The Equation of Exchange and the Metaphysics of Commerce

"The Balance of trade is the metaphysics of commerce, which few understand and which serves no other purpose than to disturb the imagination" - Thomas Fitzsimmons, 1785

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What would you all think if I wrote "By definition Y=C+I+G, so if you increase G you increase Y". You probably wouldn't take me very seriously. Even when I make a case for fiscal policy, it's never that case. Freshmen learn what's wrong with that argument. Would it improve things at all if instead I said "By definition Y=C+I+G, so if you increase G holding everything else constant you increase Y"? This version is at least logically coherent, but would your opinion of me change all that much? Probably not. Let me put it this way - I should hope you would still think I was talking nonsense. It's true that Y=C+I+G; that is trivially true. But when you change government spending, you can't expect other things in the equation to stay the same. So the first, unqualified statement that I made is logically wrong because nothing constrains C and I to stay the same, allowing me to conclude that we can increase G ad infinitum to achieve permanent growth. The second version of my statement was logically sound, but meaningless and demonstrative of a very poor understanding of economics. The lack of understanding is evident not in my manipulation of the equation itself, but in my understanding of the meaning and use of the equation.

Unfortunately, Don Boudreaux recently made precisely the same mistake with another famous economic law, the equation of exchange, MV=PQ. Don writes:

"In today’s Wall Street Journal, U.S Treasury Secretary Timothy Geithner, Singapore Finance Minister Tharman Shanmugaratnam, and Australia Treasurer Wayne Swan worry aloud that, in emerging economies, “rapid growth” increases “the risk of domestic inflation.” Baloney. Inflation is the result of too much money chasing too few goods. So by increasing the flow of goods (and services) produced in an economy, rapid growth decreases the risk of domestic inflation. That the finance ministers of three major world governments do not understand this fundamental fact is appalling." (emphasis is mine)

Don is quite wrong here, and the various finance ministers he cites are correct*. The key to understanding how to think about the quantity theory is that it's simply a balancing of the books. Alone, it tells you nothing about the causal relationship between any of these variables. I want to emphasize that because a lot of people from all sides of the aisle treat it like it's a causal law (Exhibit A being the regular testimony in the banking committee of the politician that every libertarian wants to pretend isn't just another politician).

Don is discussing the role that rapid growth (and increase in Q) plays in inflation. Taking the naive view of the equation of exchange, he reasons that since P = MV/Q, when Q increases P (the general price level) must decrease. He doesn't even say "holding everything else constant", and so his claim is logically wrong. But even if he had said "holding everything else constant", that just begs the question - why would you ever claim to hold everything else constant? Don certainly wouldn't let me get away with "holding everything else constant" in the national income identity. So how does Q grow in Don's example? Well for the answer to that question we have to turn to some method of determining output - Q. For this, of course, economists traditionally turn to supply and demand. Profit maximizers and utility maximizers come together in a market and set their respective marginal benefits and marginal costs equal to each other and come to agreement on a Q and a P**. So that gives us two of the four variables in the quantity theory - not bad. How does Q and P change in a supply and demand model? Well, the supply schedule can shift, the demand schedule can shift, or both can shift simultaneously. These supply and demand curves, unlike the equation of exchange, are actual behavioral claims made by economists. If you have a given set of preferences, and you have certain rational and informational prerequisites, and you face a particular suite of prices you will purchase Q goods for P dollars each in the market. This is claimed to be causal and it does describe behavioral relationships. It is not an accounting identity like MV=PQ or Y=C+I+G. So what happens if demand for goods and services increases? We would expect to see Q and P both increase. What happens if the supply schedule shifts to the right? We would expect to see Q increase and P decrease.

Now, to make another trivially true statement, we can say that if M and V are held fixed, these supply and demand dynamics will be reflected in observed values. On this point alone - even at this "trivially true"/"ceteris paribus" stage in the game, and after adding one supply curve and one demand curve to give some actual behavioral traction to our equation of exchange, Don is clearly wrong. Output growth can occur for at least two reasons - a supply shift (i.e. - increased productivity) or a demand shift, and a shift in demand will cause prices to increase at the same time that quantity increases***.

But presumably we aren't satisfied with a "trivially true" refuation of Don's point. When supply or demand shift, things happen to M and V too. When demand for goods and services increases, more transactions occur and people increase the rate at which they spend a given stock of money. In other words, the velocity of money, V, increases. Another way of saying this is that the desire to hold on to cash decreases if your demand for goods and services increases and your income stays the same. That cash did not circulate before, and now it is put into circulation. This is a standard impact of an increase in demand, and its inverse is why Keynesians associate low demand with an increase in the desire to hold cash or other liquid, idle assets. So if we have demand-lead growth, we would expect V to go up as well (which is another reason why when Q goes up in the equation of exchange you can't simply assume P goes down - that increase in Q may be a part of a process that simultaneously increases V).

What happens with the money stock? Well, of course that depends on how you define money. If you're thinking in terms of a very narrow definition of money, you can safely assume that that stays fixed and the explanation provided above of P, Q, and V gives you what you need. I don't know too much about this end of the theory, but clearly there are definitions of M with varying breadth. Nominal credit creation in response to an increase in demand can also be said to increase the money supply, and would also create inflationary pressure. Would you have nominal credit creation in response to a productivity (i.e. - supply schedule) increase? I don't really see why you would expect that. People need less exchange media to conduct the same amount of commerce, so it's probably less sensitive to supply-lead growth. Then again, if the aggregate demand schedule is highly elastic, maybe you would need more. These are the kinds of issues you have to think through - the equation of exchange doesn't provide you the answer to any of these relationships.

So be careful when you use these. Don't get caught saying "when we print more money it creates inflation" or "when output grows, it lowers prices". These are abuses of the quantity theory.

*George Selgin has some comments in the comment section of this post that are worth reviewing. I think Selgin is basically right and understands precisely what I'm saying here. Unfortunately he was clearly indulging Don's misunderstanding of the issue when he was taking issue with my comments, and trying to paper over a pretty egregious Cafe Hayek post.

**You could of course raise some market process objections to this story, but the basic supply and demand relationship has been experimentally verified (by other George Mason professors, in fact), so whatever non-auctioneer market process is going on is clearly giving us about the same results, which should not be surprising to anyone.

***In the article that Don discusses, the authors mainly point to demand-lead growth in emerging economies as the inflation risk for emerging economies only. They specifically cite demand for exports, growing domestic demand, and rising commodity prices (which have been demand-driven, not supply-driven).

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Quantity theory links:

- I started a thread on this issue in Jonathan's forum here.

- This recent post by Brad DeLong doesn't explicitly mention the quantity theory, but he does bring up the problems with a Monetarist approach to the crisis. His critique is based on the interpretation of Monetarism as a misuse of the quantity theory... or at least a misuse given the very special circumstances we're going through now.

- Stephen Williamson replies to Mark Thoma and writes: "This is why I'm not an old-fashioned quantity theorist. What has to be going on here is a large increase in the world demand for US currency during the financial crisis. All the more reason to be worried about inflation, as the crisis-driven demand [for US currency] goes away." I'm not sure if Williamson is saying that "old-fashioned quantity theorists" misuse the equation of exchange, but this doesn't seem quite right as a critique of the quantity theory itself. If there is an increase in world demand for US currency that you expect to be temporary, then that's the same as saying there is a decrease in V that you expect to be temporary. If you expect it to be temporary, then you'd expect an increase in V in the future. If, following the processes I outlined above, you think that increase in V is going to be paired with an increase in demand and thus P and Q, then Williamson's worry about inflation in the future is perfectly justified and perfectly consistent with the quantity theory. It's simply not on the top of my list of things to worry about right now. When we actually see that inflation, it means we're probably out of the slump.

- Bill Mitchell, of the Modern Monetary Theory school, has a weekly quiz. The second question of a recent quiz is on the quantity theory. Mitchell sets up a straw man of what quantity theorists believe (essentially attributing Don Boudreaux-type views to them), and then credits Keynes with fixing all that. This is a little much - many users of the quantity theory long before Keynes used the quantity theory without making these mistakes, and Keynes certainly embraced the quantity theory - and he used it correctly and to great effect. So Mitchell's analysis here is correct - but his history is a little self-serving.

- Jonathan reposts some thoughts by Richard Ebeling on Hayek and the quantity theory here.

- And of course, a lot of this emerges from our discussion of Hayek's Prices and Production. You'll find my post on the first lecture, in which I deal with some of these questions, here. I think Hayek does much the same thing that Mitchell does with his treatment - he provides a reasonably accurate analysis of the quantity theory, but a fairly self-serving history of the idea. He also has a weird "this isn't important and in fact it's misleading" reaction to it by the end.

- Keynes has a suberb discussion of the use and misuse of the quantity theory in the Tract on Monetary Reform (it actually is the same discussion where he says "in the long run we're all dead"). I'll hopefully get a chance to quote it at length this weekend, but if I don't please look it up yourselves

Something is very wrong here - please help: Boudreaux, Krugman, and government spending

Don Boudreaux has a post up claiming that real federal spending is positioned to increase by 40% over the 2007-2010 period. He's using inflation-adjusted OMB data (I'm not sure how they adjust for inflation). He argues that federal rose 29% between 2007 and 2009.

He cites Jim Agresti who found that government spending increased by 27% between 2007 and 2009 (apparently Agresit uses nominal BEA government current receipt and expenditure tables).

This is not the kind of growth in government spending I've been tracking with the BEA data (and I don't really follow OMB data), so I checked out the tables I normally go to - the NIPA real (chained 2005 dollar) GDP components tables. I grabbed a mix of quarterly and annual numbers for federal, state and local, and total government spending as well as GDP, and produced these:

These are in billions of 2005 dollars, which is why the levels might look a little off. State and local spending makes up considerably more than federal spending. The quarterly stats are annualized and seasonally adjusted - I'm not sure exactly what that entails, but it means we don't have to worry about comparing across quarterly and annual data (they do have different endpoints though - my annual data ends in the fourth quarter of 2009 and my quarterly data ends in the second quarter of 2010).

So I have a 6.5% increase in total government spending which of course is a weighted average of robust growth at the federal level and shrinkage at the larger state and local level.

What is going on here? I haven't had my second cup of coffee yet so maybe I'm mixing something up. Am I wrong or is Boudreaux and Agresti wrong (their numbers don't even seem to add up with each other, granted)? Why are these numbers so different - shouldn't BEA and OMB be close? I'm also concerned that budgeting practices for OMB make it not exactly what we want to look at - and that the NIPA tables are better. Is it that Agresti adjusts for inflation wrong?

If Krugman is right and government hasn't been up to the task (as I suspect he is), then this is a dangerous claim to be passing around. If Boudreaux is right and it's been "Government's Gone Wild", then that has major implications for what we think of fiscal policy. Can anyone help account for the divergences?

My BEA data is from table 1.1.6. Agresti's seems to be from 3.1. His are nominal dollars. If someone wants to look at 3.9.6, which has the real dollars that would be useful. If anyone wants to look into this more, run more numbers, and write something up I'd be happy to host a guest post sorting all this out - just let me know in the comment section.

A Response from Bob Higgs

Whenever I make a comment about some luminary directly, and they respond, I like to bring people's attention to it. The other day in a post about how government output and employment is counted in GDP, Bob Higgs wrote this:

"Just for the record, there is no "Robert Higgs school of GDP." Indeed, to be even more reassuring, I affirm that there is no Robert Higgs school of anything. Which is in no way a bad thing, of course. As Schumpeter said, fish go in schools.

I have criticized the way government is handled in the national income and product accounts, especially in regard to the so-called wartime prosperity during World War II, but my criticism springs from basic theoretical principles that were debated by such fanatics as Simon Kuznets, Paul Samuelson, Moses Abramovitz, James Tobin, and other obscure economists who analyzed the foundations of national accounting back in the 1940s and 1950s -- before the economics profession threw up its collective hands and capitulated to the arbitrary conventions of the Commerce Department. Because the government component has no grounding in market-choice behavior and the price system, as the private components do, it is simply impossible, with a clear conscience, to treat it in the way it is treated in the national accounts. Much as I would like to take credit for having been the first one to arrive at this conclusion, I cannot do so honestly.

Those who suppose that the government component of GDP means something might do well to ponder that if government only chooses to pay more for the final goods and services it purchases, it may simply do so, either by creating money itself or by employing its coercive power directly to tax or indirectly to borrow (putting its coercion in the shadow of its promise to repay). The element of sheer arbitrariness in the price and quantity data that result from this process looms very large."

First, I hope it's perfectly clear that I was using "Robert Higgs school of GDP" casually! I don't think that needs clarification, but just in case! I recognize the problem he associates with it very clearly. We discuss the socialist calculation debate and the price mechanism all the time on this blog, so I'm no stranger to the valuation problems posed by pricing goods that the public sector produces or purchases. I simply don't think Higgs is really being fair when he calls my (and the BEA's) perspective "arbitrary" (and I think he's being a little too sensitive when he facetiously calls his position "fanatical" - to be clear, I never suggest it was fanatical, simply that it was wrong).

I'm not quite sure what to make of the response. Should we go back and revise down all the GDP figures associated with housing between 2000 and 2007? Should we revise down all the carbon-related figures because the price mechanism isn't capturing all costs and benefits there? The price mechanism doesn't always operate as clean theory says it should - this is not news, and as Higgs implies, it's not exactly obscure or fanatical either. So we have a valuation problem. What is government production actually worth? We have a valuation problem for many market goods too, though, unless you plug your ears and close your eyes to much of what we know about the market process. But what is closer to being a biased figure? Not including government production which clearly has a real value simply because we can't price it exactly? Calling it zero instead of some biased positive figure? That seems odd to me. What are malinvestments if not overpaid for goods and services? And we count these.

I think Higgs's fundamental problem is that he's trying to make the argument that GDP should be GDVP, "gross domestic value production". If that's what he wants to measure, that's fine - but I don't think we can measure that. True, the prices government pay don't necessarily reflect true value. But the prices paid in the market don't reflect true value either - they simply reflect the place where marginal revenue is equal to marginal cost for producers and marginal utility is set equal to price for consumers. The value of those goods or services is likely to exceed the total output measured by GDP anyway, even for market goods. My point is simply that anyone who knows how the market process works would have a problem with GDP numbers, period - private or public (and many people do go this far).

So why do we have GDP?

To answer macro questions, not micro questions. GDP measures can't answer value questions and they're misleading because of so many arenas where we depart from the canonical price mechanism - not just in government, but in the market as well.

They can tell you (with a few exceptions that I'll discuss below) how much money people paid for goods and services. They can tell you P*Y, and we can do a pretty decent job at isolating Y. Needless to say, that's an incredibly important thing to know when you're doing macroeconomics. It doesn't matter how P or Y were determined - those aggregates are necessary for certain types of analyses. This is what Keynes was getting at when he said that his economics could be better applied to analyzing a totalitarian system than classical economics. If you read the German preface it was abundantly clear that what he was saying was that neoclassical economics had quickly become useless to German economists addressing the command economy. And for all Keynes knew in 1936 there would be more command economies coming. Macroeconomics asks questions that are fundamentally different from the kind of questions that Higgs is trying to shoe-horn into GDP figures here.

So what are those exceptions? The biggest, of course, is the black market. Illegal drugs stand out the most in U.S. GDP figures, for example. Billions are spent each year on this product, people earn a living from it, people purchase it, money is used to purchase it. It belongs in any sort of macroeconomic calculations. And talk about liquidity preference! I would guess drug dealers have just about the highest liquidity preference of anyone else in the country! Other black market production in the money economy applies too, of course - paying workers under the table, etc. The figures are wrong insofar as they exclude this stuff.

People have mentioned home production in the past as well, but this one doesn't bother me as much, personally. So it would be nice to know how much output was produced in a home because that is real, valuable, production, right? A home-cooked meal, my wife's cross-stiching that we have hanging on the wall now, the beer I brew at home, etc.. All this stuff is valuable, and we make decisions about time allocation when we make these things, but I don't necessarily think it belongs in GDP. It's not a part of the monetary economy - it's not exchanged for money or other goods. So it doesn't seem relevant for answering macroeconomic questions.

I've thought a lot about many things I've written on this blog - the 1920-21 depression, externalities, the nature of liberty, the Austrian School, Keynes, etc.. I haven't thought as deeply on this question. So if anyone wants to challenge any of this please do - but I'm still nowhere near being convinced by Higgs.

Yglesias on what "counts" as wealth and output

Matt Yglesias hits the nail on the head:

"I think it’s unquestionably true that one strength of the United States vis-a-vis Europe is that our setup is friendly to a certain kind of startup firm and this is why we’re world leaders in much of the high tech industry. But this kind of rhetoric is annoying and inaccurate:

[Google CEO Eric] Schmidt said that in parts of Europe the venture capital industry was being held back. “It takes a very long time to get a proper venture capital industry going. And in Europe there are many countries where the failure of venture capital is in fact seen as criminal, Germany, for example.” [...]

“Jobs are created by the private sector not by the public sector. Wealth is created by the private sector not by the public sector. If you are going to have great companies you have to be willing to support and encourage the creation of real wealth-generating capitalists. That means you have to put up with them.”

You would think the CEO of an Internet firm wouldn’t be totally dismissive of the idea that CERN and DARPA are contributing to wealth creation. And of course education is important to wealth-creation, and much of it is state-financed. And transportation infrastructure—typically state-financed—creates wealth. Of course even if the state completely removed itself from education finance, it’s not like nobody would go to school. Presumably the private sector would step in to fill some of the void. But conversely in places where the state steps beyond what we’d consider appropriate in the United States it still creates wealth. State-owned firms like Areva are generating value.

I raise these points not to make the case for a bigger or smaller public sector (I would say bigger than the US but smaller than France is ideal, but both are clearly workable) but simply to underscore the point that the performance of public agencies matters a lot."

This is the Robert Higgs school of GDP, of course: just don't count the public sector. The reassuring thing is that when they redefine the very definition of words like "wealth" you know they're desperate - the problem is that I think they actually believe this stuff. It's one thing to say that the government in most spheres of economic activity is less efficient at wealth production than the private sector. That is unambiguously true and completely uncontroversial. But in certain fields they are better (that's why there are a few fields where we regularly see governments: evolutionary pressures practically dictate we will see these sorts of efficiencies capitalized on by successful societies). And even where they're not better you don't just pretend they don't exist.

Anyway - this is a pet peeve of mine too. Similarly, it bugs me when people only think of "crowding out" as public activity crowding out private activity. Clearly that is a problem and it exists (again - unambiguous and uncontroversial), but you never hear anyone talk about private activity crowding out public activity. They simply define it out of the discussion. They assume it away. This is what an externality is though, if you think about it: private activity crowding out social activity. That's one way to look at it at least.

Don Boudreaux, what say you?

At Cafe Hayek, Don Boudreaux writes, in a post titled "What say you, Keynesians?":

"One data point proves nothing – but it is suggestive that Germany’s economy (including employment) is starting to boom (as reported here by The Economist) while the US economy continues to sputter: government in the former nation is following a policy of (relative) fiscal austerity while government in the latter nation is following a policy of wild-spending and deficit-bloating fiscal expansion."

I didn't know what to make of this when I read it last night. I don't know Germany that well. I know that they weren't hit as hard in the first place and that their banking sector came out largely unscathed which seems... ummm... important to mention. But besides that I honestly didn't know how accurate Don's characterization of the fiscal policies of the two countries was. Since he failed to furnish any data on that, I decided to check for myself. Readers of the blog know that I've been tracking the miserable trend in government spending in the U.S., and pointing out that you can only think we've done anything like fiscal stimulus if you're only looking at the federal government - if you look at all government spending, fiscal stimulus has been largely absent. The feds are filling the hole that the states are digging, that's essentially what things have amounted to.

Anyway, I checked out German and American quarterly percentage change in public spending, and here it is:

Fig. 1 Quarterly percentage change in government spending

It's somewhat hard to compare, but it certainly doesn't look like the U.S. is trouncing Germany in fiscal policy, does it? Particularly in more recent quarters, Germany seems to be spending more in the public sector than the U.S. - and in the first quarter of 2010 (the last year of German data I found), they're beating the U.S. substantially. But let's take these figures and look at cumulative quarterly percent change to see if my eye-balling it is meaningful:

Fig. 2 Cumulative quarterly percent change in government spending

These data seem to confirm my suspicions - for most of the crisis, Germany has been outpacing the U.S. in government spending and the gap isn't closing because Germany has kept up its fiscal policy. This is due to two factors:

1. Germany has stronger automatic stabilizers which are so integral to German political economy that Merkel doesn't even think to mention it on the public stage - and certainly not when she's brow-beating other countries about austerity.

2. The U.S. is a federal system where a substantial portion of government spending is done at the state and local level. Germany is too, of course, but the German Länder don't seem to have the pro-cyclical proclivities that U.S. states do.

If Don checked the data, he'd realize he doesn't quite have the case he thinks he does. As a rought cut, Germany seems to have stronger, not weaker, fiscal stimulus than the U.S. does, particularly in early 2010 (which of course is going to make a big difference in GDP numbers that come in now). I don't think this is firm evidence in favor of Keynesians either, but it's certainly not evidence against us.

Add to these stubborn facts that Germany didn't have nearly as bad a crisis as we did in the first place, and I'm really struggling to see Don's point. Perhaps he can tell us.


*All data is from Eurostat's national accounts. I compared their figures for the U.S. to the BEA's, and they look quite comparable - a few small discrepancies probably due to different national accounts definitions. If you look at earlier posts of mine on U.S. public spending trends, you'll see essentially the same pattern in the BEA data that I present here in the Eurostat data.

The Problem isn't Deficient Demand! It's Deficient Demand!

Ed Phelps is a great economist. He's also one of those guys that's got Keynes running through his blood without always making it obvious in what he says and advocates. He did a lot of work with Friedman, he speaks favorably of the Austrians, and he doesn't come out and get excited about Keynesianism which can obscure his Keynesian roots. I suppose that can partially explain Paul Krugman's reaction to this New York Times article by Phelps where Phelps writes:

"The prescription will fail because the diagnosis is wrong. There are no symptoms of deficient demand, like deflation, and no signs of anything like a huge liquidity shortage that could cause a deficiency. Rather, our economy is damaged by deep structural faults that no stimulus package will address."

Krugman responds with the post "Phelps vs. Phelps", where he points out that Phelps taught all of us that we would see disinflation in response to deficient demand, not necessarily deflation (and... ummm... deflation might not be that far off anyway). But even this strikes me as a little odd because you don't need to cite the Phelps of many years ago to refute the Phelps of today. All you need to do is cite the Phelps of today to refute the Phelps of today! This article was astounding because it started with Phelps making some dubious claims about why there is no deficiency in demand, and then he went on to describe in great detail a series of demand deficiencies! He writes:

In established businesses, short-termism has become rampant. Executives avoid farsighted projects, no matter how promising, out of a concern that lower short-term profits will cause share prices to drop. Mutual fund managers threaten to dump shares of companies that miss quarterly earnings targets. Timid and complacent, our big companies are showing the same tendencies that turned traditional utilities into dinosaurs.

Meanwhile, many of the factors that have long driven American innovation have dried up. Droves of investors, disappointed by their returns, have abandoned the venture capital firms of Silicon Valley...

...First, high employment depends on a high level of investment activity — business expenditures on tangibles like offices and equipment, and also training for new or existing employees, and development of new products.

Sustained business investment, in turn, rests on innovation. Business cannot wait for discoveries in science or the rare successes in state-run labs. Without cutting-edge products and business methods, rates of return on a great many investments will sag. Furthermore, innovation creates jobs across the economy, for entrepreneurs, marketers and buyers. State-led technology projects do not.

High business investment also depends on companies having confidence in the future. A company might be afraid to invest in research or product lines if it fears the rest of the economy is not doing the same — or if it fears the government might become hostile to its goals.

He's got paragraph after paragraph highlighting demand deficiency driven by concerns about the future! The problem isn't deficient demand... it's deficient demand! Hard to know what to make of this. I don't know if Phelps is thinking that "demand" is "consumer demand" and that there is no consumer demand problem. If he thinks that then I still think he's wrong, but at least I'm only disagreeing with him on half the picture. I really don't know what to say - it was a surreal article to read. You could sum up a lot of it as "firms don't want stuff". Umm... isn't that deficient demand?

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Anyway, it's not all bad. He makes a lot of really excellent points (as Ed Phelps has a tendency to do):

1. He doesn't discount technological unemployment which I think is very important. In the long-term, technological development is a net positive but people are often too rosy about the serious short-term dislocations that can result from it. This was a very common interpretation of the Great Depression at the time. It was largely eclipsed by Keynesian economics and nobody talks about it nowadays - I think people are afraid it's Ludditism or something too - but I think it's probably more important than we give it credit for. It is coming back as an explanation for relative labor demand concerns. You rarely see people talking about technological development as a problem for employment in general - but you will see people now talk about "skills biased technological change", or (SBTC) as a problem for specific sub-populations. That's a start I suppose.

2. In explaining investment demand, Phelps puts firms concerns about the future and their high discount rate front and center, which is very important I think. He mentions business confidence and policy uncertainty later (to Austrians, "the Higgs argument"), granted. Survey after survey (and this recent article too) highlight the fact that demand weighs heavier on executives' minds than policy. Oh well - for Phelps it seems to be a throw-away line. It doesn't hold that much water with me, but I don't mind it as long as it doesn't disrupt good policy.

3. He mentions the idea of a state sponsored innovation bank. I like the idea a lot. Phelps's point is that a lot of these solutions need to be structural rather than counter-cyclical. I agree and would also point out what Rizzo has always said about Keynes: his solution was essentially structural rather than counter-cyclical. He also advocated the standard counter-cyclical stuff but that wasn't the unique Keynesian contribution.

4. Finally, he supports a low-income tax credit. It's a little different from the hiring credit I've advocated here on occasion, but I like this idea a lot too. It's another structural labor demand policy. In the U.S. we are far too focused on labor supply policies, and I think this could do a lot of good. It's also an old Keynesian idea (goes back to Nick Kaldor at least).

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So one way to read this op-ed is to fume at how Phelps contradicts himself. Another way is to recognize how fundamentally Keynesian it is. Why Phelps felt a need to take a shot at demand deficiency early on and then go on to make a series of demand-side arguments I have no idea. Sometimes I think people get this weird idea that "businesses are suppliers and people are demanders". That's not based in economics at all, but it's something people can slip into. Anyway, it's a good article.

Nevermind...

This week I had written an op-ed I was going to submit to the Washington post, emphasizing the point I made earlier that we really haven't done much of any fiscal stimulus and that the only reason why everyone thinks we have is because nobody thinks about states and localities when it comes to issues of national significance (like macroeconomic performance). I was waiting for the Friday GDP numbers to come out to make my case based on the last three quarters - when they did, though, total government spending was actually positive for the second quarter of 2010. So nevermind on that op-ed. The previous two quarters were still negative, although they had change slightly. This was the original text of my submission:

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"The American economy faces a major threat to economic recovery that most of the public probably isn’t aware of: government has been slashing spending for the last nine months. This Friday it became official when the Commerce Department released its quarterly economic statistics. In the second quarter of 2010, total government spending fell by [X] percent. In the first quarter of 2010, it had been reduced by 1.9 percent while in the fourth quarter of 2009 it dropped by 1.3 percent.

Recently, economists have been debating the merits of precisely this kind of “austerity.” Some have argued that reducing public spending can spur economic growth. Others are convinced that it is a sure way to kill the recovery. This discussion has generally revolved around Europe, which is increasingly pursuing austerity measures, and whether Europe offers a model or a cautionary tale for the United States. What this debate often leaves out is that belt-tightening by the government has already come to our shores, and it has been with us for the better part of a year now.

This seems to contradict what everyone knows: that the Obama administration has been running record-breaking deficits. Politicians and cable news commentators bombard us with concerns about our profligacy over the radio during our commute to work every morning and on television every night. How can it possibly be true that government has been slashing spending for the past nine months?

What the public often forgets is that the United States is a federal system with state and local governments as well as a federal government. We don’t “forget” about federalism in the sense that we don’t realize these other levels of government exist; they are an important part of our lives. But we do forget their relevance to problems of national significance, such as the current recession. This is a serious oversight, because together state and local government budgets are about one and a half times the size of the federal budget. That means that amidst all the discussion of the role of government in the economy during a downturn, many of us are completely forgetting about a significant portion of the government spending that goes on. Unfortunately, the economy and the job market don’t have the luxury of forgetting this. The economy can’t tell the difference between a dollar appropriated by the federal government and one appropriated by a state or local government.

Government spending has been shrinking for the last nine months because the federal government has been almost entirely preoccupied with filling in the hole that state and local governments have been digging, and the states have been digging that hole faster than the federal government has been filling it since the third quarter of last year. This results in a net reduction of government spending in the United States. If you think that government spending during a recession is harmful, you may be comforted by this news. However, those inclined to celebrate this reduction in government spending should consider the fact that the economic outlook began to darken again precisely when total government spending (federal spending, plus state and local spending) started to shrink.

Austerity is pursued in state and local governments for many reasons. Municipal bond markets aren’t always as accommodating as the market for federal debt. Some of these entities are constrained by balanced budget requirements in their constitutions, or statutory limitations on running deficits. Local governments that rely on property taxes have been hit hard by the housing crash. In addition to all these real constraints, though, a lot of state and local leaders simply believe that tight-fistedness is a virtue during a recession. Many governors, mayors, and county boards don’t seem to have received the memo from much of standard economic theory that responsible governments are supposed to lean against the economic winds. They should take a step back when the economy is heating up and government spending risks crowding out private activities and jump in to buy and use idle resources when the private sector is too fearful of what the future holds.

While some states, such as California, have a legitimately difficult time convincing creditors to lend to them, others, like my home state of Virginia, have no such excuse. Virginia has an excellent credit rating, but our governor and our state legislature apparently feel an abiding need to run a budget surplus during the worst downturn since the Great Depression. This decision in Richmond has the same impact on the economy as the recent decision of many big businesses to sit on profits instead of using that income to hire and invest. The Virginia state government is essentially telling us that it makes more sense to sit on our tax dollars right now than it does to use them to put unemployed Virginians and unused equipment to productive work. Yet for this, Governor McDonnell gets celebrated by voters and the press.

The growth of the federal government in the decades since the last downturn of this magnitude in the 1930s leads many Americans to forget about the significance of our federal system of local, state, and national governments. The public debate over economic policy is distorted by the fact that we’re not even talking about the majority of government spending that occurs outside of the federal government. Those of us who acknowledge the importance of stimulus get complacent because we aren’t aware that government spending is actually being reduced right now, not increased. Those who argue against stimulus are galvanized by false claims that total government spending is soaring.

State governments have always played a fundamental role in the history of our republic, and they are just as essential today as they have been in the past. We can no longer afford to write them out of the story of the government response to the recession."

*****

The argument itself still stands, of course. The logic is still good, and we still overestimate how much fiscal stimulus we're doing because we forget about the states. The positive numbers for quarter-to-quarter change this quarter are also probably related to several previous quarters of negative growth in government spending (i.e. we're still down from where we should be but they can't fall forever so you're going to get periods of positive growth). But it's harder to make that case convincingly when one of the three quarters you're looking at runs against your thesis.

So how do we interpret these recent GDP numbers?

1. It's good news public spending is not shrinking again. Private spending probably would have looked better if we didn't have six months of austerity at the end of 2009 and the beginning of 2010.

2. Fiscal policy has a lag, just like monetary policy. Shortly after spending initially stalled out we saw a weakening (also due to the fiscal crisis). Then public spending picked up dramatically with the stimulus package, after a quarter or two GDP did too. Then after an early spring of weak stimulus, we're seeing a continued weakening in GDP. In three to six months we may see another upward trend (hold me to it - we can check the data) as a result of this increase in fiscal stimulus, but a lot of that depends on whether it is sustained through the third quarter and what else happens.

3. This all is just going to contribute to confusion over what is exactly going on, which is unfortunate. We're still doing tepid, on again-off again stimulus which isn't good for the economy or for clear analysis. Informally eye-balling it, we're seeing a something like a delayed wave pattern (I demonstrate it here) with output lagging a quarter or two behind public spending. We shall see, though.

Blinder and Zandi on the Stimulus

While I was getting increasingly bearish on the stimulus yesterday, everybody else was talking about a new paper by Alan Blinder and Mark Zandi claiming that we avoided a second Great Depression. Their point and my point don't have to contradict. After all, as I had said a few times in the comments, it clearly could have been much worse. The federal government did nothing other than balance out dumb state policy - but they could have added to bad state policy, the way they did during the Depression (I am not claiming Hoover didn't increase spending - I'm claiming he didn't do what Obama did). We also had better leaders at the Fed than we did in 1929, and we had a more immediate response to the banking crisis. So sure, we hopefully did avoid a second Great Depression (so far).

Blinder and Zandi put out interesting numbers on specific programs, but the analysis is a lot the same as what we've seen from them in the past, from the CBO, and from the White House. There's a good reason for that, which I've also explained here before. We don't have counterfactuals at our finger tips. If John Adams ever bothered to say anything about counterfactuals he probably would have said "counterfactuals are elusive things". So where do Blinder and Zandi get their baseline? Well, they back it out of the actual performance of the economy with a reasonable multiplier estimate. It's about all they can do. I don't personally have a problem with that, but it obviously has its limitations, and it boils down to arguments about theory and previous econometric work. I still don't know to what extent the broader public grasps what goes into these estimates, but the economics blogosphere is well aware of how these estimates are produced at this point. That's not particularly troubling for me. The general public is not aware of how we estimate how much oil is in the Gulf of Mexico right now without directly observing it - but I assume the experts are hotly debating it amongst themselves and holding each other accountable. That's the division of labor, and so far in human history it has worked out well for us.


A few links on the paper:


- Arnold Kling makes the standard macroeconometric critique but I think takes it a little too far. He goes as far as arguing that this is rejected by the profession. Considering so many professional economists are doing this right now, that seems to me to be obviously wrong. I also think its hilarious how many Austrians are chiming in on this point. If professional rejection of a modeling approach is such an important standard for them you'd think... ummmm... they wouldn't be Austrians. Kling does make one really good point: that macro models should incorporate the research on labor dynamics done by Davis, Faberman, Haltiwanger, and others. Which, of course, is exactly what I want to do in a dissertation!


- John Taylor critiques the paper. I'm loathe to even link this. Taylor's own postings on the impact of the stimulus have been completely devoid of even a discussion of a counterfactual. The idea that he would critique the way Blinder and Zandi deal with it when he doesn't even try to is a little odd. Anyway - he just offers the standard critique, which essentially only gets us to "your estimate is only as good as your model" - which is obviously no way to dissuade someone who believes the model.


- David Leonhardt talks about the paper here.


I'm sure there were many others - feel free to share them in the comment section. This paper really doesn't add anything to similar papers that have come out so far, and the critiques don't really seem to add anything to the previous critiques, so its not especially interesting to me right now.

Cowen on substitutes and the liquidity trap

Regular readers know that I think the liquidity trap is intriguing and certainly relevant right now, but more of a theoretical curiosity than a hugely important factor. Tyler Cowen makes much the same case in this post, which thinks through the zero lower bound argument by reviewing the importance of substitutability in other markets.

Cowen argues that adjustment can be slow for very close substitutes, but that it will happen - and many other factors are important than just the substitutability of cash and Treasuries for the adjustment process. That's all well and good, but the fact remains that the adjustment process is considerably slower for closer substitutes than it is for substitutes that are much less close. It is precisely the close substitutability of cash and Treasuries that makes all the other issues that Cowen talks about relevant right now, and that is the sense in which the liquidity trap is meaningful. Cowen uses the example of the close substitutability of grapes and pluots to talk about the liquidity trap, and he says that substitutability alone does not explain the adjustment. His appetite, for example, is also a factor. I would only add that we're only even talking about "appetite" as a factor because what is introduced is more food (pluots). If Cowen's house guest had brought, say, a bottle of wine we might think of the wine and the grapes as complements rather than substitutes. "Appetite" in the sense of how much food you feel like eating is no longer a constraint at all, because it might be very nice to have wine and grapes together. The close substitutability of grapes and pluots is disconcerting precisely because it introduces the relevance of other constraints like appetite.

That's largely how I think about the liquidity trap. It makes things problematic that wouldn't be problematic under other circumstances. Other than that, it's hard to stretch this metaphor much farther. Grapes and pluots aren't media of exchange, stores of value, or opportunities for speculation, after all - so I'm not sure how much mileage Cowen thought he was going to get out of this. I suppose it works as an explanation for portfolio adjustment, which is what he claims he's talking about. But since when is the importance of the liquidity trap derived from balancing the composition of your portfolio between cash and bonds? That's not really the major point. The point is the demand for liquidity as well as the impact (or lack of impact) of monetary expansion on the interest rate.

I guess I'd offer one more interpretation to push this metaphor a little further. If you were Cowen's house guest and you knew about his grapes/pluots dilemma, it would probably make more sense for you to bring that bottle of wine that would complement grape consumption, rather than those pluots which would be close substitutes for grapes, right?

What could possible complement liquidity preference right now - what could encourage households and firms to work through their liquidity preference - rather than exascerbate it? Probably some additional aggregate demand, right?

Politicians, uncertainty, and Bernanke's dissertation

Real Time Economics, a WSJ blog, reports on Rep. Jim Hensarling's (R-TX) questioning of Federal Reserve Chairman Ben Bernanke. Hensarling read this to Bernanke:

"Uncertainty is seen to retard investment independently of considerations of risk or expected return. Introduction of uncertainty can be associated with slack investment, resolution of uncertainty with an investment boom"

Hensarling connected this uncertainty to policy and government action, and asks Bernanke whether he's familiar with the passage. Bernanke was - it was from his dissertation, which is here. Bernanke then goes through the motions. He makes a joke. He provides a synopsis of the dissertation. He acknowledges the importance of uncertainty, but dodges any effort to pin it down and quantify it. He also raises the mixed signals the economy is giving right now about its confidence. All fine.

It would have been nice to tell Hensarling what you can figure out quite quickly from Bernanke's dissertation: it has nothing to do with policy regime uncertainty. It's all about uncertainty regarding the profitability of investment and the performance of the economy. I imagine Hensarling is thinking that policy is the only uncertain thing out there, so he tells his staff "go find something for me that Bernanke wrote about uncertainty is bad so I can use it to show him that I'm right and even he said so". If that was his goal, he seems to have picked the wrong document. Bernanke shouldn't have been so deferential (I didn't see the testimony - I'm counting on the fact that Real Time Economics would have reported if he said anything like this). He should have said "Representative, the policy regime uncertainty that you cite is obviously a relevant factor, but my dissertation talks about business uncertainty about the future, completely independent of policy - and that is primarily what they're concerned about and uncertain about now".

This whole "policy regime uncertainty" meme is real, but the way it's being presented is a distortion of what firms are actually worried about right now. They're worried about demand and economic performance. One of the biggest proponents of this "policy regime uncertainty" argument is the National Federation of Independent Businesses, the self-styled "voice of small business". The NFIB makes a lot of claims on news programs that concern about Obama's policies is strangling business right now. The problem is, this doesn't even match up with their own survey data. If you look at the most recent NFIB confidence survey, here, that becomes clear. On page 7, for example, businesses are asked to state the most important reason for their outlook on the expansion of their business. On page 20, they are asked to share the single most important problem for them. In both questions, it is the economic outlook responses and not the policy responses that dominate. This comes up in consumer surveys too, and most other confidence surveys I've seen over the last couple years. Don't get me wrong - the portion that is concerned about policy isn't trivial. But considering that their primary concern is economic performance and demand, a substantial share of them are probably concerned, like me, that policy isn't stimulative enough.

The bottom line is that Hensarling acted opportunistically with Bernanke's dissertation or at least didn't understand at all what Bernanke was saying. Bernanke was talking about a different kind of uncertainty, and survey after survey suggests that it is not policy regime uncertainty that is the primary concern of businesses. This is really spectacular - we just had the biggest health care legislation in decades. The fact that policy didn't register higher as a concern is notable in light of that. Part of this may be that there is no longer any uncertainty when it comes to health reform - they know what's going to happen and can plan for it. Part of it is inevitably a vote of confidence in the policy itself. Whatever it is, all the policy uncertainties that you could think of add up to less than the economic uncertainties.

Breaking all the rules...

Yesterday I remarked that Okun's Law seems to be broken. I think I should provide more background on this. Of course "Okun's Law" isn't a scientific law at all - it's just a rule of thumb. But it' a consistent rule of thumb that is worth remarking on when it breaks down. It states that for every two percent decrease of output from potential output, we can expect to see the unemployment rate rise by one percent. We're not seeing this now (and I should note - people have been remarking on this for a while now, it's just gotten new attention recently, even if not by name from all commenters) - unemployment is a lot higher than Okun's Law would predict. It's just a rule of thumb - there's nothing deeply existentially troubling for the economist to see that it's not working. But it is grounded in enough sensible economics that it's worth asking "why is this time so different?"

It is useful to note that this break-down is happening in a lot of places. Greg Mankiw suggests that the Phillip's Curve might be exhibiting unusual behavior too (this is not new misbehavior for the Phillip's Curve, a more regularly misbehaving rule of thumb).

Mark Thoma and David Altig note another misbehaving rule - the Beveridge Curve, which relates unemployment to job vacancies. Like the Phillip's Curve, it's not particularly surprising that the Beveridge Curve is misbehaving. It shifts up and down with the matching efficiency of the labor market. So this change is the least mysterious.

Russ Roberts remarks on the same disconnect between employment and output, and he seems to think that this is troubling for Keynesians. He circles around a couple (IMO) relatively unimportant issues for a while, and then he writes this:

"I’m not saying Keynes (or Obama or Larry Summers) is wrong because all spending does is bid up prices and wages. I’m not trying to prove that the stimulus failed. I’m challenging the standard macro textbook story that says aggregate demand leads to output that leads to employment."

So we have a situation where Russ is not trying to say that employment isn't going up because stimulus is channelled into wage and price changes (a little redundant, but nevertheless...). He makes it clear that he's not making that argument. The stimulus-to-output chain may be weak for him, but it's plausible. His problem is how "the standard macro textbook" explains the output-employment link. Okun's Law, in other words. Roberts goes on:

"The textbook aggregate demand story ignores how people view the future– the animal spirits–the confidence employers, investors, and consumers have about the future. If employers are anxious about the future (partly because the government is running up debt and because the regulatory environment is highly uncertain and partly because we’ve had a run of bad times), then spending doesn’t obviously create jobs."

I did a double-take when I read that, because it was easily the most Keynesian thing I've ever read on Cafe Hayek. Concern about the future means that money may not go to prices or employment - it may go to liquidity which ultimately has it's roots in fear of "the dark forces of time and ignorance that envelope our future". Of course Roberts doesn't seem to recognize that this is a very Keynesian insight. Perhaps he does, but there's no indication of it.

What does this have to do with all the other rule-breaking? The best explanation I've seen so far for why changes in the Beveridge Curve, the Phillip's Curve, and Okun's Law all relate to liquidity preference is Roger Farmer. I really, really, really need to get this man's new book.

So the obvious question in my mind is "did Keynes forsee this". Unfortunately, I can't say right now but I'm going to check up on it this weekend. Hicks clearly didn't. For Hicks, liquidity preference broke the link between money and output, not between output and employment. In other words, in the IS-LM model, Okun's Law should work fine because all the disruption of liquidity preference happens before output even comes into the picture. I know Hayek did critique Keynes for not presenting a detailed enough explanation of the relationship between employment and output (does anyone know where he said this... I'm very, very curious now). What I don't know is whether Hayek's critique was valid or not. Did Keynes have as simple of a view of the output-employment relationship as Hicks (in which case the critique is valid), or didn't he?

More on Corporate Liquidity Preference

The other day I approvingly mentioned Arnold Kling's interpretation of corporate profits that was puzzling Tyler Cowen, and I added that the profit rates are also consistent with corporate liquidity preference, an important dimension of Roger Farmer's recent book.

Today Matt Yglesias, drawing from Ezra Klein, Cowen, and Barry Ritholz, presents a very intereseting graph demonstrating that the trend towards corporate liquidity has been going on for well over two decades. It would have been nice to see this as a percent of non-financial corporate revenue, or with some sort of denominator, but I'm guessing the same general trend holds. Here it is:

Yglesias writes, "As an economics question, this now becomes more interesting. But as an explanatory factor for today’s economic problems, it becomes a good deal less interesting.". I wouldn't give up quite that easily.

Keynes presents a secular and a "cyclical" (or more accurately "crisis") explanation of unemployment. I've actually primarily seen Keynes as a secular unemployment theorist, but Garrison has opened me up to the idea that to a certain extent he was both.

Liquidity preference explains the secular unemployment, so in that sense this trend isn't all that upsetting to the vision of The General Theory. What explained sudden crises was:

(1.) A decline in investment demand, which Keynes believed to be largely interest inelasatic, and
(2.) Perhaps the second-order liquidity preference effects that would result from a crisis.

One thing I've been keeping track of in Garrison is all the places where he modifies Keynes, either because he thinks he's wrong or because he needs to make a modification to be able to express Keynes in the Hayekian model he presents. For example, he does away with a separate treatment of liquidity preference entirely, as Hicks had presented Keynes (Garrison makes the case Hicks was unfaithful in the first place), because Hayek doesn't treat liquidity preference separately. For the sake of comparability, it's axed (although then brought back in, but only through the loanable funds market). He does a lot of little revisions like this throughout the book.

Another such revision Garrison makes is to the response of the interest rate to a decline the demand for investment. Keynes says that when income is reduced, savings will also be reduced - so you have a decline in investment demand (the demand for loanable funds) coupled with a decline in the supply of loanable funds, so that in fact the interest rate isn't reduced appreciably by the decline in demand. Garrison insists that the supply of loanable funds won't be reduced with the demand for loanable funds, because the market will (inexplicable) stay on its PPF. No output decline means no decline in the supply of loanable funds.

So Garrison waves his hands and *poof*, the supply of loanable funds stays put and the interest rate does in fact get reduced. The reduced interest rate has distributional and structural effects that Garrison then expounds on.

What does any of this have to do with the Yglesias post?

Well when Garrison models Keynesian secular unemployment (liquidity preference) and Keynesian cyclical unemployment (animal spirits/investment demand) separately, the change in the interest rate that he ensures with his revisions and assumptions introduce some corrections into the Keynesian model which, under Keynes, did not correct itself.

However - secular and cyclical unemployment can't be compartmentalized or experienced separately in real life as they are in Garrison's book.

Garrison demonstrates that a decline in animal spirits is self-correcting because there is no shift in the supply of loanable funds. However, if a backdrop of increasing liquidity preference since 1985 (as shown by Yglesias et al.) reduces the supply of loanable funds and increases the interest rate steadily over time, then a shock to investment demand suddenly becomes more dangerous, and starts resembling Keynes's original rendition more than Garrison's revision of Keynes.

Put another way - under certain conditions it's clearly conceivable that the self-correcting tendancies of markets could have no problem dealing with a shock to investment demand. However - under conditions of increased and increasing liquidity preference, those self-correcting tendancies can short-circuit and be more problematic.

Note also that every recession since this corporate liquidity buildup began has been characterized by "jobless recoveries" where hiring doesn't pick up.

And who ties corporate liquidity preference to weak hiring? Again, Roger Farmer.

Damn, I need to get his book.

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.

-1.9%

Yesterday I noted the revised growth figures for the first quarter (real GDP grew by 2.7%) and asked people what they thought happened to government spending. Here is the answer:

Government spending shrank by 1.9%.

Of course, that drag on growth has to be weighted by the magnitude of government spending in the economy to figure out its "contribution" to the 2.7 growth rate. That weighted contribution is -0.39%.

If any of you have been wondering why there has been an uptick in talk about "austerity", this is precisely why. Sorry it's so small, but below is a graph of the percent change in real (ie - inflation adjusted) GDP and the percent change in real government spending for every quarter going back to 2007. The blue is GDP, the red is government spending.

There is a lag in the impact of fiscal policy on GDP. Quick policy changes, like changes to tax withholding or transfer payments that take effect quickly, are thought to have lags of one or two quarters. Things like public works projects obviously stretch out over a longer period, but the exact lag depends on how quickly the project is implemented. This is why I was critical of liberals who complained about tax cuts in the stimulus bill. Generally they're right - they do have smaller multipliers - but they act more quickly, and that was important.

This chart doesn't prove (remember all the empirical reservations I've raised about macroeconometrics), but it is consistent with about a six month policy lag. The spike from the stimulus came in the second quarter of 2009. GDP bumped up by the fourth quarter of 2009. A lot of this was the inventory cycle too, but it is consistent with what we would expect from fiscal policy. Government spending (as everyone who has been looking at the numbers and not listening to the pundits knows) has been shrinking. It took about six months for the exogenous government spending shock to make itself felt. I'm quite concerned that this is not going to be a very pleasant autumn.

Does this support Keynesianism? It does and it doesn't. It certainly demonstrates that a demand-side view of the economy is meaningful. The counter-argument would be that we're just putting our thumb in the dike, and we're maintaining malinvestments that need to be liquidated. There may be truth to that as well. I'm inclined to believe that story at least insofar as we're propping up the housing market, for example. But that presupposes that this downturn was not precipitated by an aggregate demand shock. I think there's ample theoretical and empirical evidence that there is, so I maintain the importance of demand management despite the fact that there's probably also some restructuring and readjustment that needs to happen (and I think this graph illustrates the point). I don't see any reason to believe that the restructuring and readjustment is enough to cause this sort of drag on the economy.

Pop Quiz/Random Guess

And no referring to your National Income and Product Accounts tables!

The Atlantic just reported an announcement by the BEA that GDP growth figures for the first quarter of 2010 have been revised down from 3.0% to 2.7%. That's low growth to begin with coming out of a downturn, and it's getting revised lower.

Geez - those Keynesians really screwed things up, didn't they! It proves it - you use fiscal stimulus and its going to give you sluggish growth.

So your quiz is: what was the growth rate of government spending - the infamous "G" aggregate in that vulgar Keynesianism equation - in the first quarter? Give a guess, please. I'll let you know tomorrow morning.

Production vs. Prosperity

I want to explore a little bit of Evan's query:

"Do those who provide goods and services contribute to useful cultivation, or do they perpetuate a practice of commoditization, either of ideas, tools, or resources?"

It's a reasonable question. Many have opined that the GDP statistics we collect are a poor measure of the true "wealth" of society precisely because this summation of values doesn't necessarily correspond to the creation of actual value in society. A homeless shelter may purchase paper plates and spaghetti from the store, and those purchases will show up in GDP statistics - but the couple of bucks that they contribute to GDP will far underestimate the "value" of that purchase to society when the spaghetti is served with a friendly face, an open ear, and a safe atmosphere.

But as Christopher Hitchens has recently pointed out: "There’s also the not-inconsiderable question of capitalism’s ability to decide, if not on the value of a commodity, at least on some sort of price for the damn thing." We need not assume that GDP encompasses all value to admit that there is value to the idea of GDP (and the products that it measures).

If we set up a straw man of modern production as some monstrous, commoditizing, corrosive influence then of course we will be able to vanquish that straw man and banish it to oblivion. But that would be a hollow victory, because that straw man doesn't really represent the "modern economy" as an idea.

Something like GDP is useful if we are realistic about what exactly it is: Gross (i.e. - after subtracting off imports) Domestic (a fundamentally political concept) Product (those things which are produced for sale in a particular jurisdiction). "Production" is a much more humble thing than "culture" or "happiness" or "value". Production includes the plows and tractors that make cultivation possible, as well as the proverbial pick up truck, farm windowsill, and apple pie (perhaps the apples are home-grown, but the flour is most likely ground somewhere else and the baking tin is almost certainly made elsewhere). This is what GDP is - production that is brought forth in the context of a market. And a market is nothing if not a social collective, and therefore absolutely relevant to "culture".

But Berry and Evan have a point that is illustrated in my example of the spaghetti and paper plates used in a homeless shelter. These contribute to GDP, but they only contribute prices - i.e., market values - and not social values. A great deal of social value is produced that is totally omitted from the GDP statistic.

Charles Murray (a real conservative's conservative) used the occasion of his March 11th Irving Kristol Lecture to speak on how a civilization's happiness is grounded in it's cultural institutions, rather than in cold economic calculations alone. On the other side of the aisle the Nobel prize winner responsible for attacking the Clinton administration from it's left flank, Joseph Stiglitz, has been tasked along with Amartya Sen by French President Sarkozy with exploring new ways of measuring growth to capture social happiness.

I think Berry's point is not lost even on those who deal with the modern, competitive market every day. The task is to:

1. Understand how markets both complement and conflict with culture and value, and
2. To be more realistic about exactly what GDP is and what markets can accomplish in the first place, and not penalize them for failing to accomplish something that it was never their task to accomplish.