Krugman on stimulus

I usually don't respond to Paul Krugman's blog posts. But last week he wrote about Stimulus and Ricardian Equivalence. The post gives a revealing view of his ideas, so it's worth making an exception.

Paul explains:

...think about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan .... If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

So, according to Paul, "Ricardian Equivalence," which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong?

How indeed?

The answer is, we didn't, and Paul got this one wrong.


We all agree that "Ricardian Equivalence" is how the economy would and should work, if there were no "frictions," or other problems.  Yes, even Paul, who writes

It [Ricardian Equivalence] is a dubious doctrine even done right; many people are liquidity constrained, and very few people have the knowledge or inclination to estimate the impact of current government budgets on their lifetime tax liability.

Read that carefully for admission of the converse: if the economy is functioning right, if people are not "liquidity constrained," if people are smart enough to recognize that today's deficits mean tomorrow's taxes, then Ricardian equivalence does hold and stimulus doesn't work. (More careful discussion with a few more ifs  here, here and here.)

So according to Paul, the prediction of a properly functioning economy is that people who take out a $100,000 mortgage consume $100,000 less in the first year; that they do not do so is proof stimulus works.

But of course it is not!  People who take out a $100,000 mortgage with $6,000 payments per year should spend about ... $6,000 per year less on other things. Much of that $6,000 comes out of rent they are no longer paying on the house or apartment they moved out of, so there is not necessarily any change in their consumption of housing services. Some of the $6,000 goes to principal payments, which are a form of saving, allowing the household to put less in the bank. So, in fact they need not change consumption or saving at all!

In fact the classic view predicts exactly what common sense predicts: No, the family does not make radical $100,000 changes in its consumption plans thank you very much.

But what about the extra $100,000 of "spending"? Doesn't the new house contribute to "aggregate demand?" What, in the classic view, goes down by $100,000?

The question is not the family's spending, but where did the $100,000 come from, and what were they going to do with the money?

Most likely, someone was saving money, and put it in a bank. If this family didn't take out the loan, another family would have (perhaps at an infinitesimally lower interest rate) done so, and the economy would have built a different house. Or perhaps the money came from an investor in mortgage-backed securities, who would have built a factory instead. These are where the $100,000 offset in aggregate demand comes from, and why the family's decision to take out the mortgage need have no effect on aggregate demand.

Can something go wrong in that process?  Sure. That's what real analyses of stimulus think about. But those like myself who, reading theory and evidence, come to the conclusion that stimulus doesn't work well, do not come to that conclusion because we think the family will spend $100,000 less!

To me, this example illustrates beautifully how Krugman "got this wrong." He never asked where the $100,000 loan came from!  In his analysis of  government borrowing and spending, he does not ask, who lent the money to the government, and what were they planning to do with it otherwise.  People "with an economics training" are supposed to remember lesson one -- follow the money and pay attention to budget constraints. His stimulus is manna from heaven, not borrowed money.

Good advice to anyone: If you get up one morning with the brilliant insight, "Bob Lucas thinks that a family who takes out a $100,000 mortgage will reduce consumption by $100,000," have a cup of coffee, settle down and think, "Wait, Bob's a pretty smart guy. Did I get this wrong somehow?" before hurling insults Bob's way in the New York Times' blog section.

(Note, this is about Krugman's analysis, not stimulus in general. There are plenty of serious analyses of fiscal stimulus that do not make simple logical errors. The plausibility of their assumptions and how they fit the data is an interesting topic. For another day.)

PS: Why is it my new year's resolution not to respond to Krugman blog posts?

Really, what do you do with a guy who insults fellow economists, while admitting in writing that he doesn't even read the opeds and blog posts that are the cause for his insults (let alone their actual academic work, where ideas can be documented and defended)?  He often doesn't even link or name the articles he's criticizing so his readers can decide for themselves!

If you don't believe me, look here , here, here, here and... well, I could go on. Just search his column for anyone he disagrees with. (And dear New York Times, is there anyone left in the journalistic ethics or fact-checking department?)

The best answer to that sort of thing is silence. Which I resolve to maintain, along with that diet and hitting the gym....