Why Does Fiscal Stimulus Work?
I'm curious about something. It's far enough above my pay grade that I'm a little reluctant to even write about it, but here goes anyway.
John Cochrane, an economist at the University of Chicago who's a frequent punching bag for Brad DeLong and Paul Krugman, wrote a post a few days ago that critiqued the Old and New Keynesian views of fiscal stimulus when we're at the zero lower bound (i.e., when interest rates have been reduced to zero and the economy is still sluggish). The mathematical details are over my head, but I still found it kind of interesting and was curious to see what DeLong and Krugman thought of it.
Well, they finally got around to reading it, and unsurprisingly, they're pretty harsh toward Cochrane (DeLong here, Krugman here). But I was a little disappointed in their responses. They have plenty of detailed issues with Cochrane, many of which strike me as well taken. But I didn't feel like they ever addressed Cochrane's core argument. He isn't insisting that stimulus doesn't work.1 Instead, he's taking aim at the stories economists use to explain why they think stimulus works. In his words, here's the Old Keynesian multiplier story:
More government spending, even if on completely useless projects, "puts money in people's pockets." Those people in turn go out and spend, providing more income for others, who go out and spend, and so on. We pull ourselves up by our bootstraps. Saving is the enemy, as it lowers the marginal propensity to consume and reduces this multiplier.
But Cochrane says that New Keynesian models don't support this story at all. When you take a look into their guts, NK models posit an entirely different underlying mechanism for why fiscal stimulus works:
If you want to use new-Keynesian models to defend stimulus, do it forthrightly: "The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow's consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based "multiplier," sorry, our new models have no such effect, and we'll stand up in public and tell any politician who uses this argument that it's wrong."
So....is this right? Or wrong? Do New Keynesians believe that the "putting money in people's pockets" story is a good one? Or do they think the justification for fiscal stimulus is different, and that NK models produce old-style multiplier-like results only by coincidence? Are multipliers just a handy mathematical shortcut? Or is it really a crowding-out story we should be telling, not a multiplier story? (This is how I usually think about it.) Or perhaps Cochrane is unfairly oversimplifying NK models, which take into account more than just consumption and interest rates?
I have an unfortunate feeling that pretty much nobody but me is interested in this, but I guess you never know. Maybe someone will take a crack at explaining it.
1In fact, Cochrane is not much of a fan of fiscal stimulus. But that's not the point of this particular post.
UPDATE: Simon Wren-Lewis suggests that most modern Keynesians assume there are two basic types of consumers. One is living paycheck to paycheck and spends pretty much 100 percent of any additional income they get. These consumers fit the Old Keynesian multiplier model. Other consumers are richer and save all or most of any new income they get. Their behavior fits the New Keynesian model. Put it all together, and a complete model ends up being sort of an OK/NK hybrid.
I've badly oversimplified Wren-Lewis's post, so be sure to read the whole thing if you're interested enough to want the real story.