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Against Fiscal Policy Nihilism

Mark Thoma sends us to the Spirit of R.G. "They Are Crying 'Fire! Fire!' in Noah's Flood" Hawtrey:

Barro on Keynesian Economics vs. Regular Economics: Readers of this blog may have guessed by now that I am not a fan of The Wall Street Journal editorial page.  (Actually that is not entirely true.  The Journal editorial page is my go-to source of material whenever I am looking for something to write about on the blog.  So the truth is that I am deeply indebted and eternally grateful to the Journal.)  But I have to admit that even I was not quite prepared for Robert Barro’s offering…. Barro, with a good deal more sophistication than [stephen] Moore, draws the contrast not between Keynesian economics and common sense but between Keynesian economics and regular economics. Regular economics is the economics of scarcity and tradeoffs in which there is no such thing as a free lunch…. Barro throws up his hands in astonishment:

If [the Keynesian multiplier were] valid, this result would be truly miraculous.  The recipients of food stamps get, say, $1 billion but they are not the only ones who benefit.  Another $1 billion appears that can make the rest of society better off.  Unlike the trade-off in regular economics, that extra $1 billion is the ultimate free lunch.

Quickly composing himself, Barro continues:

How can it be right?  Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?  Keynes in his “General Theory” (1936), was not so good at explaining why this worked, and subsequent generations of Keynesian economists (including my own youthful efforts) have not been more successful.

Nice rhetorical touch, that bit of faux self-deprecation…. But wait a second.  What does Barro mean by his query:

Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?

Where is the market failure? Hello. Real GDP is at least 10% below its long-run growth trend, the unemployment rate has been hovering between 9 and 10% for over two years, and Professor Barro can’t identify any market failure? Or does Professor Barro, like many real-business cycle theorists (say, Charles Plosser, for instance?), believe that fluctuations in output and employment are optimal adjustments to productivity shocks involving intertemporal substitution of leisure for labor during periods of relatively low productivity?…

[T]wo and a half years ago… Barro had a slightly different take on what is going on….

[A] simple Keynesian macroeconomic model implicitly assumes that the government is better than the private market at marshalling idle resources to produce useful stuff…. [T]here is something wrong with the price system. John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels.  But this problem could be readily fixed by expansionary  monetary policy…

So in January 2009, Barro was at least willing to entertain the possibility that some kind of obstacle to necessary price and wage reductions might be responsible for the failure of markets to generate a spontaneous recovery from a recession…. [I]f that is what Barro believed… it would be interesting to know if he thinks that monetary expansion, which, after all, can be accomplished at very little cost in terms of resources or foregone output is not somehow inconsistent with his conception of regular economics. I mean you print up worthless peices of paper and, poof, all of a sudden all that output that private markets couldn’t produce gets produced, and all those workers that private markets couldn’t employ get employed.  In Professor Barro’s own words, "How can that be right?"… [H]ow is it that monetary expansion works according to "regular economics"?  People get additional pieces of paper; they have already been holding pieces of paper, and don’t want to hold any more paper. Instead they start spending to get rid of the the extra pieces of paper, but what one person spends another person receives, so in the aggregate they cannot reduce their holdings of paper as intended until the total amount of spending has increased sufficiently to raise prices or incomes to the point where everyone is content to hold the amount of paper in existence. So the mechanism by which monetary expansion works is by creating an excess supply of money over the demand.

Well, let’s now think about how government spending works.  What happens when the government spends money in a depression?  It borrows money from people who are holding a lot money but are willing to part with it for a bond promising a very low interest rate. When the interest rate is that low, people with a lot cash are essentially indifferent between holding cash and holding government bonds. The government turns around and spends the money buying stuff from or just giving it to people…. [A] lot of the people who now receive the money will not want to just hold the money. So the government borrowing and spending can be thought of as a way to take cash from people who were willing to hold all the money that they held (or more) giving the money to people already holding as much money as they want and would spend any additional money that they received. In other words, i.e., in terms of the demand to hold money versus the supply of money, the government is cleverly shifting money away from people who are indifferent between holding money and bonds and giving the money to people who are already holding as much money as they want to. So without actually printing additional money, the government is creating an excess supply of money, thereby increasing spending, a process that continues until income and spending rise to a level at which the public is once again willing to hold the amount of money in existence….

[M]onetary expansion… and government spending… are close enough so that if restoring full employment by printing money does not contradict regular economics, I have trouble seeing why restoring full employment by borrowing and government spending does contradict regular economics.  But I am sure that Professor Barro, very, very clever fellow that he is, will clear all this up for us in due course, perhaps in a future op-ed in my go-to paper.

Kudos to the Spirit of R.G. "They Are Crying 'Fire! Fire!' in Noah's Flood" Hawtrey. I have been trying to say this for three years, and have never managed to say it that well.

Indeed, the only way--the only way, the absolutely fracking consistent way for anybody with half the cortical cells of a newt--to claim that monetary policy is effective at boosting nominal GDP and fiscal policy not is to assume a vertical LM curve. That is, as Hicks pointed out in 1937, a denial of the theory of value: a complete and total rejection of the ideas that money holders think at the margin and respond to incentives.

That would be a very very large deviation from "normal economics" indeed...