Lake Wobegon Keynesianism
By Scott Sumner
With the recent discussion of a possible “fiscal stimulus” coming out of Washington, I find that many people are forgetting a few basic ideas from EC101. As you may know, I do not believe that fiscal stimulus in the US has a significant impact on NGDP or RGDP. That’s mostly because of fiscal offset of the demand side impact—the Fed would simply raise rates faster than it is currently contemplating, in order to keep inflation expectations close to 2%. In addition, it has little impact on aggregate supply; indeed even the sign is ambiguous. But for the moment I am going to assume that I am wrong, and that fiscal stimulus is expansionary.
The key point to understand about fiscal stimulus is that more fiscal stimulus today implies less fiscal stimulus during the next recession. That’s because the expansionary impact of fiscal stimulus (in the Keynesian model) occurs because the full employment budget deficit gets larger than before, not because it is large in absolute value.
For the moment, let’s assume that the full employment deficit during the next recession is $X. In that case, the larger the fiscal stimulus between now and the onset of the next recession, the smaller the increase in the deficit during the next recession, and thus the smaller the fiscal stimulus during the next recession.
But it’s actually worse than this. Many pundits seem to be forgetting about the government’s long run budget constraint. Even if the national debt is never paid off, it must be serviced. And that means that even in the US there are limits as to how much can be borrowed. This means that I cannot hold the future deficit constant when contemplating fiscal stimulus today (as in the previous example), I need to assume that a bigger deficit today will imply a smaller deficit during the next recession. When you read some pundits, it almost seems as if they are assuming that fiscal policy can always be more expansionary that average. But that’s impossible! (Except in Lake Wobegon.)
Thus the fiscal policy being contemplated today would actually make the economy more unstable if the Keynesian model is are correct. Fortunately, the Keynesians are wrong (due to monetary offset) and hence the foolish and poorly timed fiscal stimulus that we are likely to get out of Washington will merely be a waste of hundreds of billions of dollars, nothing more.
I’d also point out that most infrastructure decisions and financing should be made at the state and local level, where funds are more likely to be spent wisely. There may be a few minor externality cases, such as I-95 though Delaware, but these can be handled on an ad hoc basis, by having a Federal agency require a minimal level of road quality in cases where interstate highways roads are mostly used by out of state residents. Ditto for mass transit. LA County just voted a small sales tax increase to fund a massive expansion of its commuter rail system. That’s the level of government where these decisions should be made. People make wiser decisions spending their own money, than if they are spending someone else’s money.
Alex Tabarrok has an excellent new post pointing out one area where the federal government could help—making it easier to privatize facilities such as airports. This idea is further advanced in Europe, where infrastructure is much more likely to be privately operated, and is generally of higher quality. Hopefully Trump or his advisers will read Alex’s post.
BTW, I am not suggesting that the federal government has no role here. Alex mentions some national security issues with a safe electricity grid. In addition to terrorist attacks, some worry about the impact of large solar flares. So there may be a few cases where externality issues allow for a federal role. But they are few and far between. Thus the federal government should NOT subsidize California’s high-speed rail boondoggle. My fear is that Trump likes to build grand projects—I hope I am wrong.
Not a federal responsibility:
PS. Newton, Massachusetts (where I live) does a poor job of maintaining its roads. But it’s not due to a lack of money; the town is quite wealthy and just built a $200 million high school (3 times the normal cost). It’s because voters keep voting for politicians who would rather waste money on lavish schools than fill potholes.