Right in the Short Run

In recitation tomorrow I’ll be teaching my students how the Fed’s monetary policy decisions work their way through the banking sector. As I thought about the material, I recalled an old passage from Paul Krugman’s classic, Peddling Prosperity:

Robert Bartley…describes the genesis of supply-side economics as taking place over a series of dinners at Michael I, a Wall Street area restaurant. There it was that he and [Arthur] Laffer discovered that Keynesian economics was logically inconsistent — an insight that had eluded Paul Samuelson and a few thousand other people over the course of hundreds of academic conferences. They also believed that Milton Friedman was wrong in believing that monetary policy could have important effects on the economy — an insight that had similarly eluded Friedman, Lucas, and the faculty of the University of Chicago over a generation of the notoriously brutal Chicago seminars. …

[T]he supply-siders did not believe that demand-side issues could matter. Bartley reports that Laffer educated him on the importance of Say’s Law, an eighteenth century dictum that says that supply creates its own demand. This was a rejection of Keynesian (and for that matter monetarist) economics on principle. Unfortunately, the principle is wrong: try telling the unhappy members of the babysitting co-op … that a general failure in demand is impossible. What happened there was that members of the co-op tried to spend part of their receipts of scrip, not on goods and services (baby-sitting), but on accumulating more scrip (money), which was impossible in the aggrgate, and therefore precipitated a miniature recession. But the Michael I diners thought they had neatly disposed of the whole topic of aggregate demand.

Second, the supply-siders dismissed the real-world importance of the money supply in general. Bartley tells of Laffer drawing a large box to represent the overall stock of credit in the economy, and a tiny box to represent that part of the stock corresponding to the money supply. “‘Do you really think,’ he asked, ‘this little black box controls all the others?’” Again, economists from Keynes to Lucas had spent a lot of time trying to explain just why it is that the monetary instruments controlled by the Federal Reserve exert a profound influence over the economy; but over dinner this work was found to be obviously wrong.

Hopefully tomorrow I will do a better job than Laffer and my students will understand how the money multiplier allows the little black box to have a lot of sway over all the others.

Mark Thoma has another extraordinary post at Economist’s View, this time taking on Bruce Bartlett’s claim that “hardly any economist believes what the Keynesians believed in the 1970s and most accept the basic ideas of supply-side economics.”

If you are looking for a quick primer on the two main schools of thought in Macroeconomics, I cannot recommend Professor Thoma’s post enough. Just scroll past the quoting of Bruce Bartlett’s article and look for the pretty charts. Some excerpts:

Real Business Cycle (RBC) theorists believe that most if not all fluctuations in the economy are due to supply side shocks, aggregate demand shocks such as changes in the money supply, changes in taxes, and changes in government spending affect nominal variables such as prices but have little to do with changes in output over time (however, government intervention does causes inefficiencies in these models so that less intervention is generally preferred to more). …

New Keynesians (NK) do not deny that shocks to aggregate supply can affect GDP nor that supply shocks can be large and important. However, New Keynesians also believe that aggregate demand shocks are important…

New Keynesians attempt to stabilize actual output around the natural rate as shown above. Why does NK policy tend to focus on demand shocks rather than supply shocks? The answer is that although it would be ideal if we could use supply-side polices to smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot do this. As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect output in the long-run, but they are all but useless in dealing with short-run fluctuations in the economy (thus, RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. …

For those who are already familiar with the tenets of New Keynesian and Real Business Cycle models, the post includes some political insight that’s also worth checking out.

Why do Republicans tend to endorse the RBC (real business cycle) framework? I believe in many cases that belief in the RBC model arises from an honest view that the evidence is most supportive of this class of models. But in other cases I believe it is an ideological marriage. The RBC model has two features that make it attractive.

First, because it says short-run stabilization policy is ineffective, and that government intervention through either spending or taxes generates economic distortions, the RBC framework supports an approach where the role of government in the economy is minimized.

Second, because the RBC framework allows for tax cuts to produce higher growth by reducing inefficiencies, and because it is then possible to argue that tax revenues might increase, it gives two reasons for supporting tax cuts - higher growth and less than a full loss of tax revenue, i.e. a dollar tax cut does not cost a dollar (or, for serious ideologues, the tax-cuts even pay for themselves).

The NK model, on the other hand, supports active government intervention which is at odds with this ideology. In addition, because the focus in NK models is on stabilization of output around the natural rate, not on growth of the natural rate, tax-cuts do not have the dynamic long-run effects as in RBC models (though these can be added) and hence there is not as much ideological support for tax cuts in the NK framework.

Check it out, and read through the comments to catch a glimpse of Paul Krugman butting heads with Bruce Bartlett.