Job-Creation Arithmetic, II
By Arnold Kling
On his web site, Paul Krugman has posted the textbook macroeconomics of fiscal policy for stimulating employment. In a related post, Krugman explains how this basic macroeconomic model explains what some people (like me, for instance) found puzzling about a recent column in the New York Times.
No, I didn’t forget to divide by 10…no serious economist thinks that a tax cut or spending increase will have any effect on employment more than a couple of years from now…
My own view is that the tax cut – or any fiscal policy – will have a positive effect on employment only as long as the economy remains close to a liquidity trap. That is, once the Fed is no longer constrained in how much it can cut interest rates, fiscal policy adds nothing to the ability of policy to achieve full employment. Now most forecasts presume that we’ll be out of the trap by next year – that is, before most of the supposed job creation from the tax cut takes place. Even if you’re more pessimistic than that, we’re probably looking at only 1-2 years when fiscal policy creates jobs.
Krugman is basically arguing for a classical monetarist view of macroeconomics. In that view, aggregate demand policy only affects employment for a short period of time, because the economy has internal adjustment mechanisms that cause it to return to what Milton Friedman once called the “natural rate” of unemployment. Moreover, if the monetary authorities are free to set goals for macroeconomic targets, they can offset fiscal policy changes, meaning that the latter have no effect even in the short run.
Just to give fiscal policy a sporting chance in the short run, Krugman posits that we are in a liquidity trap, so that monetary authorities are not completely free to control aggregate demand. I happen to disagree with the view that we are in such a trap, but that is beside the point here.
The bottom line is that in anything like a classical macroeconomic model, there is no long-term stimulus to employment from fiscal policy. Tax cuts can improve the economy if and only if there are supply-side benefits.
On the issue of supply-benefits, Krugman would be prepared to point out that the adverse impact of a larger deficit outweighs the positive effects of lower tax rates. I believe that such an economic argument is valid, important, and typically overlooked by supply-side economists. The mainstream economic view would be that, generally speaking, in order to realize the supply-side benefits of tax cuts, the government needs to reduce spending below what it otherwise would have been.
For Discussion. If a fiscal expansion leads to gains in employment that last two years or less, should economists be doing more to educate the public about the case against fiscal activism? Should we be arguing that the job of maintaining full employment falls outside the responsibilities of Congress and the President?