Clear Thinking in Support of Fiscal Stimulus -- with a Smackdown of Those Who Said It Can't Work

The best way to fix the economy? Conservatives think so.

The first part of this post is lifted in its entirely from a blog post by Oxford economics professor Simon Wren-Lewis, a particular favorite of Paul Krugman:

Well here is Nobel prize winner Robert Lucas:

 But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder -- the guys who work on the bridge -- then it's just a wash. It has no first-starter effect. There's no reason to expect any stimulation. And, in some sense, there's nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge.

And here is John Cochrane, also a professor at Chicago, and someone who has made important academic contributions to macroeconomic thinking:

Before we spend a trillion dollars or so, it's important to understand how it's supposed to work. Spending supported by taxes pretty obviously won't work: If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off.

Both make the same simple error. If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.

This is a completely clear takedown of Robert Lucas and John Cochrane, two economists of the freshwater school, often described as neoclassicists or Real Business Cycle advocates -- as opposed to Keynesians like Krugman and Wren-Lewis. The mistakes ascribed to Lucas and Cochrane do seem like undergraduate-level errors that Wren-Lewis described by saying " I prefer to just note that if any undergraduate or graduate student in the UK wrote this in an exam, they would lose marks." Ouch.

The key here is that the time differential between spending and taxation to pay for it leads to aggregate demand rising. As aggregate demand rises, unemployment falls. As unemployment falls, aggregate demand continues to rise. This is called a multiplier effect, and because of it tax revenues rise, which can pay for the original stimulus or reduce the need for a permanent tax rise. Or it can pay down debt or go towards further stimulus, which then has an additional multiplier effect.

I'm not an economist, so I hope what I just wrote is accurate. It sure makes sense to me.

This is important because those who oppose fiscal stimulus and instead promote fiscal austerity have come to rely on Lucas, Cochrane, and other right-wing ideologues for their rationale. That the rationale is bunk matters, but not to the ideologues who employ it.

It's hard enough getting politicians who are predisposed to fight regulation and actions like fiscal stimulus and infrastructure spending to do the right thing to create more demand and more jobs. When the institutional elite at prestigious schools like Chicago give them cover, we've got our work cut out for us.

Thanks to the Keynesians -- or New Keynesians, if you will -- for fighting the good fight. Paul Krugman goes over this very particular misconception on the right -- some may think he goes over and over and over it to a fault -- mainly because it's the central economic failure of our time, that of failing to use fiscal stimulus, infrastructure spending, and out and out giving away free money to drive down unemployment, especially at a time when we're up against the zero lower bound and interest rates near zero make the cost of government borrowing insanely cheap. What's more, we've got bridges, water systems, highways, railways, and harbors that could sure use some fixing. Why aren't we doing it?

But, as Krugman points out ad nauseum, the Very Serious People think we need to suffer for our profligacy, and so the beatings will continue until morale improves. Or something like that.

All I can say is: good grief!