Arnold Kling  

Boo, Eugene Fama

Do High-Income People Lose Inc... Fama and Fiscal Policy...

Readers of this blog know that I am against the Paulson/TARP bailout thingy and against a big stimulus. Some of you may also have read that distinguished (some would say Nobel caliber) financial economist Eugene Fama has a new blog, where he wrote a post against bailouts and stimulus. I did not link to that post, because I did not think that he contributed to our economic understanding of the issue. Today, I want to go further, because it occurs to me that we should not just leave it up to ideological opponents of Fama, such as Mark Thoma or Brad DeLong, to bear the sole burden of pointing out the vapidity of Fama's analysis.

Basically, Fama says that national savings equals national investment. So, if the government deficit goes up and private saving is unchanged, then investment must go down. Therefore, the argument runs, a government deficit crowds out private investment and does not raise output.

That story holds for an economy that is always at full employment. However, if the economy were always at full employment, then hardly anyone would have heard of a fellow named John Maynard Keynes, and we would not be talking about the issue of an economic stimulus.

In the Keynesian story, if investment declines (due to a drop in "animal spirits"), saving declines to match investment. They re-equate at a low level of total output, at which there is unemployment.

The Keynesian story is not without its problems. As David Henderson has pointed out in a couple of recent posts here, and as I pointed out at greater length in my lectures on macroeconomics, the simple Keynesian model is "priceless" in that it acts as if the usual economic adjustment mechanism, most notably the response to prices, does not work.

If Fama wants to make these sorts of criticisms, or add his own criticisms, that would be fine. But to just pretend that full-employment economics is the only economics and ignore Keynes completely contributes nothing to our understanding.

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COMMENTS (17 to date)
John Alcorn writes:

Gary Becker and Richard Posner have an exchange at their blog this week, about whether and how much the "crowding out" hypothesis is valid.

ID writes:

You are being unfair to Fama.

First, his blog post was clearly intended for a lay audience (why else would he use the phrase "cut one's teeth"?) And the argument he makes is straight Bastiat and Hazlitt. To criticize him for not "contributing to our economic understanding" is absurd. Who makes major contributions to economic understanding on a blog? That's what journals are for.

Second, you criticize him for ignoring Keynes, even after recognizing that Keynes's theory is fundamentally flawed. If we're looking for real answers and not just mental sparring, then all propositions have an equal burden of proof, and those that fail to meet that burden deserve to be ignored. The fact that people happen to be talking about Keynesian theory and the benefits of fiscal stimulus has no bearing on the truth of those propositions.

The classical position that Fama has taken is based on a common sense view of economics (e.g. people respond to incentives) and is supported by the many episodes in economic history in which recessions and financial crises ended quickly in the absence of any significant government intervention.

The Keynesian position is based on the assumption that the price system has broken down in the market for labor and the market for loanable funds, and/or that people for some reason no longer respond to incentives.

Apparently Fama finds the Keynesian account too far fetched to be worth his time. I agree. If the Keynesians want more attention then perhaps they should present something more substantial than "animal spirits" and the whining of hacks like DeLong.

US writes:


Your link to Fama's piece is broken.

[Fixed. Thanks for the alert!--Econlib Ed.]

Rich writes:

How does Fama's full-employment story relate to Real Business Cycle theory?

MattYoung writes:

I doubt that we need another economic theory for bad times and a different theory for full employment, whatever that is.

If the economy adopted a new set of aggregate labor organization that results in much less employment, then we are at full employment for that particular configuration.

All sectors are trying to define the future from the current new circumstances, why would increased uncertainty about the future redefine economic theory.

libfree writes:

I disagree, I would like to see a lot more contributions to economic thought on blog pages. It's more dynamic and I don't have a subscription to those journals (maybe I should get one and I might not need to ask these questions)..

Am I completely off base in thinking of the drop in aggregate demand as a required adjustment period. I have lots of friends who have been in construction for a long time. Some are underemployed because there are more people in construction than are needed. Some of my friends are receiving training they hope will give them future employment. Others are currently looking for new jobs.

Isn't this just a required period where the economy figures out how to employ all these people. Old jobs disappear and new jobs are slowly created. In the meantime we have lower aggregate demand? until they become employed making widgets that we want and need.

If we put these people to work, building widgets that we don't need, don't we just prolong the pain. Don't these people eventually need to go find productive jobs. What's the point in having maximum aggregate supply if its stuff we don't want or need?

fundamentalist writes:

“In the Keynesian story, if investment declines (due to a drop in "animal spirits"), saving declines to match investment. They re-equate at a low level of total output, at which there is unemployment.”

Why would anyone pay attention to Keynes today? Hayek and many others have refuted Keynes many times. In addition to his priceless economics, Keynes had no understanding of capital whatsoever and assumed unlimited resources, as Hayek has pointed out. And why would anyone take Keynes’s “animal spirits” seriously? Was Keynes psychic? Could he read the minds of thousands of businessmen? And why are businessmen guided by “animal spirits” and not government bureaucrats?

As for investment and savings declining together, Keynes was merely demonstrating his lack of interest in the topic of money. He assumes that saving is nothing but a reaction to the interest rate. It is not. The interest rate plays a role, as does risk, inflation, and productivity. But the major determinant of savings is the preference for goods in the present as opposed to goods in the future, or as the Austrians say, time preference. Contrary to Keynes, people usually save more in a downturn, not less, because of fear and uncertainty over the future.

fundamentalist writes:

Libree, excellent comments! If only economists would use such common sense.

fundamentalist writes:

Fama: “…in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit), PI = PS + CS + GS…”

The chief problem with Fama’s analysis is that is doesn’t include money. The equation he provides holds only in the world of real goods, not in one in which fractional banking exists. In his defense, the subject of his article is the fact that state spending crowds out private investment, not the cause of the current crisis. Within the limits of the subject, his article is correct and necessary for an understanding of the proposed solutions.

But savings and investment equal only in the world of real goods, or in a world without fractional banking. When every bank contributes to the growth in credit money by loaning out more than what people save, then investment can be much greater than savings for awhile. This causes the boom. Even Hayek admits that state spending can reduce unemployment quickly. He objects to such measures on the grounds that they are not sustainable and lead to the next boom/bust cycle.

Investment can exceed savings for only as long as idle resources exist. (Keynes assumed idle resources would always exist in unlimited amounts.) The process also distorts the structure of production, causing excess production in things like housing or fiber optic cable (the last crisis). When idle resources are used up, price inflation begins and the capital structure tries to return to its original shape by getting rid of the excess employment in the capital goods industries, such as housing and autos. The main problem with state stimuli is that they try to maintain the unsustainable boom.

amv writes:

What matters is the supply of money and not the level of employment. Even in case of unemployment additional government demand for credit (or supply of bonds) drive up interest rates and crowds out private investment. If money supply and the rate of time preference are constant, the supply of finance is given. A higher interest rate may induce some dishoarding, but this is empirically irrelevant at the moment. If money supply increases, as it does, their is no crowding out in investment spending: aggregate demand increases and only this impacts the aggregate demand for labor (and only if the economy grows below its capacity). If, however, some complementary factors to labor are scarce, the expansion of some industry indicates the contraction of others.

Eric L. Prentis writes:

Fed Chairman Bernanke uses trillions of dollars of taxpayer money and the Treasury uses billions of dollars of TARP money to save the stock and bond holders of failed banks, thereby weakening the ability of the US economy to quickly bounce back from this recession because failure is rewarded rather than success. Bernanke’s futile attempt to prove that Milton Friedman’s monetarism theory is practical hasn’t worked because failed banks will continue their wayward policies as long as the taxpayers are making good their losses. Dr. Bernanke, the ivory tower academician, is acting like a megalomaniac who needs to be stopped before he dooms the American economy to the Japanese disease of a lost decade of poor economic growth. Using the tried-and-true Swedish model now is imperative.

Barkley Rosser writes:

The equality of savings and investment is an automatic given, no matter what their intended values are. This falls out of NIPA and holds no matter the level of employment or lack thereof of resources. It is trivial and essentially meaningless. The criticism that Fama is trying to turn an accounting identity into a behavioral identity is completely correct.

Bill Woosley writes:

Nearly every type of consumer good being produced today could be produced in much larger quantities and somebody could use it to achieve their goals.

That even includes houses and cars.

Now, when we say that we should devote fewer resources to producing houses or cars, that means that the other goods that those resources could be used to produced are more valuable to people that the houses or cars.

Making houses or cars creates losses because people are willing to pay less for them than their costs. But their costs are based on the prices of the resources. The prices of the resources are based upon their demands in alternative uses. Their costs depend on the value of the other goods that could be produced.

Labor is scarce. There are plenty of things it could be used to produce that would be valuable.

The notion that we should just wait makes no sense. The unemployed workers want consumer goods. Why not employ the unemployed workers to produce the consumer goods they want?

What "should" happen, is that there should be industries where demand is rising faster than in those industries where it is shrinking. The problem should be that there are industries that are limited by shortages of resources, including labor. Sure, there may be plenty of unemployed construction workers, but these other industries need other sorts of workers. And they may need specfic machinery constructed. The power saws or bull dozers from the construction site, or machines from the auto assembly line are probably wrong for these other industries.

But there should be demand somewhere. It isn't like not working now will allow us to rest up and work 80 hour weeks next year.

Unless, of course, there is an imblance between the supply and demand for money.

Now, some people are working, and they may be just demanding money. They can spend that money later.. whenever they want. It makes no sense in aggregate for us to just wait to decide what they want to do with the money.

If people worked now and produced goods and services now (and there are plenty of things people could use) then they can still produce more of whatever it is people want to buy later.

Producing nothing now doesn't help increase the production of goods later.

The problem is a failure of prices to adjust.

Interest rates need to be low enough, so that the demand for current output matches the supply. So that the shortages match the surplues. So that the problem is moving resources now to produce whatever it is that people want to buy now.

If interest rates are so low that some people don't want to work, because they want to save the income they earn, and they won't earn enough interest, then fine. They can wait.

But that there are people who want to produce goods now because they want to buy consumer goods now, but the market order just makes them wait and suffer poverty until someone else decides what they want.. crazy. (Well, if someone wants to pay people to wait.. go for it.)

Of course, the interest rate cannot turn negative because currency has zero interest. No one will lend at negative interest.

But that implies an increase in the demand for money. And so, either the supply of money must increase enough to meet that demand, or else the price level needs to drop enough to that the real supply of money adjusts to the demand.

If growing real money balances can't result in interest rates falling (because they are at zero,) then what is left is the Pigou effect, which means that the increase in wealth leads to more consumption.

If no one wants to devote resources to future investment, then we use current resources today to produce consumer goods and services for today.

If no one wants to invest, then there is no social purpose to saving.

Of course, we don't know that "the" interest rate needs to fall below zero. While T-bill rates are very close to zero, there are plenty of interest rates well above zero. Personally, I think that the money supply is too low.

Uncertainty has led to a large increase in the demand for money. A large increase in the supply of money is necessary to maintain aggregate demand. To create a situation where the shortages and surpluses match.

Randy writes:


"What's the point in having maximum aggregate supply if its stuff we don't want or need?"

Agreed. I think the underlying assumption of those who want to do fiscal stimulus via huge government projects is that everything the government does has infinite value. Personally, I assume exactly the opposite. My favored approach would be to extend unemployment benefits long enough to allow people to find alternative means of support - and then let the situation work its way out. It will of course, in time.

R. Richard Schweitzer writes:

"Investment" is NOT a zero sum game.

Robert Waldmann writes:

Excellent post. I agree that it is very important for economists to have the intellectual integrity to criticize arguments even though they agree wiht the conclusions. I'm an economist. You almost give me hope for the profession (in the cold grey light of morning I'll probably be back to dispair).

james writes:

Work it out, huh? Yeah that worked great for the Great Depression. Sure, the economy has its up and downs, and we should not be so intent on taming the business cycle (esp with fiscal policy). This is why the recessions you refer to do fix themselves eventually. But sometimes, they don't. All indicators show that this will be the worst recession since the 30s. And even if they do self-correct, it is beneficial to long term growth and to the lives of individuals to minimize the harm caused by the worst recessions.

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