How did "fiscal policy" get to be the answer to a question about time and money?
Sophisticated Keynesians will object if I treat "Keynesian" as synonymous with "having a predilection for fiscal policy". But I think they would recognise that the two are correlated. And that correlation is puzzling. The correlation seemed to disappear during the "New Keynesian" era, as the New Keynesians chose monetary policy over fiscal policy; but it reappeared with the recent recession.
Assume a closed economy, for simplicity.
Y=C+I+G is the way we usually do the accounting. But there are many different ways to do the accounting, and each way frames the question differently. Here's a better way:
Y=Cp+Ip+Cg+Ig
C means consumption and I means investment. The subscript p means private and g means government.
And here are two different ways we could aggregate terms:
1. Y= (Cp+Cg) + (Ip+Ig) = consumption spending + investment spending
2. Y= (Cp+Ip) + (Cg+Ig) = private spending + government spending
And there are two different questions we could ask about the composition of output:
1. What is the optimal mix between consumption and investment spending?
2. What is the optimal mix between private and government spending?
Those two questions are orthogonal. They are two different dimensions. Consumption/investment is North/South; private/government is East/West. A change in the optimal mix between consumption and investment spending has no obvious implications in either direction for the optimal mix between private and government spending. (Maybe the government has a comparative advantage in investment spending and the private sector a comparative advantage in consumption spending, or maybe it's the other way around.)
Keynes' question was about the first of those two questions, and how a decentralised economy might not get the answer right, and could cause even worse problems as a side-effect of not getting the answer right.
It would be very surprising if getting the right answer to the first question required us to change the answer to the second question. But that is what the "Keynesians" seem to be telling us.
Suppose the economy initially had the right mix on both dimensions.
Then suddenly people decided they wanted fewer new cars and more new buses. Assume cars are bought privately and buses are bought by the government. People cannot signal that change in preferences through the market. They can only signal it at the ballot box, or by talking to government. But we know what the answer is: a reduction in private spending and an increase in government spending. Suppose the government failed to give the right answer, and didn't increase spending on buses. Would that plunge the economy into recession? I don't think it would. People wouldn't be as happy driving cars as they could have been riding buses, but they wouldn't all be unemployed. That wasn't Keynes' question.
Now suppose people people decided they wanted fewer new cars today and more new cars next year. We know what ought to happen. Car producers should reduce current production of cars, and divert resources into investment so they can produce more cars next year. But will that actually happen? Well, maybe if people placed their orders for next year's cars now, that is exactly what would happen. Car producers would see increased orders for next year, and know they should divert resources away from current production towards future production. But if people don't actually give that signal, how will car producers know what they want? All the car producers know is that demand for this year's cars has fallen. If they think this fall in demand will persist, they will actually reduce investment, not increase it as they should. And that might cause a recession. That was Keynes' question. [Update: see Daniel Kuehn's post where he cites a long passage from the General Theory to back up my claim that this was Keynes' question. I had only vaguely remembered that passage.]
"Let's have the government buy more buses so the car producers switch to producing buses instead" isn't the right answer to that question.
But why did Keynes think the market economy might not be able to answer his question correctly? Where's the coordination failure?
I think there are two reasons: a micro reason; and a macro/money reason.
The micro reason: even if producers knew that people wanted to buy fewer cars this year and more goods next year, they might not know whether people plan to buy more cars next year or more bikes next year. And it might not be next year that they want more cars; it might be the year after next. It would take a good forecast based on a market survey to figure that one out.
The macro/money reason: If people had a choice between spending their income on newly-produced consumer goods and newly-produced investment goods, and nothing else, there would be no recession. Even if we add newly-issued stocks and bonds into the list of things that people can spend their income on, it makes no difference, because the firms that issued those stocks and bonds would be buying the newly-produced investment goods. Even if we add previously issued stocks and bonds, and land, and previously produced goods to the list, it makes no difference. If one person is buying used furniture, another must be selling used furniture. Say's Law almost works.
It's when we add "money" to the list of things people can spend their income on, that Say's Law fails. Because if your income comes to you in the form of money, nobody can stop you spending part of your income on money — you just don't spend it. And if everyone does the same, then we get a recession.
The micro reason, and the macro/money reason, are related. Money is the most liquid of all goods. We don't want to place an order this year for a new car next year. We want to keep our options open, which means we want liquidity. We don't want to decide now what make of car to buy, especially since we don't even know what will be on the market next year. Or maybe to buy it the year after next. Or maybe to buy a bike instead.
It is very hard to coordinate plans when everyone is waiting for everyone else to make up their minds. We all want to keep our options open, but liquidity has a social cost. Perhaps the answer to Keynes' question is that liquidity is underpriced?
The only defence for giving a "Keynesian" answer to Keynes' question is that you don't know the right answer, and your answer is better than nothing.
(A variation on a Leijonhufvudian theme.)
Worthwhile Canadian Initiative 
Ron,
“Here is my point at the simplest level. A produces apples and B produces bananas. They produce 10 of each and trade 5. One year A and B each fear the other is not going to trade. They produce 8 each and only swap 3. Each would rather consume 10 and not 8, but uncertainty leads to a sub-optimal outcome.”
That is why contracts and the legal system (provided by a fiscal authority) exist. If A and B want to ensure that each produces 10 and trades 5 for a given period of time, they arrange a contract that either can use to seek damages if the other does not hold up his / her end of the arrangement.
“We wouldn’t actually observe an excess supply of apples and bananas in your economy.”
I agree that all market would be in equilibrium and clearing unlike in monetary disequilibrium where that is not the case. I’m fine with defining “recessions” as only the latter case. But it seems there will be multiple equilibria(?) depending upon the state of expectations about the future. This will be true in both a barter and a money economy. Some equilibria will be sub-optimal with all parties benefitting from a shift to a different one (such as in my simple example).
Nick:
it’s not just about not offering up work for sale. Bananas and apples take time, effort and resources (investment) to produce.
If a pessimistic outlook caused both producers to grow only 8 bananas and apples, then it will cause decreased trade and decreased consumption for the next production cycle: which to them feels very similar to a monetary recession.
Does this scenario lack any key feature of a recession? If not, why not call it a recession?
“Now suppose people people decided they wanted fewer new cars today and more new cars next year”.
Economic messes like the one we’re in don’t occur because people “decide they want to buy fewer new cars today and more next year”. For some endogenous reason the economy goes into a tailspin and then all of a sudden masses of people find themselves on the street without a job, and investors are running for the hills in fear. The monetarist solution always seems to be “get people borrowing more by lowering interest rates”, or “make the very rich even richer by pushing up the value of their assets so they feel a bit more confident”. So you’ve got people kicked out of their jobs and homes, the economy collapsing all around them, and monetarists are preaching that people just need to get more into debt or the rich have to get richer and everything will be okay.
A more sensible approach might be, not to “produce extra buses”, but to keep producing as many buses as you had planned on producing, and for the government to increase its budget deficit by lowering taxes and just giving money to people to spend AS THEY SEE FIT.
Anon: “Does this scenario lack any key feature of a recession? If not, why not call it a recession?”
Good question. My answer: in a recession, stuff gets harder to sell and easier to buy (money gets easier to sell and harder to buy); in a boom, stuff gets easier to sell and harder to buy (money gets harder to sell and easier to buy). That to me is an important stylised fact about the business cycle. A barter model, obviously, could not exhibit that stylised fact. Recessions are always and everywhere a monetary phenomena.
James: let me just take one misconception from the many in your comment:
“The monetarist solution always seems to be “get people borrowing more by lowering interest rates”,…”
If the Bank of Canada wanted me to spend more, it would have to lower the rate of interest I paid, to persuade me to borrow more to finance my extra spending. That is true for each individual, but it is not true in aggregate. Because one person’s spending is another person’s income. If we all spent more in aggregate, we would be surprised to discover our aggregate income had increased by that same amount. Our extra spending would be financed by our extra income. Your comment displays a massive fallacy of composition.
Where the hell did you pick up those daft and confused ideas??
“But it seems there will be multiple equilibria(?) depending upon the state of expectations about the future. This will be true in both a barter and a money economy.”
Yes. It’s strange that some economists assume that if the economy is below its potential, there must be a disequilibrium. But disequilibrium can be the solution rather than the problem.
“Our extra spending would be financed by our extra income”.
like in the recent (and ongoing) private debt crisis, where debt wasn’t a problem because extra debt equaled extra income? So the solution to the private debt crisis is more private debt because that will mean more income?
And QE has really done F-all other than make wealthy asset owners even wealthier.
Nick’s post to James: “Where the hell did you pick up those daft and confused ideas??”
I’d say from past and present observation of the economy. I don’t consider them daft and confused. I would say some to most monetarists don’t seem to believe in more borrowing as a solution, but that means going to defining “money” and how banks work.
“If we all spent more in aggregate, …”
It is not about all. It is not about patient and impatient. It is more like the rich few and the many others.
[rescued from spam filter NR]
Nick:
You are right, with your definition recessions are necessarily monetary.
But isn’t that argument employing circular logic, the result of an overly restrictive definition? You define recessions as something necessarily involving money, hence, per definition, recessions are monetary. Q.E.D.
In economic analysis, wouldn’t it be more meaningful to define recessions based on the investment, production, trade and consumption patterns – thus allowing barter based economies to exhibit them as well, at least in theory?
Furthermore, wouldn’t it be more meaningful to take existing historic recessionary episodes of monetary economies and analyse whether if those initial conditions are fed into a barter economy, they would produce similar (recessionary) outcomes? That way we wouldn’t even have to define recessions, the data series defines them.
James, “Too much Fed”:
In your replies you have not addressed Nick’s criticism of your views and you have not addressed the fallacy of composition mistake you committed.
If you are interested in a scientific discussion please respond to Nick’s criticism directly, instead of mostly just repeating your previous statements.
Keynes’s answer was to pay people to bury gold in the ground and dig it back up again. It’s still the best answer to the problem.
Anon: You are right of course, down to your “QED”. And sometimes I do think there might be something to those multiple equilibrium/barter models (like the dance, where the boys go if they expect the girls to go, and the girls go if they expect the boys to go, so we may get multiple equilibria). Those models do explain some things well, and maybe they explain business cycles too?
In response to your questions: Dunno. There’s something weird about ignoring data (OK, maybe more stylised impressionistic facts than hard data). A theory that fits data A plus B is better than a theory that fits A and is silent on B. Plus, we might simply be interested in explaining data B in it’s own right. I sort of did a post on this once.
Dunno. I’m still thinking about that one.
AH: But it would be much better just to give them the (paper) gold, rather than make them work to dig it up. Sure, the latter “creates jobs”, but those are totally pointless jobs, that don’t produce anything. Leisure beats work, unless the work actually is productive.
Nick, OK – so your question was what to do when consumers want to consume “90 this year, and 111 next year, then back to 100 again every year after that.” I agree that in that case investment spending can make up for the lack of demand “this year”.
But the really important question here (particularly as far as maximising GDP goes) is whether consumers ever actually try to do that. As I intimated above, I doubt it. That is, I see no reason why consumers in the aggregate should decide to consume less this year OTHER THAN because of an attempt to build up cash reserves or pay off debts (which is what they’ve been doing for two or three years now.)
And assuming that’s what they’re trying to do, then I think my solution (channelling cash into household pockets) is better than upping investment spending.
Please note I greatly appreciate the time you devote to discussions with me and others on your blog.
Thanks Ralph. And i find it rewarding (as well as sometimes a little frustrating!) arguing with you.
In this particular case it’s rewarding, because you sort of have a point:
Imagine a very simple economy. People live forever, and are identical. Initially there is no saving or investment, and nothing ever changes over time. And everybody holds some (central bank) cash (and I mean “cash” literally, in the sense of currency they use as money).
Let’s now imagine two different ways things could change:
1. For some reason, people decide they need to hold a larger average stock of cash. (The desired velocity of circulation has fallen).
2. For some reason, people decide to become more patient, and would prefer to consume less now and more in the future.
In both cases desired “saving” has increased from zero to some positive number. (But “saving” is such a bad word, because it doesn’t distinguish between 1 and 2, and I would prefer to use the word “hoarding” instead for 1.)
One solution in 1 is to print more cash and hand it out. (There may be others, like an open market operation that sells them cash in exchange for bonds, and which is best may depend on whether the increased demand for cash is temporary or permanent, and on whether there are lump-sum or distorting taxes, etc.)
The solution for 2 is to increase investment above zero. Because it delivers the extra consumption in future periods.
Are we on the same page? I think we are.
Ralph: channeling cash into public investments is pretty close to channeling cash into pockets: the government does not hoard, thus public spending will be private sector income.
It also doesn’t have the moral hazards of giving people money directly: the money is given to build stuff citizens find useful (roads, tunnels, bridges, hospitals, schools, etc.) – and distributed to a large group of people in the private sector.
“Assume a closed economy …”
Well there’s your problem right there. That’s a remarkable assumption for a Canadian or an Australian (like me) – we are heavily dependent on (volatile quantity) capital inflows and (volatile price) commodity outflows. Whatever the results in the US why wouldn’t our fiscal stimulus just be frittered away in a devaluation?
Hi Nick, Yes: we’re on the same page. The real $64k question here is: when consumers spend less, is that a desire to consume less now and more in a year or two, or is it a desire to build up stocks of cash / pay off debts? I suspect it’s the latter, but I can’t prove it! And that $64k question is one that would never have occurred to be but for this little debate.
Nick,
I think Ralph introduces a third possibility here:
1. For some reason, people decide they need to hold a larger average stock of cash. (The desired velocity of circulation has fallen).
2. For some reason, people decide to become more patient, and would prefer to consume less now and more in the future.
3. For some reason, people decide that they need to reduce their outstanding debt. (The desired velocity of circulation has still fallen).
In 1., there may be a perception of money as a store of value causing people to retain money. In 3., there may be a collapse in net worth inducing people to repair their balance sheets.
Ralph and Frank: we want to pay down debts to increase our future consumption relative to our present consumption. If my income is $100, my debt is $50, and r =10% my C will be $95 forever if I don’t pay down my debt. If I pay off my debt, my current C drops to $50, but my future C rises to $100. “Paying down debt” is not a third category. It is either 1 or 2.
(And remember the national income accounting identity. If one person is spending less than his income from producing goods (to pay interest or pay down debt) another person must be spending more.)
Derrida: “Whatever the results in the US why wouldn’t our fiscal stimulus just be frittered away in a devaluation?”
I think you meant revaluation.
Depends on the model. Sometimes it will, sometimes it won’t. Specifically, it depends on expectations of the future exchange rate and on the degree of capital mobility. (Also depends on whether there’s a coordinated multi-national fiscal policy.)
Yes, but that’s an aside from the main point of my post.
Nick,
“We want to pay down debts to increase our future consumption relative to our present consumption.”
Double talk. If my income is $100, my debt is $50, and r=10%, my C can still be $100 as long as I continue borrowing.
Period 1: Income is $100, debt is $50, r=10%, interest expense = $5.00, new borrowing = $5.00, C = $100
Period 2: Income is $100, debt is $55, r=10%, interest expense = $5.50, new borrowing = $5.50, C = $100
The limiting factor on how much I can borrow is the market value of the assets that I own (what I put up for collateral on a loan). And so I can continue borrowing as long the market value of my assets exceeds the value of my liabilities. Your description misses the balance sheet aspect.
Nick,
“And remember the national income accounting identity. If one person is spending less than his income from producing goods (to pay interest or pay down debt) another person must be spending more.”
Also remember that banks have furnaces as well as helicopters. A bank may not “want” its balance sheet to contract, but it may not have a choice in the matter.
Nick,
Period 1: Income is $100, debt is $50, r=10%, interest expense = $5.00, new borrowing = $5.00, C = $100, Market Value of collateral is $200, Asset / Liability ratio is 200/50 = 4:1
Period 2: Income is $100, debt is $55, r=10%, interest expense = $5.50, new borrowing = $5.50, C = $100, Market Value of collateral is $210, Asset / Liability ratio is 210/55 = 4:1
Period 3: Income is $100, debt is $60.50, r=10%, interest expense = $6.05, Market value of collateral is $100
Here I am faced with a choice. I can either try to rebuild my asset / liability ratio or I can try to maintain my consumption. Rebuilding to 4:1 would require me to pay back $35.50 of the loan (leaving $25.00 in outstanding loan balance) or I can try to maintain my consumption (C) of $100.
1. For some reason, people decide they need to hold a larger average stock of cash. – This does not apply to my situation. I was spending more than my income before my asset crashed in value.
2. For some reason, people decide to become more patient, and would prefer to consume less now and more in the future. – This does not apply to my situation. My consumption preference has not changed. I would still like to consume $100 both now and in the future. However, my consumption preference is constrained by the amount of money I can borrow to fund that consumption. My bank also sees that the value of my assets has collapsed and starts getting fidgety on lending me more money.
Nick, thanks for “rescuing” my post. I believe there are others in spam.
Anon, I’ll try again.
“If we all spent more in aggregate, …”
From observation and economic stats, I see some to many spending more on goods/services than they earn and the few spending a lot less on goods/services than they earn.
“And remember the national income accounting identity. If one person is spending less than his income from producing goods (to pay interest or pay down debt) another person must be spending more.”
1) I think there is something wrong there.
2) After listening to JKH and others about accounting, I think paying down debt is flow of funds accounting.
“Ralph and Frank: we want to pay down debts to increase our future consumption relative to our present consumption. If my income is $100, my debt is $50, and r =10% my C will be $95 forever if I don’t pay down my debt. If I pay off my debt, my current C drops to $50, but my future C rises to $100.”
Or I could continue to have a C of $95 and only need to have an income of $95.
Nick, thanks for “rescuing” my post. I believe there are others in spam.
Anon, I’ll try again.
“If we all spent more in aggregate, …”
From observation and economic stats, I see some to many spending more on goods/services than they earn and the few spending a lot less on goods/services than they earn.
Sorry if this is a repeat.
Interesting post, Nick. You had me at “orthogonal”.
I’m surprised, but I don’t know the GT so well.
Are you/Kuehn confident that while Keynes asked that question at that particular chapter in the GT, he also didn’t ask the other question somewhere else?
I.e. that he didn’t pose orthogonal questions?
Separately, just an observation on one aspect:
“It’s when we add “money” to the list of things people can spend their income on, that Say’s Law fails. Because if your income comes to you in the form of money, nobody can stop you spending part of your income on money — you just don’t spend it. And if everyone does the same, then we get a recession.”
You know this, but that scenario would be depicted with the increase in money balances as a “use of funds” (micro) in macro flow of funds accounting. The “source of funds” would be an increase in household net worth (micro), other things equal. The “spending” you refer to would be classified as a flow of funds but not NIPA expenditure. Perhaps you would view this as accounting getting in the way of the economic explanation, but I would view it as clarifying it.
“JCE: “Why would those firms be buying newly-produced investment goods? i don’t get that part”
“Nick Rowe: What else would firms be doing with the proceeds of issuing new stocks and bonds?”
Increasing CEO salaries, probably. (Eventually the company would go bust, but that would happen later.) This is the classic stock/bond scam, get a lot of people to lend you money or buy your stock… then walk off with the money. It happens all the time.
his means that it’s possible that this “saving” would have purely redistributionary effects — transferring money from the 99% to the 1%.
Nick Rowe: “If the Bank of Canada wanted me to spend more, it would have to lower the rate of interest I paid, to persuade me to borrow more to finance my extra spending. That is true for each individual, but it is not true in aggregate. Because one person’s spending is another person’s income. If we all spent more in aggregate, we would be surprised to discover our aggregate income had increased by that same amount. Our extra spending would be financed by our extra income. Your comment displays a massive fallacy of composition.”
BZZT. You’re wrong, Nick, and the guy you were responding to is right, and for one and only one reason.
There are two classes of people: creditors and debtors, or if you prefer, the 1% and the 99%. Aggregates which combine the homeless with Bill Gates are irrelevant. And the problem with most “monetarist” thinking is precisely that it ignores the distributional issue.
If the Bank of Canada wants you to spend more money, it has several options, including giving you money outright and hiring you. These are different from the option of trying to persuade you to borrow more. They are different in an important way. You know what that way is. It’s distributional.
Someone who is already deep in debt, and whose expenses exceed his or her income — that person is simply not influenced to borrow more by interest rates. If that person is crazy enough to borrow more, the bank may not be crazy enough to lend it.
And that sort of person is the 99%.
If they are both crazy enough to do so, eventually the bank is going to have to forgive the loan or the borrower is going to have to declare bankruptcy, and while these are both “money-creating” activities which boost the economy, they’re very disruptive to people’s trust in each other and institutions.
That’s why in our current situation, it’s better to use what is generally known as fiscal policy — the difference between this and so-called “monetary policy” is fundamentally whether there is some expectation that the money will be “paid back”.
In monetary policy, there is such a “payback” expectation, and with our economy structured the way it is, that is a disastrous expectation which creates trouble. In fiscal policy, there isn’t such an expectation; therefore fiscal policy works in situations like ours, while borrowing-based policy doesn’t.