John Taylor and ARRA

Lucas doesn’t have a point at all… not in the classical sense or the modern sense. And what you’re both assuming is a situation of full employment — which is really the only time fiscal stimulus wouldn’t raise GDP.

But fiscal stimulus can raise GDP in all models when we’re not at full employment because, like unemployment transfer payments, fiscal stimulus tends to give money to people who can’t readily save it. Fiscal stimulus takes some of the slack, underemployed, unemployed workers and puts them to work, thereby they’re able to pay off debt and consume. That raises GDP. If you think it doesn’t then you’re assuming that fiscal stimulus and unemployment payments are going to independently wealthy people who will just save the money.

In reality, this is much more likely to happen with tax cuts and it’s why the multiplier for the stimulative effects of tax cuts needs to be discounted heavily. A large portion of tax cuts will go to people who are already working, who will just ‘save’ their tax cuts.

Finally, even in the old models with Ricardian equivalence, a fiscal stimulus should have stimulative effects on GDP, because the perfectly rational consumer will know that the stimulus is a one-time thing, funded by longer-term government debt. So the consumer can raise his consumption by the difference between the two.

bill gross, CEO of the worlds largest bond fund PIMCO, seems to have had an epiphany about proper countercyclical fiscal policy last week; in his monthly letter to investors, he said concern about deficits can wait for a stronger economy, and called for a new stimulus program similar the FDR’s WPA…quoting economist hyman minsky, he opined that “government should become the “employer of last resort” in a crisis, offering a job to anyone who wants one – for health care, street cleaning, or slum renovation” and repeated david rosenberg’s “I’d have a shovel in the hands of the long-term unemployed from 8am to noon, and from 1pm to 5pm I’d have them studying algebra, physics, and geometry.”

Rational expectations is not crazy for saying that that if you give people money they might save it rather than spend it. It’s crazy for saying that people will save based on estimating their increased future tax liabilities because of the increased new spending (as if any self-respecting conservative would not be dreaming up clever schemes of tax avoidance instead of meekly estimating their future taxes!). The Chinese save a large fraction of their income, not because of future tax liabilities, but because they don’t have health insurance. With high unemployment, and the most unpredictable medical costs of any rich nation, it’s not hard to explain why people are saving as much as they possibly can.