In all seriousness I’m sick to death of this damned argument over what the accounting identity Savings=Investment means (I am sure you are too – but I get to write the blog posts and I need to vent. My apologies).
I never, for the life of me, expected such a substantial dispute to develop between economic experts on what it meant. These guys are more than smart enough to know what they are saying – which implies to me that they are hiding/twisting their value judgments to get the solution they want. Grrrrr.
Still Fama started it by stating that S=I always holds (true) and that this implies that government spending can’t influence employment (huh?). Then when the critics came raining in (they are mentioned here) he framed his view a little more – and randomly said that Brad Delong had the only potential criticism of his view. This annoyed me as Arnold Kling and Bryan Caplan had already discussed the enormous logical mis-step that he had taken – and he “answered it” by ignoring them …
Lets get back to his framing of the issue and discuss it:
First, however, I want to restate my argument in simple terms.
1. Bailouts and stimulus plans must be financed.
2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.
3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.
So lets accept the first premise, then the second premise does logically “follows”, and so does the conclusion – excellent.
However, it is the interpretation of the second premise that determines how we interpret this conclusion – this is where the conclusion he made in his initial piece (that government spending can’t increase employment) failed.
Lets think about some alternative uses of the funds in a STATIC setting to start with:
- Hold it and do nothing,
- Spend it on goods and services,
- Save it at an an institution that lends it out (or uses it) at some risk.
So at a given point in time this is the business that the funds could be up to. Now, the more people that are hoarding cash, or keeping it in liquid accounts, or putting it in government treasuries, the less “funds” there are going around the economy at a point in time – and given fixed prices during a “static period” this leads to lower activity.
In a dynamic sense this is related to the idea of the velocity of money (and also the ratio of bank reserves) – the money stock is moving around the economy more slowly when people are hiding some under the pillow, reducing the money supply. Given sticky prices this leads to a reduction in activity. During this whole process S=I -> but that doesn’t stop output dropping …
Now if government can attract funds from people that are holding them doing nothing (which they definitely can at the moment!) or if it does have viable public goods it can build then government does have “more productive” alternatives for the funds than the private sector does.
Now Paul Krugman and other commentators that were supporting him also criticised Fama’s piece – however, they also attacked John Cochrane. Sure Cochrane’s language was too strong in support of the S=I identity in his piece, and if you only read the first few pages it would seem like his is missing the point about this simply being an accounting relationship (especially given his discussion stating one dollar more government spending always leads to one dollar less private spending – something he eventually contradicts). However, after I read his piece I was under the impression that he was someone who was against fiscal stimulus as a matter of ideology – but could see scope for a stimulus under the aforementioned conditions.
By ignoring attacking the piece solely based on the a supposed misunderstanding of S=I the proponents of government spending are able to ignore his other conclusions – such as that if there is a credit constraint surely government loaning funds to private firms would at least as effective as (non-public good) government investment.
More fundamentally, the general method of Cochrane appears to be to look for “market failures” and figure out how government policy may be able to solve them. In my opinion this is definitely a preferable way to look at macro policy than arbitary stimulus packages aiming to “fill an output gap” …