Paul Krugman lays out part of the case and Russ Roberts responds

The evidence for the Keynesian worldview is very mixed. Most economists come down in favor or against it because of their prior ideological beliefs. Krugman is a Keynesian because he wants bigger government. I’m an anti-Keynesian because I want smaller government. Both of us can find evidence for our worldviews. Whose evidence is better? I’m not sure it’s a meaningful question. My empirical points about Keynesianism won’t convince Krugman. His point don’t convince me. I am not saying that we will never get any kind of decisive evidence on the question. I’m saying it sure isn’t here now.

Well, this clearly lays the groundwork for a very long conversation. I don’t think we have to be shackled by our ideological beliefs and that reason and evidence can lead us at least to a common state of ignorance.

That is, we might not know the answer but at least we can agree on what we do and do not know.

There are two big points that I want to address right off. First, sticky prices

Keynesian models assume sticky prices, prices are sticky, therefore? Therefore what? Therefore Keynesian models have somewhat realistic assumptions. That isn’t the most convincing selling point.

So no we don’t want to suggest that because a model has the assumption of sticky prices it must be better. What we do want to think is, “what do sticky prices imply about the world?”

Suppose everything thing else in traditional microeconomics was true except that prices were sticky. How would that change our conclusions about what happened in general equilibrium?

Importantly, I think we get the concept of Aggregate Demand. Markets no longer wash. In my mind I think of a pool of water. When markets wash its like when you put your hand in one part of the pool and the water level instantly rises everywhere so that there is no indention from your hand.

Now make the liquid in the pool ever more viscous. It no longer washes it forms an imprint from where you pressed on it. The stickier the bigger the imprint and so you can meaningfully say that portion of the pool has been depressed.

So the fact that markets are viscous means that your dynamics are going to change in a particular set of ways. This is a big deal.

Second, monetary policy

Yes, there is plenty of evidence that monetary policy can have real effects. So why isn’t there plenty of evidence of fiscal policy having real effects? He has to say that in the models (whose? which ones? All of them?) that presume monetary policy works, so does fiscal policy.

I actually think this is a bigger deal. Indeed, for the key fact that the monetary authority sets the short term interest rate on government debt makes it hard to understand how the basic mechanics of Keynesianism could not work.

To keep it simple, if you think that people respond to prices then the fact that the government can issue or retire debt without changing the price of that debt is a huge deal.

Its also why I like to focus on borrowing as the instrument by which fiscal policy takes place.

Especially when start talking about spending, stimulus is quickly confused with industrial policy. And, often stimulus is used as a cover for industrial policy so the confusion is understandable.

However, whether or not the government takes command of real goods and services is not central to fiscal policy. What is central is that the issues bonds and the central bank exchanges those bonds for cash.

The government could simply use that cash to finance tax cuts, which is my preferred course of action.

People often want to talk multiplier and we can. Though, I think there is less here than meets the eye. Monetary financed tax cuts are not costly and so there is no reason to attempt to economize on them.

In any case, once you accept the basics of monetary policy its really hard to describe why fiscal policy should not also work. You might be able to come up with reasons why government spending has such bad side effects that it shouldn’t be tried, but that’s a different question from whether the Keynesian effects exist.

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