Irrational Exuberance Over the Balanced Budget Multiplier

Christmas time is the most magical time of the year. A time to believe in elves, talking reindeer, snowmen running amok, and…for some economists, the Keynesian cross.

The Keynesian cross. We (the economics profession) like to etch it deeply into the minds of fresh undergraduates, one cohort after another. Is it any surprise that for most educated laypeople, this is the only macroeconomic language they understand?

And here is a Christmas gift–from Professor Robert J. Shiller–to those of us who have been primed since youth to be receptive to this sort of message: Stimulus, Without More Debt. The argument for why a tax-financed increase in government spending will work is summarized as follows:

The reasoning is very simple: On average, people’s pretax incomes rise because of the business directly generated by the new government expenditures. If the income increase is equal to the tax increase, people have the same disposable income before and after. So there is no reason for people, taken as a group, to change their economic behavior. But the national income has increased by the amount of government expenditure, and job opportunities have increased in proportion.

In other words, the Keynesian cross (formal exposition available here). Econ 101 in action, kids!

So what, pray tell, is your beef with this, Mr. Grinch?

First, it’s not that I have anything against the Keynesian cross, per se. I can appreciate the basic idea it is trying to convey. And it’s just a simple model, after all–it seems silly to hold a personal grudge against an inanimate object. What I am against is in placing it (or any other economic theory, for that matter) on an exalted alter. Models should not, in my view, be worshipped in this manner. And while I’m on the subject of religion, I’m also against beginning an argument with a preordained conclusion (in this case, that more stimulus will certainly be needed, because unemployment is high).

Having said this, I think that the Keynesian cross is a delightfully perverted object. It can be (and has been) used to support almost any type of government appropriation. In fact, I feel like writing a letter myself to this end.

Dear Congressman:

The economy is in dire need of help. It needs to be stimulated. I am willing to stimulate it, with your help.

To this end, I ask that you appropriate a sum of $X from my fellow citizens and divert this money to me.

As this money does not belong to me, I promise to spend it…to return it to my fellow citizens. Of course, I will make them work for it…given the clear want of work in our present economic climate. The income so earned in exchange for their idleness will undoubtedly be spent–adding income to the pockets of everyone. No one will even notice the initial appropriation, as all of the money borrowed will be returned in the manner just described.

Signed (your name); noble servant of society.

Now, try to imagine everyone writing this letter and that Congress acts accordingly. I hope you can see as well as I how nothing but good can come of this. Whatever the ailment, the cure, evidently, is to increase spending. When the Keynesian cross is your hammer, every macroeconomic nail looks like deficient demand.

Second, it’s not that I don’t believe that an increase in G will lead to an increase in Y. There is evidence that it can. Heck, even standard neoclassical theory says it can. Whether it does or not in a given set of circumstances is a different matter. And even if it does, it is not entirely clear that increasing Y in this manner is socially desirable. It may be. Or not. It depends on a lot of things. I do not view the proposition as self-evident and beyond critical examination. In contrast, according to Shiller:

But the balanced-budget multiplier is simpler to judge: If the government spends the money directly on goods and services, that activity goes directly into national income. And with a balanced budget, there is no clear reason to expect further repercussions. People have jobs again: end of story.

(Don’t you love it when you are granted license to stop thinking? End of story, indeed.)

Third, its not that I’m against increasing (components of) G. Public works projects of the sort mentioned by Shiller (building highways and improving our schools) were advocated by sensible economists long before Keynes (as evidence of this, note that public works were implemented in the Depression well before publication of the General Theory). What I have some problem with is in using some silly theory to support the notion, for example, that taxes should be raised to finance a large public capital expenditure. Shiller has been rightly celebrated for his work in the theory of finance, and on asset price bubbles in particular. But is this not a rather odd stand to take for a professor of finance?

Now, I’m no expert in finance myself, so maybe I should be careful in what I’m about to say. But it seems to me that a large capital expenditure should be financed with debt. The debt service could be supported by toll revenue (on bridges and roads) and user fees in general, backed by the Treasury, if needed. The use of tax finance advocated by Shiller in his balanced-budget exercise implicitly assumes (among other things) lump-sum taxes. For some thought experiments, the assumption of lump-sum taxes is innocuous enough. But this is not one of those cases. Taxes are distortionary and to the extent that they are needed to support public spending, they should be spread out over time. This is a standard principle of public finance (I think).

Maybe Shiller believes in this standard principle, but views it as politically infeasible (given the current appetite for debt reduction). Possibly. But if so, I would rather have expected a rousing defense of these standard principles. Americans are not necessarily against debt; they are against wasteful spending.  Given that America has an infrastructure (crumbling as it may be be) should be taken as evidence, I think, that people are generally willing to support worthy public enterprises–where worthiness is judged by a project-by-project cost-benefit analysis.

And speaking of standard principles, what ever happened to the quaint idea of evaluating the merit of public capital expenditure on a net present value basis, instead of some magic-multiplier concept? There is probably a good NPV case to be made for implementing such projects in a recession, even in the absence of positive externalities. Indeed, if what we read about America’s “crumbling infrastructure” is true, these projects should have been started several years ago. Perhaps they were not because the economy was at that time judged to be “overheating.” After all, the same Keynesian cross logic suggests decreasing G during a boom (crumbling infrastructure be damned). D’oh!…dang Keynesian cross.

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