. So if we're thinking of a theoretical explanations for downturns, it seems to me to think of both cyclical and non-cyclical explanations. I don't see why the explanatory power of a non-cyclical explanation is hurt by the mere fact that it is non-cyclical.

    Take central bank behavior. That's not cyclical - it's as exogenous as an oil shock - but Austrians consider it important. It, along with a genuinely cyclical credit cycle, constitute what most people think of as "Austrian business cycle theory".

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  25. "My point... ...I don't see why the explanatory power of a non-cyclical explanation is hurt by the mere fact that it is non-cyclical."

    Okay. I understand, and I agree. There are many reasons for things going badly. I thought we were speaking a specific type of downturn (that I attribute to central bank policy).

    With that in mind, how do you define a downturn? When you say "downturn," what EXACTLY are you describing?

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  26. How can something you attribute to central bank policy be "cyclical", Mattheus? It seems like the "cyclical" part of Austrian business cycle theory is the credit cycle. The central banking facet of ABCT is just a political-economy tack-on to the business cycle theory.

    As far as "downturn" I'm thinking of a decline in real output and employment.

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  27. It's cyclical in the sense that all the effects of interest rate manipulation always appear in the same order. I'm not claiming an unhampered market would "cyclically" (read: habitually) go through depressions. Cycle, in this sense, is the cycle between boom and bust.

    Hey listen, I'm packing for a trip now. I'd like to engage you in conversation, if possible. Conversing via comments takes time and space. How would you like to discuss this over Skype or some equivalent?

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  28. At some point perhaps. I'm going to be leaving for a trip tomorrow too, actually.

    I actually finding writing things up gives a good opportunity to think things through and express things clearly - but multiple media are good. We can keep that in mind.

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  29. Personally, I learn more in school when I stay after class to have a discussion with the professor. Clearly, there is much I could learn from you.

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