Arnold Kling  

Job-Creation Arithmetic, II

Savings, Capital Deployment, a... Spend Less on Education?...

On his web site, Paul Krugman has posted the textbook macroeconomics of fiscal policy for stimulating employment. In a related post, Krugman explains how this basic macroeconomic model explains what some people (like me, for instance) found puzzling about a recent column in the New York Times.

No, I didn't forget to divide by serious economist thinks that a tax cut or spending increase will have any effect on employment more than a couple of years from now...

My own view is that the tax cut - or any fiscal policy - will have a positive effect on employment only as long as the economy remains close to a liquidity trap. That is, once the Fed is no longer constrained in how much it can cut interest rates, fiscal policy adds nothing to the ability of policy to achieve full employment. Now most forecasts presume that we'll be out of the trap by next year - that is, before most of the supposed job creation from the tax cut takes place. Even if you're more pessimistic than that, we're probably looking at only 1-2 years when fiscal policy creates jobs.

Krugman is basically arguing for a classical monetarist view of macroeconomics. In that view, aggregate demand policy only affects employment for a short period of time, because the economy has internal adjustment mechanisms that cause it to return to what Milton Friedman once called the "natural rate" of unemployment. Moreover, if the monetary authorities are free to set goals for macroeconomic targets, they can offset fiscal policy changes, meaning that the latter have no effect even in the short run.

Just to give fiscal policy a sporting chance in the short run, Krugman posits that we are in a liquidity trap, so that monetary authorities are not completely free to control aggregate demand. I happen to disagree with the view that we are in such a trap, but that is beside the point here.

The bottom line is that in anything like a classical macroeconomic model, there is no long-term stimulus to employment from fiscal policy. Tax cuts can improve the economy if and only if there are supply-side benefits.

On the issue of supply-benefits, Krugman would be prepared to point out that the adverse impact of a larger deficit outweighs the positive effects of lower tax rates. I believe that such an economic argument is valid, important, and typically overlooked by supply-side economists. The mainstream economic view would be that, generally speaking, in order to realize the supply-side benefits of tax cuts, the government needs to reduce spending below what it otherwise would have been.

For Discussion. If a fiscal expansion leads to gains in employment that last two years or less, should economists be doing more to educate the public about the case against fiscal activism? Should we be arguing that the job of maintaining full employment falls outside the responsibilities of Congress and the President?

Comments and Sharing

CATEGORIES: Fiscal Policy

COMMENTS (5 to date)
scott writes:

Typically fiscal policy can’t be enacted fast enough to have a short term effect. However, it can have a long term effect if it alters the economics of one of the factors of production. In the current case, Bush’s tax cut proposals alter the economics of both labor and capital.

Politically, I’ll take the deficit problem if we can get the benefits of the tax cuts. In the long run we’ll be much better off.

Eric writes:

Since when is Krugman a monetarist? Does this guy EVER get called to account for the things he writes? The only consistancy is that he hates Bush and Republicans. In that, he is in perfect alignment with the New York Times.

Generally speaking, I don't think that it is the Federal government's job to tweak the economy, simply because they do such a bad job at it, and it isn't exactly one of their constitutionally assigned duties.

But you just can't argue against the Reagan tax cuts. They were so well timed, and such an integral part of the re-engineerng of the US economy into the post industrial global jugernaut that it has become, that it makes the Bush economic arguments worth examining.

There is no question in my mind that the 2001 recession was at least in part caused by high taxes. The governments take from the economy was at historically high levels. Since then, we had the first round of the Bush tax cuts, and the government's take has eased somewhat. It makes sense that a good deal of the sluggishness in the economy is in part based on taxes still being too high. The dividned tax surely has an impact on stock valuations, for example.

Paul Zrimsek writes:

It's a pity that the great divide-by-ten controversy has diverted everyone's attention from what ought to be the main point: that the comparison Krugman drew between tax losses to the government and the salaries of the created jobs is meaningless whether he's doing the math correctly or not.

One one side of the comparison, it's bogus to treat the pay earned by the holder of a newly created job as a pure benefit-- that is, unless someone's discovered that there's no such thing as disutility of labor after all, and I'm late getting the word. No doubt there are second-order effects of job creation as well, but wage data obviously tells us nothing at all about either their magnitude or their sign.

On the other side, if Krugman wants to treat a mere transfer (or rather, a foregone transfer) as a cost, he's also got to include the offsetting benefit to taxpayers. That is, unless he's assuming that it's no benefit at all because taxpayers oughtn't to have the money-- in which case he's engaged in something very different from the exercise in uncontroversial positive economics that he wants us to believe he's engaged in.

Sol writes:

Duh! and Doh!

Here I spent all this time yesterday wondering why neither side in the argument wanted to spend any time calculating the correct ratio. I found it especially puzzling that the Krugmanites weren't willing to admit that their man had fudged the numbers in the original article, considering that the corrected numbers (I estimated $100,000-$150,000 of salary for $500,000 in tax breaks) were still clearly in favor of his basic position.

But Paul is quite right above, the entire comparison is bogus. I can't believe I fell into such a stupid trap. Good thing I'm not an economist.

Bobby writes:

I wrote this a few days ago regarding the "divide by ten" thing.

Comments for this entry have been closed
Return to top