Wednesday, July 07, 2010

Are stimulus skeptics logically incoherent?

Paul Krugman writes:
There’s now a lot of talk about the fact that U.S. corporations are sitting on a lot of cash, but not spending it. I don’t find that particularly puzzling: with huge excess capacity, why invest in building even more capacity. But almost everyone seems to agree that if we could somehow get businesses to spend some of that cash, it would create jobs.
Which then raises the question: how can you believe that, and not also believe that if the U.S. government were to borrow some of the cash corporations aren’t spending, and spend it on, say, public works, this would also create jobs?....
I have never seen a coherent objection to this line of argument.
A coherent objection to this line of argument might be the following: If the government borrowed the money to spend, it would need to eventually pay the money back. That means higher future taxes, on top of the future tax increases that President Obama already will need to impose to finance his spending plans. Higher future taxes reduce demand today for at least a couple reasons. First, there are Ricardian effects to the extent that consumers take future taxes into account when calculating their permanent income. Second, those future taxes are not likely to be lump-sum but will be distortionary; it is plausible that at least some of those future tax distortions may adversely affect the incentive to invest today.

That is, businesses may be reluctant to invest in an economy that they expect to be distorted by historically unprecedented levels of taxation in the future.  The more the government borrows, the higher taxes will need to go, the more distorted the future economy will be, and the less attractive is investment today.
I am pretty sure Paul would not find this line of argument persuasive.  As far as I can tell from reading his commentary over the years, he does not believe that the distortionary effects of taxes are particularly large and so they do not figure much into his policy analysis.  But many other economists (and I suspect many stimulus-skeptics like the tea-partiers) believe that taxes have significant incentive effects and can prevent the economy from reaching its full potential.  Their argument seems logically coherent, even if it relies on a different set of parameter values for the relevant elasticities than Paul believes to be true.

Addendum: In another post, Paul plots investment and the output gap, points out the well-known fact that investment is highly procyclical, and then concludes that investment is down because the economy is weak.  I wish figuring out cause-and-effect were so easy!

When I first learned Keynesian economics, the causation was often taken to go in the other direction: Animal spirits drove investment, which in turn drove the business cycle. Unfortunately, eyeballing time series rarely tells us what causes what. Correlation is not causation, even in the blogosphere.