Fama's Fallacy, Take III
Before the First Meeting of Econ 210a

Fama's Fallacy IV: The Decline of Chicago

Note to Self: How to make the "crowding out" argument the intellectually coherent way.

Milton Friedman (1972), "Comment on the Critics," Journal of Political Economy 80:5 (September-October), pp. 914-5 http://www.jstor.org/stable/pdfplus/1830418.pdf:

I do not share the widespread view that a tax increase which is not matched by higher government spending will necessarily have a strong braking effect on the economy.

True, higher taxes would leave taxpayers less to spend. But this is only part of the story. If government spending were unchanged, more of it would now be financed by the higher taxes, and the government would have to borrow less. The individuals, banks, corporations or other lenders from whom the government would have borrowed now have more left to spend or to lend-and this extra amount is precisely equal to the reduction in the amount available to them and others as taxpayers. If they spend it themselves, this directly offsets any reduction in spending by taxpayers. If they lend it to business enterprises or private individuals--as they can by accepting a lower interest rate for the loans the resulting increase in business investment, expenditures on residential building and so on indirectly offsets any reduction in spending by taxpayers.

To find any net effect on private spending, one must look farther beneath the surface. Lower interest rates make it less expensive for people to hold cash. Hence, some of the funds not borrowed by the Federal government may be added to idle cash balances rather than spent or loaned. In addition, it takes time for borrowers and lenders to adjust to reduced government borrowing. However, any net decrease in spending from these sources is certain to be temporary and likely to be minor.

To have a significant impact on the economy, a tax increase must somehow affect monetary policy--the quantity of money and its rate of growth. (Newsweek, January 23, 1967, p. 86)....

Why "certain to be temporary"? Because the leftward shift in the IS curve is a once-for-all shift.... Put in monetarist terms, the lowered interest rate resulting from the federal government's absorbing a smaller share of annual savings will reduce velocity; the transition to the lower velocity reduces spending for a given money stock....

Why "likely to be minor"? Because the monetarist view is that "saving" and "investment" have to be interpreted much more broadly... that the categories of spending affected by changes in interest rates are far broader than the business capital formation, housing construction, and inventory accumulation to which the neo- Keynesians tend to restrict "investment." Hence, even a fairly substantial tax increase will produce only a minor shift in the IS curve....

Of course, the terms "temporary" and "minor" are highly imprecise. We get closer to a rigorous statement by comparing the changes resulting from a reduced or increased deficit without any change in monetary growth with those that result when a change in the deficit is matched by a dollar-for-dollar change in monetary growth.... [A] deficit financed by borrowing... [is] a once-for-all shift to the right in the IS curve, a higher interest rate, a higher velocity, and a higher level of spending for a given monetary growth path.... [F]inancing the deficit by creating money... shifts the LM curve to the right.... But this is not a once-for-all shift. So long as the deficit continues, and continues to be financed by creating money, the nominal money stock continues to grow and the LM curve (at initial prices) continues to move to the right. Is there any doubt that this effect must swamp the effect of the once-for-all shift of the IS curve?...

We may put this point differently. Assume a one-year increase in the deficit, with the budget then returning to its initial position. If this is financed by borrowing from the public with no change in monetary growth, then, in the most rigid Keynesian system, the IS curve moves to the right and then back again; real and nominal income rise for one year, then return to their initial values. If the one-year increase in the deficit is financed by creating money, the LM curve moves to the right as well, and stays there after the IS curve returns to its initial position. If prices remain constant, real and nominal income stay at a higher level indefinitely. If, as is more reasonable, prices ultimately rise, real income may return to its initial level, but nominal income will stay at a higher level indefinitely. Surely, to paraphrase a remark of Tobin's in another connection, the monetary effect is "alchemy of a much deeper significance" than the fiscal effect...

For Friedman, the NIPA savings-investment identity is the prelude to the analysis: the meat of the analysis involves going deeper by:

  • arguing that savings and income levels will adjust so that the economy will quickly move to a point at which unwanted inventory accumulation is zero (that's the "IS curve").
  • analyzing the combination of possible values for interest rates and output levels at which unwanted accumulation is zero (that's the shape and position of the "IS curve").
  • assessing how the changing financial asset supplies and demands in the economy pick out a particular point on the IS curve (that's the "LM curve").

For Fama, the NIPA savings-investment identity is the completion of the analysis--hence he gets driven to the conclusion that not just fiscal policy via the government deficit but monetary policy via open market operations has no effect on employment and output as well.

This makes me think I should finish writing up one of the talks that I gave in Singapore--the point of which was that Chicago economists today are profoundly ignorant of what the Chicago School of economics--the school of Friedman and Stigler--believes.