John Cassidy has a nice article titled A New Way To Learn Economics for The New Yorker on a new online introductory economics curriculum. produced by a lot of collaborators.
I went to the website which has the full book. Although there seems to be some progress, I have a strong reservation against it.
The chapter titled “Banks, money and the credit market” has a much better description on it than textbooks widely used, such as the ones by Paul Samuelson, Gregory Mankiw or Paul Krugman. On a cursory look, I didn’t find anything about the “money multiplier” model. Instead, the book says that central banks set short term interest rates and this has an effect on aggregate demand. If I missed something and if you find something orthodox, please let me know.
The chapter on fiscal policy looks like being written by fiscal hawks. There is a description of the government expenditure multiplier, which is not much different from other textbooks. There’s no mention of the more complicated nature of this process because of interactions between stocks and flows. For example, in stock-flow coherent (SFC) models, this one-step multiplier has a limited role.
Now, fiscal policy has strong effects and the book hardly does justice to any of this. It reads more like a defense of the establishment wisdom.
But it is in the area of international trade and globalization under the current rules of the game that the book is the most disappointing. The authors do tell students that it can produce “losers” but the problem of such an approach is that it doesn’t appreciate the fact that it leads to polarisation and divergences in fortunes of nations, instead of individuals. The assumption and conclusion (the same thing in most of economics!) is that if losers are compensated, fortunes of nations can converge.
This by Nicholas Kaldor, written in 1980, is change.
Not the new book, The Economy.
As Morris Copeland emphasised, the root problem of economics is the total confusion of anyone and everyone on what money is. And his approach shows us that it’s not complicated. One just needs to study flow-of-funds or social accounting. There is hardly any emphasis of this in the book. Till then, students will remain confused and ignorant about the way the world works.
The blurb of a recent article, The Ruthlessly Effective Rebranding Of Europe’s New Far Right by Sasha Polakow-Suransky for The Guardian, says:
Across the continent, rightwing populist parties have seized control of the political conversation. How have they done it? By stealing the language, causes and voters of the traditional left
A better way to put it is that the left has genuinely lost interest in addressing people’s grievances, and is promoting policies of neoliberals. The far right has found a clever winning strategy.
Donald Trump will soon be the President of the United States 🇺🇸 and economists and financial analysts have discussed Trump’s liking of fiscal policy. There seems to be a tendency of economists who are leaning toward the Democratic Party in the US to not support this. To me it just looks like a defense of the party than a defense of the correct principles of political economy.
To be fair to them, Donald Trump indeed has a character and ideology leaning to the dark side. But it still doesn’t mean why the US government shouldn’t engage on a fiscal expansion plan. Because this is a principle which belongs to the traditional left. Else they should stop pretending to be ideologically leaning to the left in the “political spectrum”.
Brad Setser has a post on his blog Follow The Money in which he seems to be not excited about a possible fiscal expansion by the US government. Now, Donald Trump is an erratic person and we’ll never know what he’s going to do until he does it but let’s just assume that he does it.
Setser’s point is that surplus nations have more room for fiscal expansion than deficit nations and I agree with that. But Trump’s policy is also to declare China 🇨🇳 a “currency manipulator”, in his own words. In another post, Setser opposes this and favours status quo on this issue from the US viewpoint.
Currently, although the US has a large negative international investment position (minus 44% of Q2 GDP), it’s not that the US economy is under immediate threat from a collapse of the dollar. The US economy can expand by raising tariffs and also asking other governments to do fiscal expansion. Even if others don’t initially, they might when they start to see the positives.
But none of these points will be made by economists. Trump’s fiscal stimulus may not even be large and its effect on the US international investment position may not be that bad. The US anyway has the option to appeal to the Article 12 of the GATT (General Agreement on Tariffs and Trade).
I think Bernie Sanders said it the best about the Democrats in a speech at Berklee, a few days back (at 38m, 58s in the video):
In other words, one of the struggles that you’re going to be seeing in the Democratic Party is whether we go beyond identity politics. I think it’s a step forward in America if you have an African American head or CEO of some major corporation. But you know what, if that guy is going to be shipping jobs out of his country and exploiting his workers, doesn’t mean a whole hell of a lot if he’s black or white or Latino.
The Democrats have clinged on to social issues because Trump’s views are horrible on this. While Trump should be passionately opposed on such issues, it’s an attempt by the Democrats to impose neoliberalism on the population. Sanders, although a Democrat, understands this.
Sanders’ opinion on this, his statement after the US election results were out, is the right one and should be followed:
Donald Trump tapped into the anger of a declining middle class that is sick and tired of establishment economics, establishment politics and the establishment media. People are tired of working longer hours for lower wages, of seeing decent paying jobs go to China and other low-wage countries, of billionaires not paying any federal income taxes and of not being able to afford a college education for their kids – all while the very rich become much richer.
To the degree that Mr. Trump is serious about pursuing policies that improve the lives of working families in this country, I and other progressives are prepared to work with him. To the degree that he pursues racist, sexist, xenophobic and anti-environment policies, we will vigorously oppose him.
Donald Trump is the President-elect of the United States. It hardly needs to be mentioned how bad his campaign was. Glenn Greenwald rightly called him an abusive, misogynistic, bigoted, scary, lawless authoritarian.
However on the economic scale, Trump’s plans seem to be to the left of Hillary Clinton. Trump wants to pump the prime, meaning do a fiscal expansion and also put tariffs.
Trump is yet to take his office, but the narrative change about fiscal policy has already started. The important thing to remember is that this is done by economists who might otherwise not object to it – at least the fiscal stimulus.
In other words, just to oppose Trump, economists are on the path to build a conventional wisdom that fiscal policy is neutral or impotent or even destructive if it’s expansionary (as in higher expenditure and/or cuts in tax rates).
Example: Lawrence Summers’ articleA Badly Designed US stimulus Will Only Hurt The Working Class for Financial Times. While obviously unable to deny the importance of fiscal expansion (because it works), Summers says:
I am optimistic regarding the efficacy of fiscal expansion. But any responsible economist has to recognise that, past a point, it can lead to some combination of excessive foreign borrowing, inflation and even financial crisis. As Dornbusch showed, in emerging markets this can happen quite quickly. In the US the process would take longer.
Moreover, he also goes on to argue that China is not gaining unfair advantage by keeping its exchange rate at a highly devalued level. Notice the change in tone in Summers’ language. From writing about how the constraints are far, Summers is now saying that fiscal policy is not that good. Surely he’s using a language to hedge himself —as any economist should do—but he’s clearly not saying that, “Fiscal expansion will be good for the US economy. Trump should rather design taxes to be progressive” but instead, giving innuendos that fiscal policy is not that good.
Even a non-progressive system of taxation or even tax cuts for the wealthy can be expansionary. It raises inequality but the size of the pie is still rising. To me it’s still better than a neutral fiscal stance. But Summers’ language is such that it is worse.
Obviously no economist will jump overnight to shifting his/her position to saying, “fiscal policy is impotent or worse expansion destructive”, after the elections, from a position, “fiscal policy should be expansionary” before the elections. So conventional wisdom will be created slowly over the next few months – slowly manufacturing constent, borrowing the phrase from Noam Chomsky.
Is my reading of Summers wrong? Time will tell! But why didn’t Summers ever complain about the non-progressive system of taxation earlier?
Trade has always been a subject close to non-orthodox economics. Post-Keynesians emphasize the principle of circular and cumulative causation, which in the words of Nicholas Kaldor means, “success creates further success and failure begets more failure”. The importance of trade for the prospects of the US economy was emphasized the most by Wynne Godley in his series of papers for the Levy Institute from the mid-90s to late 2000s. In his paperSeven Unsustainable Processes, Godley said,
The logic of this analysis is that, over the coming five to ten years, it will be necessary not only to bring about a substantial relaxation in the fiscal stance but also to ensure, by one means or another, that there is a structural improvement in the United States’s balance of payments. It is not legitimate to assume that the external deficit will at some stage automatically correct itself; too many countries in the past have found themselves trapped by exploding overseas indebtedness that had eventually to be corrected by force majeure for this to be tenable.
There are, in principle, four ways in which the net export demand can be increased: (1) by depreciating the currency, (2) by deflating the economy to the point at which imports are reduced to the level of exports, (3) by getting other countries to expand their economies by fiscal or other means, and (4) by adopting “Article 12 control” of imports, so called after Article 12 of the GATT (General Agreement on Tariffs and Trade), which was creatively adjusted when the World Trade Organization came into existence specifically to allow nondiscriminatory import controls to protect a country’s foreign exchange reserves. This list of remedies for the external deficit does not include protection as commonly understood, namely, the selective use of tariffs or other discriminatory measures to assist particular industries and firms that are suffering from relative decline. This kind of protectionism is not included because, apart from other fundamental objections, it would not do the trick. Of the four alternatives, we rule out the second–progressive deflation and resulting high unemployment–on moral grounds. Serious difficulties attend the adoption of any of the remaining three remedies, but none of them can be ruled out categorically.
In his 2008 paper, Prospects For The United States And The Rest Of The World: A Crisis That Conventional Remedies Cannot Resolve, he said:
At the moment, the recovery plans under consideration by the United States and many other countries seem to be concentrated on the possibility of using expansionary fiscal and monetary policies.
But, however well coordinated, this approach will not be sufficient.
What must come to pass, perhaps obviously, is a worldwide recovery of output, combined with sustainable balances in international trade. Since this series of reports began in 1999, we have emphasized that, in the United States, sustained growth with full employment would eventually require both fiscal expansion and a rapid acceleration in net export demand. Part of the needed fiscal stimulus has already occurred, and much more (it seems) is immediately in prospect. But the U.S. balance of payments languishes, and a substantial and spontaneous recovery is now highly unlikely in view of the developing severe downturn in world trade and output. Nine years ago, it seemed possible that a dollar devaluation of 25 percent would do the trick. But a significantly larger adjustment is needed now. By our reckoning (which is put forward with great diffidence), if the United States were to attempt to restore full employment by fiscal and monetary means alone, the balance of payments deficit would rise over the next, say, three to four years, to 6 percent of GDP or more—that is, to a level that could not possibly be sustained for a long period, let alone indefinitely. Yet, for trade to begin expanding sufficiently would require exports to grow faster than we are at present expecting, implying that in three to four years the level of exports would be 25 percent higher than it would have been with no adjustments.
It is inconceivable that such a large rebalancing could occur without a drastic change in the institutions responsible for running the world economy—a change that would involve placing far less than total reliance on market forces.
So there was a voice for the Post-Keynesian community talking about US trade.
Dean Baker has an article saying the TPP gave us Trump and I agree. Although Donald Trump is a disaster socially, he is less dogmatic about trade and has promised to put tariffs on China (and has even promised fiscal expansion!). Since the Democrats (except Bernie Sanders) didn’t say anything about it and guarded orthodoxies, I believe this was decisive for Trump’s victory.
For the sake of quotes, here’s fromThe New York Times, July 31, 2016:
Mr. Trump himself said in a telephone interview last week that he believed more borrowing and spending would help lift economic growth, a departure from traditional Republican economics.
“It’s called priming the pump,” Mr. Trump said. “Sometimes you have to do that a little bit to get things going. We have no choice — otherwise, we are going to die on the vine.”
He added: “The economy would be crushed under Hillary. But no matter who it is, the debt is going up.”
Here’s a fun video of Donald Trump saying China in loop
click the picture to see the video on YouTube.
Since today morning the BBC has been saying how immoral Trump’s policies are: that fiscal expansion invariably burdens future generations and that thinking of the Chinese government using unfair trade policies is orthodoxy.
That’s not all, Paul Krugman even claimed that equity prices aren’t going to ever rise to pre-Trump level, a position which he flipped within hours after financial markets recovered.
So it’s not difficult to conclude that purely for the sake of defending one’s favourite party or ideology, people are going to make the case against fiscal policy and for free trade. We might hear a lot of pre-Keynesian orthodoxies from smart people more and more. I won’t even be surprised if Paul Krugman becomes a fiscal hawk again.
This has already been the case in discussions around wars. George Bush started the Iraq war and faced a lot of opposition from the so-called progressives. But then Barack Obama is the record holder for the most number of days as being in office as the President of the United States while the nation was at war but hardly gets any opposition from those who opposed him. I have also noticed that the same people who opposed Bush are now war apologizers.
So economic orthodoxy lies ahead. What will be sad is that it will come from people to the left of Republicans in the political spectrum.
Jason Furman, Chairman of the Council of Economic Advisers to the President of the United States, has an article, The New View Of Fiscal Policy And Its Application for Vox. In this, he admits how wrong economists have been about fiscal policy. I’ve quoted his paper on which the article is based before here on this blog.
Furman says:
A decade ago, the prevalent view about fiscal policy among academic economists could be summarised in four admittedly stylised principles:
Discretionary fiscal policy is dominated by monetary policy as a stabilisation tool because of lags in the application, impact, and removal of discretionary fiscal stimulus.
Even if policymakers get the timing right, discretionary fiscal stimulus would be somewhere between completely ineffective (the Ricardian view) or somewhat ineffective with bad side effects (higher interest rates and crowding-out of private investment).
Moreover, fiscal stabilisation needs to be undertaken with trepidation, if at all, because the biggest fiscal policy priority should be the long-run fiscal balance.
Policymakers foolish enough to ignore (1) through (3) should at least make sure that any fiscal stimulus is very short-run, including pulling demand forward, to support the economy before monetary policy stimulus fully kicks in while minimising harmful side effects and long-run fiscal harm.
Furman then goes on to highlight how wrong each of the “principles” is.
He also says,
In the immediate postwar decades, economists broadly supported fiscal stimulus (e.g. Blinder and Solow 1973). But much of modern academic macroeconomics has ranged from dismissive of any effect of fiscal policy on the macroeconomy …
While that’s good, the main issue with the article is that it fails to mention that Post-Keynesians have argued about the strong effects of fiscal policy since long. Not only that, Furman advocates fiscal policy coordination across countries:
Finally, there may be larger benefits to undertaking coordinated fiscal action across countries.
Again, this is not “new” in any sense, just non-orthodox. Here is what Nicholas Kaldor said in 1984 in his lecturesCauses Of Growth And Stagnation In The World Economy:
I should like to end this series of lectures by suggesting the outline of a world-wide agreement on the necessary policies for recovery. The programme could be summed up under four main heads:
The first is coordinated fiscal action including a set of consistent balance of payments targets and “full employment” budgets.1 If this does not prove to be politically feasible, it is inevitable that the growth of unemployment will sooner or later force governments to take measures that would make it necessary for them to expand demand without being frustrated by the inevitable balance of payments consequence of expanding their economies relative to their trading partners. This means that there needs to be some form of restriction that would limit the increase in “competitive” imports to some target ratio in relation to exports. Trade liberalisation, which played such an important part in the rapid economic progress during the years of expansion, becomes a serious obstacle to economic recovery in the case of prolonged stagnation due to the inability of countries to achieve a coordinated set of policies. But, given a proper recognition of the problem, that under conditions of unrestricted free trade the actual volume of production and trade may in fact be considerably less than under some system of regulated trade – a system which relates the volume of imports in manufactures from a particular group of countries, such as the members of the EEC, to some mutually agreed ratio to the exports of individual members to the rest of the group – there is no reason why full employment should not be restored through policies of expansion, preferably directed by the expansion of State investment. This coordinated action by all countries, instead of isolated actions by each country, is the first and most important requirement of recovery.
1 At present all countries have fairly large deficits in the general government budget, but these are largely the consequence of the low level of activity. On a “full employment” basis they would show a highly restrictive picture – they would show surpluses and not deficits. Contrary to appearances, the requirement of stability is for expansionary budgets with lower taxes and higher expenditure, and not further fiscal restriction (as is advocated, for example, by M. de Larosiere of the International Monetary Fund).
But finally some sense prevails in the economics community. Jason Furman’s article should be used to argue against anyone who says: “we always knew” even though his/her position has shifted. So there’s nothing new about the “new view”. Just that economists from the mid-70s till now have been orthodox.
Writing for the Broadbent Institute’s blog, Marc Lavoie argues that now that Conservatives are out of power in Canada, the Federal Balanced Budget Act passed in June 2015 should be repealed. According to the Act, pay of the Prime Minister and Ministers and Deputy Ministers have to be reduced by 5% if the federal government is in deficit outside a recession and frozen if the economy is in recession.
Marc Lavoie says:
The Federal Balanced Budget Act that was included in the omnibus Bill C-59, and which passed third reading in June 2015, does not seem to have attracted much engagement either. The Act does not force the federal government to adopt a balanced budget – it has some of the flexibility advocated by the PBO. But it includes measures that discourage the federal government from taking expansionary fiscal measures pre-emptively before a recession is declared. Furthermore, it will induce the federal government to attempt to minimize budget deficits during recessions and to quickly achieve a balanced budget or budget surpluses.
The article also coins the phrase new fiscalism (term originally by Mario Seccareccia):
counter-cyclical fiscal policy should only be used when things are really bad, in particular when monetary policy seems to be running out of ammunition; otherwise, governments should achieve balanced budgets or surpluses.
Marc Lavoie instead argues that the Canadian federal government should use the large borrowing powers to aim to achieve full employment.
The full article Wage Suppression And The Federal Balanced Budget Act is here.
Rules about fiscal policy always have some dubiousness about them. This can easily be seen in stock-flow consistent (SFC) models. Let government expenditure be denoted by G, the tax rate by θ, and households’ propensities to consume out of income and wealth by α1 and α2, respectively. Imagine two almost similar economies
Economy 1: High propensities to consume – i.e., high values for α1 and α2.
Economy 2: Low propensities to consume – i.e., low values for α1 and α2.
Also assume the government expenditure G, and the tax rate θ are the same for both the economies. The budget deficit depends (among other things such as firms’ behavior) on G, θ, α1 and α2. Economy 1 will have a lower budget deficit and higher output and employment than Economy 2. So in order for Economy 2 to have the same level of output and employment as Economy 1, the government of Economy 2 should have a more expansionary fiscal policy than Economy 2. What the fiscal rules do is to endogenize fiscal policy (the government G and the average tax rate θ) with respect to the budget deficit. This is further deflationary for Economy 2. This implies that fiscal rules have no legitimacy. Even within an economy, (such as either Economy 1 or Economy 2), propensities to consume are changing with time.
Fiscal policy rules sometimes are slightly less strict and accept balancing current expenditures with taxes. Even this is dubious – expenditure on paying school teachers isn’t less important in any sense than building a school. Even more importantly, the budget deficit depends on the current account balance of payments and a nation with a higher current account deficit than a similar economy with no external trade will have a lower output and higher budget deficit for the same fiscal policy.
Budget rules are hence deflationary to output and are anti-full-employment.
I hope the new Canadian government follows Marc Lavoie’s advice.
Harvard economist Dani Rodrik recently responded to a question/critique on why he doesn’t believe in the faith about free trade between nations while not showing that much dissent for trade within boundaries. Among the various points in his defence are fiscal transfers and regional policies. Rodrik says:
Another thing that happens is that there is an overarching state that will engage in transfer payments and other policies that aid the lagging region. The region will have political representatives in the national government who will push for the interests of those adversely affected.
That’s a nice point. See my blog post on how fiscal transfers help in reducing regional balance-of-payments problems.
Cafe Hayek responded to Rodrik here. An important point in that argument is: why does it matter if the consumer buys from a domestic producer as opposed to a foreign producer. The Cafe Hayek author Don Boudreaux says:
Now to point (1) – the more narrowly economic point. Sellers in foreign countries sell things to buyers in the home country only because they – the foreign sellers – wish to increase their wealth. The motives are identical to those of sellers in the domestic economy. What do foreign sellers do with the revenues they earn from the sale of their exports? They spend them. They save them. They invest them. Perhaps on occasion they hoard them. These options are no different from the options confronting domestic sellers. If the funds spent on imports return to the domestic economy as demand for exports, jobs and economic activity shift from import-competing domestic industries into exporting industries. No problem. If these funds instead return as investments in the domestic economy, again there’s no problem: when, for example, Ikea opens a store in New Jersey it employs workers in that store no less than would an American who opened a similar store.
Now to argue straight with the above. FDI flow is just one flow in the capital and financial account of the balance of payments. And in the stock sense, FDI is just one type of liability among many others such as government debt held by foreigners. These just pay interest to foreigners.
Apart from that, foreigners are not likely to import as much as they export. A nation can have a high amount of imports and less exports. So there’s an asymmetry here – differing level of competitiveness.
But even if competitiveness were equal, nationality of buyers and sellers still matters. This is because creditor nations’ governments may not expand fiscal policy to the extent that is needed for the benefit of the world as a whole. If the government of a nation keeps fiscal policy relatively tight, it affects domestic demand, output and incomes of economic units and hence their imports.
So to summarize, difference in competitiveness and a relatively tighter fiscal stance of creditor nations affects trade and balance-of-payments of other nations. This in turn affects output because a nation which could potentially grow fast may find itself with balance-of-payments problems. Free trade doesn’t help poor nations.
This discussion can also be used in the case of the Euro Area where trade was made more free when the Euro Area was formed. Since there is no central government for the Euro Area, free trade works against nations which have been affected by the crisis.
As I said, you might think that ending deflation is easy. Can’t you just print money? But the question is what do you do with the newly printed money (or, more usually, the bank reserves you’ve just conjured into existence, but let’s call that money-printing for convenience). And that’s where respectability becomes such a problem.
When central banks like the Federal Reserve or the Bank of Japan print money, they generally use it to buy government debt. In normal times this starts a chain reaction in the financial system: The sellers of that government debt don’t want to sit on idle cash, so they lend it out, stimulating spending and boosting the real economy. And as the economy heats up, wages and prices should eventually start to rise, solving the problem of deflation.
…
… When you print money, don’t use it to buy assets; use it to buy stuff. That is, run budget deficits paid for with the printing press.
Now, there are several things wrong about this. The most important one is the implicit assumption in the “model” that fiscal expansion via increased government expenditure is about neutral and that domestic demand is boosted only because of the way in which the government debt is financed – i.e., central bank purchases of government debt. In other words, Krugman is saying that if there is deflation and if there is an expansion of fiscal policy via a rise in say government expenditures, it will have little effect when the central bank doesn’t purchase government debt. Put it in another way, it is saying that the government expenditure multiplier effect acts mainly because of central bank purchase of government debt and not because of the increase in government expenditure per se.
This is silly intuition and the cause of this is the notion that fiscal policy is more or less neutral except in special circumstances.
In reality, it is the other way round. If the government expenditure rises, and if the central bank purchases government debt, the rise in output is mainly attributable to the former. This can of course be seen in a stock-flow consistent model but can also be seen by simple accounting and flow of funds. A rise in government expenditure on goods and services raises output directly and also via the multiplier effect. The central bank has a huge control over interest rates and the additional debt is simply absorbed by the bond markets easily. There’s no competition with other borrowers as the wealth of the private sector rises. In addition, if the central bank purchases government debt, it is hardly clear if households know if inflation is going to rise and increase their consumption because of “inflation expectations”. Even if they think that if inflation is set to rise, they might reduce consumption as inflation might reduce their real wealth.
Which is not to say that asset purchase programs of the central bank or “quantitative easing” has no effect on demand and output. It works via capital gains in wealth leading to higher consumption and the feedback effects of this. It also works if economic units shift their portfolios to buying non-financial assets. The effect of all this is unclear. In addition, as mentioned earlier, casual Monetarism like the language used by Paul Krugman mixes up correct attributions of government expenditure and central bank government debt purchases on output, misleading everyone.
Simply say “raise government expenditures”. Why all this casual Monetarism with “printing presses”?
Cullen Roche – in response to Paul Krugman – says Keynesians should learn to love tax cuts. His argument is that since Keynesians believe in the principle of effective demand and that since tax rate cuts boosts domestic demand and hence output, it is surprising to find Paul Krugman not favouring tax cuts.
Tax cuts raise output by increasing disposable incomes of economic units who will raise their expenditures in response. This via a multiplier effect will raise output. But it’s not as if tax rate cuts is the only tool available to the government.
Let’s see 4 different ways the government can boost domestic demand:
Raise government expenditures,
Decrease tax rates,
Raise government expenditures and decrease tax rates, and,
Increase government expenditures and raise tax rates.
The expansionary nature of the first three ways above is obvious. For the fourth, it depends on the numbers. So if the government raises tax rates from say 25% to 30% and increases government expenditure by 1%, it is likely contractionary. Instead, if the government increases its expenditure by 25%, it is expansionary.
These are not the only ways available for demand management. The government by coordinating with the central bank can reduce interest rates. It can make lending/borrowing easier by other ways. It can give guarantees to bonds issued by corporations, thus giving an incentive for corporations to increase expenditures. It can raise tariffs on imports. There are several ways but here those things are less relevant for now.
Each of the four ways above has a different effect on output and the distribution of income. Tax cuts usually favour economic units who earn more. Richer economic units such as rich households have a lower propensity to consume and hence this will have a smaller multiplier effect. If Keynesians favour tax cuts, they’d favour it for low earning households than for corporations.
Of course, the multiplier effect is not a complete argument in itself as the opponents might argue “So cut taxes even more according to your logic”. But at any rate, let’s see how it works.
In stock-flow-consistent models, there’s the concept of a fiscal stance toward which GDP converges for a given government expenditure G and a tax rate θ. So we have
GDP = G/θ
With that,
dGDP/GDP = dG/G − dθ/θ
So a percentage rise in government expenditure will have the same multiplier effect as a percentage fall in tax rate.
This of course is the long-run output. For the short run, the expression in the simplest Keynesian model:
GDP = G/(1 − α1·(1 − θ))
α1 < 1
The parameter α1 is the propensity to consume.
In this case, i.e., for the short run,
dGDP/GDP = dG/G − [α1·θ/(1 − α1·(1 − θ))2]·dθ/θ
By taking some values such as 0.6 for α1 and 25% for θ, you can convince yourself that a proportional rise in government expenditure is more effective than a proportional fall in tax rates. Of course, this is not a complete argument but illustrative. If a tax rate cut of x% doesn’t achieve a $1 rise in government expenditure, one can make the case for a higher tax rate cut to achieve a similar result.
Apart from that there are other implicit assumptions of the model: there is no income inequality in the simplest Keynesian models. So rich economic units will have a lower propensity to spend: households working as employees of firms with higher compensation will have lower propensity to consume. Households may have an even lesser propensity to consume out of other incomes such as interest and dividends.
So the multiplier analysis illustrates that a tax cut for richer economic units is not the same as the poorer units because the multiplier in the short run depends on the propensities to spend.
The correct stand hence is about the distributional effects of fiscal policy and the effect on output. So the correct stand is to argue for a rise in government expenditure and fair rates of taxes for economic units. Many economic units will have to pay higher taxes in this view. What’s fair of course is debatable but at least in this line of argument, souls believing in the principle of effective demand needn’t love “tax cuts”.
There is another argument for not promoting lower tax rates. This is because once tax rates are reduced, it is politically difficult to raise it if needed.
So Comedy Central had a nice show on the Reinhart-Rogoff episode and how their work was used to drive world-wide austerity. The show featured Thomas Herndon – the graduate student from the University of Massachusetts Amherst who found errors in R&R’s work.
Great work Thomas!
Worth a watch:
(Click the two pictures to watch the videos from the original website)
