Fiscal policy — whipped out only as a last resort

8 December, 2013 at 14:58 | Posted in Economics | 1 Comment


Let’s look at the way economists see fiscal policy for one second. I will use three examples, John Cochrane, Paul Krugman and Lars Syll, to represent differing views on the subject. And the impression you should be left with after reading their views is that there is no general agreement at all on how to model fiscal policy, how it works, and whether it is effective.

Let’s start with John Cochrane. He is against using fiscal policy actively. Recently, he wrote this about Keynesian (fiscal) stimulus:

Many Keynesian commentators have been arguing for much more stimulus.  They like to write the nice story, how we put money in people’s pockets, and then they go and spend, and that puts more money in other people’s pockets, and so on.

But, alas, the old-Keynesian model of that story is wrong. It’s just not economics. A 40 year quest for “microfoundations” came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly …

If you want to use new-Keynesian models to defend stimulus, do it forthrightly… That, at least, would be honest. If not particularly effective!

Paul Krugman on the other hand wrote about the New Keynesian case for fiscal policy in response to Cochrane saying that:

It’s been a bit funny on the academic front being a Keynesian during a Keynesian crisis. Much of the academic profession decided more than 30 years ago that the whole thing was nonsense and what we needed was an equilibrium model of the business cycle. By the time the utter failure of the equilibrium project became apparent, you had a whole generation of economists who knew that Keynesianism of any form was nonsense based on what they had heard somewhere, so they didn’t read any of the stuff, old or new — and were flabbergasted to learn that there was in fact an extensive New Keynesian literature that provided a justification for fiscal policy at the zero lower bound …

Now, is there a way to get a rise in consumption, and a multiplier bigger than 1? Yes. That Euler condition is based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate. If some of them are instead liquidity-constrained, the increase in income from the rise in G will lead to some increase in C as well, and we have a story that is even closer to the old Keynesian version. This isn’t hard — at least it shouldn’t be for anyone with a graduate training in economics. Just try actually reading what New Keynesians write.

Krugman’s piece is a bit wonkish for non-Economists but suffice it to say he tries to make the case for fiscal stimulus using New Keynesian models. And this puts Lars Syll, a post-Keynesian economist from Sweden, over the top:

According to Krugman, this shouldn’t  be hard at all — ‘at least it shouldn’t be for anyone with a graduate training in economics.’

Hmm. This doesn’t seem convincing at all.

1 So, according to Wren-Lewis, macroeconomics has really made progress on monetary issues thanks to central bank economists and since we have been able to definitely conclude that wages are “sticky”. Wow! That’s really impressive! (And the earth still isn’t flat?) Keynes argued that conclusively more than 75 years ago …

2 And are central bank economists really “taking an objective view”? How is it even possible to think that thought today, when the “relevant jury” for at least four years has known that these guys to a large extent were the culprits of the latest financial and economic crisis. Devoted Ayn Randian Alan Greenspan “taking an objective view”? I’ll be dipped!

3 Is ideology only playing a role when it comes to fiscal policies? Hard to believe. As already Gunnar Myrdal argued 80 years go, ideology is all over all economists. Whether they are into monetary or fiscal policies is immaterial.

4 And — perhaps most disturbing of all — in both Krugman and Wren-Lewis we see a rather unbecoming self-congratulatory attitude, according to which all macroeconomists (allegedly) share the same basic mainstream neoclassical theory, so when we discuss and argue it’s only about which policy and model to choose.

Let me sum this up. None of these economists agree. For the non-economist, a lot of what I just quoted is dense and undecipherable technical jargon while dropping obscure names from the field of economics. Almost no one but an economist is interested in any of this. It would be really difficult to choose a story to follow based purely on the logic. And so the layperson has to pick based largely on ideological predisposition …

You get the impression from Cochrane that no one in Washington shares his anti-Keynesian stimulus views. However, the reality here in Washington is that Cochrane’s framing is popular. And this is exactly why, despite the worst financial crisis in 80 years, US government spending has grown at the slowest pace since Eisenhower.

My whole contention here is that fiscal policy is whipped out only as a last resort, Monetary policy is the only game in town. And it is because of the view Cochrane expresses, that this is so.

Edward Harrison/Credit Writedowns

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1 Comment »

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  1. Prof. Syll,

    If you could clarify the following I would appreciate as I’m naive about these deep issues but I’ve been following Krugman for some time (when I can of course because he is more of a political economist than a pure economist in my view):

    1) Krugman to my understanding has been an advocate of fiscal stimulus, not only in US but also in Europe. Isn’t the basic difference between him and a post-Keynesian the way he is trying to justify this, i.e. the causality between stimulus and output? Or am I missing something big here, which is quite possible.

    2) Stimulus in itself may raise consumption but not productivity in cases when there is a large trade deficit (ex. European south). People get more money to spend but they buy iphones, Chinese goods and German cars. In turn, the deficit becomes larger and they must finance it with more debt. Isn’t this what is happening in the US also?

    3) Do you think that the QE in USA is fiscal policy or just a bank recapitalization scheme and fiscal effects are secondary?

    Thank you

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