Krugman's Optimal Fiscal Policy Illustrates Everything That Is Wrong With Modern Macroeconomics
Monday December 29, 2008
Paul Krugman on the need to model the current situation:
Having studied at Rochester and being primarily a micro guy, I must admit that I am not an expert on the New Keynesian Economics literature. But I can, however, recognize the limitations of an economic model.
Krugman constructs a model where "consumers maximize an intertemporal utility function" that is strictly increasing in consumption, quantity of money held, and government spending. Seems reasonable enough. Government spending is paid for by lump-sum taxes, which is enough to throw the model into doubt, but I have seen worse. But there is one other variable in there I find puzzling:
But what caused this s to shock downward in the first place? The model does not address this. Why would, say, a helicopter drop of money with an expiry date, placebo (like getting everyone to wear a button), or other non-standard monetary policy not increase s? We have a variable that we cannot see, cannot measure, do not fully understand, but is driving the entire result of the model.
None of this is unique to Krugman or New Keynesianism. In almost any macroeconomic model that is both mathematically tractable and gives reasonable sounding results, unreasonable assumptions and questionable concepts lie underneath the hood.
One thing that’s been bothering me about the discussion over fiscal stimulus is the virtual absence of fully worked-out models, with all their t’s dotted and eyes crossed, or something. Not that a rigorous model is always better than a rough-and-ready but more realistic approach, but I like to have both on hand. So I’ve tried a very rough sketch of a full, intertemporal maximization yada yada analysis of the fiscal policy issue...I don't disagree that having a model is helpful. And I highly recommend that anyone interested in macroeconomics read Krugman's paper; a PDF is available here.
Having studied at Rochester and being primarily a micro guy, I must admit that I am not an expert on the New Keynesian Economics literature. But I can, however, recognize the limitations of an economic model.
Krugman constructs a model where "consumers maximize an intertemporal utility function" that is strictly increasing in consumption, quantity of money held, and government spending. Seems reasonable enough. Government spending is paid for by lump-sum taxes, which is enough to throw the model into doubt, but I have seen worse. But there is one other variable in there I find puzzling:
I’ve introduced a shift factor s on consumer demand, as a crude way to allow for the kind of negative demand shock we’re experiencing right now.With that variable, Krugman can show that:
But what if the required nominal rate is negative? In that case monetary policy can’t get you there: once the interest rate hits zero, people will just hoard any additional cash – we’re in the liquidity trap.And thus monetary policy is ineffective.
But what caused this s to shock downward in the first place? The model does not address this. Why would, say, a helicopter drop of money with an expiry date, placebo (like getting everyone to wear a button), or other non-standard monetary policy not increase s? We have a variable that we cannot see, cannot measure, do not fully understand, but is driving the entire result of the model.
None of this is unique to Krugman or New Keynesianism. In almost any macroeconomic model that is both mathematically tractable and gives reasonable sounding results, unreasonable assumptions and questionable concepts lie underneath the hood.
Comments
Are you allowed to say that?
Why Mike, how very heterodox of you
. I’m piqued.
As a fellow micro guy, I’m inclined to agree with you — but I’ve often heard macro guys claim that their assumptions are no more unreasonable or questionable than the assumption of perfect competition that underlies so much of micro.
Now, two wrongs don’t make a right, but…
I was interested to find this blog. 20 years ago I had a book published on different economic concepts to point the way to a sustainable world economy. Someone who liked the book contacted me this year to suggest that I update and re-publish it as a blog. She set up the blog, and the book is now complete on the blog in a series of postings. There are now also additional pieces on global warming and other subjects. Here is the link:
http://www.economicsforaroundearth.com
With all good wishes,
Charles Pierce
I would think that they could increase s, but they are not monetary policy as defined by the laws of this country. The Fed can lend, not give money, but a helicopter drop is just what is needed. Giving money is fiscal stimulus from congress. Paying interest on deposits is as close as they have come.
Perhaps what s can represent is the marginal consumer preference to use additional money to pay down debt rather than spend immediately. This could then indicate the liquidity preference of consumers.
Where do we begin to analyze rapidly shifting self perceptions of consumer wealth in a burst bubble? Should we be mindful of the potential persuasive impacts of exposure and focus? An attempt at realtime analysis may itself produce changes in “s”. Consider, for example, the possible effects of a sustained effort by major media to quantify any backlash of consumers to purchases of U.S. made automobiles in the face of a series of bailouts. Increased focus to this issue itself may influence and drive increased “comparative shopping” or delayed purchases. Merely posing the question, hypothetically, in this forum, raises issues and focus. Here is another “survey” question (that appears as realtime analysis but may impact “s”) “If you knew that your dollar would be worth 5% less six months from now would that influence your spending habits today?” Major media does this every day, on a broad range of issues, that extend far beyond the confines of the editorial page. Note media coverage of the next stimulus package. Should “s” even be studied in realtime? Should it be left to marketing consultants,
spinmakers and political leaders desiring to bolster confidence?
The bottom line of this thesis of Paul is that the government should spend more so as to get the macro-system going again. It can get the money to do this by two ways, either by raising taxes or inflating the currency. It is my contention that both schemes are unlikely to work, particularly over a long duration. Over a short time the inflation will have a favourable effect and raise demand but as soon as prices catch up and wages eventually too, the situation is the same as before if not worse, due to what savers have lost as well as what debtors have gained (and surely don’t deserve). The increase in taxation alternative gives the government more to spend and the consumer less and so its total effect on the whole system is zero.
Therefore without any modelling of a more serious kind (and I do have such a model that is useful for short term equilibrium studies), it is clear that in order to return to prosperity something more effective is needed.
The alternatives here are to reduce the prime rate and offer more national bonds, both actions intended to encourage the “matress” cash holders to re-invest, particularly with the government, and secondly to make working more productive by removing productive based taxation and placing the burden on the land-owner. Since the slump was due to the speculative nature of this kind of individual, it is socially just to stop it happenning again whilst simultaneously taxing land values. We should all be aware of how the slump was caused (land speculation bubble bursting along with bank over extending of credit) and how this situation can be avoided by land value taxation in the future.
TAX TAKINGS NOT MAKINGS.