Pissing Contests
Take a look at the cartoon to your right. It's funny, no? But humor aside, the cartoon reflects a serious idea. It's the idea that wealth transfers from the rich to poor can create wealth--at least, in depressed economic conditions. This basic idea is a staple of undergraduate level "Keynesian" economics -- the so-called "spending multiplier."In terms of the cartoon, this is how the spending multiplier works. Imagine that the rich dude drops a dollar in the poor guy's tin cup. Or, equivalently, imagine that the state takes the rich dude's shoes and gives them to the poor guy. (The multiplier story does not depend on whether transfers are voluntarily or not, or whether they are made with cash or in kind.) What happens next?
Well, let's imagine that there's an unemployed cobbler in the neighborhood and that the poor guy really wants shoes. Then the poor guy takes his dollar and uses it to order shoes from the (previously) unemployed cobbler. Shoe production (GDP) goes up. The same thing happens if the rich dude wants to replace his stolen shoes. The spending multiplier at this stage is one: a one unit transfer of shoes results in a one unit increase in the production of shoes.
But a multiplier greater than one is possible if there are also unemployed butchers, seamstresses, etc. That is, after receiving his dollar, the cobbler himself goes on a shopping spree, the effect of which is to increase employment in other depressed sectors.
What is the empirical support for this seductive idea? In a recent WSJ piece, Robert Barro argues that there is no "meaningful" support for the idea (either theoretical or empirical). Barro's dismissal of the "wealth transfers create wealth" idea was quickly mocked by Paul Krugman, who called it "anti-scientific." Antonio Fatas also weighs in here with his own characterization of what he calls the "anti-demand coalition."
Goodness, where to begin? Well, first off, I think that Barro goes too far in suggesting that there is no "meaningful" theoretical support for the idea (it depends on what one considers "meaningful," I suppose). We can certainly write down coherent "Keynesian" models where the result--or something like it--holds. The result can also hold in models with perfectly flexible prices, like the OLG model, or neoclassical models with credit constraints (see also the work of Roger Farmer). Of course, whether one buys into all the assumptions that drive these results is another matter. But this is where the need for empirical support comes in. And of course, that's one of the most problematic parts of our discipline.
I'm not sure what the evidence says about the wealth-creating propensity of wealth transfers in depressed economies. Let's just say that I, like many others, are skeptical that the mechanism is quantitatively important. As Barro says, "I am awaiting more empirical evidence." Note that Krugman offers no direct empirical support for the proposition in question. For that matter, nor does Barro provide any for his favored hypothesis. So far, all we have is a pissing contest.
I've already explained why I don't like the way Barro pissed on "Keynesian" theory. Now let me explain why I don't like the way Krugman pissed on "regular" economics. Here is Krugman:
If you read Barro’s piece, what you see is a blithe dismissal of the whole notion that economies can ever suffer from am inadequate level of “aggregate demand” — the scare quotes are his, not mine, meant to suggest that this is a silly, bizarre notion, in conflict with “regular economics.”While macroeconomists frequently use terms like aggregate supply and demand, one should keep in mind that these objects are not so straightforward to identify in general equilibrium theory (let alone in reality) where everything seems to depend on everything else simultaneously. In any case, "regular economics" offers plenty of examples where equilibrium allocations are socially inefficient. While a well-designed policy intervention may be desirable in such circumstances, it does not necessarily imply that wealth is created through wealth transfers, although this may certainly be the case. So we don't need theories of "deficient demand" to motivate policy interventions.
You’d never know, either from the WSJ or from people like Barro, why anyone ever felt that regular economics — the economics of supply and demand and all that — was inadequate. But you see, there are these things we call recessions. And if you believe regular economics is all there is, you should find them very upsetting.The suggestion that Barro -- or anyone who does not subscribe to the "deficient demand hypothesis"--somehow missed the recession is quite funny. I know this is too much to bear for the true believer, but alternative interpretations are possible.
Think, for example, about the Great Recession and its aftermath. Regular economics says that economies should normally get richer each year, as their work force and capital stock grow, and technology advances. But after 2007 the United States and other advanced countries suddenly went into reverse, becoming poorer instead of richer, and for an extended period too.Regular economics says no such thing of course. Whether an economy grows or not depends on a host of factors, including the parameters of the institutional environment (property rights, tax regimes, regulatory regime, etc.). Here is Antonio Fatas using the same rhetorical device to make the other side seem silly and anti-scientific:
Their models are only driven by changes in the productive capacity of an economy which means that the Great Recession (or the Great Depression) must have been the result of some destruction in our capital stock or our inability to remember how to work or produce or somehow our technology got worst than in previous years.
First of all, technology does not not have to "get worse" to generate a temporary recession. It is easy to build equilibrium models with Schumpeterian "gales of creative destruction" that generate recessions. Although I have never seen it, one could conceivably combine this impulse mechanism with a Fisherian "debt-deflation" dynamic to produce prolonged economic slumps from a positive technology shock.
Second, it is easy to generate what look like "aggregate demand events" in even RBC models. One way to do this is to hypothesize the existence of a "news shock;" see, for example, here. Most dynamic models have something like this equation living inside them:
Investment = Increasing function of ( Expected After-tax Return to Investment )
So investment demand (the most volatile component of GDP) depends on "news" (information) concerning the likely future return to investment. Note that investment could be interpreted broadly here to include human capital investment and (in labor market search theories) investment in recruiting activities.
It is not implausible to imagine that expectations concerning future returns might fluctuate a lot, or remain depressed for long periods of time. (This was certainly an important theme in business cycle theory well before Keynes ever coined the term "animal spirits.") Changes in these expectations are likely to be interpreted by econometricians as "aggregate demand shocks" because they induce movements in output and employment when contemporaneous measures of "supply" (technology and capital) remain fixed.
An important question here, I think, concerns the source of these expectation shocks. Do expectations move around passively in accordance with movements in the perceived reality? In other words, do people become rationally optimistic/pessimistic ex ante (even if they may be wrong, ex post)? Or do expectations move about in ways that are inconsistent with the surrounding reality--irrational mood swings? Or can expectations themselves move about for no good reason, shaping reality in a manner that results in a self-fulfilling prophecy? (Here is a paper on the question.)
But surely, one might say, is it not obvious that the current problem is insufficient demand? For example, many firms cite as their main problem a "lack of sales." In the same vein, Fatas reports:
I am not even sure I agree with Fatas on the point of why so many people appear to resist the idea of countercyclical policy. A majority of people likely do buy into countercyclical policy--there certainly seem to be a lot of "automatic stabilizers" built into the U.S. economy, and both the fiscal and monetary authorities have taken considerable discretionary measures (some would have liked more, and some would have liked less, of course). But maybe Fatas is correct in saying many people just do not trust the government to do the right thing with sequestered resources in current economic circumstances and given the current political climate. Most economic models assume away inconvenient political-economy issues. Optimal interventions can be easily identified in theory, but whether the political landscape is likely to permit implementation of an optimal policy is a different question altogether.
This is already getting way to long for a blog post, but I'd like to conclude with one final thought. At the end of the day, the real issue at stake was how to rationalize an extension to UI benefits. It should be noted that Barro was not arguing against the UI extension -- indeed, his column was subtitled: Food stamps and other transfers aren't necessarily bad ideas, but there's no evidence that they spur growth.
O.K., let's suppose transfer doesn't spur growth (create wealth). There are still other ways to rationalize the extension using "regular" economics. There is a consumption-insurance aspect that might be relevant in a world of incomplete insurance markets. There is the idea of helping the unemployed finance an extended spell of job search to increase the likelihood of a good match. And so on. The same holds true for how we can rationalize public infrastructure investment based on standard cost-benefit analysis--a lot of unemployed construction workers and interest rates at very low levels. Let's stop the pissing contest and start looking for some common ground here.
Second, it is easy to generate what look like "aggregate demand events" in even RBC models. One way to do this is to hypothesize the existence of a "news shock;" see, for example, here. Most dynamic models have something like this equation living inside them:
Investment = Increasing function of ( Expected After-tax Return to Investment )
So investment demand (the most volatile component of GDP) depends on "news" (information) concerning the likely future return to investment. Note that investment could be interpreted broadly here to include human capital investment and (in labor market search theories) investment in recruiting activities.
It is not implausible to imagine that expectations concerning future returns might fluctuate a lot, or remain depressed for long periods of time. (This was certainly an important theme in business cycle theory well before Keynes ever coined the term "animal spirits.") Changes in these expectations are likely to be interpreted by econometricians as "aggregate demand shocks" because they induce movements in output and employment when contemporaneous measures of "supply" (technology and capital) remain fixed.
An important question here, I think, concerns the source of these expectation shocks. Do expectations move around passively in accordance with movements in the perceived reality? In other words, do people become rationally optimistic/pessimistic ex ante (even if they may be wrong, ex post)? Or do expectations move about in ways that are inconsistent with the surrounding reality--irrational mood swings? Or can expectations themselves move about for no good reason, shaping reality in a manner that results in a self-fulfilling prophecy? (Here is a paper on the question.)
But surely, one might say, is it not obvious that the current problem is insufficient demand? For example, many firms cite as their main problem a "lack of sales." In the same vein, Fatas reports:
In fact, when most people are asked to describe the dynamics of economic crisis, they immediately refer to some notion that shortages of demand cause recessions.But as I have discussed before (here), we have to be careful how we map these individual (micro) impressions to what is actually happening at the macro level. Consider, for example, a market-clearing model with intersectoral linkages (like the original RBC model). A real shock in one sector is going to affect the derived demand for a product in another sector. An individual supplier in this model may very well report a "lack of sales" to be his main problem--but this does not necessarily have anything to do with the deficient demand hypothesis. Similarly, we can't say something like "Hey, if the problem really is deficient demand, then wouldn't we expect all beggars to have signs like the guy in the cartoon above?" No, I'm afraid not.
I am not even sure I agree with Fatas on the point of why so many people appear to resist the idea of countercyclical policy. A majority of people likely do buy into countercyclical policy--there certainly seem to be a lot of "automatic stabilizers" built into the U.S. economy, and both the fiscal and monetary authorities have taken considerable discretionary measures (some would have liked more, and some would have liked less, of course). But maybe Fatas is correct in saying many people just do not trust the government to do the right thing with sequestered resources in current economic circumstances and given the current political climate. Most economic models assume away inconvenient political-economy issues. Optimal interventions can be easily identified in theory, but whether the political landscape is likely to permit implementation of an optimal policy is a different question altogether.
This is already getting way to long for a blog post, but I'd like to conclude with one final thought. At the end of the day, the real issue at stake was how to rationalize an extension to UI benefits. It should be noted that Barro was not arguing against the UI extension -- indeed, his column was subtitled: Food stamps and other transfers aren't necessarily bad ideas, but there's no evidence that they spur growth.
O.K., let's suppose transfer doesn't spur growth (create wealth). There are still other ways to rationalize the extension using "regular" economics. There is a consumption-insurance aspect that might be relevant in a world of incomplete insurance markets. There is the idea of helping the unemployed finance an extended spell of job search to increase the likelihood of a good match. And so on. The same holds true for how we can rationalize public infrastructure investment based on standard cost-benefit analysis--a lot of unemployed construction workers and interest rates at very low levels. Let's stop the pissing contest and start looking for some common ground here.
0 comments:
Post a Comment