1. "If a private firm decides to borrow more and increase its investment spending, aggregate demand will increase."
2. "If government decides to borrow more and increase its investment spending, aggregate demand will increase".
3. "If government decides to borrow more, and lend to a private firm to increase its investment spending, aggregate demand will increase."
All three sound reasonable to me, in current circumstances. A small number of economists may believe (1) but not (2). The majority of economists would say it's inconsistent to believe (1) but not (2). They ask: "What's the difference?". But then we can re-use that argument and ask "What's the difference?" between (2) and (3).
If we are considering fiscal policy to increase aggregate demand, should we also consider having the government borrow and lend to private firms instead? What's the difference?
One difference may be in future taxes. This difference could go either way. If the government investment is productive and increases tax revenue, while the private investment fails, and the firms defaults on the government loan, then (3) increases future tax rates, while (2) does not. But if the private investment succeeds, and repays the loan, while government investment does not increase tax revenue, the opposite is true. Higher future tax rates are bad in themselves, and may also reduce the size of the multiplier, via neo-Ricardian effects. (This is not to deny that there are many good government investments which are productive in making life better, but do not increase tax revenue).
A second difference may be in whether they displace other investments. This difference could also go either way. If the private firm undertakes an investment project which is a perfect substitute for another firm's investment project, the first may crowd out the second. Similarly, if the government undertakes an investment project which is a perfect substitute for another firm's investment project, the first may crowd out the second.
Now, since the government usually invests in very different sorts of projects than those normally undertaken by private firms, direct crowding out is unlikely in this case. And if government investment is a complement to private investment, there will be crowding in of private investment instead. But if the government offered increased loans to all private firms, we will not get direct crowding out unless all private firms run out of investment ideas.
All this assumes, of course, that the government is able to induce private firms to borrow more and invest more. If private firms have no more investment projects that are profitable at the rate of interest on government debt, then the only way that government could do this is by subsidising investment. But then governments can also run out of investment projects that meet standard cost-benefit criteria, and explicit subsidies to private investment might be either dearer or cheaper than implicit subsidies to government investment.
It is not obvious, on purely macroeconomic grounds, whether it is better for the government to increase aggregate demand by borrowing and investing directly or by borrowing and lending for private firms to invest. It all depends on the relative microeconomic benefits of government vs. private investment projects. In general, we would expect the best plan would be a mix of both, where both government and private investments yielded equal benefits on the margin.
In the simplest macroeconomic model, where there is only one rate of interest, and firms do not face borrowing constraints, it is impossible for the government to borrow and lend to private firms and get them to increase investment, without subsidising investment. Private firms are already borrowing and investing as much as they want at that rate of interest. But a model with one rate of interest cannot explain, or even describe, the recent increase in interest rate spreads between government and private debt.
Many have argued, including John Cochrane, that the underlying problem is a massive shift in demand away from private debt towards the more liquid government debt (and money). While interest rates on government debt have fallen, interest rates on private debt have increased (or at least not fallen as much). If so, the direct solution is for the government to change the supplies of assets in the same direction, just as the correct response to an exogenous increase in the demand for money is to increase the supply of money. If the government borrows and invests, this increases the supply of government bonds to meet the increased demand. If the government borrows and lends to private firms to invest, this does the same thing. Issuing government bonds to buy newly-issued private debt is one way to do this.
You could argue that the government lending to private firms at below the previously existing interest rate on private debt is a subsidy. Or you could argue that the government has a comparative advantage, at the moment, in supplying a necessary input, debt. We make a similar argument for government infrastructure spending.
How much the government would need to spend would depend on the interest-elasticity of new private investment. If it were very low, most new investment would have taken place anyway, even without government loans. If high, or if firms were borrowing-constrained, the policy would be more effective.
As Brad DeLong has argued, there are mistakes in Cochrane's paper. But there may also be some useful insights.
While waiting to hear the the news on Canadian fiscal policy…
Worthwhile Canadian Initiative 
This reminds of how how the municipal government in Vancouver is handling the Olympic Village – borrowing up to 800m to lend to a private developer in place of pulled private equity funding.
That was a quick response brendon! I was still doing minor editing. (I’m really bad at that. No matter how much I preview, it’s only when I post I see things I ought to change).
Yes, very similar. I should check out interest rates on municipal debt, compared to Federal debt. Of course, municipalities have a bigger coordination problem than the Federal government, because of “imports” from other municipalities. So it’s probably best if the Federal government does it.
You’re much more charitable than Krugman. PK ripped Cochrane a new one, and it does seem that Cochrane’s mistake, by it’s apparently elementary nature, may not be an honest one given. But maybe I’m being just a little paranoid.
Patrick: thanks for the tip. I just read PK’s post now.
What’s strange is that PK and BDL have different criticisms of the same passage in JC. PK says he is misusing an accounting identity; BDL says he is assuming velocity of circulation is technologically fixed. And what’s doubly strange is that JC, later in his paper, considers a case where desired velocity changes, and he also describes a case where an excess supply of money and bonds creates an excess demand for goods (or maybe it was vice versa), which shows he can think outside the Say’s Law identity.
And if either of them wanted to explain to JC why he was wrong in that passage, using his own terms so he (and Fama) would understand it, they would talk about how an initial excess demand for loans (when the government tries to borrow) causes an incipient rise in the rate of interest, which either increases velocity or the money supply, creates an excess supply of money, and so on.
But yes, everyone, even smart people, say daft things sometimes. Keynes himself made the same mistake, IIRC, treating S=I as an identity, therefore “proving” that loanable funds theory must be wrong. Best to explain the mistake, and not ignore the things you might learn.
I believe it was an honest mistake. If it were dishonest he could have hidden it much better. Plus, mistakes are just so common anyway, we don’t need to attribute it to anything other than the standard “cock-up” theory. PK’s “Dark Ages” comment was on the ball though, because we do forget stuff we used to know (I mean “we” as a profession, not just “we” as individuals).
Now, where have I made a daft mistake in my post? Am I making some daft implicit assumption about the relative demands for government debt vs private debt? I might be. We have all spent too much time thinking about the relative demands to hold money vs. bonds, and very little about the relative demands (and supplies) of money+govt bonds vs. private debt. In other words, what is my implicit theory of the spread between private and government interest rates?
I don’t agree with the assertion that money and Treasuries are equivalent unless it’s cash money under your mattress he’s talking about. When the banking system is feared to be insolvent, short-term Treasuries are more desirable than money because you are sure to get your money back (sort of civilization ending). Yeah, sure deposit insurance covers some of it, but most of the hi-fi billions that flow around the world aren’t covered. Anyway, that’s probably nit-picking. The thing I really don’t get is why he thinks this will work:
“I would be happiest if the Fed and Treasury satisfied the large demand for government debt and money by transparently buying or lending against high quality corporate and securitized debt, at market prices. I am happiest of all when they buy newly-issued commercial paper and securitized debt, acting as the missing intermediaries to help address the “credit crunch,” as well as supplying government debt. These actions are easiest to unwind. When investors get sick of holding so much money or government debt, the Government can, in effect, take back in government debt in exchange for this private debt, and probably make a good profit.”
It does make some sense to me, given the broken credit markets, but I don’t understand how it is going to help pull us out of the recession. No company with the required credit rating he’s talking about is going to expand capacity when aggregate demand is in the toilet and unemployment on the rise, even if they can borrow money cheaply. Doubly so if everyone is panicky and risk averse after getting burned over the last year.
If he had said the Gov’t should be lending to new businesses creating new jobs, it might makes sense to me; the US has just had two major sectors vaporized (HiFi and housing) and they desperately need something to fill the hole. I’m not an economist though, and I freely admit I might be missing something.
This gave me a chuckle: Nick on Cochrane “I believe it was an honest mistake. If it were dishonest he could have hidden it much better.” [We, professional economists, and also upstanding citizens, (at one and the same time!) cannot bear the thought that JC is more dishonest than incompetent] and I too, believe that this is not a nefarious Nick but…the other sort…more honest than competent…which could both B sky high…of course.
But good on you for noting the zeal (BDL) attached to punishing the Mistaken [Lookit how I bangs me head on wall…] rather than examining the mistake and learning the lesson or failing that, the nature of the beast, or failing that, taking it out on the entire profession you once had some respect for, or failing that, taking the dog for a walk, or failing that, promising to take the dog for a walk as soon as it quits raining.
In these times of Trouble and having this Once in a Life Time to Shine (Lookit Roubini and if that doesn’t get you out walking the dog, even in a hail storm, nothing will.) and Solvitall, we need this kind of attitude: “Now, where have I made a daft mistake in my post? Am I making some daft implicit assumption about…” and the answer, Plunko, not so much.
So I like your engaging soul so much more than any other distracting propositions so far.
Do you figure that the primary fuel for the zeal (BDL, PK, MT…) is that the alternative, is pretty scary…for such sensitive and over-reactive fellow economists?…and that those calmer cooler heads will prevail as we wait for the bad actors to leave the stage and we can make efficient use of Federal funds by aiding those surviving companies…rather than the parasitic homeless bums and ok, a few investment banks?
Patrick: I did have currency in mind, but you are right to make the distinction. Don’t think it matters much for this argument though.
Regarding that JC quote: I see how it could work, if done on a large enough scale. If the government swaps enough government debt for private debt it would drive up the price and drive down the rate of interest on private debt, making it more profitable for firms to issue new debt to invest. If it created the expectation that it would go on doing so, this might make it more effective. What I don’t know is how large a scale would be needed. It might be very large, like TARP only bigger. The Bank of Canada has already been doing this in a relatively small way, by buying CMHC-insured mortgages. It depends how elastic is the private demand to hold that private debt.
If the government could segregate the newly-issued private debt from that market, and just buy the newly-issued debt, it should not need to buy as much of that debt to drive down the rate of interest on newly-issued debt.
In normal times, the effect of interest rates on investment is quite big enough for the Bank of Canada to control demand by adjusting interest rates. In a recession, the demand for investment will be lower, for any given rate of interest, but I don’t see why a cut in the rate of interest would be any less effective. (Of course, just swapping money and bonds, which is what central banks normally do, won’t be effective in lowering the interest rates that matter).
What’s the difference between the Gov’t lending to new businesses creating new jobs, and the government buying up (say) 50% of all newly-issued private debt? Maybe in the first case the govt asks what the debt will be used to finance, before buying.
Thanks calmo! (I was writing as you were posting). Looking back on all the times we have changed our beliefs, both individually and as a profession, and at the mistakes economists make in seminars, even when there’s absolutely nothing ideological at stake, leads me to like the general “cock-up” theory. (And economists are not alone.)
Regarding the zeal of PK and BDL (I don’t see MT as so zealous): It is frustrating to see other people say something, especially in print, when you know it’s a mistake. Even more frustrating when you figure they ought to know it’s a mistake. Still more frustrating when you know that policy decisions may depend on the mistake. And more frustrating when you believe that the policy in question will work better when people believe it will work (expectations matter).
[But that zeal is dangerous. Sometimes those other idiots will be right, or at least partly right.]
If there is ideology at work (on both sides), I think it is as much an internal economists’ ideology than ideology in the wider political sense. As much economic methodology than politics (they don’t always coincide, as the Austrians, for example, tend to be right-wing politically, but closer to the left-wing in their methods in some ways). Plus macroeconomists vs finance theorists (especially with the current crisis, which is on the border of macro/money and finance). Plus rivalry between schools. Plus simple personal ambition. Dunno.
I see 3 ways of looking at things: www(dot)cbc(dot)ca/health/story/2009/01/22/f-weeklycheckuptaylor(dot)html
The author says primary sectors yield the highest “supply chain revenue multiplier” in the context of stimulus, but some services (from doctors to ABCP brokers) would yield the highest GDP growth.
The multiplier that is desired to be distilled here IMO is to use stimulus funds in a way that employs someone made unemployed as a result of permanent USA consumer contraction (much not until a balanced budget).
The USA consumer was 40% of their economy, and will maybe be 30% in the sustainable long-term? My strongest criticism in this context of lending to businesses to hire instead of directly, is that the businesses will maintain the USA consumer bubble just by virtue of being more exposed to it than are Crowns.
Another way the price signal is broken is that GDP doesn’t measure happiness well. The GPI and CWI metrics in the link solve this. In the USA this is obvious: no Universal Healthcare, the highest incarceration rate on Earth and an enviro-record better only than the Saudis and Canada.
In Canada is a tougher estimation, the GDP + social-capital sum, I’d guess it still leans towards money for public over private. Our daycare facilities are last among the OECD 20 and our child poverty rates are now at the bottom 1/2 and falling. German Watch ranked our enviro-policy 56th among 57. I wouldn’t want to subsidize CTV demonizing a future cap-n-trade over CBC’s public education.
A 3rd analysis is to view sectors as a pyramid. In the link, primary sectors like lumber and farms, sell housing components and chicken legs that are worth more than is porn or a manicure.
Chicken truckers are in trouble if the farm fails and stimulus loans further down the chain are useless if farmers go bankrupt. There is a strategic value in having a functional pyramid and it might cost more to do without or to source the pyramid’s lowest levels globally, than it would to pay the stimulus bill. I’m not supporting protectionism. At the same time there is a cost of having all your strategic sectors sourced globally given an imperfect just-in-time economy and much of the lowest pyramid blocks are publicly funded.