David R. Henderson  

A Question for Krugman

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Paul Krugman has a post today about how badly some Republican governors have been doing with their budget policies. His basic criticism is that they have cut taxes. But he also has, at various times recently, complained about austerity. What, to Paul Krugman, is austerity? He has often been vague about whether it means raising taxes or reducing government spending, but he seems to mean a combination of those.

So, on the one hand, he doesn't like austerity right now, given current macroeconomic conditions, which means, in part, that he doesn't like tax increases. On the other hand, he doesn't like tax cuts. That could leave the possibility that he wants taxes to stay the same. But then he praises the California government for its fiscal position, which, as he well knows, is due in part to tax increases.

Is there a way out of this apparent contradiction? Yes. What he might be arguing is that we shouldn't have austerity at the national level because he wants the Keynesian fiscal multiplier to work and to do that, you need either tax cuts at the national level or government spending increases at the national level. But, he could argue, that doesn't make sense when we're considering fiscal policy at the state level. If, for example, the Kansas government cuts taxes, that might be marginally good for the country, because people will take their higher after-tax income and spend it mainly in the United States, but it will be lousy for Kansas, which will find itself in a fiscal bind. I've seen him make the "lousy for Kansas" point, although I've never seen him say, which I think he would have to, that it's slightly good for the United States as a whole. And, Kansas, after all, is such a small economy that any policy there can't have much effect nationally.

Given Krugman's demand-side fiscal policy view, there is an internal coherence here. But that coherence starts to fray as he brings in to his evidence base larger states. He has singled out California and praised that government for a fiscal position that has come about, in part, due to recent tax increases. California is about 1/8 of the U.S. economy. So how many Republican governors need to cut taxes for how many states with what percent of the economy for Krugman to praise them for resisting austerity?

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CATEGORIES: Fiscal Policy , Taxation

COMMENTS (8 to date)
John Thacker writes:

I believe he would note that states are required to balance their budgets (in general, with some accounting tricks), so there tends to be little net austerity or stimulus. Tax cuts tend to be a direct substitute for state government spending.

He has recently in general been of the mind that government spending is more stimulative than tax cuts of any nature, so therefore by his lights tax cuts are austerity.

Daniel Kuehn writes:

One other point worth noting with states is that unlike at the federal level, falling revenue is much more likely to come with spending cuts for various constitutional reasons.

Daniel Kuehn writes:

Clicking through he also seems to be interested in "fiscal responsibility" as Republicans themselves define it, not macro policy per se.

Devil's Advocate writes:

Krugman, I think, is arguing that GOPers who pose as fiscally responsible (favor lower taxes and/or lower government spending), do not actually get the results they espouse...and his point is valid. However, I think bringing in the "lousy for Kansas" argument muddies the water. State fiscal policies are not made (presumebly) with the economic health of the Nation at heart. They are made with the State's economic health at heart (among other things). Analyzing how a state's economic health influences the nation's is interesting, but our country's polticial system is just not set up to incentivize this behavior, in this way.

foosion writes:

State constitutions tend to require balanced budgets, so you're not going to see much net fiscal austerity or stimulus.

That doesn't mean state fiscal policy can't be stimulative or contractionary. For example, if we cut taxes on those who have a very low marginal propensity to spend and cut spending which benefits those with a much higher marginal propensity to spend, this can have the contractionary effects of austerity, especially in a low interest rate environment.

Bob Murphy writes:

David I applaud your efforts to give Krugman an escape hatch, but remember this one.

Devil's Advocate, I would have no problem if Krugman were *merely* pointing to (alleged) hypocrisy among Republican officials. But he said in this post that tax cuts have led to "an epidemic of fiscal crisis." Quick, we need to balance the books before the confidence fairy leaves!

bill writes:

I believe that the difference is that states don't issue currency. I think that Keynesians view state level spending and taxation as endogenous or something like that.

ThomasH writes:

“Austerity” in modern-day politics seems to be to mistakenly use (or claim to use) the level of debt as an argument of the public expenditure function rather than following standard public finance criteria: making expenditures whose NPV>0 when discounted by the borrowing rate. (Something similar goes on with taxes. Cutting taxes allows the private sector to make expenditures with NPV> 0 ) “Austerity” then is pretty much the polar opposite of “fiscal responsible responsibility.”

“Austerity” is particularly damaging if it means reducing expenditures during a recession – NGDP is below trend -- when borrowing rates tend to be low and many inputs into public expenditures have opportunity costs below prices that will be paid to employ them, which tend to increase the amount of expenditures which meet the NPV>0 criteria. It is the employment of inputs with opportunity cost below their price that can lead to a “multiplier” > 1

Of course if there are expenditures with NPV less than 0 they should be cut recession or no recession, but that still has nothing to do with the debt.

States should not engage in “austerity,” either, although their borrowing costs will be different (the spread over Federal borrowing may rise as their tax revenues fall) and this will affect the levels of tax and expenditures that are fiscally responsible. I think Krugman’s gripe with Kansas is that there, tax reductions were sold as self-financing and when they turned out not to be, expenditures with NPV>0 were reduced. I take it he thinks California got it right.

More generally I think Krugman and Wren-Lewis think that "austerity" is being sold as some sort of macroeconomic necessity when it's really just a difference of opinion about the marginal value of public expenditures that will be reduced.

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