Monday, January 16, 2012

Scott Sumner v. Paul Krugman on a Simple Identity

Sumner tried to tease out the proposition that a rise in government purchases has no effect on the real economy from an identity, which prompted Krugman to school him on comparative statics. Sumner replies by basically repeating himself:

If Krugman were right that consumption smoothing somehow refuted Cochrane’s argument, then it would be impossible for consumers to react to a $100 million dollar fall in after-tax income as follows: Spending on consumer goods falls by $20 million. Spending on new homes falls by $80 million. Or spending on inventory accumulation falls by $80 million. Now I’m not saying that would happen, but if it did it would validate Cochrane’s claim and yet would incorporate consumption smoothing. So consumption smoothing can’t be the issue; it plays no role in whether Cochrane is right or wrong.

Time to call a time out. It is not the existence of the national income identity that is at play here but rather Sumner’s claim that the rise in the sum of consumption and government purchases necessarily completely crowds out investment. Two points:

(1) Complete crowding-out would occur if we were at full employment or if we had some sort of insane Federal Reserve policy that mandated we stay as far below full employment as we are now. Of course, neither condition describes today’s economy.

(2) Even if we did have complete crowding-out, notice that Sumner left off the transmission mechanism here. In his example, real interest rates would rise to crowd out the investment spending. So there would be at least this real effect.

As the title of Sumner’s second post notes – it is what he didn’t say that is revealing.

Update: Noah Smith and Paul Krugman anticipated my argument. First Noah:

Accounting identities are mostly just definitions. Very rarely do definitions tell us anything useful about the behavior of variables in the real world.

Then Paul:

the question is how the identity gets reflected in individual motives — is it via the interest rate, via changes in GDP, or what?


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