Saturday, September 4, 2010

Economic Policy and Politics

My roots are in Canada where, as far as I can tell, we are all socialists, with the exception of a few oddballs, including this guy and his spouse. In Canada, liberal is not a pejorative. Indeed, we capitalize that word, apply it to a political party, and sometimes have those people run the country. When I was growing up, the Williamsons were Liberals. My parents were active in the local Liberal Association. My mother worked as an enumerator (like a census worker - in Canada they actually make an effort to find you and put you on the voters' list), and my father got good Liberals out to the polls on election day. In the 1968 election, to their chagrin, this Tory was elected Member of Parliament for our constituency, but they were ecstatic over Pierre Trudeau's landslide victory and majority in the House of Commons. Trudeau of course had a long run in Canadian politics, and the man was very appealing. He was an intellectual; he had taught law at the Universite de Montreal; he was fluent and articulate in both English and French; he could evoke behavior similar to what would happen if Elvis or Paul McCartney were in town.

Trudeau's legacy was tolerance (official bilingualism, getting the government "out of the bedrooms of the nation"), toughness (controversially, he invoked the War Measures Act, suspending civil liberties in response to violent acts - including kidnapping and murder - by a radical wing of Quebec separatists), and constitutional reform. He was fiercely principled, and not afraid to speak his mind, to the point of apparently telling an opposition member to "f*** off" during question period in the House of Commons (though whether Trudeau said this, mouthed it, or thought it, is subject to debate). Trudeau is not the type who could be elected to anything in the United States. In particular, his preference for a flower (rather than a large flag pin) on his lapel would not go over well.

Now, here's where I come in. In 1975 I was an undergraduate at Queen's University, Kingston, Ontario. I was a math major, and most of what I knew was math, statistics, natural sciences, and computer science. I couldn't see myself (just) proving theorems for the rest of my life, or being an actuary, and someone suggested I take economics. I ended up in an Introduction to Economics class taught by Neil Bruce. This was a full-year course, using Dick Lipsey's book. The first half was micro, taught by Neil.

One day, late in the fall of 1975, Neil Bruce walked into class, and announced that he wasn't going to teach the lesson he had planned. He told us that he and his colleagues had watched Trudeau on the television the evening before, they had discussed Trudeau's new policy initiative, and he (Neil) was going to spend the next 90 minutes talking about it. That policy initiative was the Anti-Inflation Board (AIB), a government agency that was to spend the next 3 years overseeing collective wage agreements and price-setting in Canada. One story behind the AIB is that Trudeau was influenced by another Canadian, John Kenneth Galbraith, at that time a professor at Harvard. Trudeau apparently didn't buy Milton Friedman's notion that "inflation is always and everywhere a monetary phenomenon," but instead went with Galbraith, whose ideas on inflation control seemed to have been shaped by his service with the Office of Price Administration during World War II. The solution to high inflation? Legislate it out of existence.

Neil Bruce had been busy teaching us the standard basics of microeconomics. By then we had covered price theory, consumer and firm behavior, and the effects of taxes and subsidies, etc. Neil could show us, using some basic tools, how the AIB would introduce distortions and would misallocate resources, and we could add that welfare loss to the waste from the creation of a new government bureaucracy. There were three important lessons here. (i) Smart and well-intentioned politicians (in this case, one I admired, Pierre Trudeau) could be misled by smart and well-intentioned, but nevertheless misguided, economists. (ii) The Ivy League is capable of harboring bad ideas. (iii) A guy (Neil Bruce) who received his PhD from the University of Chicago Economics Department, which some people thought was full of right-wing bad guys (and the bad-guy image hasn't gone away), was making more sense than the Prime Minister and the economist from Harvard.

Now, for a person with an urge to fix what is wrong with the world, a course in microeconomics might be quite discouraging. Mostly (and this of course depends very much on how it is taught), conventional micro is a series of exercises in how governments can screw things up. Rent controls end up hurting the people they were intended to help. Various subsidies, inappropriate taxation, tariffs, and quotas reduce welfare in general and cut down on the gains from exchange. If we want to fix things, this will involve undoing stuff, and that stuff may be the pet projects of our well-intentioned but misguided friends, who will only give us grief. There are, however, ways out for good-deed-doers. There are externalities (positive and negative), market failures, and monopoly power. Working out how to fix the externalities, complete the markets, or regulate the monopolies requires work, though. It may be the case that one can fix the externality through a clever market mechanism - cap and trade for pollution for example. However, the government may actually be no better at supplying some item the private market fails to provide or monopoly power might actually not be so bad - it may actually promote innovation. The answers are not clear at the outset. One has to weigh alternatives, and carefully measure the costs and benefits of government intervention.

However, there may be a refuge for the good-deed-doer in that other branch of economics - macroeconomics. There is a large body of work - Keynesian economics - that tells us that intervention is the name of the game, and it looks easy. According to Keynesians, the government can, and should, act to make things better. Doing nothing in a recession, when unemployment is high and real GDP is low, would be cruel as well as inefficient. That is what I was taught in the macro portion of my Intro course. At the time, it didn't occur to me that what I learned in the fall semester should have something to do with what I learned in the spring.

I have had plenty of opportunities to talk to Keynesians and learn from them over the years. Mark Gertler, for example, has strong Keynesian leanings, and I learned a lot from in him in graduate school. However, both Mark and I were learning a lot from someone else - Rao Aiyagari, who had been a Neil Wallace student at Minnesota and, in 1981, had the complete tool basket together, i.e. everything we now know as modern macro. Rao, and the writings of Lucas, Wallace, Sargent, and Prescott, made sense to me, and I caught the Minnesota bug.

There seems to be a view among some people that interest in Minnesota macro is all about the aesthetics of mathematics. I certainly think that a functional equation is an object of beauty. I also think that the average North American has a bad attitude toward mathematics. Indeed, some people seem quite proud, rather than ashamed, of the fact that they don't know it. Mathematics is a language that, in some circumstances, is simply an efficient tool for getting the job done. I could be like Adam Smith, and write it in words, or I could be like Bob Lucas and write down an economic model and analyze it using some mathematics. I can walk 8 miles from the University to the Fed (and maybe get lost on the way), or I can get there on the train.

There are many things about the recent financial crisis that have surprised me. One of those surprises was the wide support for Keynesian-style fiscal programs, in particular the American Recovery and Reinvestment Act of 2009 (or stimulus package). Why did I think that policymakers might at least stop and think before jumping into something like that? First, New Keynesians, led by Mike Woodford, with their renewed popularity in central banks and among academics, were primarily interested in monetary policy. I took this as some sign that they had recognized that Milton Friedman was right in his analysis of policy lags. Even if fiscal policy works as Lipsey said it did in his book, the legislative process is too cumbersome, the effects are so uncertain, and the lags are so long that you just should not bother. Further, there seemed to be something different going on here. By calling this a "financial crisis," we were recognizing that the key forces at work were financial. It wouldn't seem that the economics of sticky wages and prices would have much to say about that, so why would we be following some simple Keynesian policy prescription?

Now, Christina Romer, in her farewell speech is quite unrepentant. She argues that the stimulus package worked, and her interpretation of what is going on in the economy would have fit right into the second semester of my 1975-76 Intro to Economics course. Indeed, Christina could have showed up in class and said the following, and everyone would have understood her:
The … United States still faces a substantial shortfall of aggregate demand. GDP by most estimates is still about 6 percent below trend. This shortfall in demand, rather than structural changes in the composition of our output or a mismatch between worker skills and jobs, is the fundamental cause of our continued high unemployment….

This represents the extreme end of Keynesian economics. She seems pretty sure about this. GDP is not where it should be. She knows where it should be, and she knows how to get us there. Y = C + I + G + NX. We don't have enough Y because of too little C, I, and NX, so we just replace that with some more G. Easy. As Brad DeLong says here, "the government's money is as good as anyone else's."

New Keynesian Economics is less extreme, in that it makes a clear assumption about what the friction is in the economy - typically the distortions from sticky prices, in an otherwise-standard modern macro model. In a Woodford model, we're at least recognizing that what we think of as the efficient level of GDP can fluctuate - it's a moving target, and we're going to be uncertain about what it is in real time. You can quarrel (as I do, and others as well) about how New Keynesian models are put together, and whether they fit the empirical evidence, but at least there is something recognizable here as economics.

Unfortunately, what Romer says in the quote above, and what DeLong says here in the debate with my friend Boldrin, is mostly bilge. Let me explain. Why does an increase in spending by the government on goods and services matter in basic Keynesian models? Expenditure on goods and services is income for consumers; when consumers get more income, they spend more; that is also income for consumers, so they spend more, etc. That's the multiplier. This is a wonderful thing - it's essentially a free lunch. For every $1 the government spends we get more than $1 in GDP. How much more? Here, Christina claims we get about $1.60 more, and she argues that that's probably a lower bound. This is great! Followed to it's logical conclusion, of course, this should make us want an infinite-sized government so that we can all be infinitely rich. Keynesians aren't that stupid of course. Typically the argument would be that this only applies when there is "resource slack" in the economy. Like now.

Now, what is left out of the typical textbook Keynesian analysis or, put another way, what implicit assumptions are they making?

No Ricardian equivalence. Ricardian equivalence is the notion that forward-looking consumers take account of the implications of current government policy for future taxation. Suppose the government increases spending on goods and services today. It must finance this by increasing taxes, or by borrowing. If it borrows, it is going to have to increase taxes in the future to pay off the debt. What difference does the financing make to me as a consumer? Either way I'm stuck with the tax bill - it's just deferred if the government borrows to finance its higher deficit. Now, a Keynesian would then say that there are two problems here. One is that credit markets are not perfect. Indeed, if some consumers are credit constrained, Ricardian equivalence does not work. But if the problem is in credit markets, why not address that directly? Government intervention by way of spending directly on goods and services seems rather roundabout. A second Keynesian response might be that consumers are not as sophisticated as Ricardian equivalence requires them to be. Who has the knowledge to see through the government's behavior and understand the future tax implications of current policies? The answer to this is that it is never good to fool people. By saying people are too stupid to get it, we are just saying that we can make them do something that is not in their interest - spending more today when they should be saving.

There are resources lying around that can be put to use to produce the goods and services the government wants to buy. If the government wants to build a bridge, this requires labor, materials, and capital equipment. If the government wants to fight a war, that also requires labor, materials, and capital equipment. Typically, we would think of these inputs to production as having an opportunity cost, which is what we could have done with them in the best available alternative. In the most basic kind of Keynesian model, the opportunity cost of government spending is zero - it's literally a free lunch. The notion is that, with a 9.6% unemployment rate, for example, and given the quantity of existing empty buildings and idle machinery, we just take all the idle resources we have and put them to work. Of course it's not that simple. Do the unemployed workers have the skills that the government needs to produce things that are actually useful for society? Are the unemployed workers living in the places where these government goods and services are going to be useful? What if the increased government spending actually uses labor skills that are in high demand, and soaks up resources that would actually be more useful in the private sector? What if the government's intervention actually slows down the adjustment that needs to take place in the economy, i.e. moving jobs and resources across industries and from one geographical location to another? In the excerpts here, from Christina Romer's farewell speech, she is quite proud of the speed with which the stimulus package was passed and implemented. Do you think that much thought went into how that money was spent, or that anyone attempted to seriously answer questions like the ones I just asked?

When I do a class in intermediate macroeconomics, the first thing we do is to see how far we can go with conventional microeconomic tools in understanding how the macroeconomy works. Basically, this is the analog of what Neil Bruce was doing in our micro intro class - he was using conventional micro tools to think about a policy that was addressed to a macro issue - inflation. This past spring, as fiscal policy was very much on the agenda, one exercise my class did was to think about all the ways that government spending could matter, without bringing sticky wages and prices onto the table. This is essentially extending what I do in Chapter 5 of my book. There, I start with a basic case, which is government purchases as pure waste. This is a good model for spending on a war. The spending (hopefully) is for a good purpose, but the benefits will not be reflected in the National Income Accounts. Standard microeconomics tells you that GDP will in fact increase as a result. Under the assumption that consumption and leisure are normal goods, consumers will work harder to support the larger government, as higher taxes have caused their after-tax incomes to fall. The multiplier, however, is less than 1, since consumption decreases. Consumption is crowded out by the larger government. The opportunity cost of government spending here is lost leisure and consumption. One can now think about many other types of government purchases. There are government-provided goods and services, for example those associated with National Parks, that provide consumers with direct benefits. There are items like roads and bridges that make private sector production (e.g. trucking) more profitable. For some of these types of spending (e.g. government-provided goods and services are perfect substitutes for private goods and services), the multiplier can be zero. In other cases (complementarities), we can get substantial multipliers. This boils down to the issue of whether the government is more efficient than the private sector at providing particular goods and services, or particular kinds of capital inputs. We have a whole field of economics that deals with this: public economics. Actually, that's Neil Bruce's department.

Now, this analysis does not say much in particular about the cyclical nature of government intervention. In general, this type of analysis is concerned with the long run. What do we want the government to do? How large should it be? We can, however, make the case that, if we have some project we think it would be socially advantageous for the government to undertake, the opportunity cost of doing it in a recession is lower. Recently, some forces in my school district convinced me that a new middle school was needed. Some other forces wanted to argue that this wasn't the time to do it, as we are in a recession. My answer to that was that this is indeed exactly the right time. The school could be built quickly and at low cost, and I was pleased to vote in favor of floating a school bond at a low interest rate. However, I did not notice arguments like that being used in favor of the stimulus package. This appeared to be a set of new initiatives that we would otherwise not have been contemplating.

Is there some case for a fiscal policy initiative that we could construct based on the particulars of the financial crisis? If we think that a key source of our recent problems is a temporary increase in credit market frictions, one approach might be a pure Ricardian one. When there are credit-constrained economic agents, a temporary tax cut for everyone, with a promise to pay off the resulting debt with higher future taxes, is effectively a large government credit program. It does not require any new government bureaucracy, and just works through the existing income tax mechanism. Those who are credit constrained spend the tax cut as if they were getting a loan, and work harder or consume less in the future so as to pay the higher future taxes, as if they were paying off the loan. Those who are not credit-constrained save the tax cut so as to pay their future taxes. There are no long-run implications for the government budget. Why didn't we just do that?

By now, we are well past the financial crisis. The financial system is not entirely out of the woods, but we're well beyond the need for emergency measures. However, the recovery has been weaker than expected, and there is some shouting, particular from you-know-who that we need to do more, and "more" appears to mean more spending by the federal government on goods and services. Krugman does not seem to be particular about the specific goods and services that comprise this extra spending. Here's Krugman:
As I pointed out in February 2009, the Congressional Budget Office was predicting a $2.9 trillion hole in the economy over the next two years; an $800 billion program, partly consisting of tax cuts that would have happened anyway, just wasn’t up to the task of filling that hole.
Interpretation: Krugman knows, and he's using the CBO for support, what the "right" or efficient level of GDP is, and he's telling us how to get there. It's easy - like filling a hole. And who wants a hole anyway?

What I was taught in Intro to Economics was that the role of an economist in society is to give advice. I think this was in Dick Lipsey's introduction, where he talks about positive and normative economics. Learning and practicing economics can be a purely intellectual and selfish exercise. We want to understand how the world works, and having that knowledge makes us feel better, and perhaps more in control. However (and some people I know disagree with me here), we also want to make the world a better place. Now, that's a delicate thing. Economists like to think about efficiency, but there are few, if any, practical policy interventions that imply Pareto improvements - making everyone better off. Someone always loses. What we can do however, is to analyze the effects of particular policies, and then give a rundown of who wins and loses. Alternatively, if you give me a particular objective, I should be able to design a policy that accomplishes the objective efficiently.

What does Paul Krugman want? He may want money and power, but that's not saying much. The quest for that stuff seems universal. What he says he wants, given the current circumstances, is for fewer people to be unemployed and more people to be employed. Why does he want that? It appears that he is concerned with equity. For him, it is criminal that some people are doing well and won't help out the unemployed, who are in dire straits.

What Krugman appears to be arguing for is insurance. Some people who are unemployed today never expected to be, and some of the currently employed (maybe me) will be unemployed in the future. Bad stuff happens to everyone, the private market for some reason does not insure us against all these bad events, and we accept that there is a role for government in providing insurance. Lucas, in his 1987 book Models of Business Cycles conducts a thought experiment, where he asks what the representative consumer would pay to get rid of business cycle risk, and the answer is "not much." Of course, we knew that had to be wrong on some level, as business cycle risk is borne disproportionately by the poor and less-educated. But why would you insure these people by having the government employ them during recessions? If we think our unemployment insurance system is badly designed, as I think we can argue it is, why not fix that?

Krugman has good intentions, as did John Kenneth Galbraith. However, just as Galbraith was selling a flawed policy to Pierre Trudeau, Krugman is selling snake oil to the American public. And man, he is selling it in a nasty way. The second Bush administration included people who were masters of deception, and the art of pandering to fear and ignorance. Krugman acts like someone who has studied those methods and put them into practice, and this does not serve anyone well.

The Republican party does not seem to have much to offer us. They seem to be about further pandering to fear and ignorance, with no constructive economic ideas. The Democrats do better on the fear and ignorance front, though there could be many improvements. On economic policy, there is clearly room for either political party to push forward an agenda of sound fiscal policy, driven by careful economic research and good economic principles. In Canada, a Liberal government (those characters would be far to the left of the Democratic Party, remember) actually turned deficits in the neighborhood of 8% of GDP into surpluses in the mid-to-late 1990s. If Krugman wanted to, he could lead a revolution in the Democratic party that would give the party a fiscally-responsible image. But that would mean talking sense for a change.


  1. It's official, Professor. You're the most intellectually honest econo-blogger around. Thanks.


    (Though you really should have started this adventure ten years ago, but better late than never!)

  2. @hamed you need to read more econ bloggers.
    @stephen. to me this is actually really sad:someone from a left wing background getting indoctrinated in an ideology that makes him into a right wing economist. this is why i'm seeking out heterodox economics schools like university of massachusetts amherst, university of utah (the anti-chicago), bard college and university of missouri kansas city.In those places i can read Adam Smith and actually understand what he's saying.

  3. Thank you Stephen for this long post. It's helped a lot for me to understand your thinking. That said, the first three quarters I've read so far make me side even more with Krugman (Sorry, you said economists should have thick skins and implied you did. I'm still very impressed with some of your specialized expertise.)

    Here are problems, or potential problems, I see so far (I'll have to divide this into several comments to get it all by your blogs comment size limit):

    1) "There seems to be a view among some people that interest in Minnesota macro is all about the aesthetics of mathematics... Mathematics is a language that, in some circumstances, is simply an efficient tool for getting the job done. I could be like Adam Smith, and write it in words, or I could be like Bob Lucas and write down an economic model and analyze it using some mathematics. I can walk 8 miles from the University to the Fed (and maybe get lost on the way), or I can get there on the train."

    Here's the big problem with how mathematics is often used in economics and finance (my area of Ph.D. training sans dissertation):

    It's not just that, hey, we'll write it math. It's shorter and easier to avoid slips when dealing with a lot of complicated things.

    It's very often instead, we'll write it in math, but massively limit our vocabulary because we'll only write things that we can solve in closed form – even if the only way to do that is to make ludicrous assumptions that in the end make it so that the model doesn't tell us much about the real world. Now, sometimes such a model will still tell you valuable things about the real world if your conclusions don't get decimated by relaxations of the assumptions, or, if all you're saying is how some (but not all) of the factors work by looking at them in isolation (and you don't then grossly exaggerate the strength of those factors given the real world evidence).

    The problem with too many freshwater economists is that they interpret their models literally, or grossly over-literally, rather than intelligently, taking into account what happens when you relax the assumptions to realistic levels, and all of the other relevant evidence, both formal and informal. Sometimes the literal interpretation is downright comical, like recently with Prescott (but I think it's likely that Prescott and most of those as extreme as him know this, and are just trying to deceive people into supporting their libertarian, anti-government preferences, and obfuscating the ridiculousness of what they're really saying with impressive looking math and jargon that few people can translate)

  4. 2) My next point is related to, and intertwined with, the last:

    "That is what I was taught in the macro portion of my Intro course. At the time, it didn't occur to me that what I learned in the fall semester should have something to do with what I learned in the spring."

    Ok, the microfoundations macroeconomics thing.

    Micro can give good intuition for how the marco environment works and why, but it is possible to understand how a macro environment works very well without always starting at the smallest atom like units and extrapolating up to the giant whole. I can understand how to drive a car extremely well, and do it extremely well, by just understanding bigger chunks, like how the accelerator pedal behaves, how the brake pedal behaves. I don't have to extrapolate precisely from how the atoms in my foot interact with the atoms in the accelerator pedal. Likewise, I can understand how a computer works very well – and operate it magnificently – without understanding machine language, let alone electrical engineering, let alone the behavior of atoms and electrons and then aggregate up from that to my end product Word document.

    There's a retired finance professor of the University of California Irvine who I think described much of this issue very well (but not all), Robert Haugen. Here's a quote:

    Chaos aficionados sometimes use the example of smoke from a cigarette rising from an ashtray. The smoke rises in an orderly and predictable fashion in the first few inches. Then the individual particles, each unique, begin to interact. The interactions become important. Order turns to complexity. Complexity turns to chaotic turbulence...(page 122)

    How then to understand and predict the behavior of an interactive system of traders and their agents?

    Not by taking a micro approach, where you focus on the behaviors of individual agents, assume uniformity in their behaviors, and mathematically calculate the collective outcome of these behaviors.

    Aggregation will take you nowhere.

    Instead take a macro approach. Observe the outcomes of the interaction – market-pricing behaviors. Search for tendencies after the dynamics of the interactions play themselves out.

    View, understand, and then predict the behavior of the macro environment, rather than attempting to go from assumptions about micro to predictions about macro...(page 123)

    For this quote and more on this issue, see:

    Now here's the related to point 1 part: In the lust to have a mathematical model that aggregates up from the smoke atoms to the smoke cloud – that can be solved for in closed form – the only way they can do this is with massively unrealistic assumptions. This can be ok, IF you then don't make literal conclusions from your model to reality, if instead you interpret the model intelligently, thinking about what happens when you relax the assumptions, and about all of the other evidence you have from reality, but as I said in point 1...

  5. 3) Regarding Ricardian equivalence: "By saying people are too stupid to get it, we are just saying that we can make them do something that is not in their interest - spending more today when they should be saving."

    First off, they're not saying you have to be stupid. You could be a genius and just not have massive knowledge about everything that's not in your career, and tremendous education and expertise in every area there is, and even if you have all that, have it be worth your time to do long intricate analyses.

    Then there's externalities, etc., which are more than just an afterthought. They're enormously important, and a reason why government today is so grossly underinvesting that it's easy to enormously increase total societal utility over the long run by tremendously shifting dollars to government investment (I'll get back to this hopefully).

    But there's more to it than this. There is, as Cornell economist Robert Frank calls it, "Smart for one, dumb for all". Just because something may be best for a single individual, this doesn't mean it's best for the group as a whole. The classic example is when someone stands up in a stadium. It's best for him individually, but if everyone does what's best for him individually, they all end up worse off, with no one's view improved and everyone a lot less comfortable.

    This is what Keynesians are saying; it might be best for a person to save heavily individually, but when everyone does this all at once, including all businesses and other organizations at least not compensating, the economy collapses due to lack of demand. No one is investing that savings in real projects, or borrowing it to consume it. Money is just being hoarded.

  6. Richard Serlin said most of it. But there is something simpler:

    Did it not occur to you that all known human societies are structured? That they have hierarchies of role, power and knowledge, and that these constrain individual choices? And that this is simply not compatible with the assumptions of micro-economics? Which do you prefer - the abstractions or the reality?

  7. Peter T, please explain what structures prevents you from choosing to buy less bananas if you find them too expensive after the government increases the tariffs on banana imports.


  8. 1. Thanks for the compliment, Hamed.

    2. Some of you folks missed the point. There is no right or left. There is no micro or macro. Only economics.

  9. I agree with many things here, but disagree with some:

    Suppose tax cuts were (permanently) money-financed, rather than bond-financed. The Ricardian Equivalence wouldn't apply. They would shift the AD curve right (in {P,Y} space. Now, it's true that the money would cause inflation, and create a future inflation tax. But that only happens *if* it causes the AD curve to shift right. So money-financed tax cuts must shift the AD curve right, one way or another. What I've been trying to get my head around is *whether*, under current circumstances, tax cuts would in fact be money-financed (at least in part).

    The "radical" cure is not always the best, or the only cure. Sometimes we cannot remove the ultimate cause at the root of the problem (or removing it is too costly). That doesn't mean that other policies can't improve things.

    We don't know what the "right" level of GDP is. But that doesn't mean our best guess is whatever it is today. Like good Bayesians, we should grab whatever information and reasoning we can get hold of, even if we know it's imperfect, and try to shift the AD curve right if it looks like that's what's needed. When I see expected inflation starting to rise above target, then I will know we are starting to overcook it with AD.

    There are two sorts of economists (or, two sorts of economics): those who keep their noses on the scent, and slowly and methodically follow that scent where it leads; and those who use their eyes, and say "forget the scent for a minute, the hare has doubled back, and is just over there!". We need both. But immediate policy needs the second. It can't wait 50 years for the scent-followers to work their way back around. Assume sticky prices.

  10. Stephen, this was a very enjoyable post. Good comments by Serlin, too. I think a lot of students might use your walking-to-the-Fed example, Stephen, to justify not reading any of the great classical works. It takes too long. Without any understanding of doctrinal history, these students will be unable to place themselves within the great stream of economic thought. After all, the vast majority of economics done since the 14th century has been in carried out in words, not numbers. This sort of severing has consequences, although you might not agree. I don’t need to point out to you how much folks like Wright, Kiyotaki et. al. love to bring up Menger ;)

    Nick, I’d say your two economists are both misguided. Seconding Stephen, neither is able to see or smell where your rabbit, GDP, should actually be. All they’ve got to go on – all anyone has to go on - are market prices. If government bond prices are shooting up, then of course governments should meet this demand, issue debt, and spend it on worthwhile projects. But in this case the rabbit they are seeing or sniffing out is a visible price (high bond prices, low interest rates), and not some hypothetical aggregate.

  11. "Assume sticky prices."

    No. That's not how you should do policy. You keep all the models on the table, and you continuously evaluate whether these models are telling you something useful about the data that is arriving. Then you make decisions. All the time, in the background, you are busy trying to make the models better, and coming up with new ones. If you say: "stuff is going wrong, what I know well is sticky prices, let's fall back on that," I'll tell you there is a lot of off-the-shelf economics you should learn about.

  12. Stephen,

    Thank you for the thoughtful post, and Richard for your excellent comments. I have two points...
    1) On the stuff of multipliers, via Mark Thoma, is this paper on the value of multipliers during the business cycle. This suggests that if we are going to get a free lunch, we have to get the timing right.

    2) Krugman argues “Potential output” is what the economy would produce at “full employment”, which is the maximum level consistent with stable inflation.
    He claims that we can and should remain on the typical GDP trend, and to use monetary and fiscal policy to get us there. You seem much less sure that there is a correct "target GDP" or that full employment should be part of the government / Fed mandate. My concern is that there are externalities besides a slack labor force that can lead to slower growth. My concern is resource depletion, but maybe credit imbalances are more of a concern to economists.

  13. JP:

    "I think a lot of students might use your walking-to-the-Fed example, Stephen, to justify not reading any of the great classical works."

    I have found some great things in Adam Smith, Keynes, Menger, and other places. I have also read some of Wicksell and thought, "if this guy knew some math, he could have weeded out some of the weak ideas and been more understandable." Sometimes it helps to start with the modern stuff and work backward.

  14. Well, I'm sure it goes both ways. When Wallace worked out an overlapping generations model to describe fiat money in 1980 it amounted to a description of money as a store of value. He needed to be reminded of the old money-as-a-medium-of-exchange tradition, an idea as old as the hills passing through Turgot, Say, Menger, and many more. A case of "if this guy new some econ history, he might be able to create better mathematical models". If I'm not mistaken, search theories of money have emerged as the modern response to the classical Mengerian medium-of-exchange criticism of OLG models; indeed Wallace is a big contributor to the field.

  15. 5) "What do we want the government to do? How large should it be? We can, however, make the case that, if we have some project we think it would be socially advantageous for the government to undertake, the opportunity cost of doing it in a recession is lower. Recently, some forces in my school district convinced me that a new middle school was needed. Some other forces wanted to argue that this wasn't the time to do it, as we are in a recession. My answer to that was that this is indeed exactly the right time. The school could be built quickly and at low cost, and I was pleased to vote in favor of floating a school bond at a low interest rate."


    You, me, and Krugman are in exact agreement on this important point.

    But there's something you miss and/or underemphasize: Due to externalities, especially positional/context/prestige and carbon, asymmetric information, the zero marginal cost of idea/information use, high transactions costs, great economies of scale and the problems of monopoly power, inability to price discriminate well leading to inefficient provision, and much more, the current level of government spending, insurance, and especially investment is far below the optimal level. Thus, the marginal benefit of smart increased government spending is huge. A few extra trillion of smart government investment per decade is highly efficient, and total societal utility maximizing, even aside from the recession/high unemployment. It just makes that much more sense during the recession/high unemployment.

    So you should support the Obama stimulus. If you'd read what's in there you'd see that there is a great deal of extremely high social return investment of the kind the free market will grossly underprovide or inefficiently provide. Again, I suggest this Time article:,8599,2013683,00.html

  16. Richard,

    "So you should support the Obama stimulus. If you'd read what's in there you'd see that there is a great deal of extremely high social return investment of the kind the free market will grossly underprovide or inefficiently provide."

    My point is that what you are saying is unlikely. There may be some nice words in the bill, but in terms of the projects that were actually implemented, this was not well thought-out. I'm reading between the lines here, but it could be that what you, and Krugman, are saying is that there are a lot of high-social-return projects that go unfunded, the stingy American public is too dense to recognize this, and you have to scare the crap out of them to extract the resources from the Congress. If that is what Krugman is up to, I don't think it's a good idea - better to address the issues honestly.

  17. "If that is what Krugman is up to, I don't think it's a good idea - better to address the issues honestly."

    You're an economist, but you don't appear to be that expert in politics. It's very hard to get highly positive government policy passed by just being honest, with no crisis as an impetus, and without spending vast amounts of scarce political money and capital, when the Republicans have a vast propaganda machine that will lie shamelessly – death panels, global warming is a hoax, freedom will come to an end, the estate tax is largely on hard working small businessmen,...And when special interest money has so much power and lack of limits.

    And this is especially true with the recent elevation of the filibuster into a regular supermajority requirement.

    We didn't even get basic decent social insurance until the impetus of the Great Depression. It took about a century to finally get a sketchy universal health insurance program, and only after the system had reached crisis proportions.

    Honestly, again and again I think you grossly underestimate asymmetric information and how time costly it is to learn a great variety of things, and gain a great variety of expertises, for things not in your career. This is not about stupidity for most people, it's just very very time costly for people with historically little free time, who already spend way too little time with their families, to want to spend hundreds or thousands of hours learning the economics of government investment, specifics of investments and policy, other economics, and more. And without this learning they're vulnerable to Republican catchy soundbite "economics" and other misleading and lies. So often it does take a crisis to get large positive change through

  18. With regard to specifics of the Obama stimulus, here's some from the Time article:

    bailed out every state, hustled record amounts of unemployment benefits and other aid to struggling families and funded more than 100,000 projects to upgrade roads, subways, schools, airports, military bases and much more. But in the words of Vice President Joe Biden, Obama's effusive Recovery Act point man, "Now the fun stuff starts!" The "fun stuff," about one-sixth of the total cost, is an all-out effort to exploit the crisis to make green energy, green building and green transportation real; launch green manufacturing industries; computerize a pen-and-paper health system; promote data-driven school reforms; and ramp up the research of the future. "This is a chance to do something big, man!" Biden said during a 90-minute interview with TIME.

    For starters, the Recovery Act is the most ambitious energy legislation in history, converting the Energy Department into the world's largest venture-capital fund. It's pouring $90 billion into clean energy, including unprecedented investments in a smart grid; energy efficiency; electric cars; renewable power from the sun, wind and earth; cleaner coal; advanced biofuels; and factories to manufacture green stuff in the U.S. The act will also triple the number of smart electric meters in our homes, quadruple the number of hybrids in the federal auto fleet and finance far-out energy research through a new government incubator modeled after the Pentagon agency that fathered the Internet. (See TIME's special report "After One Year, A Stimulus Report Card.")

    The only stimulus energy program that's gotten much attention so far — chiefly because it got off to a slow start — is a $5 billion effort to weatherize homes. But the Recovery Act's line items represent the first steps to a low-carbon economy. "It will leverage a very different energy future," says Kristin Mayes, the Republican chair of Arizona's utility commission. "It really moves us toward a tipping point." (Watch the video "TIME Polls America: Spend or Cut?")

    The stimulus is also stocked with nonenergy game changers, like a tenfold increase in funding to expand access to broadband and an effort to sequence more than 2,300 complete human genomes — when only 34 were sequenced with all previous aid. There's $8 billion for a high-speed passenger rail network, the boldest federal transportation initiative since the interstate highways. There's $4.35 billion in Race to the Top grants to promote accountability in public schools, perhaps the most significant federal education initiative ever — it's already prompted 35 states and the District of Columbia to adopt reforms to qualify for the cash. There's $20 billion to move health records into the digital age, which should reduce redundant tests, dangerous drug interactions and errors caused by doctors with chicken-scratch handwriting. Health and Human Services Secretary Kathleen Sebelius calls that initiative the foundation for Obama's health care reform and "maybe the single biggest component in improving quality and lowering costs."


  19. You don't think this is high return public investment?

    And yes, I'm sure you can find some waste, but the high return meat makes it well worth it, and a lot better than nothing, or the opportunity cost – a lot more private predominantly consumption spending on items of relatively high positional/context/prestige externality and relatively low intrinsic utility. You want no waste then produce very little or nothing. And by the way, you can find massive waste in the private sector too -- a million dollar birthday party for the wife of Tyco's CEO billed to the shareholders, billion dollar CEO salaries, Enron. You want zero waste then produce very little or nothing. Humans are imperfect. There will be some flaws and a lot of agency problems in any large complicated organizations.

  20. Richard,

    "You're an economist, but you don't appear to be that expert in politics."

    Correct. What I stated sounds naive. Passing legislation is a minefield. I have some experience with politics though. Hiring a new faculty member in an economics department is a minefield too.

    "you grossly underestimate asymmetric information"

    No. This is my stock and trade. It's on my mind all the time.

  21. Richard,

    Another comment: I thought this piece was far too long for a blog post, but what the heck. You have been working hard in the comments section, though. You may have surpassed my word count.

  22. Commenting helps me to learn (and hopefully others sometimes). But I wanted to study this post thoroughly as it really had a lot of information on how you think. I was concerned that perhaps there was some big thing you knew from New Monetarist economics that I, or Krugman, didn't. I'm almost finished and so far I haven't found that. Most of it actually I, and I think Krugman, would agree with generally, if not on major details, empirics, and other specifics.

    With regard to fiscal stimulus, in your earlier comment I do see you're getting at that Krugman supports more than just high return government spending if necessary to bring down unemployment.

    Sure, building a bridge to nowhere might use some workers who would be sitting idle anyway, but you're still wasting a lot of expensive steel and concrete, and a lot of those workers, like say the engineers, still have skills that are very much in demand and they wouldn't have been sitting idle anyway.

    But there are two important points to counter that:

    1) As Mike Konczal recently said (and I say all the time), "All things considered, less waste here is always better, which isn’t hard when there are so many low-hanging fruits for the government to spend on infrastructure and other investments and when the administration is so worried about scandals blowing up." (at: You don't have to build bridges to nowhere or anything like that to produce $1 trillion or more in stimulus that will be activated whithin a year or two (and high unemployment is expected to last at least that long). Government investment has been so far below the optimal level for so long that it would be easy to find that much in high, or extremely high, social return investments. You could spend $100 billion easily just to prevent layoffs of teachers, police, shortened school years, shrunken universities, etc. at the state level.

    2) Even if the work were not that productive, there are very important social, personal, and psychological benefits to putting people to work. Longterm unemployed people lose confidence, social skills and connections, and specific career skills; studies have shown their children suffer and are less likely to go to college. This has decimated a generation of young men in Japan, see:

    So yes, due to this, which is very important and not in many (if any) models, Krugman is a lot less picky about the otherwise calculated return of the spending. And there are other reasons, indirect things – unemployment is a lot lower then Democrats do far better in the midterms and 2012, which may lead to the monumentally important cap and trade being passed, improving the health care bill rather than trashing it, much greater investment in basic science and medicine and education, trillions in tax cuts not going to the rich and super rich, etc., etc.

  23. Richard,

    "Most of it actually I, and I think Krugman, would agree with generally, if not on major details, empirics, and other specifics."

    Bingo. I think Krugman, and others, know all this on some level. What they seem to want to do is to turn off parts of their brains when they think about "stabilization policy."

  24. Richard,

    Would you mind elaborating on this:

    Due to externalities, especially positional/context/prestige and carbon, asymmetric information, the zero marginal cost of idea/information use, high transactions costs, great economies of scale and the problems of monopoly power, inability to price discriminate well leading to inefficient provision, and much more, the current level of government spending, insurance, and especially investment is far below the optimal level.

    Do you have any way of quantifying the importance of these "externalities" you highlight above? And what is the "optimal" level of government spending, investment, taxation, etc.?

  25. I'm with Dave here, Richard. Take asymmetric information. It's everywhere, but we know that there are private contractual arrangements that we have developed over time to deal with it. Suppose that I say that there is asymmetric information in the credit market, so the government should step in to, say lend to the credit-constrained, or cut their taxes. But private financial intermediaries are specialized in dealing with asymmetric information. Basically, they sort credit risks. What is it that makes the government better-equipped to do that? How do I know that a bad risk person in the credit market isn't someone who will also default on their future tax liabilities?

  26. Karl Smith makes the case for urgency here:

    You say it is bad to fool the people. Is that actually always the case? If there is a collective action problem in which private and public interests diverge, it can be good to fool all the people into doing the socially beneficial but privately harmful thing. I believe rational expectations is supposed to say you can't consistently do that. Eventually some people will start reading the blogs in which such interventions are advocated!

  27. Wonks Anonymous:

    The idea of private and public interests diverging is consistent with rational expectations. That's what you get in a coordination failure model. These are not currently popular, as New Keynesianism is in vogue now among most of the people who care about Keynesian economics. You're free to argue that coordination failure is what you are seeing now. What is the evidence, and what does the theory tell you to do about it?

  28. Arriving late and with a footnote, but an important one:

    You criticize PK for wanting to use employment as a distribute policy or insurance as opposed to income. My question: Aren't we as economists missing out on something fundamentally important when we think that the only benefit of employment is the consumption that it allows us to purchase?

    Keynes called his book "General Theory of Employment, Interest and Money", not "General Theory of Income, Interest and Money". At least since the 30's, employment protection policies have been a very important part of the toolbox of the welfare state. Were these all motivated just by a confusion between insuring employment and insuring income? Or is there something more fundamental there?

    Happiness research usually points out that employment has a huge effect on levels of personal satisfaction. There is also all the research pointing out to extremely persistent losses in income following unemployment since new jobs tend to be worse paid. Perhaps these have to do with losses in productivity/ human capital?

    I don't know the answer for these questions or which is the best way to do it. But I think we should be more careful in dismissing policy advice that focuses on employment as opposed to income just because we have yet to develop good models to understand the difference between the two.

  29. Anonymous:

    Some valid points. A little hard to square with the fact that for most of recorded history, people were wanting leisure, not work.

    Also, some food for thought here:

  30. Steve,

    Wonderful post and discussion. I only wish this part were true: "There is no right or left ... Only economics."

    I think that for most economists, political views are primary and the models they produce are constructed to justify their politics. I don't think it will ever change.

  31. David:

    Good point about historical attitudes towards labor and employment. Another variation that we are at loss at explaining. Still, what matters for current policy are current attitudes and preferences.

    The link you sent underscores the idea that policy should aim to protect employment as opposed to help the creation of new ones. What makes people happy is not just any employment, but is the one they are used to.

    I'll throw a somewhat sociological hypothesis out there: Perhaps employment is valuable because of the social network it brings with it? In older times, people's networks were largely given by their extended family and communal life. Now a days it is much more linked to the workplace. This hypothesis also explains why new jobs will not necessarily make up for the lost one.

  32. "Do you have any way of quantifying the importance of these "externalities" you highlight above? And what is the "optimal" level of government spending, investment, taxation, etc.?"

    David (and Stephen),

    This is a very big question. A good complete answer can be book length (or books length). It's far from a few simple statistics and p-values. And I'm especially short of time right now, but I think I can give you some big important indicators that I hope will encourage you to really think about this, logically utilizing all of the evidence you've seen in your lifetime, not just the fraction that's considered "formal". As the great growth economist and perennial Nobel shortlister Paul Romer of Stanford said:

    In evaluating different models of growth, I have found Lucas's (1988) observation, that people with human capital migrate from places where it is scarce to places where it is abundant, is as powerful a piece of evidence as all the cross-country growth regressions combined. But this kind of fact, like the fact about intra-industry trade or the fact that people make discoveries, does not come with an attached t-statistic. As a result, these kinds of facts tend to be neglected in discussions that focus too narrowly on testing and rejecting models.

    Economists often complain that we do not have enough data to differentiate between the available theories, but what constitutes relevant data is itself endogenous. If we set our standards for what constitutes relevant evidence too high and pose our tests too narrowly, we will indeed end up with too little data...

    My greatest regret is the shift I made while working on these external effects models...I suspect I made this shift toward capital and away from knowledge partly in an attempt to conform to the norms of what constituted convincing empirical work in macroeconomics. No international agency publishes data series on the local production of knowledge and inward flows of knowledge. If you want to run regressions, investment in physical capital is a variable that you can use, so use it I did. I wish I had stuck to my guns about the importance of evidence like that contained in facts 1 through 5.

    – Journal of Economic Perspectives, Volume 8, Number 1, Winter 1994, Page 20.

    That said, let's lay out some big chunks of evidence:

    Stephen, regarding asymmetric information, you talk about contracts and credit markets, but asymmetric information (or just lack of information – or, as is often forgotten by economists, the lack of expertise to evaluate it well in a very advance complicated world, expertise that can take years or decades of full time study to obtain) is far more extensive than just this kind of thing. Here is a link to a 2009 Eureka Alert:

    It notes a large scale survey which found 97% of climatologists who are active in research think that human activity is a significant contributing factor in global warming, but only 58% of the public thinks this.

    And there's the AP poll from July ( which found that 59% of Americans would oppose any climate bill if it would cause their electricity bill to rise by even $10 a month.

    Now that's what I call asymmetric information!

    But this is asymmetric information that, David, will lead to massive government underinvesting in basic scientific research related to alternative energy, as well as related infrastructure, as well as undertaxation of carbon (either direct or indirect).

  33. But there's more than this; how many people understand the underlying economics, that the free market alone isn't the most efficient at all for providing many things (especially after the constant and massive disinformation efforts of the Republicans)? How many people understand the list of potential market problems referred to in the beginning of this comment? And how many people can you expect to have the time or willingness to learn this much economics, when the vast majority have careers are in very different areas, and they have historically little free time?

    Or foreign policy. How many people really understand the extent of the effect a declining price of oil has on positive change for some of the worst authoritarian and terrorist sponsoring regimes in the world (including the Soviet Union in the 80s), where terrorism costs us trillions per decade, let alone the loss of life.

    How many understand that that $10/month, or $100/month, on average, progressively applied, will essentially not make their monthly budgets any tighter after a period of adjustment (see: ).

    So this should give you an idea of the true extent of asymmetric information and the magnitude of a large source of government underinvestment.

    But let's now look at another huge one.

    Cornell economist Robert Frank in 1999 wrote:

    A cautious reading of the evidence suggests that we could spend roughly one-third less on consumption--roughly $2 trillion per year--and suffer no significant reduction in satisfaction. Savings of that magnitude could help pay for restoring our infrastructure, for cleaner air and water, and a variety of other things.


    Now let's think about this.

    I'm 47. I spied on David's vita and found he finished his undergrad degree in 1985, so he's probably around 47, and Stephen has admitted to 55. So all of us should remember 1978 very well.

    Disco was sweeping the country and real per capita GDP was $25,503 (from the BEA, in 2005 dollars). In 2009 it's up to $41,890, for a difference of $16,387. Multiplied by the current population of 308 million, that's $5.05 trillion per year (and keep in mind here the yearly GDP figures are adjusted very little for increases in quality, like increased effectiveness of medical treatments).

    Now, let's compare how people lived in 1978, their happiness, their utility, to how people live today. Have we added that $5.05 trillion per year efficiently from the standpoint of optimizing total societal utils? (and I care even less about the Pareto definition of optimality, or efficiency, than Stephen. What's Pareto optimal can have tragically comically small total societal utility).

  34. In 1978, I lived like a pretty typical member of the middle class, in a three bedroom suburban house in Oak Park Michigan. Our floors were all carpet except for the kitchen and bathrooms which had nice linoleum. Our kitchen countertops were linoleum too. It was carpet and linoleum, not wood, stone tile, and granite. But for all that our home was much smaller and less expensive than a comparable one today, from my human experiences, our family (like those of our peers) found it just as beautiful and just as high quality as a comparable one with comparably middle class families today.

    Now, there's no t-statistic here, but I can take assumptions just as mild as those on which t-statistics typically are based, or milder, and construct a logic chain showing that it's extremely unlikely that my experiences throughout 47 years in many cities and neighborhoods, with many people, were completely unrepresentative of the population as a whole – and that's what they would have to be to not conclude that a huge amount of that $5.05 trillion was positional/context/prestige utility, of zero sum game at the societal level. This is as opposed to intrinsic utility like increased incidence of air conditioning since 1978, or improved medical effectiveness, which is a quality increase little included in that GDP statistic.

    As Paul Romer said, things that don't come with a t-statistic can be a lot more valuable pieces of evidence. And I'd add that their logic chains can be just as rock solid and anchored to assumptions as mild – or far milder – than those behind the t-stat, or other formal empirical evidence.

    Now, today total government spending on R&D is about $100 billion per year. That includes all of the government spending on basic scientific and medical research on curing cancer, arthritis, backaches, headaches, obesity, robots building robots, solar power, everything, including military R&D. And these are things well known to be provided more efficiently by the government directly, or largely indirectly, say through sponsorship, or purchase from the private sector – Paul Romer quote time:

    As just one example, recall that the increasing returns to scale that is implied by nonrivalry leads to the failure of Adam Smith’s famous invisible hand result. The institutions of complete property rights and perfect competition that work so well in a world consisting solely of rival goods no longer deliver the optimal allocation of resources in a world containing ideas.

    – Forthcoming American Economic Journal paper, page 8, at:

    "Think about the basic science that led to the discovery of the structure of DNA. There are some kinds of ideas where, once those ideas are uncovered, you'd like to make them as broadly available as possible, so everybody in the world can put them to good use. There we find it efficient to give those ideas away for free and encourage everybody to use them. If you're going to be giving things away for free, you're going to have to find some system to finance them, and that's where government support typically comes in... Because everybody can use the idea at the same time, there's no tragedy of the commons in the intellectual sphere. There's no problem of overuse or overgrazing or overfishing an idea. If you give an idea away for free, you don't get any of the problems when you try and give objects away for free. So the efficient thing for society is to offer really big rewards for some scientist who discovers an oral rehydration therapy. But then as soon as we discover it, we give the idea away for free to everybody throughout the world"


  35. So again I ask you, do you really think there will be much loss of utils for these super wealthy individuals with this 5/8 diversion to basic scientific and medical research?

    And you have to decide one way or another here, however happy you are with your data and evidence, not making a choice, or the status quo, is a choice. And one that must be justified with the data and evidence you have – not fancy non-existent data and evidence that you'd like to have – because the theory is not determinate due to all of the market imperfections of the invisible hand that are well acknowledged, that are referred to at the start of this comment.

    Do you really think that this little intrinsic utility loss per person – over this tiny an amount of people – would outweigh, over the long run, the utility from a five fold increase in basic science and medicine and other government R&D?

    Again, you have to choose a level of government investment too based on the same data and evidence that I do. The data and evidence is no more formal and fancy for you (although I'll give some additional strong formal data and evidence at the end). You have to rely on the same data and evidence that I do to justify your decision if you say we should keep the level of government investment the same, if you say we should cut it, or if you say we should cut it by 99%. The theory is not specific. It's clear due to externalities etc. that government investment shouldn't be zero and it's clear that it shouldn't be 100%. To find out what it should be in between you have to use the data and evidence you have, and it's well established in statistics that it's inefficient to throw away data and evidence. Now, I hope to illustrate this with a little parable:

    A snobby empirical economist is hiking with a friend who eats a berry off a bush and immediately keels over and dies. The snobby economist thinks to himself, well it's just a sample of one berry; you can't draw any conclusions from a sample of one. And being hungry himself, he eats a handful.

    Moral of the story: It's very inefficient, and perhaps very dangerous, to ignore abundant a priori information at your disposal, even if that information is not formal, but still logical – the logic chains are completely solid – and based on relatively realistic assumptions. You just currently don't have a formal version of it.

    It wasn't hard at all to put together a completely solid logic chain showing those berries were poisonous using common, but informal, a priori knowledge about biology, human physiology, evolution, similarity, and extremely realistic assumptions.

    Now, I think I could put together a similar case here with regard to the magnitude of positional/context/prestige externalities, the magnitude of the effect of the zero marginal cost of idea/information usage, etc., etc.

    In any case, this is plenty for now. As I said at the start of this, a good complete answer can be book length (or books length), and I can't write that here, but I hope what I have written gets you to really think about this. And here is a start for what I think is some strong formal evidence:

    Robert Barro and Jong-Wha Lee, "Educational attainment in the world, 1950–2010", Vox,

    Charles I. Jones, "Sources of U.S. Economic Growth in a World of Ideas", The American Economic Review, Vol. 92, No. 1 (Mar., 2002), pp. 220-239

    Charles I. Jones and John C. Williams, "Measuring the Social Return to R & D", The Quarterly Journal of Economics, Vol. 113, No. 4 (Nov., 1998), pp. 1119-1135

    Zvi Griliches, "Productivity, R and D, and Basic Research at the Firm Level in the 1970's", The American Economic Review, Vol. 76, No. 1 (Mar., 1986), pp. 141-154.

  36. Anonymous:

    There are interesting issues here about work and leisure and the roles they play in our welfare calculations. Way back (I am thinking pre-agriculture), humans spent most of their time just finding enough food to stay alive. As we progressed, we could afford to have at least some segment of the population producing music, art, and literature. In the United States, even on into the 20th century, life was arduous for a lot of people who still did not have electricity, running water, and sewers. It's still like that for many people in the world. Today in the United States, only a small fraction of GDP is actually simple sustenance. A large fraction of GDP is a leisure industry that entertains us and keeps our bodies and minds occupied. Now, it is clear that unemployment is a very bad experience for some people. It produces depression and suicide. On the other hand, there are people who choose to retire at 55, and seem quite happy about it. This is all pretty interesting, but I'm not sure that it has a bearing on whether the government should be buying more goods and services right now.

    David B.:

    Good to hear from you. Yes, I'm being idealistic.

  37. It's not the divergence that I was suggesting was inconsistent with R.E, just the ability to "fool" people consistently. The possibility of divergence is an argument against the assumption that it is bad to fool the people. And maybe there isn't actually a divergence, but in that case one should give an argument why we can be confident that is not the case. Karl's argument is that there is idle capital & labor that could be doing something but it currently depreciating, basically the productivity gap. I'm sure New Monetarists have a theory of that gap, though being a layman I don't specifically know what it is.

  38. I think it is obvious to everyone that there is idle capital and labor. There are factors of production that were busy producing output at the end of 2007, and now they are not doing so. The fundamental question is whether the private sector can do a good job of reorganizing itself to put all of these productive inputs back to work at their best possible uses, or do we need the government to direct that reorganization. One argument says that the resources are idle in particular geographical regions (e.g. Michigan), and particular sectors of the economy (housing construction), and the resources are needed in other geographical regions (e.g. North Dakota) and other sectors (e.g. health care). Then, there is little that monetary policy can do. On the fiscal policy front, it's not an "aggregate demand" problem; maybe it's a problem of removing any inefficient frictions to mobility across regions and sectors.

  39. Stephen, the 'recalculation' problem seems to be a topic of debate within the Fed (cf. Kocherlakota's speech). Do you think it is debated in fiscal policymaking circles?

  40. Stephen. Excellent post!
    Maybe a little long but definitely your best post yet.

  41. Anonymous,

    I had to Google "recalculation problem" to understand you. I had not heard of the roots in Austrian economics, but the idea of sectoral reallocation and mismatch has been around a long time in modern macro. In the 1980s, David Lilien, Richard Rogerson, Kevin Murphy, and Steve Davis, among others, thought about sectoral reallocation and business cycles. It certainly is part of what search and matching theory is about. If people are not thinking about this in "fiscal policymaking circles," they should be.

  42. Robert Frank today comes out with more strong evidence: