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

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). 1

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. 4 5

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. 7

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. 8

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. 11

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

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. 14

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.     17

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. 18

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. 20

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). 22

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.

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. 26

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. 27

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

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

References  (for the extended version)

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

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