Paul Krugman to the Rescue (I’m serious…but even more so Milton Friedman to the Rescue)

by robekulick

So I promised I’d stop blogging about the debacle in the macro-blogosphere, but to tie things up I have to do one final post. One reason I have to do this post, is because it gives me an opportunity to praise Paul Krugman something which hasn’t happened that much on my blog yet. But more importantly, I finally feel like I have some answers to the questions I’ve been confused about.

For those following, there’s been a major battle on the macro-blogosphere, which in its most recent iteration has gotten the usually staid Scott Sumner very riled up taking on Paul Krugman (and crew). In a number of posts Sumner tries to demonstrate to Krugman and Krugman’s fellow Keynesians why he is right (the particular issue itself isn’t important to my blogpost) using a bunch of Keynesian style examples. In his most recent post, Sumner summarizes his argument: and suggests that he won’t stop pushing this argument until Krugman acknowledges or at least confronts his actual argument directly. Now, I definitely understand Sumner’s position and I really hope he does get the acknowledgement, but I don’t think he will. And the reason it will he hard to get that acknowledgement is that the arguments that have been made throughout this process have been made in an un-rigorous fashion. Actually, it’s worse than that, as the arguments have proceeded as follows:

Someone makes a non-rigorous statement giving the idea behind why they think an economic principle is the case. Someone else on a different part of the ideological spectrum criticizes adding an element of rigour without specifying all of their assumptions. Someone else uses some of the remaining lack of rigour to add a new argument…and it goes on and on.

Now in a move I definitely didn’t see coming, yesterday, Paul Krugman madethe argument that what this debate really needs is a rigorous foundation:

Krugman provides a link to an academic paper that not only summarizes the New Keynesian model that Krugman prefers but also the neo-classical model associated with U Chicago types.  Here is the paper by the eminent macroeconomist Michael Woodford:

Now in fairness this whole debate started when Krugman jumped on some comments Robert Lucas made in a speech given two years ago in a totally non-rigorous setting. In the speech, Lucas essentially argued that the efficacy of fiscal stimulus was limited and gave the following example:

“But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.”

Krugman criticized creating a stylized example of his own, and then John Cochrane of the University of Chicago joined the fray.

So why do I now say that Krugman has come to the rescue? Because this one paper does a very good job of demonstrating that the ultimate points being made by all of these economic giants are grounded in real economics and what we really just have is a battle of models.

What’s ultimately being debated here is the size of the Keynesian multiplier. If the Keynesian multiplier is above 1 then fiscal stimulus not only causes the economy to grow because of the increase in government activity but also induces expansion in the private sector. If the multiplier is less than one, then the economy measured as a whole grows because the public sector grows, but there is some shrinkage in the the private economy through reductions in investment or consumption. In other words the private economy is crowded out to some extent.  Finally, if the multiplier is zero then any resources used by the government are totally offset by resources taken out of the private market and stimulus has no effect on growth. In the traditional Keynesian model the multiplier is always greater than one in a recession.

So now to the paper. In the first part of the paper, Woodford shows us a basic version of the neo-classical macroeconomic model based on the assumptions of Ricardian equivalence and prices and wages that instantly adjust. Woodford shows that in this model the multiplier must be smaller than one.  Furthermore, he demonstrates that under certain conditions the multiplier will tend toward zero, for instance, when the marginal cost of employing resources in production is sharply increasing. So what we see from this is that there certainly is a basis for the arguments made by Lucas and Cochrane. Now specifically what set off Krugman (and Brad De Long) was Cochrane’s assertion that the basis for his and Lucas’ opinion could be found in the principle of Ricardian equivalence. But looking back at what Cochrane wrote:, he clearly invokes the idea of Ricardian equivalence and “a well-functioning economy.” By well-functioning economy I think it’s clear he means one where wages and prices adjust quickly. And of course since the marginal cost of government employing resources should be related to how “well-functioning” the economy is, I think that pretty much explains where Cochrane was starting from.

Moving on, Woodford’s paper goes on to show that when there are rigidities in the economy like sticky wages and prices multipliers can be above one. However, as Scott Sumner has often argued, the model also shows that the fiscal multiplier being above one depends on the possibility of monetary expansion. Woodford writes, “the size of the multiplier [in the New Keynesian model] depends crucially on the monetary policy response.” So both Krugman and Sumner can be seen to be on firm footing as well in terms of the logical consistency of their general economic outlook.

What this demonstrates pretty clearly to me at least is that the arguments being made by econ giants like Krugman, Lucas, Cochrane and Sumner are based on consistent economic reasoning. So I want to say Thank you Professor Krugman for finally putting up a rigorous model that puts all the cards on the table! Would I still like more information in terms of responses to my “Letter to Prominent Economists.”? Definitely. But this is a very good start.

So what to make of all of this? Surely I can’t be saying that these economists with mutually exclusive policy prescriptions are all right about fiscal policy?

My point is that there is rigorous logic behind all of the major schools of economic thought. That’s how they got to be major. And what’s clear is that logic isn’t enough. In his seminal essay, the Methodology of Positive Economics, Milton Friedman argues that economics can only advance as a science when models are empirically tested. Large scale empirical testing isn’t possible on an economics blog, but rather than engaging in these arcane quasi-theoretical disputes and accusing each other of not understanding economics, economics bloggers do the most to support their beliefs when they present empirical evidence in support of the theories favored by the authors.