Responding to a student question after a recent Kansas State debate with Brad DeLong I posed a conceptual puzzle. I asked students to ponder why textbooks treat Treasury sales of government bonds as a “stimulus” to demand (nominal GDP) in the same sense as Federal Reserve purchases of such bonds. “Those are very different polices,” I noted; “Why should they have the same effect?”
The remark was intended to encourage students to probe more deeply into what such metaphors as “stimulating” or “jump starting” really mean, not to accept as dogma that fiscal and monetary policy are equally effective or that economists are certain just how they work.
DeLong’s misinterpretation of my question led him to lecture me that, “if you really do think that monetary expansion undoes fiscal expansion because monetary expansion buys bonds and fiscal expansion sells bonds, you need to educate yourself.” Citing that wholly imaginary rewriting of my question, Paul Krugman wrote, “My heart goes out to Brad DeLong, who debated Alan Reynolds and discovered that his opponent really doesn’t understand at all how either fiscal or monetary policy work.”
Did I really say that “monetary expansion undoes fiscal expansion”? Of course not. If that had been my question, I would have answered myself by saying that piling more debt on the backs of taxpayers is unlikely to stimulate private spending (much less encourage more or better labor and capital) unless the added debt is “monetized” by the Fed and regulators allow banks to lend more to private borrowers. DeLong made much the same point by saying, “Expansionary monetary policy makes it a sure thing that expansionary fiscal policy is effective by removing the channels for interest-rate and tax crowding out.”
The Fed’s current bond-buying spree is bound to have some effect, if only to facilitate cheap corporate buybacks of shares and speculative day trading of such stocks on margin. But selling more government bonds per se (if the Fed won’t buy more) would be just as much an added burden for taxpayers as it would be a benefit to whoever receives the resulting government transfers, contracts or subsidies.
This make-believe squabble about monetary expansion undoing fiscal expansion exists only in DeLong’s imagination, like my non-prediction of mammoth inflation or Krugman’s non-facts about Ireland’s fiscal frugality.
I do have a few minor issues, however, with DeLong’s remark that, “It’s not possible to get confused if you have the IS-LM diagram in front of you.” To lean too heavily on John Hicks’ 1937 ad hoc diagram, which reduced the whole economy to two curves manipulated separately, is not an answer but rather part of my question. As theory goes, I much prefer Hicks’ 1975 book, The Crisis in Keynesian Economics (57) including his assessment (57) that “one of the worst things about Keynes’s doctrine … is the impression he gives that Liquidity Preference is wholly, and always, bad… .The trouble lies deep in his version of short-run macroeconomics, in which one form of investment appears as good as another.”
The question I posed to the Kansas students was more clearly explained in my 2009 Cato Journal essay, “The Misuse of Economic History.” I wrote that “it is a non sequitur to claim a ‘liquidity trap’ demonstrates that aggressive fiscal policy will ‘raise aggregate spending.’ Fiscal stimulus means selling more government securities; monetary stimulus mainly means central banks buying such securities with new money. Those are distinctly different policies, and their effectiveness raises distinctly different questions. Do big budget deficits stimulate demand? In postwar U.S. data there is no discernible connection, over short periods or long, between cyclically adjusted budget deficits and the growth of final sales to domestic purchasers. It is easier to find connections between aggregate spending and exogenous monetary policy changes.”
These are questions of fact, not theory. I was using historical data to show that monetary policy appeared relatively potent at times when Krugman claims it was not, while fiscal policy in the demand-side sense (budget deficits rather than tax rates) had no clear links to nominal or real GDP even during the Great Depression or post-1991 Japan.
Although Keynesian theory postulates a solid link between cyclically-adjusted budget deficits and changes in aggregate demand (nominal GDP), I find no such correlation in any data at home or abroad. Counterfactual simulations from Keynesian black box models are not evidence.
The burden of proof is entirely on those who assert that some measure of fiscal stimulus is linked with some measure of aggregate demand. Where did that happen and when? I am almost begging for some shred of evidence. In End This Depression Now! (234) Krugman could only uncover a study of military spending which suggests, he says, that “every year in which there was big [military] spending increase was also a year of strong growth.” Even if that causality was not ambiguous (i.e., we could afford a fatter defense budget when the economy and revenues were strong) any effect of military contracts on (defense industry) output says nothing about deficits per se, nor about the bulk of federal spending which is on payrolls, subsidies and transfers.
DeLong believes “anything that boosts the government’s deficit over the next two years passes the benefit-cost test–anything at all.” Just as there is no obvious reason to expect identical economic effects from marketing or monetizing federal debt, however, there is likewise no reason to expect all types of government spending (purchases, payrolls, interest expense and transfers) to have the same effect. The evidence that different sorts of taxing and spending have quite different effects (to get back to my initial microeconomic question) is entirely on the side of Casey Mulligan, who found increased transfer payments positively harmful to employment and output.
Unless government debt was literally a free lunch, how could it possibly be true that “anything that boosts the government’s deficit over the next two years passes the benefit-cost test”? Suppose interest rates doubled or tripled, as consequence of faster growth of nominal GDP, that would greatly increases the government’s deficit through larger interest payments. Would the “benefit” of that larger deficit really exceed the added interest cost to taxpayers? Would it qualify as a stimulus?
In the Brookings Papers on Economic Activity Brad DeLong and Larry Summers remind us of the changing fashions defining the mainstream economic consensus: “The late 1960s and 1970s,” they write, “provided powerful demonstrations that monetary policy had major effects on economic performance. The 1970s provided convincing evidence … that in the medium and long runs demand-management policy [whether fiscal or monetary] could affect levels of nominal but not real income. The late 1970s and the 1980s brought increased emphasis on the supply-side aspects of tax and expenditure policies. These three factors had led most economists by the 1990s to reject discretionary fiscal policy directed at aggregate demand as a tool of stabilization policy. Indeed, a central element of the economic strategy of the Clinton administration was the idea that deficit-reduction policy was likely to accelerate economic growth.”
For the DeLong and Summers to switch from advocating deficit-reduction in the Clinton-Bush years to advocating deficit-expansion in 2012 demonstrates impressive intellectual agility. Yet actual results of larger spending and debt have been far less impressive than the results of U.S. and Canadian spending reduction from 1992 to 2000.
For me to continue to “reject discretionary fiscal policy as a tool of stabilization policy,” just as “most economists” (including DeLong and Summers) did a decade ago, is now being redefined as ignorant heresy by DeLong and Krugman, who both wrote of being terrified by modest budget deficits in 2003-2004. The new reality, as opposed to old theory, is that national, historical and international evidence that increased government spending, borrowing and taxing is commonly unproductive or counterproductive has only grown stronger in recent years. Compare, for example, Ireland and Iceland.