Krugman: Bad Anti-Stimulus Arguments

Krugman has been a vocal proponent of government spending to end the recession. He is among the comfortable class of economists who never left the Keynesian school of thought: the government has the ability and responsibility to fine tune economic output and fiscal spending is a key tool. And, he is solidly in the camp of economists who believe that the current downturn is likely to be quite bad. As such, it comes as little surprise that he believes the Obama plan is too timid. There is intellectual merit to his arguments.

One of his blog entries, however, is very misleading. In this entry (Bad Anti-Stimulus Arguments), he accuses conservative economists of a basic misreading of economics. In turn, I accuse Krugman of intentionally twisting the truth himself.

Here is a quote from the entry:

Yes, the standard theory of consumer choice says that a consumer gains more utility if he or she gets to freely allocate a dollar of spending than if someone else makes the choices: I’d rather buy myself a $10 meal than have you feed me $10 worth of food that you select.

But that’s not what we’re talking about when we talk about stimulus spending: we’re not talking about the government buying consumption goods for the public at large. Instead, we’re talking about spending more on public goods: goods that the private market won’t supply, or at any rate won’t supply in sufficient quantities. things like
roads, communication networks, sewage systems, and so on. And every Econ 101
textbook explains that the provision of public goods is a necessary function of government.

It’s the last sentence where he is most misleading. The provision of public goods is a necessary role of government: true. It is however a jump in logic from this statement to a statement on stimulus. The fact that the government is the only efficient provider of transportation infrastructure does not imply that government spending on infrastructure can stimulate output, at least in the sense of avoiding downturns in output or fine tuning.

There are two basic problems with the leap: the government should already provide public goods independent of the point in the cycle and even efficient government spending can crowd out private investment and consumption.

Public Provision of Public Goods: To understand the first point, think of the rate of return on government investment. If the marginal rate of return on government investment is higher than the marginal private rate of return, government spending is efficient. That is, if the rate of return on a new highway is greater than the best private rate of return, the highway should be built.

There is lots of government spending that may meet this criterion: police, fire, roads, education, ameliorating liquidity crises. But this does not mean that any of the projects are appropriate for stimulus. From Krugman, “we’re talking about spending more on public goods.” We don’t need the average return on government spending to be high; we need the return on the marginal dollar to be high. These new stimulus projects must have a high rate of return. If they exist, why did the government not make this investment prior to the downturn?

In the stimulus plan, Obama’s team is planning to fund projects that states have on their drawing boards but have decided to postpone for budget reasons, the shovel ready projects. Which projects are states most likely to drop? Those with the highest return? There may be some scope for relaxing state-level liquidity constraints, but it is foolhardy to think these projects are going to have a high social rate of return. The states will continue to fund their best projects. There are no free lunches.

Crowding Out: Even when government spending is efficient, the spending still uses real resources. If the government builds a road, it must hire workers, build capital, and disrupt commutes during the construction. Wages are higher, capital is more expensive, and commuting costs more. As a result, some marginal private investment projects do not occur. The extra money spent by both the private and public sector as a result of the project reduces resources available for consumption.

Private investment and private consumption must fall. This is economics 101.