Trinity Papers No. 37 - 'The Relevance of Keynesian Fiscal Policy Today '

The Relevance of Keynesian Fiscal Policy Today

[Shortened and edited version]

Symposium: The Current Relevance of John Maynard Keynes April 1 2009 Trinity College, University of Melbourne

Included in the extended version of this paper are: Appendix 1: Context on the Varieties of Keynesianism Appendix 2: Contesting the 1930s Appendix 3: The Global Financial Crisis (GFC) Appendix 4: The Blame Game

Abstract

Recent fiscal stimulus packages in Australia and the US have been extensively criticised. Some grounds are pragmatic (cuts in tax rates would have been better than cash payments, or infrastructure spending would have been better still). Other critiques complain that Keynesian policies cannot work as a matter of logic.

Defenders of Keynesian policy have responded to these criticisms.

The debate has been in the public arena, so the deep differences in the approaches of Keynesian and classical economics have been stated in plain and accessible terms.

Analogies have been used to show the intuition underlying the case of each side. This paper strives to identify the meaning and significance of the assumptions made when they explain their positions. Some of these assumptions are tacit, and neither side seems to be much aware of the exaggerations underpinning their confident claims and counter‐claims.

This has been a rare opportunity to get into the minds of the rivals who are major figures in the discipline. Disagreements about theory and policy follow patterns, and the internal logic of each side has great consistency across a wide range of

interconnected ideas concerning fiscal deficits, demand‐side economics, wealth, finance, money and the relationships between consumption, saving and investment.

For decades technical economics has masked these deeper differences that have been long and deeply debated in the history of economic thought and never properly resolved.

Dr Bruce Littleboy, School of Economics, University of Queensland b.littleboy@uq.edu.au

Revised March 31

The Relevance of Keynesian Fiscal Policy Today Extended version Symposium: The Current Relevance of John Maynard Keynes April 1 2009 Trinity College, University of Melbourne

We are debating big ideas and core principles again. Is a restoration of spending crucial to recovering from the global financial crisis? Can fiscal policy work at all in raising total spending? Are tax cuts more effective than increases in government spending? Should stimulus be targeted, timely and temporary or pervasive, predictable and permanent? Can we afford to run fiscal deficits? If over‐spending and over‐indebtedness got us into this mess, how could more of these be the way out?

Until the last year or so, monetary policy has fully crowded out fiscal policy as an instrument of short‐term demand management. As a result, recent policy decisions have been rushed and ill‐prepared. Research into fiscal policy became the poor relation. I conjecture that the atrophy of expertise in the Treasury concerning short‐term fiscal policy reflects how the best graduates for years have gone to the RBA.

And academics bear a great part of the blame for no longer training students properly in short‐term fiscal policy. Indeed, most would be taught that it is ineffective (especially under flexible exchange rates with mobility of financial capital), so it does not matter much whether any type of spending is raised or cut!

Fiscal policy is coming back. And it may be around for a while, if only because large stimulus packages now will need to reversed in later booms by using fiscal policy rather than by relying on higher interest rates.

Disagreements about the potential role of fiscal policy as a form of demand management take two forms. Some are pragmatic: in theory demand stimulus could work, but lags and a lack of potent instruments make it infeasible. There is much to be said for this view.

The second form of disagreement is the critical one. Fiscal policy cannot work as a matter of logic and principle. The deeper intuition here needs to be identified. And it is appropriate to foreshadow how this paper argues that fiscal policy in principle can work. In a deep slump, a wide and complicated network of financial connections has been disrupted or destroyed.

Isolated individuals cannot readily repair a network. But a government can inject funds to restore viable, even if not optimal, connections simultaneously across the economy.

The aim of current policy is not to bring the economy back to the level reached before the crisis when the economy was likely overheating even against what is now revealed to be an unsustainable trend. A damaged financial system cannot support the level of transactions that were sustainable before. And many of the transactions made before the crises were unsustainable anyway (people buying houses that they could not as individuals afford, consumption based on asset bubble “wealth” and so on).

Output

Former bogus trend

New sober trend

Are we here?

Big buildup of fiscal deficits occurs

Time

Perhaps the trend will drift upwards as the financial sector heals. The next peak may be close to target.

The main focus here will be on fiscal stimulus and its consequences. Budget deficits, government debt and national wealth are interconnected. This paper aims to remind people of the intuition underlying Keynes’s logic or explain it to them for the first time. We are not just playing academic games now; ideas matter again. And many of these ideas are old ideas, the meaning and significance of which have been largely forgotten.

We now have economists and commentators pompously reciting fallacies that were exposed decades ago in texts now almost forgotten. Old debates and their modern corollaries are being re‐argued spiritedly; see for example the web debate in The Economist (2009).

Keynesians regard classical precepts as fallacious, and classical economists shudder at the restoration of overt Keynesianism, a doctrine they thought had been disproven and buried.

All models simplify, and squeezing the world’s complexities into these intellectual corsets will always leave awkward bulges hanging over. The line between the simple and the simplistic will be difficult to draw deeply. In this paper, I argue that a significant measure of Keynesian economics is valid. Assertions that it is conceptually invalid, or that it can have no beneficial effect in logic, will be attacked. The risk is that I will over‐sell and present the Keynesian logic as self‐evidently and universally valid.

Science may not be a fully efficient process; the best knowledge is not always well known.

The latest working paper does not contain all the relevant knowledge of the discipline. While money on a pavement is soon picked up, good ideas are often left lost in the library.

Systematic error is possible, and we may be very slow to perceive it.

In most textbooks, the economy is regarded as a machine. Apply the correct control system and you will get the best outcomes humanly possible. Keynesian fiscal fine‐tuners, who would keep GDP on target, were replaced in the 1970s and 80s by monetarists who would keep the money supply on target. And they were replaced in the 90s by those who would

keep inflation on target by following a Taylor rule. But the machine, if it ever was one, has run amok lately. The standard levers and institutions don’t work properly, and we are openly turning again to Keynes.

Have Keynesians Been Hibernating or Hiding?

Joshua Gans (2008) has asked “How exactly did Keynes survive?” Reading Keynes and pursuing fiscal stabilisation has essentially disappeared from mainstream US graduate training. A Keynesian orientation became a toxic liability on the CV. So where have the Keynesians sprung from? Most introductory textbooks today at least take a simple Keynesian model as their starting point, so a fragment of Keynesian activism was saved.

Perhaps the explanation of the speed with which Keynes was rediscovered is that the generation now aged in their 50s, who are currently in positions of influence, was the last to have been taught this branch of economics remotely properly. Had the crisis been delayed ten or fifteen years, there may have been a true catastrophe.

To be blunt, the Keynes of The General Theory did not survive. Only vestiges were preserved in the textbooks. Historians of thought complained long ago that the fiscal fine‐tuning textbooks around in the 1970s were poor reflections of Keynes’s writings1. (Leijonhufvud in the 1960s rightly referred to them as emasculated renditions of Keynes.) Animal spirits of investors, speculation in bond and share markets, and much else clearly relevant today do not fit in with the doctrine of efficient markets. Even a “New Keynesian” model based merely on short‐term wage‐price inflexibility still simulates fluctuations that can respond to demand stimulus. The traditional AE= C+I+G+ net exports is still the starting point.2

“Deficit” is a word, not a sentence. It triggers moral panic in many circles, but Keynesians are almost blasé about it. Doing whatever needed to be done, and accepting whatever fiscal deficit that resulted (i.e. “functional finance”), was once publicly acceptable, perhaps with the contemporary proviso that over the cycle the budget should be balanced. Building reserves in good times to run the down in bad times should make tolerable sense to any conservative3. But sound finance is instinctive for much of the populace. Allan Meltzer (2009) wrote: When Keynes read Abba Lerner's paper on functional finance, he accepted Lerner's argument for large deficits, then he added: "but heaven help anyone that tries to put it across."

It would be an interesting exercise to map the decline of the paradox of thrift, for example. Even when retained, the treatment is sometimes confusing and dismissive. Related to this is the careless treatment of what was once called the ex ante and ex post distinction, and the policy fiasco over the twin deficit hypothesis stems directly from the decay of Keynesian training. And what about government spending mostly or even fully financing itself? I wonder if anyone under 50 even knows what I’m talking about, which is my point, I suppose.

2 AE is aggregate expenditure; C is consumption spending by households; I is private-sector investment; G is government spending on currently produced goods and services, and it excludes transfer payments to households.

Pensions and cash payments are regarded as reverse-flow taxes that are included in GDP only so far as households spend them (primarily on C).

3 Keynes’s words were wilder than his principal immediate policy recommendations. Luck (2009) cites Mario Rizzo’s interpretation of passages from Keynes it should be noted that bloggers have severely and validly critiqued Rizzo’s slant. See Rizzo (2009a).

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When two pieces of common sense collide, the conventional, the one introduced earlier and the one most verified in your personal experience has the advantage in debate. Principles of sound finance are applicable to the individual, and are taken in, as Keynes once said, with one’s mother’s milk. Functional finance still sounds blasphemous to many.

Textbook writers looking for a bulk market want to reflect “modern macroeconomics” without wanting to be confined within a “school of thought” or within a system with a wider social agenda. Phil Bodman4 rightly observed that these textbooks contain Keynesian models but are most reluctant to use the “K word”, Keynes.

The Broad Approach

Rather than follow the over‐trodden path of extracting quotations from Keynes to strive to convict or convince others of their doctrinal errors or to expose misinterpretations of textual evidence, my goal is to identify key ideas and steps in a chain of reasoning. As far as possible, I will translate Keynesian teaching into language that (even) anti‐Keynesians should be able to understand. Whether you agree is not my concern; my hope is that you grasp the intuition. J.S. Mill (On Liberty, ch.2) said, “He who knows only his own side of the case, knows little of that.”

The key ideas of Keynes’s economics are fairly simple, but Keynesians have delighted in presenting them as paradoxical, and this may have been a bad rhetorical tactic. (“You have to be in a really clever minority, like me, to understand Keynesian economics.”) But simple truths probably will sound paradoxical when placed against conventional half‐truths. Most plausible arguments are valid in some domain, and I hope to identify expressly some of what each side assumes tacitly.

This paper deals with both the conceptual and the pragmatic objections to Keynesian policies. I will not change the mind of anybody committed to classical economics by instinct or by deep study. I hope to influence the emerging position of the wavering thinker whose thoughts are swirling with indecision.

Many of the specific, pragmatic objections raised against proposed stimulus packages make . significant sense5 The target of this paper is those who reject attempts at fiscal stimulus on principle

In particular, there is the idea that bond‐financed deficits must fully crowd out other spending. You may have encountered claims that the government is scooping a bucket of money from one end of a swimming pool and tipping it into the other expecting the water level to rise beyond its starting level. You may heard the old illustration about whether one could or should stimulate the economy by smashing windows so that we’ll be busy repairing them. Some think that a joke or a metaphor is enough. But for every metaphor there is a Conversation, March 5, 2009.

Some objections are silly though. Lucas, in Huizinga, Murphy and Lucas (2009), wondered how fiscal policy could be tightened later on to repay the deficit. Pointing to the stimulus package involving the laying of optic cable, he joked whether the plan was to pull it up later. It got a laugh; it should have been derided. It’s a version of the “joke” that Keynesians would build hospitals in booms and close, or even demolish, them in slumps.

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rejoinder. For example, no Keynesian is advocating the policy‐equivalent of breaking windows, but, if they are already broken, it makes sense to repair them.

Metaphors are intended to have didactic value and to contain a kernel of truth. They should be taken more seriously than they commonly are. They have rhetorical power and they provide insight into how scientists frame their explanations of more complex phenomena.

Some illuminate more exactly than any formal modelling what each disputant has in mind.

They point to what is assumed and to what causal connections are held as dominant.

Metaphors can be overextended and overworked, as will become evident. A metaphor that merely claims is less useful than one that explains.

Keynesians need to meet common sense with common sense. Suppose someone in a meeting says, “Too much spending and debt got us into this mess, and you advocate more borrowing to spend our way out?!” A suitable answer may be, “Suppose that overeating and lack of exercise put us into the cardiac intensive care. The solution is not to pull out the tubes and go jogging. Bed rest is needed for now.” Or maybe “If a morphine addict is injured and in pain, it may be right to administer morphine.” Or suppose someone says, “Financial regulation created the problem, so it cannot solve it!” Reply: “Botched surgery may require more surgery to fix it – preferably by a different surgeon.” These rhetorical exchanges do have mirror images in economic debates. They are not evasions.

Here is how a Keynesian sees things. Nobody would advocate setting fires to burn houses down to induce rebuilding and raise GDP. But it is still true that rebuilding will raise GDP and not merely crowd out other spending. There could be a bushfire‐led recovery. Indeed, less federal stimulus will be necessary in view of the upcoming rebuilding in Victoria.6 If construction workers would otherwise have been idle or underemployed, we are more prosperous than if we had chosen to wring our hands and wear sackcloth and ashes. Our stock of wealth would be restored, according to Keynesian reasoning, and GDP would rise while we replenish it.

The contrary argument is that these unemployed workers would not have been idle. They would be resting, rethinking, relocating and retraining. And we would be over‐investing in houses if individuals had not insured them. Recorded GDP figures do not count these things properly. The apparent short‐term rise in GDP upon reconstruction masks the reality that later GDP will be lower than it would otherwise have been. This is a classical argument that deserves a hearing. To date, Keynesians have largely ignored this argument or have dismissed it as absurd. And because it, in essence, has recently resurfaced in several forms, it requires a reply – and perhaps some accommodation.

Many related disputes are whirling around. They need to be pinned down in isolation and then explained as connected sets of ideas. There are disputes over the significance of fiscal deficits, the effects of changing taxes in various ways, the importance of the distinction between productive (infrastructure) spending and unproductive consumption (via cash payments), whether we should be consuming to boost the economy versus saving to boost it, and there are others. A fundamental question is whether one accepts that markets overshoot in the face of large shocks. If you cannot accept this, you do not regard idle labour 6

Contrast the scandalous paralysis in redeveloping the Twin Towers site in New York.

or bankrupt firms and financial institutions as problems. Instead these are part of a healthy process of dynamic restructuring. It’s quite a tangle, and I hope this paper can sort most of it out.

Fiscal sceptics

Many economists of stature do not accept that fiscal stimulus is appropriate in principle or feasible in practice. To fund fiscal deficits, existing money needs to be borrowed or new money created. If it is borrowed, then it is diverted from a productive alternative use. (This assertion will occupy much of the paper.) Total spending is unchanged, even if quick government spending may bring some spending forwards. Government spending, even if it is productive (i.e. on infrastructure), crowds out other spending. (This is disputed intensely.)

Resources used on government projects will likely be diverted from an alternative and private use. Furthermore, government projects are likely to be managed less efficiently than private ones. (Sensible, but this is not open‐and‐shut case.) As these resources are also being diverted from a more valuable use, our wealth is less than it would otherwise have been.

(This analysis is disputed in the next section.)

If the outlays promote consumption (e.g., lump‐sum tax cuts, or cash transfer payments), then nothing is left behind after the spending except the deficit. And rational taxpayers will realise that payments now will need to be recouped by the government in the form of higher taxes later. So this means that many will save the payments to meet the future tax burden.

(This is based on what is called Ricardian equivalence, something I had thought was regarded as discredited long ago.)

It may be a better idea to have “permanent” (this term is explored later) cuts in marginal rates of taxation. Disposable income not only rises for a period long enough to encourage consumption, there is also a supply‐side stimulus in that people have greater incentives to work and invest. Current fiscal packages omit the only measures that are likely to be beneficial.

When the stimulus (if any) stops, we’d revert anyway, so what’s the point of a “temporary” stimulus? (This simply fails to grasp what is meant by pump‐priming. If a recovery can be hastened by timely pre‐emptive policy, private‐sector confidence returns and the government activity can quietly recede.) Clearly the critics of fiscal policy are baffled by the widespread academic and expert acceptance of fiscal stimulus.

If deficits are funded by printing money, then any stimulus is really attributable to monetary policy, according to the fiscal sceptics. And monetary stimulus risks imminent or subsequent inflation that can only be prevented by severe monetary tightening later on. The slump is just being shifted through time. (At the risk of trivialising what is a significant difficulty, this is a technical matter that later monetary and fiscal policymakers will need to discuss soon in order to be well prepared prevent a slump down the track.) If a government is trying to

appropriate resources beyond the country's sustainable capacity to supply, fine, later inflation erodes the real value of the government debt. During a slump, this not an issue7.

In the Australian context, it is not unfair to focus on people who have made a point of openly opposing the stimulus package partly along lines similar to the points made above: see Ergas (2009), Kates (2009a: 2009b) and Makin (2009a; 2009b). There are real differences in nuance and degree, but their contributions dovetail. Some of their reasons are based on practical grounds, and I share some of these misgivings, but the thrust of their objections is conceptual and theoretical. Fiscal stimulus is close to oxymoronic in the eyes of its circle of hardline critics.

Deficit attention disorder?

Here is a broad reply to the points above outlined as criticisms of spending packages. Why do Keynesians worry rather less about fiscal deficits than just about everybody else? We do partly because of experience. At the end of World War 2, the ratio of government debt to GDP in the US, Britain and Australia was around 1.7 to 2.4; i.e., around double GDP.

Budget Deficit as a Percent of GDP

Source: US Congressional Budget Office, via Mankiw (2009)

Is this relevant here?

Efforts made in Australia to paint an extrapolated figure of 20% as a severe burden on future generations of taxpayers would appear to be over‐statements. Had economists urged us to surrender to the Japanese to prevent an excessive national debt, we would have called this treason. But we are being urged now to hold our fiscal ammunition back as though it was in tight supply.

Contrary to conservatives writing in the tradition of classical economics, full‐strength Keynesians would argue that we and our children will gain from our recent fiscal deficits. The relationship between fiscal deficits and the generation of wealth and income clearly require discussion. What follows is a Keynesian critique of the classical position that is championed in the Chicago Circle and by members of the Austrian School.

There is a gigantic difference between what is true when resources are idle in a slump and when resources are already in efficient use. In the former case we can sustainably produce more of everything. In the latter, more of one thing must come at the expense of something else. This idea impacts on how we should evaluate the effects of fiscal stimulus on wealth, In particular, stagflation is a scenario to consider, but outcomes in 1970s drew somewhat from the different institutional context prevailing then.

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indebtedness and income. As there is idle capacity, recent increases in government outlays in Australia will not be a burden, regardless of whether it is devoted to investment or to consumption.

Our problem now is not our lack of productive capacity. Our problem is that we are unable to use the capacity we already have. So the fundamental solution is not more infrastructure, lower tax rates or greater labour market flexibility to boost supply. These things may be useful and desirable to a point, but they are not essential to what needs to be done.

It is true that by increasing our long‐term productive capacity, investment will enhance our national wealth more than consumption would. Greater supply makes debt easier to deal with too, but increased government debt need not deter us from greater household consumption as a temporary stimulus. Consumption does not send us backwards; it carries us forwards out of a slump, in terms of income earned, much as capital investment would.

But capital indeed is still there after the slump has passed. The usefulness or otherwise of government infrastructure spending is discussed elsewhere.

Our wealth is our ability to produce. If resources are left idle, output is lost forever. It is not stored up for later use. It is therefore better to produce and consume now than not to produce at all. Compared to producing nothing, more consumption spending does raise GDP. This is true when idle resources can sustainably be re‐employed by the restoration of demand. Of course, the situation is different if wasteful spending causes an economy to overheat.

Low demand today reduces the incentive to invest today. Less investment today means less capital exists tomorrow for our children. Both consumption and investment can rise if idle resources are available. Production and income today need not reduce production and income tomorrow.

Though production and spending may recently have overshot what we now realise is sustainable over the trend, we are not currently in much danger of crossing the line into overheating. The task now is to minimise the extent to which markets will overshoot in the direction of contraction. At best, the concerns expressed by Makin about the need for IMF‐ imposed fiscal discipline apply only to lesser developed countries over‐working a limited trend capacity to produce. They are irrelevant to Australia’s situation, and this IMF‐think should be flicked aside.

Finance coordinates the transition of inputs into output. It is the economy’s signal bearer.

Buyers tell sellers what they want them to produce by offering to pay money. The healthy circulation of funds is vital. Without oil exactly where it is needed, an engine seizes up. Too little money, credit and debt are bad because resources will be idle as a result. Too much finance is bad if output and spending are unsustainably high.

Deficits and debt activate wealth when they enable greater sustainable production. Wealth is more than our available land, labour, capital and technology. These resources must be financially coordinated so that output occurs.

If our capacity is permanently idle, it would not count as wealth at all. It may be wealth in some notional and hypothetical sense, but it would not be wealth in any effective sense.

Inactive capacity is less valuable than active capacity. Wealth rises when it is used. In a slump, a rise in effective demand raises effective wealth.8

We cannot afford to avoid debt, if debt is needed to keep our current potential capacity in production. In 1942 Keynes (CW XXVII, p. 272) rightly said, “anything we can actually do we can afford”. If all the resources are just sitting there going to waste, it is silly not to use them instead. If the only thing holding production back is a temporary reduction in demand, then raise demand back towards a sustainable level.

Employment preserves human capital and lessens de‐skilling and demoralisation. As people learn by doing, ongoing employment avoids “forgetting by not doing”. Systems do not spring back into shape if the short‐term shock inflicts long‐term damage, and this is known as hysteresis. Relying on automatic market‐led recovery is even more problematic if the shock attacks the system’s very capacity to recover. Market dynamics are not optimal and they may be improved upon.

If the resulting fiscal deficits are funded by bond sales, taxpayers eventually bear the burden of their repayment. But taxpayers also directly or indirectly own the bonds. We are paying money to ourselves, and there is no net burden.9 During later years of overheating, the government should sternly impose surpluses and suck out the excess money and bonds. This is a rather silly‐looking piece of paper churning10 taking years, and there may be a better way of doing things. But it places no great burden on the economy, just on officials at the Treasury and the RBA. Preaching about the sinfulness of debt is Sunday school economics.

Fiscal deficits have two sources. A decline in income automatically reduces the tax harvest and creates a deficit. Even the Federal Opposition tacitly accepts that these deficits are necessary. The fiscal tide will turn later. Although these deficits reduce the size of the downturn, they impart no fiscal thrust to push the economy back to a higher sustainable position. Second, there are policy decisions to change government spending, welfare eligibility and taxation scales. These impart active fiscal stimulus. They increase what economists call the structural fiscal deficit. The only questions then are how much and what type of stimulus. I return to this issue later in the paper.

Tony Makin is concerned that government outlays already over‐fund private consumption. If payouts to foster consumption are so bad, we all should be much more concerned than we are about the mega‐dollars already spent on middle class welfare. But note that each outlay dollar that funds consumption contributes equally to a fiscal deficit. The last ones on board from the December and February packages are no more inherently pernicious or virtuous Share prices rise, for example, as expected profits rise during recovery. The distinction between notional and effective is made in the works of Clower and Leijonhufvud, who are mentioned in Appendix 1. I have extended the distinction into the domain of wealth.

9 Some of the debt will be owned by foreigners, it is true. The world is a closed economy, so if all governments increase the borrowings to fund deficits. But if all governments issue bonds in proportion to their GDP, this broadly cancels out. We earthlings owe it to ourselves. (Besides, the Martians aren’t silly enough to lend to us.) The peculiar imbalance between China’s high saving and the USA’s consumption is globally important but is not much relevant to fiscal policy settings in Australia.

10 It is made even sillier-looking by the simultaneous massive increases in base money to prop up the balance sheets of the private banks.

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than the earlier ones. As economists know, money is fungible. But Makin is right about cutting ineffective and inequitable middle‐class welfare spending, provided he proposes to replace it immediately with something fairer and more effective in boosting short‐term demand.

Wasteful spending simply sounds bad. It suggests that the economy could even go backwards. To put popular speech into unpopular jargon, wouldn’t the multiplier be zero or even negative? But what do we mean by “wasteful”? Do we merely mean that resources could have been put to even better use and that a better opportunity was forgone? Do we mean that it would have been better to keep the resource stocks unused now for a better use later? This makes sense for a reservoir of oil, but the productive capacities of capital and labour are flows that cannot be stored in any significant way. Better to consume more output now than to have nothing at all now and in the future too.

Consumption itself is not wealth, of course. It directly uses up existing wealth in so far as capital wears out when producing consumption goods. A higher trend share of consumption from full‐capacity output reduces the trend investment share and this reduces wealth, other things equal. In this case consumption now comes at the expense of more consumption later. But present consumption might encourage firms to increase capacity, and it is the latter that constitutes wealth. Consumption and investment are therefore complements as well as substitutes. Consumption might also reactivate idle resources, especially during slumps. Idleness reduces quality of resources and therefore the effective value of productive wealth. The effect of consumption on wealth therefore is indirect and not generalisable.

In one case though, Keynes’s rhetorical flair got the better of him11:

During a 1934 dinner in the U.S., after one economist carefully removed a towel from a stack to dry his hands, Mr. Keynes swept the whole pile of towels on the floor and crumpled them up, explaining that his way of using towels did more to stimulate employment among restaurant workers. [See Reddy (2009).]

This only makes sense if Maynard is sent the bill and pays it. Raising the private costs of doing business without raising demand (revenue) by at least as much does no good.

Of course greater consumption may increase short‐term income and total output, as distinct from increasing the wealth underpinning the economy’s current potential capacity to supply12. And consumption can erode wealth (partying away your life savings, or chopping down trees to make confetti). As measured in the national accounts, consumption raises GDP if output rises. But sometimes we in effect consume our capital (our stock of wealth) and misleadingly define this as higher income.

Infrastructure (capital) spending tends to find greater political and academic support, partly because they may be financially viable from an accounting viewpoint. User charges may be Steve Kates has also criticised Keynes here, but this example in fact rather poorly explains what Keynes meant. It was a carelessly chosen metaphor.

12 Potential capacity is what the economy could sustainably produce, given the quantity and quality of its resources, the state of technology and the framework of institutions, laws, taxation and culture. The current value of potential supply is crudely approximated by the trend line through observed output. Of course, the willingness and ability to supply may be affected by changes in technology, rates of taxation or microeconomic reform. Keynesians argue that these factors change fairly slowly, so trend output is a sensible approximation.

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levied, or firm’s will face lower production costs and be able to pay the taxes required to repay the debt incurred. By contrast, “unproductive” consumption spending certainly triggers an almost visceral sense of distrust and revulsion.

Perhaps normative concerns about the immorality of debt are still entangled in debates over fiscal deficits. This is often combined with another moral panic about supporting consumption without work. The undeserving poor should not be given money: they’ll just spend it (on plasma TVs and pokies) and there’ll be nothing to show. But Sunday School Economics is a politically potent opponent of Keynesian economics.

Is funding the deficit a problem?

Why do critics of fiscal stimulus believe that people won’t buy the large volume of bonds to fund a series of deficits? (I put aside the extra funds devoted merely to prop up financial institutions.) Some argue that big deficits will drive up interest rates to make buying these bonds attractive, and higher interest rates will contract the economy.

We know that this is wrong, generally speaking. When private‐sector spending autonomously declines, a slump may occur. Inflation falls in a slump, so central banks cut interest rates to below average levels. Interest rates in slumps are lower than they are in booms (the important exception being when a central bank raises interest rates to disinflate the economy and thereby create a recession). During slumps, large deficits emerge. Large deficits are therefore associated with low interest rates.

Neither does active fiscal stimulus raise interest rates in modern monetary regimes. Only if the economy is overheated through ill‐judged fiscal stimulus would inflation rise. Innocently Ergas (see 2009a) trusts the textbooks. The old argument was that fiscal stimulus, under flexible exchange rates and with mobile financial capital, would raise interest rates, strengthen the domestic currency, reduce net exports and this would offset the stimulus.

But these days interest rates would remain unchanged until there were fears of overheating.

Aside from being irrelevant under modern central banking regimes, the logic itself is patently bizarre. It would equally imply that contractionary policy would have no effect on total spending. Even more absurdly, it implies that no change in any component in spending can change total spending. Stronger demand by households, firms and even foreigners would supposedly raise interest rates and thereby soon crowd out the extra private spending.

Textbooks13 have also confused matters by failing to distinguish short‐term from long‐term behaviour. Over the trend, by contrast, sustained fiscal stimulus raises interest rates by creating excessive spending growth compared to the growth in productive capacity.

The second concern about fiscal deficits is that they eventually get monetised, and this causes inflation. This is a problem for the future that needs to be addressed, and it is discussed later. Governments are at least making noises about the need to raise surpluses later to repay debt. This is a responsible course only after the economy has fully recovered and is overheating. It may take a few small booms to recoup the deficits created in a deep

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An exception is Littleboy and Taylor (2005; 2009).

slump, and the time frame could be one or two decades. Monetary policy may need to take a holiday for quite a while from being the main weapon against fluctuations in inflation.

Third, the deficits are so large that governments will default – see Buiter (2009) – but this is not relevant to Australia. The US and UK may be in greater danger of a lack of public (actually, I may probably just mean “market”!) trust and lack of credibility14.

Another problem, I think, is that these new bonds are sold when interest rates have bottomed. When interest rates rise later in the cycle, holders make a capital loss on the bonds they’ve bought at such low yields. This strikes me as a more plausible reason not to buy long‐term bonds than concerns over sovereign default or the later inflation risk as the debt matures. It is not clear (to me) why governments do not offer variable‐rate bonds as part of the suite, offering the average annual overnight cash rate plus x%. Selling inflation‐ indexed bonds also may ease anxieties that some buyers might have.

Keynesians, especially old‐style hardliners, are dismissive of concerns about deficits. They are pretty harmless; besides, they may mostly be transitory.

This standard Keynesian position is put by Krugman (2009):

In this picture savings plus taxes equal investment plus government spending, the accounting identity that both Fama and Cochrane think vitiates fiscal policy — but it doesn’t. An increase in G doesn’t reduce I one for one, it increases GDP, which leads to higher S and T.

This sounds too good to be true15, and there is a catch. The increase in G is soon self‐funding as shown above, but there is still the matter of covering the cyclical deficit created by the slump itself. For this, there will need to be subsequent booms to generate cyclical fiscal windfalls. However the fiscal stimulus does fund itself, so a large part of the total (global) debt should soon disappear.16 This comforting conclusion also stems from the key assumption that investment is autonomous, unaffected by the higher G. There is neither crowding out nor crowding in (the latter referring to how infrastructure spending may Buiter (2009) argues that the US and the UK lack fiscal credibility already.

Ergas (2009) dismisses this as nonsense on stilts, but provides no reasoning, except perhaps the idea that government spending is wasting resources that were going to be put to a better use soon anyway.

16 The extra saving and taxation generated in the restoration of GDP to trend recoups either the new structural (the stimulus) component of the deficit or the existing cyclical (automatic stabilisation) component of the deficit, but not both. To repay both, you need a boom (or a few smaller booms) as big as the current slump, and in practice this could take a decade of fiscal discipline or rather more to claw back. But a big chunk (half) of the deficit would quickly be self-funding.

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promote investment or that successful pump‐priming can restore investor confidence).

Crowding out requires separate attention.

Problems multiplying

If fiscal stimulus is regarded as necessary, is greater government spending better than tax cuts? Is government spending is likely in practice to deliver the stimulus promised? Even if governments invest in infrastructure rather than promote consumption, will total spending, output and employment respond as hoped?

Two concerns about the efficacy of fiscal policy relate to the size of the fiscal multiplier for government spending. First, crowding out reduces the stimulus resulting from the injection if the extra government spending literally took resources away from imminent use by the private sector. The second concern is that the multiplier depends on the size of induced consumption. If people earn more income from a government project, how much will they spend on consumption?

1. Crowding out

When resources are in tight supply, as they may be in some sectors of the economy at any time, multipliers are low and demand stimulus there is inappropriate anyway. Empirical studies on fiscal policy tell us little if data is collected at all phases of the cycle and cases where the timing and size of stimulus were faulty are included. What we would like to know is the size of the multiplier in slumps when fiscal policy is clearly warranted.

Keynesians note that a possible advantage of government spending is that it can also be directed to industries and to regions most affected by the downturn in total spending.

Crowding out is not an issue where resources are patently idle. But conservative classical economists challenge this rationale too on the grounds that important structural distortions occur in practice regardless of the form of government spending.

Basic Keynesian models do assume that labour and capital are homogeneous aggregates, so the model discounts the very possibility of supply bottlenecks. If unemployment is widespread and substantial, an elastic supply response is reasonable. Keynesians are rather blasé about micro‐structural concerns and they regard these constraints as small enough to ignore in practice. (We return to this later.)

But domestic multipliers would be higher, if expenditure programs are properly targeted towards industries with idle capacity and with a substantial contribution of domestic inputs.

And they would be if fiscal policy was conducted in a professional manner instead of being improvised in desperate haste. But even this feature of skilled fiscal policy‐making has its critics (the usual suspects).

Becker (2009) provides an argument against the specifics of the Obama package, and he maintains that crowding out occurs in many cases. The supply of already scarce health care workers cannot much respond to increases in government spending on health.

This same conclusion applies to spending on expanding broadband, to make the energy used greener, to encourage new technologies and more research, and to improve teaching.

If Becker is right, the fiscal stimulus will be weak. This is an empirical question and a matter of degree. But one may concede that in a modern world fiscal stimulus is trickier than in the 1930s. Back then, unemployed ship builders could switch from cargo ships to battle ships. In the 1930s, one could replace the private demand for steel with government demand (Hoover dam, battleships). Today, governments cannot really buy coal and iron ore to make up for the missing exports to China and Japan. Although there also was a financial crisis in the 1930s, I doubt that standard Keynesian remedies are as fully applicable today.

A more obstinate objection to fiscal stimulus is provided by John Huizinga, Robert Lucas and Kevin Murphy (2009). Don’t hire construction workers who formerly worked in the over‐sized housing industry. Let them exit the construction industry instead. Markets are telling them to exit.

But are markets sending true signals? Axel Leijonhufvud (1968) stressed that a lack of effective demand falsely signals agents that purchasers don’t want their products. They do, but if there is involuntary unemployment and a contraction of spending, these signals are perverse and false. When markets go haywire, false signals spew out. Markets mal‐ coordinate when disturbed by shocks that are too large quickly to absorb or neutralise. If demand is restored, true signals are restored too. Macrostructural shocks may require fiscal stimulus so that the resources rendered idle will more smoothly find a new use elsewhere.

The upshot is that Chicago economics brazenly says that greater government spending should not occur in industries either facing labour shortages or experiencing substantial unemployment.

Aggregate demand shocks in reality are not spread remotely evenly across the affected sectors. The income elasticity of demand differs between products, and things that are less necessary (buying new durables, dining out, buying flowers etc.) will be cut disproportionately. There is always a seemingly structural impact.

The dispute centres on the weight placed on macro‐aggregates versus efficient micro‐ allocation. Is total employment the primary target total or is getting the right composition of employment more important? Keynes (1936, ch. 24) felt that markets did a good enough job with the latter, but it is impossible in practice to alter total employment without for a time affecting the composition.

Keynesians would concede that there is sometimes a vague line between structurally targeted stimulus and outright bail‐outs. Economists are not fans of propping up industries that merely have political lobbying power. Why support dying industries, or ones with chronic global oversupply? Even if one rejects industry supports, a general environment of fiscal stimulus is conducive to transition.17 Structural adjustment only occurs if there is an effective excess demand for the goods that will replace the old. Phase‐out is better than bail‐ out. Employment levels are governed both by jobs being created and jobs being saved.

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This is another extension of the economics of Leijonhufvud.

The strength of induced consumption

The standard Keynesian story is that households fairly reliably spend the bulk of extra income earned. A worker employed to build a road will buy groceries. The retail sector will obtain more revenue and the fiscal stimulus will ripple through the economy.

And if the worker mostly bought imports, the expenditure would son leak out of the domestic expenditure flow. Just as bad, diverse and widespread anxieties would encourage saving rather than consumption, possibly the hoarding of funds in mattresses.

Since the 1930s, consumption patterns have changed. Nowadays much spending is discretionary, and it is driven by peer pressure and status rather than by physical need.

Consumer durables are more important, and these can be deferred. Provided funds are targeted to the cash‐constrained, the marginal propensity to spend is likely still to be high. In the 1930s one could rely on the many desperate, liquidity‐constrained people spending extra income on necessities. If people were hungry, you know that they would buy food most of which would be produced locally.

Standard Keynesian models warn us that open economy multipliers may be much smaller than the closed economy multiplier, especially as the domestic marginal propensity to import may be high (plasma TVs, mobile phones, computers etc.).

So far as the potential power of fiscal stimulus is concerned, what is the multiplier likely to be during a global slump? The globe is a closed economy. There is no leakage of imports, so the global multiplier will exceed the multiplier of an average individual nation. If all governments apply stimulus, what leaks out from Australia is on average matched by foreign stimulus that is injected here. Talk of multipliers being small18 and usually lying between 0.6 and 1 only indicates the scale of our profession’s misunderstanding. If there is concerted stimulus, will econometricians attribute extra exports from A to the fiscal expansion of B?

In the case of a global slump and a global stimulus, the import leakage would cease to be an issue, of course, though, if fiscal stimulus is practices unevenly, import leakages will be an issue in some countries. This is one reason why the US is lobbying the EU to increase fiscal stimulus, but, under the guise of fiscal prudence, the Europeans are practising beggar‐thy‐ neighbour policies and hoping to free ride on the American stimulus to global spending.

Say again?

According to John Cochrane (Chicago) during the Economist’s web debate: Robert Barro's Ricardian equivalence [RE] theorem was one nail in the coffin. This theorem says that stimulus [via lump‐sum tax cuts, strictly speaking] cannot work because people know their taxes must rise in the future.

“The” multiplier as measured by econometricians is often a sludge average of untargeted policies across the cycle commonly initiated for purposes unrelated to macro-stimulus You may need to watch whether they strip out the effects of money-financed G and call it monetary policy.

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Tony Makin (2009b) also takes this argument seriously. Many do not. If people are not spending much of their cash payments, higher precautionary saving (including debt repayments) would be a more likely explanation.

The point of RE is that forward‐looking people won’t spend a tax‐cut if they believe that it will later be reversed and the funds returned (with interest) to repay the fiscal debt. Few outside Chicago are convinced that RE is much relevant to reality, today or ever. Are people so forward looking and well‐informed? Liquidity constraints and involuntary unemployment are possible, and people thus affected will spend on the basis of their frustrated pent‐up demand. But New Classical Economics (its modern mantle is equilibrium real business cycle theory) assumes that markets optimise.

One wonders whether Barro is aware of Say’s Law and any sense in which he relies on it.

Continuous market clearing is a long way from Say who wrote about derangements, distortions and dislocations of supply. About all they share is a willingness to blame governments for shortcomings in market performance. The history of economic thought, classical or Keynesian is not Barro’s strongpoint. Ricardo himself rejected Ricardian Equivalence, according to O’Driscoll (1997) 19.

Say’s Law points to the powerful insight that economic exchange is precisely that: exchange.

All parties to the exchange needs to supply a good or service wanted by the other(s).

Production involves a complex series of exchanges through time. But often more is read into this insight than is warranted. In particular, there are recurring fallacies that refuse to die.

Stakes in hand yet again, let us attend to each of these ever‐resurrecting vampires.

Fallacy 1: “Markets cannot fail. Unemployment is caused by resource owners being unwilling to accept the market clearing price. It is voluntary in the sense of being the result of our own free choices. Governments spending money they have printed do not supply anything in return for what they buy. Governments that instead borrow money repay by printing money or taking money from taxpayers. Rational buyers won’t give up something for nothing.”

Rebuttal:

In a deep slump, a wide and complicated network of financial connections has been disrupted or destroyed. Money flows required for debt repayments and purchases of inputs and outputs contract. Isolated individuals cannot repair a network of coordination across space and time. They can only reconfigure the system slowly, one pair of connections at a time. By contrast, a government can take a system‐wide viewpoint and inject funds widely to restore viable connections simultaneously across the economy. Governments can supply coordination and clarity. Printing and distributing money is supplying a valuable service.

Cutting your price in terms of money does not re‐activate trade. Choosing to offer your labour at too high a wage or choosing to supply output at too high a price are not what 19

But see Barro (1996) for his earnest attempt to deflect O’Driscoll (1977). Barro’s ignorance of Keynesian texts (and certainly his lack of intuitive understanding of them) is rather clearer. He claims that Keynes stressed wage-andprice inflexibility as crucial to obtaining his results. But see Keynes (1936, ch. 2, ch. 19). Alas, Barro writes textbooks.

frustrates market exchange during a macroeconomic slump. New classical economists simply do not grasp how unemployment can be involuntary. Many classical economists cannot grasp that the “real balance effect”20 upon which some misapplications of Say’s Law ultimately depend, has no role in a real‐world monetary economy.

Spending raises output

All economists know that in reality an increase in the money supply raises output, at least over the short period. The quantity theory is a long‐term theory. In the short term, quantities respond and the economy reflates. During a typical market slump (one caused by a sudden decline in private‐sector spending), upward pressure on prices is weak to non‐ existent.

Demand is someone with money spending it. Even those who claim to uphold Say’s Law know that higher demand elicits an increase in the quantity supplied. Elementary microeconomics shows this: D right leads to increase in p and q. In the case of an increase in total spending, demand curves for each normal good would shift to the right.

(For simplicity keep the nominal price of inputs and technology constant so that the MC line is unchanged throughout.)

Suppose there is an increase in demand caused by a fiscal injection calculated to return total demand to normal. This means that the positions of the demand curve of each good on average returns to normal21.

In the case of a broadly based stimulus, spending is widely spread across the economy. A firm neither knows nor cares where the money (its extra revenue) came from. It may have come from overdrafts or by dishoarding. It may have been newly printed and dropped by a helicopter, or as payment to workers and firms to build a road. It could be a tax rebate or a gift to households from the government. It does not matter much what the source of demand is. The factors of production were happy to produce this output before in normal times and at the then prevailing normal nominal price. The demand curve returns to normal, and p and q of each typical firm returns to normal. And the factors of production will find that their real remuneration will return to normal.

For recovery, the supply curve does not need to shift to the right for the fiscal stimulus to succeed. Improving incentives by cutting tax rates, freeing up labour markets, providing more infrastructure and so on are simply not required for output to rise towards a higher sustainable level.

Even unproductive consumption spending raises short‐term income and promotes restoration of normal or trend GDP. Simply dropping money from a helicopter may have a This is the idea, long ago discredited, that deflation will raise the real purchasing power of money. As prices and wages approach zero, purchasing power approaches infinity. Of course, as the price level collapses, so does the economy, politics and social structures in general. Mathematical “economists” are routinely blind to this.

21 It is not possible for centralised expenditure to replicate an outcome for each demand curve exactly the same as the outcome resulting from a restoration of confidence by the private sector. Austrians bemoan the ruinous distortions that are claimed to result, but “near enough is good enough” in an emergency for us Keynesians. An urgent life-saving operation may leave an unsightly scar. That’s a pity, but the patient ought to be grateful considering the alternative.

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similar effect, but it helps if the money drops are targeted in a way that those who pick the money up are likely soon to spend it. Greater spending raises output regardless of the type of spending.

This is equivalent to Friedman’s (1969, p.4) famous helicopter example, if it is newly created rather than borrowed money.

http://www.ronpaulforums.com/showthread.php?p=1780466

Friedman regarded any increase in the money supply as essentially monetary policy, even if it was delivered by fiscal means, such as a tax cut, government spending or a cash payment.

Friedman clearly was a demand‐side economist; it’s just that he argued that governments in practice were unable to fine‐tune total spending and should not pretend that they could.

This means that other economists, who reject demand‐side economics root and branch, do not always agree with Friedman.

In Friedman it does not matter much how the new money entered the economy. In Keynesian economics, it does matter whether the injection occurs in the expenditure stream (fiscal policy by their definition) or in the financial sector (monetary policy). Keynesians often regard easier monetary policy via open market operations (where the central bank buys bonds) as less reliable in slumps. Funds may sit in financial portfolios and not reach the expenditure stream in a predictable or timely manner. Consumers spend most of a tax cut or

an increase in transfer payments, and all government spending by definition is injected into the circular flow of income.

Friedman and the Keynesians agree that it does not matter at first that at the point of initial demand stimulus the government supplied nothing more than money22. Demand drives output over the short term. There is the same response if the recovery had instead resulted from a restoration of willingness to spend by the private sector through dishoarding (or by bank overdraft).

Suppose that the government has the will and expertise to follow Keynesian teaching during the entire business cycle. When the confidence of the private‐sector recovers sooner or later during a robust recovery phase, the government extracts as much as is required of the new money it created or injected in its stimulus package (road building perhaps).

All that is then left behind is a new road, and better a road that currently leads nowhere than no road at all. And it will probably lead somewhere one day. There is no more of a “distortion” in allocation than if a natural event made transport easier than before. A road that is built, or a river that is navigable, is there to be used. A road that is built is largely a sunk cost. There is no opportunity cost if all the cost is sunk. If the choice is between a road to nowhere and no output at all, the former involves greater aggregate economic wealth. If resources later are attracted to the river, there is no market “distortion”. If resources are attracted to a road, likewise there is no distortion in allocation.

Fallacy 2: “Government spending cannot raise employment because government borrowing reduces private spending.” (e.g., John Cochrane, University of Chicago)

Partial Rebuttal:

This is simply the notorious British “Treasury view” of the 1920s and 1930s. The claim is that public spending fully crowds out private spending, or the multiplier is zero. The rejoinder that seemed obvious at the time is that idle money (or unused lines of bank and trade credit) exists in a general business slump because nobody in the private sector is willing to borrow it to buy new investment goods23. The seemingly simple solution is for the government to borrow this idle money (or even print new money) and place orders for capital infrastructure. This breaks the vicious cycle that the market economy had stumbled into.

Old-style Keynesians tended not to care much whether this money was newly printed or borrowed from the holdings (hoards) of wealth holders.

23 There is a long, largely forgotten, theoretical debate about why those with excess cash will not lend it at a rate of interest low enough for the borrower to accept. In the real world, we know that Keynes was right. A loss of spending confidence by households (a decline in consumption) does not, over any reasonably short time frame, raise the supply of saving and sufficiently reduce the rate of interest on loans for investment projects by firms. If anything, a sudden increase in saving is associated with business pessimism and a decline in investment. The possible long-term connection between saving by households and investing by firms is a separate issue, and it is not directly relevant to short-term demand management (according to Keynesians).

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People don’t seem to realise that in the Treasury View even a contractionary policy would not contract. When it comes the time to raise taxes to repay the fiscal debt, nothing unpleasant happens.

Tax cuts During February 2009, we all viewed a political pantomime when discussions shifted to discussions about the size and mix of the urgently proposed stimulus package. The “debate” in February frequently converged to the proposition that productive infrastructure would be ideal stimulus. Next best would be tax cuts. The Federal government does not have projects ready to go, so the lead times (part of the inside lag, as macroeconomists say) are impracticably long. (See a later section for an exploration of this point.)

Attention now turns to whether lump‐sum transfer payments to households (reverse‐flow taxes) would be more effective in imparting fast and large fiscal thrust than cuts in the rate of taxation on household and corporate income, the third way tax cuts could provide stimulus.

The Coalition appeared to argue that the fiscal stimulus should have been about half the size and delivered by cuts in tax rates rather than by cash payments. Parliamentary debate and concurrent commentary related to the following question:

Which provides greater fiscal stimulus?

1. A cash payment of $950 this year. (Labor) 2. An unspecified ongoing cut in the marginal tax rate, but one unlikely to result in a tax cut of about $500 in any one year so that this year’s deficit increase won’t be as large. (Coalition)

This is a rather vague question, but people confidently answered it. How on earth does one compare a single once‐off cash payment with an ongoing cut in marginal tax rates?

Attention came to centre on the difference between temporary and more permanent stimulus. John Taylor and Milton Friedman were enlisted by the Opposition in support of the claim that cutting tax rates was more “permanent” than a “once‐off” windfall. Thus tax cuts would yield a greater stimulus, according to the permanent income hypothesis.

Friedman argued that fiscal policy was uselessly weak as a tool of counter‐cyclical demand management. A tax cut in a slump will be removed later when the economy fully recovers24.

The restoration of normal capacity utilisation would normally take a year or two, or more.

Such tax cuts are temporary in Friedman’s system. At best we are arguing about whether a temporary cut is much stronger than a very temporary (once‐off) cut.

If the Coalition advocated cuts that would only last for a year or two, Friedman would have rejected their proposal – and so would John Taylor.

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I don’t recall Friedman going further and saying that it was important that it would be reversed in the next boom.

Friedman’s agents are not as super-rational and forward-looking as in New Classicism.

According to John Taylor in an interview with Fran Kelly on RN, one should reduce the tax rates for “a while”. Perhaps this time span is measured with … a piece of string. In the Wall Street Journal, Taylor (2008) advocates enacting tax cuts that last for more than just a year or two. This is consistent with the medium to long‐term focus he places on fiscal policy in his textbook. This strategy only makes sense if tax rates were too high in the trend sense to begin with. It’s not obvious that it’s good short‐term management to commit credibly to hold tax rates low for too long so that people will regard them as “permanent” and spend them. Perhaps Taylor believes that tax rates drift up too high and that recessions are politically advantageous times to cut them back to where they should be. Alternatively, perhaps the financial crisis has been so destructive that incentives to produce need to be increased for several years while potential supply heals and the effects of the negative shocks to financial technology have faded.

A better defined question is this: Which provides greater fiscal stimulus?

1. A quick once-off cash payment of $950 this year 2. A once-off cut in the marginal rate resulting in a taxcut of $950 spread over the year Answer: The spending stimuli are the same over the entire year. If speed of injection matters, option 1 hits the expenditure stream quicker, and this would probably trump the small additional supply-side stimulus offered by 2.

To sensibly answer questions like these, you need to frame the options properly.

1. You must have definite alternatives regarding both size and duration.

2. You must compare a series of single payments with an extended tax‐cut of the same size

Which provides greater fiscal stimulus?

1. Cash payments of $X in a year repeated for as long as required 2. An equivalent cut of $X in a year via a cut in the marginal rate that applies for as long as required Answer: About the same? Option 1 is more flexible in timing and delivery. But option 2 has the added supply-side effect.

Lump‐sum rebates were argued by the government to be quicker means to put cash into people’s hands and better able to be targeted to those who would spend it quickly.

First, there is speed of delivery and impact. A quick burst of ammunition may obviate the need to use more up later, and those concerned about fiscal deficits quickly worry that the

ammunition is running out. But we may have confused haste with speed, if the stimulus is crudely delivered and poorly targeted. Those most in need of support should already have been identified and protocols in place for the delivery of these funds. We should be permanently prepared to deal with sudden emergencies.

Second, there are fewer people today who are cash constrained and desperate to buy necessities. One must concede that the Australian cash‐payment packages have been poorly targeted. For example, I shall receive the second payment in April (as a result of the February decision), and my marginal propensity to consume is zero. But (relatively) affluent academic economists should not extrapolate from their own experience and dismiss the payout as mere pocket money (c.f. Makin 2009b).

It is commonly estimated that up to 80% of the government's first (December 2008) stimulus package in of $10.4 billion had been saved and not spent, which makes the fiscal transfer payment multiplier small. If the funds were used to repay credit card debt and rebuild buffers (repair balance sheets), then the resilience of future spending is enhanced. People may be saving on precautionary grounds, so that they can spend if conditions worsen. If the slump turns out to be lengthy, then these funds will still handily dribble from saving into the expenditure stream.

One idea to get more bangs for the fiscal buck is a debit card that could only be used in retail outlets over a brief time span to supposedly ensure 100% of government stimulus dollars are spent rather than saved.25 Similar is the US proposal, Barnett (2009) to give children vouchers to buy toys and games. And Makin (2009b) makes the same point about payment’s to fund children’s consumption, though with heavy irony.

At this point (and probably much earlier), you would be thinking that there must be better ways to inject stimulus. Had we been better prepared, there certainly would be. I know of nobody (retailers aside) who would not prefer to target fiscal stimulus to infrastructure. But time may be of the essence.

Government spending

Government spending (G) is claimed to have some advantages over taxes in affecting total spending. But there are drawbacks too. An obvious point is that altering G has long lead times and this may make G unsuitable as a countercyclical instrument. Few projects are soon “shovel‐ready”. The first subsection will look at how the implementation lag, part of the so‐ called inside lag26, may be reduced.

Reducing the inside lag

State governments already have infrastructure projects in the pipeline. Why not accelerate these and provide federal funds? The standard Keynesian policy is to spend on infrastructure during slumps, which is precisely when this sector is disproportionately affected. This policy 25

AAP (2009) The inside lag includes the time taken to recognise the problem, decide what to do and then actually do it. The outside lag refers to how long it takes for these actions to have the bulk of their multiplier impact.

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puts idle skilled labour to good use, saves households from unemployment and protects the private‐sector’s balance sheet. The State government stands as a body shield between households and the global financial crisis.

By contrast the State Opposition prior to the recent election (it lost) had promised to balance the budget by the end of its first term (even though the global slump is likely to persist for the next few years). This is the fiscal equivalent of the army opening fire on its own citizens. It took Hayek decades to recover his credibility and prestige after being almost alone among leading economists of advocating balanced budgets and rejecting easy monetary policy in the 1930s. He is favourably remembered today mostly for other contributions.

The States’ emergency borrowing required to sustain or increase infrastructure spending could be done by or backed by the Commonwealth, which would help protect the credit ratings of the States27. Again we have been caught with our trousers down28, and despite many months to prepare and debate contingency plans, the government and the Treasury have done little to prepare for direct and predictable impacts on the fiscal positions of the States. There may be rational concerns about the efficiency with which the States invest in infrastructure, but is the problem that Federal politicians want the kudos and are unwilling to fund State projects?

Idle thoughts

If the dispute is to be resolved about the potential value of counter‐cyclical demand management by fiscal policy, then isolating the source, if there is just one, of the disagreement would be helpful. If we have learned anything from the debates so far, there is a consistent source of disagreement between classical economics and Keynesian economics.

Classical theory emphasises efficient resource allocation and a flexible micro‐structure.

According to the Keynesian view, this emphasis is fine if the economy is operating at target capacity (full employment, for simplicity). But if resources and money initially are idle, then completely different dynamics come into operation and a completely different analytical framework is needed. Stories that are valid at full employment become dangerously wrong outside this domain.

We have already explored the issue of idle resources, what about the issue of idle money?

This draws us to consider rival views about how the financial sector works and the importance of the healthy operation of the financial sector to the effective operation of the real (goods and services) sector. The global financial crisis has forced us to revisit debates of the 1930s about saving, financial wealth and investment in real production capacity.

The Austrian View

The sharpest and most potentially instructive contrasts with Keynesian reasoning stems from the Austrian school of classical economics. Financial markets work well if governments See AFR, Monday March 2, 2009, p.1.

I can only treat with disdain the observation that this condition is ideal when urgent stimulus is needed. Metaphors break down.

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leave them alone. Tinkering with the money supply and interest rates distort the size and composition of investment and exacerbate cycles instead of reducing them as intended.

The financial sector leads the way. When it is allowed to work properly, the real sector then produces the right size and mix of output. Saved funds return to the real economy as productive investment in due course after an efficient linking and networking of financial flows through space and time. Keynesians are wrong to regard these funds as “idle” and ripe for borrowing. Whether circulating around the financial system or sitting in a short‐term savings vehicle, these funds are busily linking present saving to future consumption. Just as investment is roundabout, so is finance.

The Keynesian view

The Keynesians see the economy in terms of aggregates. A rising tide raises all boats. Of course, a rising tide does not raise the seaworthiness of any of the boats. Neither does it raise the skills of any of their crew, but these faults at the micro‐level are not the central concern of Keynesians. The Keynesians tend to regard simple hydraulic metaphors as representing simple attributes worthy of modelling. Economies as a whole can be pumped up and they can be contracted.

The Keynesian approach to financial markets is also macro: a rising financial tide raises all assets. The fine microstructure of financial markets is no more crucial than the fine microstructure of the real economy. Indeed, financial markets are often more speculative and unruly than product markets and price outcomes are less likely to be grounded in objectively verifiable conditions or in stable conventions. The value of both real assets (gold, art, antiques) as well as the value of financial assets (bonds, derivatives, shares) can vary with shifts in market sentiment. The stock of savings can be regarded a pool, though it need not be flat and quiescent. During a slump, funds may be siphoned by government borrowings and returned to the circular flow of income. Prosperity increases the pool of savings: as income rises, replenishing funds flow back into the pool of saving.

At very low interest rates it may be that the only buyer of long securities is the government, and they are paying high prices by historical standards. Instead of spending or on‐lending these funds, wealth owners speculate that interest rates can only go up. They will wait accordingly for bond prices to fall and re‐purchase the bonds they have just sold to the central bank. This is the “liquidity trap.” Open market operations cease to be effective. But this is the very case where bond sales to fund fiscal stimulus should be easier.

The early Keynesian vision was of wealthy, do‐nothing, coupon‐clipping rentiers being rewarded merely for “waiting”. Siphoning funds from them can do no harm to production; indeed, their gradual and automatic “euthanasia” in a maturing economy is something to look forward to.

Keynesians often speak of idle money as the counterpart of idle resources. They argue that fiscal policy can impart stimulus if monetary policy cannot. Idle savings can be borrowed and re‐injected into the circular flow. If funding extra government outlays by printing new money is unacceptable, the necessary funds can be borrowed.

Anti‐Keynesians retort that funds in reality are seldom idle or unproductive. While brief periods of hoarding are possible, saved funds generally are put to work to earn a return, and real returns can be sustained only by increases in real productivity. If someone puts money in the bank to save up for a holiday, these funds are used by someone else in the meantime.

The complex tendrils of asset and finance markets are too opaque and delicately structured to allow heavy macro‐interventions, especially in the form of lorry loads of broadly homogeneous government paper being dumped in one part of the system.

The Keynesian use of the term, “idle”, has probably misled many people, including some Keynesians. Money held as wealth in the financial sector may be whizzing around from one financial market to the next. Money can be “hot” and energetic or it can instead sit in cold storage in a term deposit. The asset velocity of money may be extremely high, but its income velocity may be low. Funds churned furiously do not lead to the generation of currently produced goods and services. Asset prices (house prices, share prices) rise, but the production of new houses and new factories lags, or never eventuates. Asset bubbles lack real substance: there is a serious disconnect between financial markets and the real economy. Keynesians believe that this circuit of funds from savers to investors is slow, weak and unreliable. If you have studied first‐year economics, this is why investment is autonomous (and not connected to saving), at least in the short run. Asset markets are not efficient in most renditions of Keynes29.

One has to admit that Keynesians have unwisely dismissed the possible intricacies of financial network. The Keynesian assumption that the financial sector can adapt rapidly to digest large volumes of government bonds should have been subjected to more critical scrutiny. Funds may not simply be there to be easily siphoned off. What Keynesians regard as mere liposuction of surplus fat, Austrians regard as the excision of crucial healthy tissue.

Meeting in the middle?

Let me put words into the mouths of Keynesians in the hope of opening dialogue with the Austrian school. Markets have missed the opportunity of using resources productively while supposedly generating complex optimal solutions to problems of coordination of saving and investment through time. A flow of bridging finance to preserve full employment during the transition has failed to emerge through market forces30. By borrowing money and returning it to the circular flow of income by expansionary fiscal policy, needless unemployment is avoided.

A Keynesian may be justified in arguing that funds once supporting bubbles are better diverted to fund government infrastructure. In the Keynesian world view, funds circulating in “New” Keynesians defend rational expectations and the efficiency of asset markets. In this important respect, they scarcely deserve to be called Keynesians at all.

30 Relying on input and output prices to free-fall would be the Austrian “solution”, but Keynesians would regard this as price overshooting and the spreading and amplification of the market failure as the resulting deflation is likely to generate a perverse market spiral and possible implosion. You are free to disagree, but do acknowledge that the argument is there and deserves to be addressed and not dismissed out of hand. You may regard reasoning or the assumptions that underpin it as fanciful, but do appreciate its internal coherence.

29

the financial sector are not in an elaborate process of an upcoming and triumphant return to the circular flow of income. Savers have put funds in liquid form because they are uncertain.

They do knot know what they want to buy or when they want it. Entrepreneurship is about animal spirits, not the accurate semi‐clairvoyant guessing of what consumers in future will want to buy. If anything, saving sends a false signal to investors and firms. Higher saving signals to sellers that purchasers do not want the product. It is unlikely that any sensible firm would interpret low consumption today as expressing the desire for more consumption tomorrow31. Quite the contrary would likely be the case. Indeed, if we are referring to short‐ term fluctuations, sudden changes in consumer sentiment will be associated, if anything, with a decline in investment. Even classical economists must know this basic fact.32 The effect on trend investment of a gradual and sustained increase in the rate of saving is a different issue.

Both the Austrian and the Keynesian positions are perfectly intelligible and each may be valid in a particular time or place. These judgements are central to the art of economics.

Keynes’s point was that the stock of saving is very large, and some of the money now churned in the financial sector can be borrowed and spent on G without significantly reducing the ability of private investors to obtain funds for real investment. You can agree or disagree, but the point is whether you understand what economists are disagreeing about.

Fiscal Policy Rules, OK?

Suppose the preceding lengthy discussion lends weight to the proposition that, in principle, fiscal policy could work. The next question is how to make it work better in practice. What follows is an outline of fiscal reform33 .

We could have a set of fiscal policy rules appropriate for a) financial disruptions, b) short‐ term demand management and c) long‐term stability. These rules would be pre‐announced and be implemented independently of politicians. Politicians would need to approve of these rules or the process by which these rules are decided.

a) In an asset boom of 10%, raise capital gains taxes by y% as a pre‐emptive strike against bubbles.

In a crisis, move spending projects X, Y and Z forwards.

In a crisis, make emergency payments prioritising persons in the following categories…

b) In a boom (slump) of 1%, raise (cut) direct taxes by x%.

In a boom (slump) of 2%, raise (cut) the GST by x% for 6 months only34 This view stems from the early pages of chapter 16 of The General Theory, and forms part of Axel Leijonhufvud’s interpretation of Keynes (Appendix 1).

32 They may interpret it differently though: wise investors overlook short-term noise. If thrift turns out to be sustained, there will be a lag before an excess supply for consumption results in the excess demand for investment becoming realised in the form of extra output of investment goods. This argument concerning logistic lags in structural readjustment features surprisingly little in debates over the coordination of saving and investment.

33 I broadly approve of Henry Ergas’ call for a temporary cut in the GST, an indirect tax. But I would bind GST changes to a rule. See and Taylor (2005, p. 247; 2009, p. 265). However, I do not speak for Taylor at all. An alternative would be to raise the GST threshold.

31

In a slump (boom), move projects A and Z forwards (back).

c) Over the longer term, aim for a balanced budget (on average the structural balance should be zero) or some small deficit if long‐term infrastructure is debt‐funded.

In this way, fiscal responses in response to actual and potential crises become assertive, agile and alert. Crisis management should be triple A. These rules are quite predictable in their mode of implementation, but flexibility is preserved. Additionally, short‐term stabilisation is enhanced as timely interventions in the face of crises and bubbles would reduce the amplitude of fluctuations, and longer‐term fiscal settings are not compromised.

During routine fluctuations, the TTT (temporary, targeted, timely) principles would apply.

The rationale of targeting expenditures and tax cuts, “more bangs for the buck”, is intended to provide a quick injection, especially so that those with little can at least keep most of what the have. Even if not large, an early stimulus may pre‐empt a social hardship.

Targeting would also pertain to industries and regions selected either for alleviation of distress, availability of idle resources or for longer‐term development.

Over the longer term PPP (permanent, pervasive, predictable) apply. Overall, the strategy is “ATP”: the As apply if urgent action is needed, the Ts typify short‐term management, and the Ps provide long‐term protocols. The point is to get G* and t*, the trend values of G and the trend marginal tax rate (scale), correct in the light of the provision of public goods and the achievement of other long‐term social goals. Over the short term, automatic stabilisation can be used as well as an active rule to manipulate structural deficits. If monetary policy is used in tandem, these structural changes are likely to be relatively small.

Even the champion of activist monetary policy, John Taylor, sees scope for fiscal easing now.

Taylor’s fiscal orientation is conservative. Rely on automatic stabilisation to limit the downturn and cut tax rates to improve the longer‐term recovery of trend growth as aggregate supply reconfigures. So he rejects the principles underpinning recent short‐term stabilisation packages, TTT (temporary, targeted, timely), in favour of a longer‐term approach based on PPP (permanent, pervasive, predictable).

Remarkably, conservative economists have advocated policies that would take several years to have an effect. This may be based on their suspicion of the efficacy of short‐term “sugar‐ hit” outlays based on cash handouts and ad hoc expenditures. Cuts in marginal tax rates are popular – e.g., Kates35, Makin. The IMF has even suggested increasing the retirement age, presumably to make it easier for governments later to collect enough taxes to unwind their fiscal deficits; see Uren (2009). These policies don’t make much sense in the current context, except so far as now is as good a time as any to get long‐term settings right. By contrast, in the ATP approach, PPP would be the long‐term criteria, and TTT would inform short‐term stabilisation.

Payments to the States could be averaged over the cycle, or, better, extra revenue raised in booms would be passed to the States in slumps.

35 Even Kates is friendly to tax cuts (supply-side fiscal action), but he presumably would still strive to balance the budget.

34

The ATP approach in summary:

Short‐term crisis responses Short‐term stabilisation Longer‐term strategy

AAA TTT PPP

Assertive, agile and alert.

Temporary, targeted, timely Permanent, pervasive, predictable

Brad DeLong (2006) argued that it may be time for a fiscal stabilisation board made up of “thoughtful, public spirited technocrats” like those on the Board of the Fed. He trusted that they would expand deficits only for non‐political reasons. He provided no details36.

Conclusions

This paper strives to make clear what Keynesians and classicists are assuming, in many cases tacitly. In principle, there is a legitimate domain for each body of thought. Truth cannot contradict truth (as JP2 said in 1996). The choice may appear bleak. Keynesians are highhanded about the structural consequences of their policies whereas classical economists are paranoid about “distortions” and sanguine about unleashing free‐market dynamics.

Weeding out the inefficient is one thing, but blanket defoliation is another.

But we need to talk about the real analytical source of the disagreement. Can money be idle in the sense that it is missing from more valuable use the circular flow of income? Can resources be really idle rather than just appearing to be so in a way that misleads a Keynesian into thinking there is some market failure. Both sides can agree that is true that each individual puts resources to what is judged by them as most valuable in the light of the constraints imposed on them by the decisions of other individuals. But to assume that whatever markets generate must be the best outcome or trajectory, assumes away the conditions that underpin any intervention designed to achieve better outcomes for individuals by collective coordination. If market coordination is assumed to be as good as humanly possible, clearly government actions are counter‐productive. But the conclusions are contained in the assumptions. They are a re‐wording of the assumptions.

The debate reminds me of the dead end reached in debates with creationists. What is evidence of evolution to one side is simply interpreted in the light of a large set of preconceived ideas that form a mutually supporting structure resistant to analysis one issue at a time. These ideas lie outside the subject matter in focus: they are not talking about rocks and fossils; they are talking about sexual morality and countless other things that they regard as axiomatically linked. In macroeconomics, we seem trapped in the same pit. It is neither obviously true nor obviously false that money is “idle” in slumps and can be borrowed with or without much concern about side‐effects now or later. This is a research topic to explore, not one to decide by edict as a core assumption.

36

Anon. (2006) also raises some practical objections.

It is rationally harder to believe that resources are not really idle when they observably are.

Of course, there will always be some solution if you let individuals sort things out. There is no reason to think that this must be the best feasible solution. Coordinated action is a technology taps into mutually beneficial exchange that require simultaneous actions among agents. (I can invest if you buy my output. I can buy your output if a third part hires me. The third part hires me if an investment order comes through.) Government pump‐priming may permit these reconfigurations to occur more rapidly than they (or different ones) would have done otherwise. The ability to make rapid reconnections in the face of a network crisis may a boon, not an impediment. There is no reason to believe that systems respond to large shocks as they do to small ones every day. Why selling apples on a street corner (an example from Lucas) or mining for gold (Rueff) is more efficient than holding a shovel and building a road is simply not obvious.

But how big is big shock? How much idle capacity does there need to be to justify action confidently. This is a judgement call and not a doctrinal one.

The debate has mostly reflected a clash of visions. Observers may be able to work out what each side is assuming so that better assessments of the merits of the arguments can be made in the specific context of application. Neither side is going to convince the other. What matters is which crucial members of the audience will be swayed. And some may be aroused enough to explore more deeply what the critical issues truly are.

What is the contemporary relevance of old‐fashioned Keynesianism? The answer depends on the extent to which the problem is caused by, or reflected in, a deficiency of total spending relative to our potential to supply. Clearly, over‐indebtedness was causing some over‐spending (and over‐production) prior to the crisis. We cannot strive to pump AD up to quite the level it was before. We can rationally argue about the relative merits of tax cuts and government spending, but some deep minds may be too narrow to see things differently.

We may reasonably regard the banking crisis as a negative technology shock that has resulted, or is likely to result, in a necessary contraction or slowdown. But markets (financial and real) overshoot, and failure to accept this is the principal failing of equilibrium real business cycle theory. There is the likelihood of an over‐contraction of total spending and production. Pre‐emptive fiscal stimulus may thus be a good idea: a hasty stitch in time may save an elegant nine later. Early stimulus reduces the chance of sliding into the zone of output price deflation. It is prudent to remain in the zone where you have some measure of control.

Though they may disagree on how to proceed, pragmatists now are mostly in charge of policy. Narrow technicians and ideological dogmatists are not.

Even if one accepts Keynes’s relevance for today, what about his relevance tomorrow and beyond? If and when this crisis passes, will Keynesian economics go back into the antique display case?

Politicians and intellectuals talk about the demise of the economics of Mont Pelerin and the extreme free‐market libertarian approach37. But predictions make fools of us all. Hayek had

37

See Hlynur Gestsson (2009) regarding Iceland.

impressed some by predicting the imminent demise of the Soviet Union for about 70 years.

The USSR lasted longer than neoliberalism, Hayek’s fatal conceit.

But only Neoliberalism Mark I may have failed. Predicting a restoration of Keynes may be naïve. What we see is a restoration of pragmatism.

Is recent government policy sincerely Keynesian, or is it desperately improvised just to prop things up? Those with gigantic stakes in the current system will do and say whatever is necessary to protect what they have. Expensive suits may clothe shabby arguments. The Keynes “brand” may merely be there to lend legitimacy to ad hoc interventions. The creation of a civilised social, economic and political framework of a sort envisaged by Maynard Keynes is nowhere in sight. "Liberal society yes, liberal economy no" fits Maynard better.

Dr Bruce Littleboy, School of Economics, University of Queensland b.littleboy@uq.edu.au

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