Monday, November 21, 2011

Four arguments that I don't buy

Paul Krugman has pointed out that a number of fallacies have re-emerged as fresh insights on economic problems in the current political environment.  Four which I find most perplexing and annoying are that (1) the unemployment problem is basically structural, (2) government spending cannot increase aggregate demand and the related contentions that (3) Ricardian equivalence means that government spending through issuing debt cannot increase aggregate demand and that (4) government spending will crowd out private spending/investment.

The idea that the unemployment problem is structural is absurd.  To believe this, we have to assume that somehow 4-5 percent of the labor force has recently become unemployable for all intents and purposes.  This is really crazy.  Reproduced in the graph below is the unemployment rate for full-time workers from the late 1960s until the present.

Somehow we are to look at this and think that, unlike before, the unemployment rate would not easily enough return to, say, five percent if aggregate demand were to return to its prior trend.  Instead, we assume that in the matter of a few years, say 2008 to the present, the labor market has made many workers unemployable.  Now there could be a situation where some people have simply left the labor market permanently or have lost skills, but that does not say that the main problem with the U.S. economy is structural unemployment.  It is not and it should be obvious to anyone.

The contention that government spending cannot increase aggregate demand is another strange myth.  There is a fundamental logic to it when one does not think too hard.  The logic is basically that the government operates by taxing the rest of society, so whatever the government spends is at the cost of private spending.  There is a major problem with that idea.  The government spends virtually all the money that it receives in taxes and businesses and individuals save a portion of their incomes, foregoing spending today for higher potential expenditures tomorrow.  Assume that the savings rate is ten percent and there are no taxes (just for simplicity).  If the government taxes an individual one dollar, then the individual is foregoing 90 cents of spending, but the government is spending virtually the whole dollar.  Thus in the first round of expenditures, the aggregate demand is up by 10 cents, but 9 cents of that 10 cents will be spent by the next individual which receives it as income and so on, until the long-run multiplier is realized.  It is plain to see that the government, in fact, can increase aggregate demand.

What about the effects of the government borrowing money for spending?  Beyond the argument which has already been laid out, which indicates that even if the government borrows money and the lender reduces their income by the same amount, there will be an increase to aggregate demand, there is the question of Ricardian equivalence.  What if, for example, the government borrows from foreign lenders, so that domestic expenditure is increased by government expenditure and there is no contraction by the lenders?  How will those who will eventually have to be taxed to make up the difference react?  A misreading of the Ricardian equivalence theory states that any amount of spending by the government in excess of its tax receipts will be compensated by increased savings by those who expect their taxes to rise as a result.  If it were a permanent increase in the the government's budget deficit, that reading might be rational.  If, on the other hand, there is a merely temporary increase in the budget deficit, then the individuals would be compensating only for the increase in the debt over the time horizon of its repayment or maybe even just interest-only payments on the additional debt.  Thus, if the long-term interest rate is about 2-3% (which is usually unreasonable, but not in the current environment), then a 1 dollar one-time deficit will cause a 2-3 cent increase in savings and therefore a 2-3 cent decrease in expenditures (which have to go through a multiplier process), but which is, nonetheless, negligible.  Even a high interest rate like 10% on sovereign debt would be only 10 cents (multiplied by the multiplier) reduction compared with the 1 dollar increase in government spending.

The main problem with the final fallacy is that the United States economy is currently in a liquidity trap, where short-term interest rates on U.S. government debt are roughly 0%.  At 0% interest, government debt can not effectively crowd out private investment.  The reason for this is clear.  The mechanism through which crowding out occurs is through the interest rate.  In normal times, when the government runs a deficit, the demand curve for funds (IS) raises aggregate expenditures and increases the interest rate.  The increase in the interest rate is what makes it more expensive for individuals and firms to borrow, thus crowding out their demand for funds.  That means that they would not have as much money at their disposal for investment or consumption as if the government maintained its spending at its prior levels.

What is really disturbing is that there are some economists and pundits in the mainstream media that do not seem to understand these basic ideas.

1 comment:

  1. Willful ignorance, I would say, based on their right wing ideology.