Reactionary Keynesianism revisited

I wrote my original post on this to counter the idea that the size of any increase in the deficit was at least as important as its composition, with particular reference to any fiscal expansion likely to come from Donald Trump. To put it very simply, I argued that any fiscal expansion that focused on tax cuts for the very rich and extremely dubious mechanisms designed to increase infrastructure investment should not be welcomed by those who think (as I do) there is still spare capacity in the US economy. Some subsequent helpful feedback suggests that in making this argument I should have said some things a little better.

I started my discussion with an example of how a tax cut for the rich could, in theory at least, be deflationary. The idea was that the rich would immediately consume very little of any tax cut, but if the non-rich thought that in the future their taxes might rise because of the higher deficit they might decrease current consumption. [1]

Talking about the rich and non-rich was very imprecise of me. I actually had in mind people who were income rich. The distinction between income and asset rich could matter, following an Econometrica paper by Kaplan and Violante that Narayana Kocherlakota pointed me to. This paper argues that there is an important group that they call the ‘hand-to-mouth wealthy’. These are asset rich individuals that hold their wealth in non-liquid form (e.g a pension), and because of the non-liquid nature of the wealth they might have a high marginal propensity to consume out of current income. It is an interesting idea with some empirical backing, but which I think only emphasises the importance of thinking about the composition of any tax cut when calculating the degree of stimulus.

In retrospect it might have been simpler to give a better known example of the potential disconnect between the aggregate deficit and a stimulus, which is the balanced budget multiplier. To the extent that fiscal policy under Trump may involve cuts in government consumption, that example could be very relevant, as Paul Krugman notes.

In the case of public investment, I again argued that the nature of this investment mattered. If the mechanism used to increase public investment (see this piece by Stiglitz for example) meant that a good proportion of this investment involved projects with a low social return (white elephants), then once again people on average would not be better off. This point depends on something which I took for granted but which I should have been spelt out: monetary offset.

Because the US economy is no longer at the zero lower bound, then an increase in GDP caused by building lots of white elephants would almost certainly lead to an increase in interest rates. [2] As a result, GDP might not actually increase, and useful private investment would be crowded out by useless public investment.

Once interest rates start rising from their zero lower bound, then those who argue that demand should be increased in the US (see here or here) are really complaining about monetary policy, not fiscal policy. An expansionary fiscal policy that is crowded out by the Fed might have some indirect advantages, in raising the natural interest rate for example, but the famous ‘digging holes’ argument used by Keynes no longer applies.

Once we leave the zero lower bound, tax cuts for the rich amount to a regressive redistribution of income. People should not be fooled into thinking that the tax cuts will somehow pay for themselves, through Keynesian or any other means. There is an extremely strong case for a large expansion in public investment financed by additional public borrowing, but this investment needs to go where it is needed, rather than to schemes that will generate a quick return to private sector financiers. There is a strong case for using additional demand to expand the US economy, but it will not happen as long as the Fed believes otherwise.

[1] I confusingly talked about the wealthy as acting as if Ricardian Equivalence held, when I should have simply said that because they were wealthy they would focus on lifetime rather than current income, and so would have a low MPC from a temporary tax cut. Assuming a tax cut for the rich is permanent is equivalent to assuming the Republicans never lose power.

[2] Assuming, of course, that the Fed remains independent, but Krugman argues that even if it did not we might still see higher interest rates.

Reactionary Keynesianism

Under Donald Trump we might get what some have called Reactionary Keynesianism. But a stimulus is a stimulus, right, and for those of us who think most OECD economies should be ‘run hot’ to try and make up some of the ground still lost from the Great Recession any fiscal stimulus should be welcomed? So Martin Sandbu writes

“it is hypocritical of anyone to warn that Trump’s promised tax cuts will endanger the public finances if they called for fiscal stimulus under Obama and his putative Democratic successor. …. While the composition of tax cuts and spending increases may matter, the overall size of any deficit increase matters at least as much.”

If by this he means don’t worry too much about the composition, the overall size of the deficit is more important, I think this is terrible macroeconomics. It is foolish to believe that anything that raises the deficit will stimulate.

We know that a part of any Trump stimulus will be large tax breaks for the very rich. The very rich will almost certainly consume virtually none of this tax break in the short term. It is the one part of the population where Ricardian Equivalence almost holds. You might think that therefore it does at least do no harm to short term aggregate demand. But this could be wrong, because the logic of the intertemporal budget constraint still operates. Those tax cuts will not be paid for by higher activity in the short term, so they may mean higher taxes down the road. Now if people who are not very rich think that these might be their taxes that are increased down the road, they will reduce their consumption today. The net effect could be a drop in demand.

You may think that consumers may not be so foresighted, so demand will not actually fall. But the logic of the intertemporal budget constraint still holds. If tax cuts for the rich just raise the deficit with almost no short run demand boost, then that is a transfer to the rich today from the non-rich tomorrow. If tax cuts for the rich were paid for by tax increases on everyone else today many politicians would be up in arms. Delaying the tax increase on everyone else by borrowing is a trick that should be seen straight through.

Yet I fear this is still not the case, and talking about tax cuts for the rich as part of a stimulus just helps confuse politicians. Those on the right understand this: tax cuts for the rich are nearly always part of a general stimulus: when Nigel Lawson did this it helped bust the UK economy. We should just repeat again and again: tax cuts for the rich paid for by borrowing are really tax increases for everyone else.

The example of tax cuts for the rich is the example that refutes the general proposition that the composition of any fiscal stimulus matters less than the overall size of any increase in the deficit.

Trump has also said he wants more investment in public infrastructure. That is something the US desperately needs, but remember that Trump will usher in an era of crony capitalism and politics like never before. The infrastructure that you might get could be far from the infrastructure the US actually needs, and instead may be whatever buys votes or other kinds of deals that help a Trump administration. Now if that infrastructure was produced entirely by those who otherwise would be out of the workforce but would like the jobs involved, then aggregate welfare would still increase: it is Keynes’s famous digging holes example. But in practice that seems unlikely to be completely or even mainly true, and so these white elephants may in practice crowd out better projects. In that case US citizens would not be better off in the short term as a result of this fiscal stimulus, even if GDP did rise. And the stimulus would not pay for itself, so once again other people should worry about the government’s intertemporal budget constraint.

If the economics of Reactionary Keynesian is bad, I think the politics is even worse. Quite simply, by achieving very little beyond redistributing to the rich and unworthy, it gives Keynesian policy a bad name. But we can avoid that, when we can, by not calling every increase in the deficit a stimulus. And by saying tax cuts for the rich paid for by borrowing are really tax increases for everyone else.