Corrections and amplifications

I've attracted some odd attention from Brad DeLong and Paul Krugman about a post I hesitated to put up only because I thought it rather stated the obvious.  The good professors disagree.

Brad DeLong says:

Megan McArdle writes:

All you have to do is believe . . . - Megan McArdle: The real question, I think, is how close the permanent income hypothesis is to being true.   The basic idea is that people are forward looking, and they try to smooth their consumption over time.  So if you give them a "temporary tax cut", they save most of it, knowing that eventually they will have to give the money back. But of course, this should also be true of "temporary government spending"--if people think the money won't be there next year, they'll salt as much of the money away as possible.  This is a topic very underexplored in the various estimates of the stimulus multiplier...

No it isn't. This is a topic that economists have been exploring for fifty-five years. It is a topic that has been very thoroughly explored in all of the estimates of multipliers.

Indeed--and I see that I have been unclear.  All I meant was that I would like to see more economists talking about how consumer savings affects their current estimates of the multiplier for Obama's stimulus plan.  It seems to me that the rather extraordinary credit binge American consumers have been on for the last seven years has got to affect the knock-on effects of direct government spending--the marginal propensity to consume seems to be dropping rapidly as people focus more on their future income stream.  Perhaps my intuition is wrong, but if so, I long to have better heads than mine explain why.

Professor DeLong's misunderstanding was my fault for not being clear--the penalty of a form that is written quickly.  But I confess to being purely puzzled as to Professor Krugman's addendum:

Brad DeLong links to Megan McArdle saying something wrong about the effects of a temporary increase in government spending. But he fails to note that it's not just wrong, it's 180 degrees wrong: a temporary increase in government spending should have a larger impact on demand than a permanent increase, not a smaller impact.

And that's actually an important point: one way to explain why government spending is better than tax cuts as a stimulus is to say that temporary tax cuts aren't effective at increasing demand, but temporary spending increases are.

Here's the logic (which follows directly from Milton Friedman's permanent income hypothesis, by the way): suppose that the government introduces a new program that will cause it to spend $100 billion a year every year from now on. To pay for this, it will have to raise taxes by $100 billion a year, permanently -- and if consumers take this into account, they might well cut their spending enough to offset the increase in government purchases.

But suppose the government introduces a one-time, $100 billion program to repair bridges over the next year. The government will have to issue debt to pay for this, and will have to service that debt, requiring higher taxes -- say, $5 billion a year. That's a much smaller impact on consumers' future after-tax income than the permanent program. So much less of the spending rise will be offset by a fall in consumer demand. (I'm not considering the effect of the spending in raising income, which would probably cause consumer demand to rise rather than fall.)

So economic theory -- Milton Friedman's theory! -- says that spending is a more effective form of stimulus than tax cuts.

Which is extremely interesting and informative--but it has nothing to do with the content of my post, which did not address the relative virtues of permanent and temporary spending increases or tax cuts.  I was simply interested in how much of the spending people will save to cover the future taxes needed to pay for it.

It does make me wonder, though:  if Professor Krugman believes this to be true, why isn't he making more fuss about the likely-to-be-permanent components of the stimulus package, like the new Cobra provision to pay for many of the health care costs of laid-off workers over 55?


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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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