David R. Henderson  

Krugman Speaks Truth to Stiglitz

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And, moreover, uses some of Milton Friedman's best work to do so.

First, Joe [Stiglitz] offers a version of the "underconsumption" hypothesis, basically that the rich spend too little of their income. This hypothesis has a long history -- but it also has well-known theoretical and empirical problems.

It's true that at any given point in time the rich have much higher savings rates than the poor. Since Milton Friedman, however, we've know that this fact is to an important degree a sort of statistical illusion. Consumer spending tends to reflect expected income over an extended period. If you take a sample of people with high incomes, you will disproportionally include people who are having an especially good year, and will therefore be saving a lot; correspondingly, a sample of people with low incomes will include many having a particularly bad year, and hence living off savings. So the cross-sectional evidence on saving doesn't tell you that a sustained higher concentration of incomes at the top will lead to higher savings; it really tells you nothing at all about what will happen.


This is from Paul Krugman, "Inequality and Recovery."

Three comments:
1. By "rich," it's clear, in context, that Krugman means "high-income." Those aren't the same. You can be high-income and have relatively modest wealth.
2. Krugman states Friedman's thesis correctly. Friedman laid this out in his 1957 book, Theory of the Consumption Function. It's Friedman's first major empirical work and one of his best. It also seems to be broadly accepted among economists. Friedman has an interesting discussion of it on pp. 222-227 of his and Rose Friedman's book, Two Lucky People. I remember when Armen Alchian, in my first-quarter microecon class at UCLA in the fall of 1972, discussed it. Alchian, a friend and strong admirer of Milton, said, "Friedman is a first-rate economist and a second-rate statistician. And even a second-rate statistician will see that in the consumption/income data, you have regression to the mean." He said this, by the way, with total admiration.
3. Acceptance of Friedman's idea has strong implications for Keynesian fiscal policy. It implies that if the government temporarily boosts people's incomes, either with a temporary tax cut or an increase in transfer payments, people will not spend anywhere near a dollar per dollar of tax cut or transfer payment, but will spend more like 20 to 30 cents per dollar. That strongly undercuts the multiplier part of Keynesian fiscal policy. Does anyone know if Krugman has used this reasoning in his discussion and advocacy of Keynesian fiscal policy? I don't recall his having done so.


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COMMENTS (5 to date)
Floccina writes:

What about this:

The evidence is mixed, but seems to suggest that I was wrong. In "Do the Rich Save More?", economists Karen Dynan, Jonathan Skinner and Stephen Zeldes found a strong relationship between personal savings and income. However, other research suggests the opposite conclusion. Julia Lynn Coronado, Joseph Lupton and Louise Sheiner of the Federal Reserve studied (PDF) the effects of the 2003 tax cuts' child credit and found that the rich were actually more likely to spend most of the credit. Most of this is due to the fact that high earners were less likely to have to pay off debt:

Also I always wonder what people mean by the word "saving" in a given context. Is it saving or spending if I buy a stock. Is it spending or saving if a business owner buys a new machine? Surely it is saving if a low income person pays down a loan?

Daniel Kuehn writes:

The third point is important. As I understand it, this is precisely why New Keynesians focus on monetary policy and credible commitments to permanent changes in the monetary stance. Krugman's discussion of fiscal stimulus - for example in his Japan paper - is about giving traction to monetary policy by increasing the demand for credit.

I also think this is why a lot of people strongly prefer direct job creation to cutting checks. When the government directly creates a job the job-holder is thinking in terms of a permanent income shock and is going to behave accordingly. And if they move to another job after the economy picks up, who cares?

I think there's more to think about than just MPC when it comes to the multiplier (although I'm not sure if this is canonical or not - it is in some more heterodox thinking). You've got to think about the marginal propensity to invest too - and investment is a big part of the volatility in national income, not consumption. If firms are operating below capacity the marginal amount of every dollar of revenue they invest is not going to be very high. That's fundamentally different from the marginal propensity to consume - we don't assume there's a stock of consumption goods people have. We do think there's a stock of capital goods. So there's no underutilization of consumption goods to speak of, but there's certainly underutilization of capital goods.

Bostonian writes:

Off-topic, but David Henderson favorably reviews Alan Blinder's book "After the Music Stopped" on the financial crisis in the Wall Street Journal this weekend.

During the Bush administration, I thought Paul Krugman had taken himself hostage and was refusing to make sense until a Democrat was elected. It took a while, but Paul Krugman finally appears to be back.

In Krugman and Eggertson (2011), there are two types of agents, differentiated by their discount rates. The more patient agents lend to the less patient agents, so in equilibrium the more patient agents are rich. Rich is equivalent to saver in the model. (Rich refers to high wealth-- all agents have the same income.) The model works out so that only the Euler equation of the rich drives the dynamics. Thus the interest rate is determined by the discount factor of only the rich agent.

In the model, a deleveraging shock constrains the borrowers, so they have to reduce their consumption. This leads to a liquidity trap if the rich agent can't be induced to consume enough to make up for the reduced spending of the poor agent at any nonnegative nominal interest rate. So the liquidity trap dynamics depend on the MPC of the rich.

However, the brief section about fiscal policy in the paper says that it works by increasing prices which reduces the real debt burden of the poor. Effectively, since the poor agents are liquidity contrained, their MPC depends only on current income (as in old-Keynesian analysis) rather than on expected future income. Krugman uses this to get around the Lucas critique, and get higher multipliers.

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