Tuesday, June 21, 2011

Keynesian Dismisses Crowding Out

Alan Blinder helped instigate the "cash for clunkers", with his July 2008 op-ed piece in the New York Times. This gave a one-time boost to car sellers as the subsidy mainly went into a rise in auto prices, and by destroying over 500k working substitute cars. If you measure a government program by its price tag it was a huge success, as it cost taxpayers $3 billion. You see, the 'G' in the famous Keynesian top-down measure of aggregate demand C+I+G and therefore output, so all a government has to do is spend more and output rises! The indirect effects--like higher prices for used-car buyers in Blinder's last genius plan--don't exist because they are too subtle for the big picture that is captured via macro aggregates like C, I and G. Indirect costs, opportunity costs, are too hard to measure, so conveniently assumed to be zero, while the transactions are meticulously counted from initial expenditure to the next and present valued (you can see how pointless the conversation can become via Keynesian logic, see here for more). The obvious benefits of government spending has been proven mathematically (in partial equilibrium) 2,423 times in peer-reviewed journals, which is why the revolutionary Keynesian model has always been so popular, as it rationalized what many have always wanted.

As a good Keynesian Blinder today defends the eternal Keynesian solution when he defends deficit spending in today's WSJ:

When the government borrows to finance spending, that pushes interest rates up, which dissuades some businesses from investing. Thus falling private investment destroys jobs just as rising government spending is creating them.

There are times when this "crowding-out" argument is relevant. But not today. The Federal Reserve has been holding interest rates at ultra-low levels for several years, and will continue to do so. If interest rates don't rise, you don't get crowding out.

If crowding-out can only occur when interest rates rise, does that mean that the fiscal stimulus could not have created any jobs because the unemployment rate is still so high? The Keynesian line was that prior stimulus created millions of jobs when compared to the hypothetical basket case that would have occurred were it not for spending. I'm not trying to be a hobgoblin of foolish consistency, but it seems Keynesians believe stimulus works via the 'back from the brink' hypothetical narrative, but that the same 'more extreme' hypothetical is not allowed for crowding out?

Interest rates are currently lower than their 5-year average, but know one really knows what they should be, or what is considered 'low'. When they were rising from 1955 to 1980 they seemed 'too high' the whole way up, and most economists were wrong the whole way (see graph below). As rates fell, they then seemed too low the whole way down, and I remember in 1988 and in 1994 listening to most smart macroeconomists think that rates would revert to their 5 year moving average. People think the past 5 or 10 year average is the right level, intuitively. Thus, it's easy to say today's current rates are 'low', but are they really as low as they would have been without the massive US deficit and QE2 policies? I doubt it, and these policies are simply non sustainable.

The problem, is the graph below (click to enlarge). Greece enjoyed virtually limitless borrowing at riskless rates until 2008 when problems appeared. The line is the Greek sovereign credit spread since 2005, and the white spike on the right is the straight line up to the current level of 25%, which basically means they can't borrow from the market any more, just governments and their central banks.

The biggest mistakes are the ones everyone makes, because it's easy to dismiss criticisms because there are many smart people doing what you are doing. Smart, however, just means you can articulate your beliefs well, not that they are correct. In this case, the US government, the states, the counties, and the major cities, have all been spending more than they take in for years. Once the Fed stops printing money to buy our debt (end of this month!), and the Chinese realize they have better ways to invest, the march towards sovereign bankruptcy seems inevitable. As asset markets have stagnated revealing overoptimistic pension fund assumptions, the problem becomes a positive feedback loop. Blinder wants to spend out of this mess, as the fiscal multiplier implies that government spending money on anything not only creates jobs but decreases the present value of debt, an idea that's so stupid only a professional economist could entertain it.

It goes without saying that economists--especially macroeconomists--have a poor track record on big historical trends (eg, most economists in the 1950s believed that socialism was more productive yet less polluting than capitalism, that a permanent trade-off between inflation and unemployment existed, that the third world would grow dramatically after colonialism, that dynamic programming would be useful for fiscal policy, or more recently, that requiring 20% down payment to get a home mortgage was merely a pretext for racism and should be abolished, to name but a few).

Too many believe in the naive Marxist fantasy about a life of dilettantish activities unrelated to economic scarcity. How many times are programs justified by the fact that 'The US is the richest country in the world' or some corporation has billion of dollars, as if that capital was sitting there, unused and probably stolen.

Bankruptcy will make us a better society because currently many people think that solutions are as simple as creating a mountain of debt (Bill Gross estimates it at 500% our GDP) to create make-work or new economic rights, and those sinecures don't create what Arthur Brooks calls perceived earned success, the satisfaction that comes from work that is appreciated both by your boss, who compares your cost to alternatives, and your customers, who compare your value to alternatives. There are no shortcuts to the rewards of the virtuous life, as a person or a society.


Anonymous said...

Perhaps there are no shortcuts to virtue, but bankruptcy wipes the slate clean and allows virtue to exert itself.

Greece can't declare bankruptcy (or the sovereign equivalent) because it lacks control of its currency. Not a problem faced by the US. In the US we could (should?) print 30 trillion to wipe the slate clean. We won't be able to access credit markets for a while, but hey, who cares, the bankruptcy-enabled virtue is its own reward.

randian said...

I think that would be foolish. Straight up default would be preferable to debasing the currency. Plenty of countries have come back just fine from sovereign default. Look at Russia, for example.

Anonymous said...

Again with the scorched earth economics. It's a perverted philosophy, certainly not a virtuous one. Virtuous people don't relish destruction and suffering...at least (for males) not past the age of 30 or so.

Anonymous said...

Does anyone have a clue what "scorched earth economics" is? I have a sad feeling that the prior poster meeds "free markets" but I'd love be wrong.

AHWest said...

Great post! Most economists are witch doctors, who think that production of useful goods and the economization of scarce resources is easy and automatic, leaving them to their preferred task of using government to fool people into consuming more than they can collectively afford. Mission accomplished Mr. Blinder!

tc said...

interest rates aren't just low compared to the past 5 years, they're low compared to the past 50, as your graph shows. what would they be without the deficit - 0%? it would be silly not to borrow at those rates.

Eric Falkenstein said...

ty: using that logic, people who got NINJA loans circa 2006 to buy houses were making good decisions. Unlike the lucky homebuyer--later portrayed as the victim--who could walk away from his obligation, the US just adds this to the total, moving the tipping point closer.

Anonymous said...

I happened to be reading a paper written by Milton Friedman in 1948 (the "Chicago Plan") and it occured to me that you would consider him a Marxist. He took it for granted that Keynsian macroeconomic stabilization was one worthy policy objective (though not the only one) - and even said some nice things about equality (ooh! very very Marxist!). Friedman wasn't in favor of discretionary fiscal stimulus, but he was equally against fiscal austerity. He preferred to fix fiscal policy and let the deficit go up or down automatically with the economic cycle.

Eric Falkenstein said...

anon: ceteris paribus, I too prefer equality--I don't dislike it--I just prioritize liberty and prosperity. Like Friedman, I like the automatic stabilizing features of fiscal policy; I don't like big, ad hoc plans to prime the pump with new top-down spending.

I agree that if there was a fiscal rule that diminished cyclical volatility, it would be a good thing, and perhaps even worth a certain level of average growth. But like sacrificing liberty for equality, sacrificing stability for growth is not a trade-off: less of one does not cause the other to rise.

MR said...
This comment has been removed by the author.
MR said...

Johannes wrote:

"At that age, humans have had plenty of exposure to cultural/social norms and conventions, which would tend to influence their decision."

But the study suggests the behavior of 4 and 5 year olds is bias against the norm:

"About 75 percent of 4- and 5-year-olds decided in favor of the owner, versus about 20 percent of adults. […] In a final experiment that presented two cartoon adults, one using a cell phone that the other owned, most 4-year-olds but only a minority of adults declared that the device should be returned to its owner even before the borrower had a chance to use it.”

To defend a cultural explanation you would have to argue children misunderstand the norm or observe adults behaving in ways that don’t reflect the adult’s stated preferences.

Anonymous said...

"Like Friedman, I like the automatic stabilizing features of fiscal policy; I don't like big, ad hoc plans to prime the pump with new top-down spending."

That's fine. Nobody sensible supports stupidity like cash for clunkers. But then you have fiscal conservatives (in both parties) irrationally fretting about the deficit and inflation. It's maddening.

And remember that the states act pro-cyclically since they are revenue constrained.

randian said...

Worrying about the deficit is irrational? That's crazy.

Anonymous said...

randian, I meant that worrying that the deficit is too large is irrational.

It is of course rational to worry that it is too small.

bankdude said...

Quite simple: Enforce proper tax policies. Including luxury taxes.

randian said...

Luxury taxes are a terrible idea.

Frank said...

This is a poor argument. Really. It would be one thing if businesses were generally liquidity constrained at present but the fact is financing after the crisis has not been a large problem or even a top problem for businesses. The biggest problems businesses suggest they face is slack demand, not high interest rates.

Therefore while interest rates MAY have been lower the effect on business may have been marginal compared to an increase in aggregate demand therefore the marginal benefit from the increase in aggregate demand is greater than the marginal cost of slightly higher interest rates. It is logically inconsistent of you, in fact, to suggest in one post that one does marginal analysis to figure out what the net present value of government spending is, and in another suggest that it is logically inconsistent to do marginal analysis of the net present value of government spending/borrowing...

Therefore one CAN hold a logically consistent position that there is no crowding out (more likely that any "crowding out" is offset by the benefits of increased aggregate demand) because interest rates have remained low and we are not currently at the edge of the PPF.You KNOW what Alan Blinder means, you are clearly a smart guy, so why even make this post?

One could even rationally argue that interest rates should and could be much HIGHER than they are now had government adhered to fiscal austerity. As a natural experiment of sorts, why not look at all the countries that have practiced austerity and see how interest rate spreads compare?

You're presupposing the point. Since your natural bias is to believe government borrowing/spending = bad you presuppose the the point that interest rates must unambiguously rise when government spending increases. Ceteris paribus you are right but Japan continues to defy that meme and life goes on.

Anonymous said...

Re: Logic of NINJA loans -- Those buyers were making an extremely rational economic decision. Heads they win. Tails other people lose.
They'd be stupid not to take that bet.