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Monday, May 24, 2010

Modern Macroeconomic Theory and Fiscal Policy

I suppose I should respond to this. After getting home from Beijing, a process that involved a 12 hour flight followed by a 6 hour layover in SF, then a 3 and 1/2 hour delay, a flight cancellation, a last minute flight from SF to Portland, renting a car since there were no more flights to Eugene, then driving to Eugene for 2 hours, finally arriving after 28 hours with only the sleep one grabs here and there on planes, I did manage to catch a few hours sleep. But not enough. I then got up, tired and crabby, read this post, found myself a bit annoyed and did something I don't usually do, I left a comment at another blog.

Let me explain. It wasn't the overwhelming evidence of Krugman/DeLong derangement syndrome that got to me in my tired and crabby state. It was this part:
Where is the evidence that Paul Krugman has ever thought deeply about the theoretical foundations of Keynesian theory? (Maybe there is some and I have just missed it). As far as I can tell, his "deep" understanding goes no further than an elementary Keynesian cross (OK, OK, maybe he knows a bit more than this).

So, what do I take away from all this? Well, I conclude that it should be clear enough that this dynamic duo are primarily interested in pushing their own pet political agendas; they have no interest in pushing the frontier of economic theory... Nothing wrong with this... Nothing wrong, that is, except when they label these activities as "fair and balanced" or as "rooted in rigorous theory." That's just plain dishonest.

It's the suggestion that the policy advice Krugman and DeLong have been giving is not "rooted in rigorous theory" that annoyed me the most. The suggestion that Krugman's policy advice was based upon an understanding of the models no deeper than the Keynesian cross contributed as well.

So let's get something absolutely clear. The fiscal policy intervention that Krugman, DeLong, and others have been advocating can be analyzed and supported using the New Keynesian model. See Woodford and Eggertsson's work in particular, or see this work by my colleague George Evans along with his coauthors. For the most part, these models support the types of policies the administration has put into place. (Generally, demand side policies are the solution when the economy is stuck at the zero bound. Supply side polices such as a capital gains tax cut actually make things worse. The reason is that an increase in supply when demand as already insufficient causes prices to fall, and the fall in the price level raises the real interest rate. At the zero bound, the rise in the real interest rate cannot be offset by the Fed. Away from the zero bound, the Fed can stabilize the real rate and the policy has positive effects, but it depends critically on the Fed's ability to offset increases in the real rate and the nature of the reaction).

There has been an attempt to discredit fiscal policy intervention by suggesting it is based upon old fashioned Keynesian cross models. My reaction to the original post was because it read like another contribution to those pushing this idea. If David wants to back away from that, and it seems he does from his latest post (the part where he pats himself on the back for being so open minded), great. Because the attack along these lines is, to echo a term, "plain dishonest." There's no doubt whatsoever in my mind about Krugman and DeLong's knowledge of modern theory, but that's not my main concern. It's the suggestion that the people advocating fiscal policy cannot possibly understand what modern models say, that they must be relying on old-fashioned, out of date theory, that brought the reaction. There's nothing at all inconsistent with advocating fiscal policy when the economy is stuck at the zero bound and what modern macro has to say on the topic. Those who suggest otherwise either explicitly or implicitly are the ones pushing an agenda rather than helping to illuminate what modern models have to say on this topic.

    Posted by on Monday, May 24, 2010 at 01:17 AM in Economics, Fiscal Policy | Permalink  Comments (107)


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