Following an argument with a friend, who’s persuaded that Paul Krugman’s pro-fiscal stimulus arguments are all based on a sound empirical basis, I did a little brushing up on the debate last night. I’m not only trying to persuade my friend, but I’m trying to get my thoughts about the recession in order for my political economy class this fall. Feedback, particularly correction of errors, is requested, as are answers to my questions (all in bold).
The basic fiscal argument is that fiscal policy works because the private sector has stopped spending and investing (aggregate demand has fallen), and is effectively just sticking the money under their mattress.
The basic monetarist argument is that people don’t put their money under their mattress when they stop spending, but in the bank, so if spending falls, savings rise, which reduce interest rates on borrowing, which increases investment, which ultimately increases spending. In other words, fiscal policy stimulus can’t work because it just diverts money from private spending/investment (I/S) to public I/S. I.e., it crowds out private I/S rather than increasing total I/S.
Krugman argues that stimulus doesn’t crowd out private I/S, but actually crowds in private I/S because of the multiplier effect of public I/S–because every dollar borrowed and spent creates more than one dollar in value, that stimulates further private I/S.
on the contrary, there’s crowding in, because a stronger economy leads to more investment. So fiscal expansion increases future potential, rather than reducing it.
Of course that argument depends upon the assumption that fiscal stimulus actually leads to a stronger economy, which is, in fact the central question–if crowding out occurs, then stimulus won’t lead to a stronger economy. So it’s a bit circular to say that crowding out won’t occur because stimulus creates a stronger economy
Setting that problem aside, let’s assume for the moment that Krugman’s basic argument that fiscal stimulus strengthens the economy, which leads me to the following questions.
1. There’s nothing approaching consensus on the size of the multiplier effect of public I/S. Robert Barro argues, based on a study of WWI, for about 0.8, which would mean stimulus hurts rather than helps. German economist Volker Wieland calls it 0.5-0.6 (although he’s talking about permanent, rather than temporary spending)/. The Obama administration is calling it 1.5, but frankly there are few historical examples of presidential administrations choosing realistic budget numbers (for example, the CBO is normally much less optimistic in their estimates of future than the OMB). Does it make any sense to place much faith in a policy when the experts are in so much disagreement about whether it will have positive effects or not?
2. Even if public I/S is positive, so that it does crowd in private I/S isn’t the crucial comparison between the multiplier effect of marginal public I/S and marginal private I/S? That is, don’t we need to compare the multiplier effect of the next dollar in government spending vs. the dollar in private spending it will (if only temporarily*) displace? On what basis is the assumption made that the public I/S has a higher multiplier effect than the private I/S? Or am I missing something, and that’s not relevant?
3. If that’s all correct, doesn’t it mean Krugman’s crowding-in argument still depends on the basic fiscal belief that people are just “putting their money under the bed?” Because that’s the only way I can see a (presumed) positive multiplier effect from public I/S being, with any certainty, greater than what’s coming from the private sector. Is there any real empirical evidence that during this recession people in fact were just sticking their money under their mattresses, or did it it actually result from a vast disappearance of wealth (albeit paper wealth), effectively reducing the money supply dramatically?
4. Krugman’s argument seems to suffer from a paucity of empiricism because there is such a paucity of historical examples of fiscal policy working. In fact Cowen says there are no such examples. Nevertheless Krugman argues that it’s only because the stimulus was never big enough. Cowen asks whether we really want to take the risk of that much government borrowing/indebtedness based on an unproven theory. Krugman seems sure that’s not a risk. Doesn’t Cowen have the upper hand on this argument? It’s not as though Krugman’s argument is the consensus in the discipline, or anywhere near the consensus–isn’t he asking us to take a huge risk on theory that is historically unproven, that requires assumptions that are strongly disputed, and whose multiplier effects are so wildly uncertain?
Of course it’s necessary to note that Krugman is making this argument specific only to the zero-interest-rate bound. He’s agreed that monetary policy works in normal recessions, but that this recession isn’t normal, with the primary evidence being that we’re up against the zero-interest-rate bound. So in normal times fiscal policy might crowd out investment, but in this particular type of situation it doesn’t because there’s no private borrowing for I/S to be crowded out. Does this save Krugman’s theoretical argument, or is there still a flaw there? If it does save his theoretical argument that fiscal policy works, does it actually prove that fiscal policy works better than monetary policy in that case? (The argument seems to be that monetary policy has no more tools when the zero-interest-rate-bound is hit, but Quantitative Easing seems to me to demonstrate that this is untrue (and see Lucas)–in fact Krugman’s own well-known arguments about the policy effects of creating inflation, or at least inflation fears, seem to me to demonstrate that simply creating more money, which the Fed is effectively able to do, continues to be a viable alternative).
[Addendum: Related question–At the zero-bound, is fiscal policy stimulative with certainty, because “more spending” is necessarily more stimulative than “not more spending”?
*Because even if gov’t I/S ultimately crowds in, the immediate effect of borrowing that dollar has to be that it’s pulled from the private sector.