Streetwise Professor

February 1, 2009

Freshwater vs. Bilgewater

Filed under: Economics,Politics — The Professor @ 10:48 pm

One contentious element in the “stimulus” debate is the role of Ricardian equivalence.  That is, that private individuals will take actions that undo the effects of additional government spending or tax reductions financed by government borrowing.  Krugman endorses this relatively intuitive rejoinder to the Ricardians, so it seems like a good place to begin:

Menzie is right about transitional changes in tax policy not being able to change consumption in this Barro-Ricardo model, which is why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool. But what about transitional changes in government purchases? It is interesting that Wikipedia noted Ricardo’s 1820  Essay on the Funding System:

Ricardo studied whether it makes a difference to finance a war with the £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that “In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever … are precisely of the same value”.

Let’s modernize this example. Suppose we decide to have an additional $100 billion in public investment in 2009. In Ricardo’s example, permanent taxes will increase by $5 billion per year which would have a very modest offsetting reduction in consumption. So if government purchases rise by $100 billion and consumption falls by $5 billion, then isn’t the direct impact on aggregate demand closer to $95 billion for the year rather than zero?

In a blog post today, Krugman repeats the same argument almost word-for-word:

But suppose the government introduces a one-time, $100 billion program to repair bridges over the next year. The government will have to issue debt to pay for this, and will have to service that debt, requiring higher taxes — say, $5 billion a year. That’s a much smaller impact on consumers’ future after-tax income than the permanent program. So much less of the spending rise will be offset by a fall in consumer demand. (I’m not considering the effect of the spending in raising income, which would probably cause consumer demand to rise rather than fall.)

So economic theory — Milton Friedman’s theory! — says that spending is a more effective form of stimulus than tax cuts.

So this makes it clear: the stimulus is a good thing because even in the presence of Ricardian equivalence, it increases current aggregate demand/consumption/measured output, and the expense of future demand/consumption/measured output.  

So that’s the metric, eh?  Current output goes up. QED.  End of story.  Vote for the stimulus.  And opponents–shut up!  

Well, to put it mildly, that’s a stupid metric.  I, you, etc., are not necessarily better off just because current measured output goes up.  

Framed this way, the “stimulus” and the associated increase in government spending is a forced intertemporal reallocation of consumption.  That is not necessarily welfare improving.  

Note the question that is begged: if individuals prefer to enhance current consumption at the expense of future consumption, why can’t they do this trade themselves?  

There is an implicit assumption here: namely, that there is some constraint on intertemporal resource allocation that precludes people from attaining this putatively superior consumption pattern.  They want to borrow, but can’t for some reason, so the government does it on their behalf and makes them better off by doing so.  

You can make arguments as to why moving consumption from the future to the present is constrained (relative to some ideal, first best world.)  For instance,  it is costly to use human capital and future labor income as collateral for borrowing.  You might also argue that the problems in the banking system have also made it impossible to consummate some welfare-improving trades.  

But, to argue that the government has the ability and incentive to identify and fix the distortion in intertemporal consumption, you have to presume that it can solve the knowledge problem and the political problem.  That is, it must have the ability to determine what the preferred consumption pattern is (which would require immense amounts of information about individual preferences and technological possibilities) and the political mechanism must be able to translate that information into efficient action.  Color me skeptical.  Extremely.

Moreover, even if you overlook those minor details, you can’t use the increase in current income to measure the benefit of the stimulus, because this ignores the cost in future consumption.  If the stimulus does improve the intertemporal allocation, the difference between benefit and cost is positive, but the cost (the value of future foregone consumption) is zero.

In the analysis quoted above, the difference benefit is zero; the $100 million increase in current income is worth exactly the same as the $5 million per year lost in perpetuity.  Given the inefficient constraint on private intertemporal resource transfer, this difference would be positive (i.e., $100 million today is worth more than the $5 million lost in perpetuity), but it ain’t $100 million, or $95 million.  

Even if the inability of individuals to implement their desired intertemporal consumption plans is the rationale for a stimulus package, this does not justify a preference for direct government expenditure, as opposed to a tax cut, financed by borrowing.   Indeed, as the latter allows each individual to choose his or her own consumption bundle so as to maximize utility, rather than consuming a one size fits all bundle chosen by a political process.   Why, pray tell, should we believe for a nanosecond that the bundle of “goods” (more on the use of this word below) selected in a political Bacchanalia is optimal in any sense of the word?  

Arguments over the form of the stimulus also demonstrate a fundamental contradiction at the heart of the government spending stimulus argument.   Advocates of this view vehemently oppose (for the most part) tax relief in place of direct government spending because individuals will save, rather than spend the tax cut.   But, if the fundamental problem is that people are constrained in their ability to implement their optimal consumption plans, and want to borrow more and thereby shift consumption from the future to the present, as is implicit in the stimulus argument, they wouldn’t save the tax cut.   They’d spend it.   So, if one argues that tax cuts are not stimulative because people save them rather than consume them, one cannot believe that people are prevented (due to some capital market imperfection) from trading future consumption for present consumption.   But if you don’t believe that, what is the justification for government borrowing to fund current consumption via direct government spending?     Maybe there’s an explanation, but it seems very hard to square denigration of tax cuts with advocacy of government spending.  

The inability to achieve optimal intertemporal allocation also seems to be inconsistent with another phenomenon observed during the credit crisis; the intense desire to increase holdings of government liabilities (Treasury securities and money).     Certainly, individuals are liquidating private claims (e.g., equity, corporate debt) and using the proceeds to buy government securities and increase their money balances (note the stratospheric increases in base money).     But, if they really wanted to increase current consumption, they could liquidate private claims and use the proceeds to consume.   The evident desire to save in low risk-low return (and close to zero return) forms, rather than consume, is flatly inconsistent with the intertemporal misallocation justification for a fiscal stimulus.

At root, stimulus advocates appear to be substituting their preferences for those of the great unwashed.   People want to save too much, the bastards.   If we give them money, they’ll STILL save it.   So, we’ve got to consume for them.     Traditional Keynesians attributed this demand to save to “animal spirits”—i.e., irrationality, or perhaps, insanity.   Maybe modern Keynesians are of the same view.  

Whatever the rationale, it is fundamentally elitist, and anti-individualist.   It is the attitude of those who know what’s good for us.     They’re from (or for) the government and they’re here to help us.   And we all know how that usually works out.

I suggest it’s better to start from a presumption that people aren’t idiots, driven by irrational impulses, and to try to understand the reason for their behavior.   A substantial increase in the demand to save—i.e., to transfer consumption from the present to the future—likely has a rational explanation.   Like, oh, I don’t know, maybe an incredible increase in uncertainty associated with the potential implosion of the financial system.     Just a guess.     But the stimulus advocates, the neo-Keynesians, argue that people have things exactly backwards, and just don’t know what’s good for them.   What they REALLY want, the NKs are saying, is to consume more today and less tomorrow—even though through their behavior people are revealing the exact opposite.   The arrogance of this is pretty mind blowing.

This further strengthens my belief that the stimulus is akin to identity theft.   People borrowing in our name to do what they want, not what we want.

The decline in consumption, which as Bob Lucas has noted NEVER happens in US data, indicates a strong desire to increase saving.   To consume more tomorrow.   The “stimulus,” whether delivered via direct government spending or a tax cut, implicitly assumes the exact opposite.   Moreover, it means that to understand the situation, and to devise a reasonable, efficient policy response, it is necessary to understand and address the source of this increased demand to save.  

The most immediately obvious explanation is the implosion of the financial system.   This, in turn, suggests that efforts should be focused on ameliorating that problem.   And every dollar p***ed away for ACORN or some bridge in the Right Honorable Foghorn Leghorn’s district is one that can’t be used for that purpose.    Thus, this spending is doubly wasted.   It doesn’t buy anything we want today, and diverts resources from a beneficial use.

Maybe I’m wrong that individuals are increasing their demand to save due to an increase in risk associated with the financial meltdown.   So, by all means, let’s investigate alternative explanations.   But let’s not propose “cures” based on dubious (at best) diagnoses of the disease.     And any diagnosis must explain why the demand to save by LENDING to the government has exploded.

The other key issues is “measured output/consumption.”  That is, from an accounting perspective, the $100 million in government expenditure is counted as income.  But what if the money is largely spent on things that people don’t value, but we have to give up things we do to pay for it?  Much of the stuff in the “stimulus” package is of dubious value.  Hell, to me, some of it has a negative value; they’re bads, not goods.  So, let’s say $100 million in resources are used to buy things that are worth only $50 million (to be generous).  But to pay for it, I–and you–have to pay higher taxes in the future, and give up stuff we do value; in my case, say, travel, books, iPods, a new SigSauer 9mm, leisure.  

So, here’s the real trade-off involved in the stimulus (and remember, economics is all about trade-offs): we give up future private consumption in exchange for current consumption of all the stuff–I wouldn’t say goods, unambiguously–in the stimulus bill.   My view is that the stuff in the stimulus bill is largely worthless–if we’re lucky.  So, the measured increase in income overstates the true increase in income.   The stuff we’ll have to give up due to higher future taxes isn’t worthless.  Moreover, even if there is an argument to justify that a reallocation of consumption over time can (due to some capital market imperfection) improve welfare, it’s clear that the measured increase in output overstates the benefit of this.

In brief, the case “for” the stimulus, namely, that it will increase measured income/consumption, is highly misleading.  It overestimates the benefits and underestimates the costs–when it doesn’t ignore them altogether.

The views I have expressed here are clearly those of a “freshwater” economist, as one wag calls Chicagoans, hard by the shores of Lake Michigan, as distinguished from “saltwater” economists on the seacoasts.     Guilty as charged.   But, I would rather be a freshwater economist than a bilgewater economist any day.   And, in my view, the pro-stimulus arguments are just bilge.   They are bilge because they propose remedies that are flatly contradicted by the symptoms that are there for all to see.     The stimulus would make sense if some market failure precludes an efficient transfer of resources from the future to the present.   But people seem quite intent on doing the exact opposite, transferring resources from the present to the future.     Add to that the fact that the government will use resources to purchase goods of dubious value, and indeed, to purchase some bads, and the case for the stimulus disappears altogether.    

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  1. You are too kind and much too reserved in your analysis, to wit: what if the guv can – force – you to do what it thinks is good for you?

    Also, I have a very hard time seeing how $200 million for sod on the National Mall is going to provide any sort of stimulus – not even a multiplier effect.

    Plus, I’m confused – during the Bush era, we consumers were repeatedly criticized for being overly consumerist. Now, apparently, the idea is that we are not consuming enough. And, in either case, not consuming the “right things.”

    Comment by elmer — February 2, 2009 @ 10:41 am

  2. How would we fix the financial system? Merely pouring billions in those that hold rotten eggs doesn’t sound convincing to me. Shouldn’t we have just let them fail in September? One those with bad assets go bankrupt, we would know the others are good and lending can continue!

    Comment by Surya — February 2, 2009 @ 10:59 am

  3. Surya, darn right they should be left to fail, that’s the beauty of capitalism. Rotten apples are left to disintegrate allowing capital to be applied anew. It’s painful but thorough. This is death by a thousand paper cuts.

    The Dems are clowns, well, a lot of Republicans are too. We’ve entered an age of sheer stupidity and hubris. I never thought I’d live to see America turn Euro socialist, but, hey, we live in an age of dumbed down schools and a MSM that’s stupid. Economic literacy is at it’s lowest it seems in our history.

    Comment by penny — February 2, 2009 @ 11:51 am

  4. Sad to say, Surya & Elmer, but due to deposit insurance, Uncle Sam is potentially on the hook for a lot of $$$. Even if the debtholders and equity holders of banks are wiped out (i.e., not bailed out), there is the very real possibility that assets

    The ProfessorComment by The Professor — February 2, 2009 @ 9:05 pm

  5. Penny–you have every right to be confused. I’m confused too–and we’re confused because there’s absolutely no connection between the proposed “cure” and the cause of the problem, as would seem to be necessary to devise a coherent response. This is fiscal quackery, prescribing Dr. Obama’s Cure All fer Whatever Ails Ya.

    The ProfessorComment by The Professor — February 2, 2009 @ 9:08 pm

  6. Prof – I guess you meant Surya and penny in (4) and Elmer in (5). I just happened to be in a nitpicky mood. Now I see the picture a little bit more clearly. Atleast we could have let the investment banks fail, no? Since there is no fdic risk to the govt.

    Comment by Surya — February 3, 2009 @ 12:14 am

  7. […] Craig Pirrong explains the Keynesian system, which he aptly describes as “bilgewater economics.” At root, stimulus advocates appear to be substituting their preferences for those of the great unwashed. People want to save too much, the bastards. If we give them money, they’ll STILL save it. So, we’ve got to consume for them. Traditional Keynesians attributed this demand to save to “animal spirits” — i.e., irrationality, or perhaps, insanity. Maybe modern Keynesians are of the same view. […]

    Pingback by Craig Pirrong on Intertemporal Consumption | The Beacon — February 4, 2009 @ 12:56 pm

  8. I keep thinking about TARP and I’m persuaded that Chapter 11 is better.

    Im copy pasting from Emmanuel Derman’s blog…

    “Maybe it’s time to stop the trick-le of bailout money to the moribund. Put all failing banks and companies into Chapter 11. The bankruptcy laws are adequate: equity holders, who took risk knowingly, get zero; bondholders get the company, which then restructures and can go about its business. Replace many of the people at the top: these guys are already too distracted with trying to save their own skins and reputations to do a good job. They’ve been burned and can’t forget it soon. New people and a clean start is the right capitalist solution — take risk, suffer the consequences. Then the government can help the new equity holders go about their business of creating credit again.

    Never been a libertarian, but I think creative destruction is the right thing at this point. It would put an end to the drip drip drip, and to the sight of formerly evangelistic free-marketsters now asking for government help to survive. “

    Comment by Surya — February 4, 2009 @ 6:54 pm

  9. Surya–Agree that the financial equivalent of cryogenic (a la freezing Walt Disney) preservation of dead banks is pointless, and that there needs to be an expedited way to restructure the industry. The issue (as Holman Jenkins points out in his column in today’s WSJ, echoing my response to you and Elmer on Monday), even if shareholders are wiped out, US taxpayers on on the hook for huge sums due to deposit insurance. Any approach must focus on minimizing this cost.

    Bad bank approach can work. Historically, bad banks were carved out of banks that regulators seized (e.g., SL crisis in 89-90). There was no issue of buying the assets from troubled institutions. That is what must be avoided now, and ch. 11 or some variant has that virtue.

    Along with several colleagues, in 1989 I performed an analysis of how the gov’t handled the original phase of the s&l bailout in 1988 (this turned into a book). We showed that when negotiating with financially sophisticated parties (e.g., the Bass Brothers) the gov’t types were taken to the cleaners big time. That could happen again. Stakes are far, far bigger this time, so even more important to keep this lesson in mind.

    Re Derman–many bondholders likely to be wiped out too. Drip, drip is the bad thing. Wielding the meat axe today may be messy, but expedite the ultimate resolution of the process. Another case where the perfect is the enemy of the good.

    The ProfessorComment by The Professor — February 4, 2009 @ 11:58 pm

  10. For once, I can agree with all the Russophobes on here.

    Ingest a large enough portion of toxic assets, and it could poison anything…even a beast as big as the federal government. And too much of the stimulus is composed of tax cuts and pork. Although it does have good parts like education funding, updating rail, energy and information infrastructure, digitizing medical records…

    Comment by Da Russophile — February 5, 2009 @ 12:13 am

  11. Thanks SWP, it is always enriching to read your arguments.
    One question still lingers — at the backdrop of all this mess is the outsourcing of higher paying jobs to other locations (which is in fact the logical thing to do for businesses). So we are left with a population with very little spending power and huge debts. Where is the way out?
    Has the dynamics of carbon turning taken a sharp U turn from June to Jan? I hear that the govt is slowing down on the imposition of cap and trade regulation.

    Comment by Surya — February 5, 2009 @ 11:03 am

  12. Surya–Thanks. Will punt on the outsourcing ? for now.

    Re carbon. In a very weak economy, it is plausible that the appetite has declined for a dramatic tax increase, either directly through a carbon tax, or indirectly, through a cap and trade system in the US. Things are on track in Europe, as it appears.

    I hope to blog on this issue in more detail. I am team teaching a carbon course with an environmental law professor from the UH law school. I know markets, he knows the law/regulation. I’m learning a lot from him about the implementation details of a cap and trade system, and I can say, given my knowledge of commodity markets, and the practical difficulties arising from measurement, standardization, and enforcement in such markets, that any c&t system will be a living nightmare rife with enforcement difficulties and opportunism.

    An extended political debate in the US (most likely, focusing on the senate) will certainly shed a lot of light (and heat) about these practical implementation details, and hence, when people understand the direct and indirect costs of a carbon control regime, I doubt the enthusiasm will be there. I envision a high likelihood of a repeat of the Clinton health care debacle in 94.

    The ProfessorComment by The Professor — February 5, 2009 @ 11:37 am

  13. The carbon cap and trade is pretty interesting. I took a look at the slides. Pretty kewl. I particularly liked the attention you gave to measurement issues – very streetwise!
    I wish you could figure out the details of how to setup a labor market exchange..which would give an insight to the labor market participants as to what skills are in demand 😉 Right now I would happily take short positions in “I Bank senior execs” spot and near futures. 😀
    But seriously, the issue of exec compensation has taken a center stage now. And I like most of the avg. Joes feel that a company that takes the Federal bailout money should be imposed with exec compensation. The opponents say that this would drain those companies of the really “smart” people needed to run them. But I have met quite a few “senior execs” in my life and I feel that there is nothing so great about these men. They are guyz with ordinary ability who have reached those positions thru good ol’ boy club, politics and just hanging in there for long enuf (e.g. Hank Paulson , Rick Wagoner). If top “talent” does drain out, I am sure it could be replaced by others in the company that are just as competent and as “old”. 😀
    But more to the point, the corporate sugar daddys since the 80s have dished out enormous sums of money to their henchmen McKinsey, Bain, Booz Allen etc., to say such ridiculous things like “80% of the output in a company is produced by 20% of its people”, in order to justify such huge bonuses. I find the idea of the management paying consultants to get an “independent” opinion, which more often than not, just happens to “coincide” with what they were thinking, rather suspicious.

    Comment by Surya — February 5, 2009 @ 3:08 pm

  14. Looks like a mutiny is on at UBS re exec comp!

    Comment by Surya — February 5, 2009 @ 7:28 pm

  15. […] very well put here: At root, stimulus advocates appear to be substituting their preferences for those of the great […]

    Pingback by Step back and look at the big picture… — February 5, 2009 @ 11:43 pm

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