The Stimulus Debate: A comment

I love it when economists with different political leanings and opposed economic ideologies begin to debate. In my view, nothing gets quicker to the underlying, and often unstated, tenets of their beliefs. With over a trillion dollars of spending on the table and potentially the largest downturn in the post-war era already begun, economists of every stripe are falling out of the woodwork. And, of course, the name calling has begun in earnest (see Krugman)

To oversimplify, on one side we have the Chicago school. In this camp, monetary policy, in the spirit of Milton Friedman, is the one and only tool that can stimulate output. On the other side we have what I will label the East Coast Paradigm (Krugman is the banner wielding leader of this camp). In this camp, monetary policy is next to useless, at least when nominal interest rates are low, and fiscal policy is a panacea ready to fulfill its promise of returning the economy to full employment. I live in neither camp but visit each with a full measure of skepticism.

I use a recent essay by John Cochrane as a representation of the Chicago School. His note aptly titled Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies? disputes the premise that “by borrowing money and spending it, the government can raise the overall state of the economy, raising output and lowering employment.” Clearly he takes umbrage with the basic premise of fiscal stimulus. Yet, I think he is closer to the East Coast Paradigm than he would ever admit.

Take a look at his second paragraph:

One form of “fiscal stimulus” clearly can increase aggregate demand. If the government prints up money and drops it from helicopters, this action counts as fiscal stimulus, since the money counts as a transfer payment … A trillion dollars more money in private hands … People naturally don’t want to sit on a trillion dollars of extra cash. They spend it, first creating demand for goods and services, and ultimately inflation.

This is perhaps the only prediction that it utterly uncontroversial among economists.

Cochrane clearly believes monetary policy can stimulate output. A helicopter drop of cash creates demand for goods and services. He does not give us any more information on how this drop is going to work. We must take it on faith.

Or rather, Cochrane takes it on faith.

This is not the way I learned about helicopter drops (I am of course a student of the Chicago school) nor is it the way I teach them. A helicopter drop is the instantaneous delivery of money to every agent in the economy, say $1000 in every pocket.

How might this stimulate demand for goods and services? The start of the story is easy. I wake up in the morning and finding an extra thousand dollars in my pocket consider myself to be rich. Being a rational permanent income consumer, I decide to run out to the store and spend a portion of my new-found wealth. Every other agent in the economy responds in a similar fashion. We have an instantaneous increase in demand for goods and services.

The end of the story is a bit more complicated. Why didn’t the shop keeper raise his prices? In almost any incarnation of an economic model, prices rise with demand. If he failed to raise his prices (either because he wouldn’t or couldn’t), why didn’t he run out of goods? Surely he does not keep so much inventory on hand to accommodate this type of unexpected demand surge.

A helicopter drop is simply a change in units. Paraphrasing Hume, would we expect the United States to be richer if we listed GDP in trillions of Yen rather than billions of dollars.

It seems to me that for Cochrane’s helicopter drop to boost real demand for goods and services real resources in the economy must have been unused before the drop and that through some unmodeled mechanism the helicopter drop allows these resources to be used. We could, perhaps, write a model in which the drop boosted output but it would not be one that was “utterly uncontroversial among economists”.

Viewed through this lens, the loosely labeled East Coast Paradigm is very similar in fundamental beliefs to Cochrane. They believe that there exist unused resources in the economy. They believe that fiscal policy can exploit these resources to boost output.

Again, the start of the story is the same. Workers or capital lie around idle. The government sweeps in and hires these resources, thereby boosting output. If the spending does nothing more than this, the multiplier is 1. If in addition, these workers spend their paychecks and increase demand for goods and services the multiplier can be greater than one.

I’ve already said my piece on crowding out here. So I won’t rehash it now. The basic point is that if you believe monetary policy (Chicago school) or fiscal stimulus (the East Coast Paradigm) can boost output then you believe real resources are idle. I will caution against this view. Workers become unemployed during recessions. We have to understand why they are unemployed before we can employ them and boost output. For example, the workers may be unemployed because they need new skills to fit the new jobs firms want to create. Hiring them to work for the government may prevent or delay this skill acquisition. They may simply be unemployed because it takes time to find a job; government hiring may slow their search.

For the fiscal stimulus to work, the spending must, in effect, ameliorate some private-sector friction. If we assume the government is good at removing the friction, use fiscal stimulus. If we believe otherwise, do not use fiscal stimulus.

Again, we can build models in which fiscal spending at the magic moment can boost output and increase welfare but they would not be models that were “utterly uncontroversial among economists”.