Paul Krugman: Demystifying Taylor’s Confidence Fairy (Wonkish)


 

I was wondering, but Noah Smith does the work.

According to Smith, Cogan-Taylor et al simply ignore the zero lower bound — which means that they ignore the whole reason we’re talking about fiscal policy in the first place.

They also assume that spending cuts fall overwhelmingly on transfers, not on government purchases; their own model actually suggests considerable impact from declines in purchases. The reason for the small effect of transfers is presumably some kind of near-Ricardian equivalence: spending doesn’t decline much from a cut in transfers because people expect offsetting tax cuts later. And they then assume huge distortion effects from taxes, so that lower tax rates add substantially to expected future pre-tax income too.

Right away, we see that they’re being disingenuous: their difference from Keynesians isn’t because those dumb Keynesians don’t take account of the future, it’s because they’re making very different and highly dubious assumptions both about policy and about how the economy works.

And should the Ryan plan really be thought of, for macroeconomic purposes, as a cut in transfers that is fungible with future taxes? First of all, a lot of the spending cuts come from discretionary spending, which is basically goods and services. The rest comes largely from Medicaid, food stamps, and other in-kind aid programs serving families in need. So how does that work?

Let’s think this through. If you take $200 billion a year from the poor and hand it to the rich, and people believe that this transfer is forever, permanent income theory says that consumption among the poor should fall by $200 billion while consumption among the rich rises by the same amount. There are, however, two reasons not to believe this.

One is that there is some evidence that permanent income doesn’t work all that well, that the rich persistently consume less of their income than the poor.

More to the point here, however, is that it’s very likely that people would view both savage spending cuts and the tax cuts they pay for as less than permanent, likely to provoke a backlash or at any rate a reversal at some point. And in that case the rich would not spend all of their tax cut.

The poor, on the other hand, would probably cut spending by almost all of their benefit cut. For one thing, these are in-kind benefits — health care is not a perfect substitute for other spending. Also, poor people don’t have pools of savings to live off or ready access to capital markets! So we’re taking money from liquidity-constrained people and giving it to people who don’t face that kind of constraint. Result: contractionary policy is very likely to be contractionary.

Of course, none of this matters to most WSJ readers; this stuff confirms their prejudices, and that’s all they care about. Still, they should know that what they’re getting isn’t what “modern macroeconomics” says; it’s just what a couple of guys who are actually very much at odds with many other modern macroeconomists say.

Demystifying Taylor’s Confidence Fairy (Wonkish) – NYTimes.com

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