Friday, January 16, 2009

Is He Serious?

Eugene Fama, a giant in the world of financial economics, argues against a stimulus (hat tip: Greg Mankiw) for reasons that...to put it politely, I don’t understand. Maybe he is trying to satirize the way Keynesians often ignore or dismiss alternative theories – giving the Keynesians a taste of their own medicine. Or maybe he is deliberately making a wrong argument, as a pedagogical technique, to see if we spot his error. Or maybe (as Greg suggests) he is actually arguing something different from what he is literally saying, but he thinks that the rigorous argument is too complicated to discuss in a short article. Or maybe he just hasn’t thought through the issue. Or...your guess is as good as mine, but, as far as I can tell, if you take his words in their plain sense, they don’t make any.

In a nutshell:
...bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use
Which makes perfect sense if you assume (as he seems to) that bailouts and stimulus plans have no effect on the total amount of private savings. I understand the need to make simplifying assumptions in any discussion of economic phenomena, but there is a difference between the usual “not quite true but perhaps close enough to make a reasonable argument” assumption and one so far from reality as to be thoroughly ridiculous. The aforementioned assumption is in the latter category.

Bailouts (usually) and stimulus plans (almost by definition) raise someone’s disposable income. Is it even remotely plausible that an increase in disposable income would not have a significant effect on someone’s savings? (By “someone” I mean the generic, average person who might be receiving funds from a bailout or stimulus plan; I don’t deny that there may exist some individuals for whom the assumption would almost be valid, but the funds from bailout and stimulus plans seldom go to a single, unusual individual.) Think about it. Suppose you received an unexpected check for $1000. Would you go out and spend the entire $1000 immediately?

That fact is, even if you wanted to, you couldn’t. Perhaps, with today’s technology, you could spend it within a few seconds, but the instant after you receive the funds, your savings necessarily increase. More likely, though, even if you intended to spend all of it quickly, it will take at least a matter of days to do so. In the mean time, there are more savings to finance the government deficit.

But what happens when you do spend it? Someone else must be receiving the money from you as income. And just like you, they won’t be able to spend it instantaneously. Your savings have been reduced, but the savings of the vendor have increased by the same amount. The vendor has received income and is saving that income in the form of money. And the vendor will either save it or spend it, and in the latter case it will immediately become part of someone else’s savings, and so on. So the very act of implementing the bailout or stimulus plan creates the savings that are necessary to finance it.

One might try to argue that, since the money necessary to finance the stimulus must come from somewhere, someone’s savings must be reduced by the amount of that money. But that argument is wrong. When the government sells, for example, a T-bill, the purchaser of the T-bill has the same savings as before. It’s just that some of the savings they were previously holding in the form of money, they now hold in the form of a T-bill. The T-bill itself is a form of newly created wealth, so by the very act of issuing it, the government causes personal (or corporate) savings to rise.

You might argue that the T-bill is not in fact net wealth, because people will realize that the government borrowing raises their future tax obligations, and they will accordingly consider their wealth to be reduced by the amount of the T-bill, thus offsetting the increase in wealth resulting directly from the issuance of the T-bill. (This is what some economists call Ricardian Equivalence.) In that case, though, those people will choose to save more of their income to provide for the increased future taxes, so private savings will still rise in response to the stimulus.

Granted, in that case the stimulus doesn’t work, since people will have to reduce their consumption by the amount of the stimulus, thus offsetting its effect. That argument is theoretically valid, although the empirical evidence tends to indicate that people do not generally behave in accordance with Ricardian Equivalence. In any case, that is not the argument that Professor Fama is making. According to him (using the example of a tax cut),
Suppose the recipients of the tax reduction from the stimulus don't know about Ricardian Equivalence, and they use the windfall to buy consumption goods. Does this increase economic activity? The answer is again no. The composition of economic activity changes, but the total is unchanged. Private consumption goes up by the amount of the new government debt issues, but private investment goes down by the same amount.
And here he is clearly wrong. Private investment does not go down. When he says that “recipients...don't know about Ricardian Equivalence,” that is equivalent to saying that government debt is (from their point of view) net wealth. By consuming more, people have indeed reduced what they save out of their old income. But by issuing debt securities (new wealth) and using the proceeds to cut taxes, the government has given people new income, so their total quantity of savings has remained the same. Therefore, for any private investment that was financed out of that savings, it can still be financed.



Greg Mankiw and Brad Delong have been discussing this issue, and I disagree with both of them. Brad says:
Fama mistakes the NIPA savings-investment accounting identity for a behavioral relationship that constrains the behavior of investment
As I see it, Professor Fama has simply got the accounting wrong: he is ignoring the fact that newly issued government securities constitute new wealth and therefore new savings. (Or, if you want to look at it in terms of Ricardian Equivalence, he is ignoring the deferred revenue asset that the government “saves” to offset the increase in the deficit.)

It has nothing to do with behavioral relationships. You can see this by considering a simple Keynesian multiplier model: the amount of private saving created by an increase in the government deficit is independent of the behavioral parameter. (lf you don’t believe the algebra, do the calculus: calculate how much new saving is done by each individual in the chain of income recipients, and take the infinite sum. Or just do a finite sum, and recognize that the remainder must be saved. Or take it far enough out and ignore the remainder.)

Greg says:
I think Fama's arguments make sense in the context of the classical model
I don’t see how that can be the case. For one thing, the reduction of investment is supposed to happen “despite the existence of idle resources.” In the classical model, market clearing would prevent those resources from being idle. (Unless by “idle” he means intentionally devoted to leisure.) Moreover, in the classical model, Ricardian Equivalence holds, but Professor Fama argues that investment will decline even in the absence of Ricardian Equivalence. (Unless he means to say that Ricardian Equivalence holds in fact even if people don’t act accordingly. But then, as I said above, he’s ignoring the government’s deferred revenue asset.)

Maybe Greg can explain this to me, but I find no way to make sense of what Professor Fama writes, unless he means something very different from what he says.




DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

7 comments:

Anonymous said...

Andy, your incredulity is an unflattering debate technique; the derisive scoff. There is a whole school of economic thought (at least one that I know of), which has been quite well developed over a century of time, that does seriously question the value of government stimulus. It's called the Austrian school, but I'm sure you knew that.


Government is an inefficient way for a society to allocate capital, and a rushed $850 billion stimulus plan will be even more inefficient than normal. Maybe three quarters of that money will be lost through waste, corruption, needless bureaucracy, misallocation, instead of the normal 60% that government wastes. You may disagree with those percentages, fine I pulled them out of thin air. But anyone who has observed the workings of both government and private industry knows that the two are incomparable. Private capital strives for return on investment, public capital strives for the re-election of those currently in power. One may think those goals would lead to the same end, but one would be wrong.

Government does not know where to deploy society's capital; it's not that smart. You are not that smart and neither am I. Our banks of computers are not that smart. The collective intelligence of millions of consumers and producers is the only way of allocating society's productive capital, any other method of central supervision will waste what we have and send us further down the road toward either government default or hyperinflation.

I know academic economists have little use for the Austrian school. It's much more alluring to think that we can tweak the levers of the economy from some high place and gently steer it along the path we want. But the Austrian school won't die, because the facts keep it alive. The Greenspan/Bernanke housing bubble is the latest example. The fed's distortion of interest rates created a false signal about the availability of capital in the real economy, with a resultant housing bubble. The current fiscal and monetary stimulus, will have the same impact, waste and misallocation of resources.

If the economy has idle resources at present, let them sit idle for a while. They will eventually find a productive outlet and create some good or service that we need or want. This is the way capitalism works. This is the only way capitalism works.

I don't have a PhD in economics, so you are welcome and entitled to disregard my advice, but here it is just the same. In the spirit of open-mindedness, spend a little more time trying to understand the Austrian perspective. Read Hayek and von Mises, if you haven't already. Read some of the Austrian blogs on the web. Listen to folks like Peter Schiff; sometimes they get it right (http://www.youtube.com/watch?v=B8r-nDBx5Jg). I don't expect you to become a convert, but just maybe you can occasionally acknowledge that we are indeed "serious".

The Original Fred said...

There's a simpler way to refute Fama. Household savings must always equal Corporate borrowing (including bank loans and newly issued stocks and bonds) + Government deficit spending. In a crisis like the current one, household savings are going up (definitely ex ante and probably ex post as well). If government deficit spending remains the same (and the current account balance remains the same), then simple bookkeeping logic shows that corporate borrowing must go up to compensate for increasing household savings. But corporations are NOT in a mood to borrow right now. So the only way for the bookkeeping identity to hold is for corporations to be forced to borrow/dissave, which is equivalent to saying corporationsn suffer unwanted decreased profits and/or losses.

When corporations suffer unwanted decreased profits and/or losses, they tend to lay people off and their stock prices fall, both of which consequences cause households to increase savings even more, and the vicious deflationary cycle continues until enough of the economy has been destroyed that we are at the subsistence level and households are thus incapable of further savings.

There are only two way to counteract this spiral down into deflationary depression: either the government increases deficit spending to compensate for increased household savings, or the government takes steps to increase household and corporate "animal spirits" so that the former save less and the latter borrow more. But there is no quick way to increase animal spirits, which is why countercyclical spending is the answer. This is the essence of the Keynesian argument for countercyclical fiscal policy. Talking about infinite sums is pointless when poor anonymous and the other Austrians can't even do basic bookkeeping.

Andy Harless said...

I apologize for not being more careful in the way I expressed myself. I didn't mean it as a derisive scoff (but I can see how it would appear that way). I'm genuinely confused at how someone of Professor Fama's statute could make what seems to be such a fundamental error. When I attack the error itself (assuming it is an error), it is more with a "love the sinner but hate the sin" attitude. I was aggressive in explaining why I believe the argument, as stated, is fundamentally flawed, but I meant to leave open the possibility that I may be misinterpreting what was intended.

As to the Austrians, according to my understanding they are saying something quite different from what Professor Fama is trying to argue. AFAIK they don't deny that a stimulus will mobilize idle resources; they just deny that there will be any benefit in mobilizing those resources in that way.

I'm not sure I understand the Austrian view well enough to comment further on it, but there are certainly plenty of reasonable arguments against a stimulus. I happen to disagree with all of them, but I don't see them as making fundamental errors.


Fred, your argument seems to rely on savings having risen in the first place. That view is certainly relevant to the present situation, but my argument is more general. I'm saying that, even if savings had not risen in the first place, as long as there are idle resources, government deficits will create the necessary savings to finance themselves. I see Professor Fama's argument as being internally flawed in a way that does not depend on the empirical state of the world.

Original Fred (not the imposter) said...

>I'm saying that, even if savings had not risen in the first place, as long as there are idle resources, government deficits will create the necessary savings to finance themselves.

You could make an argument that government deficits might depress animal spirits (and thus decrease consumption and/or investment spending) sufficiently that the net effect of the deficit was contractionary. I have never been able to get a clear answer myself as to what is meant by "Austrian", but it is pretty clear that people who proclaim themselves to be Austrian react violently to all talke of government deficits. Which suggests they might indeed reduce their personal spending enough to offset the effect of increased deficits. So if the Austrian personality-type is dominant in our society, then this is an argument that government deficits might not be stimulating (at least until there is no further possibility of spending reductions by the private sector).

timothy straus said...

only one comment; the idea that the government thru the issuance of a t-bill is both receiving wealth, i.e. the savings and cash of the purchaser and is at the same creating wealth thru the issuance of the governments obligation to pay the note with interest at some future time is a total joke. Debt is not wealth. Credit is not wealth. In addition, the issuance of an I.O.U. on the part of the government to allow that government to transfer the real wealth of the lender to someone else, very likely to a very inefficient consumer of that largess, is wealth is absurd. This is why the whole chimera of credit and debt as wealth has destroyed this world.

Anonymous said...

Fama perfectly expresses the logic behind either (a)the Hoover era "Treasury View" or (b)full employment crowding out. It is not clear to which he refers. The former completely ignores dishoarding and/or increased loan creation from utilizing formerly idle excess reserves. Either/both of these reduce interest rates that have increased due to deficit finance back toward ("fully back to" in the Liquidity Trap) their pre-deficit-financing levels. The conditions for full employment crowding out do not, alas, apply today. Ricardian Equivalence is a red herring here.

suvie said...

During the 70's - a period of inflation - the public didn't buy as many houses
due to high mortgage rates. And once one buys a house, one has to spend money
to fill it. That probably didn't happen. Perhaps people saved money betting on
Arthur Burns' Fed to turn things around?

As rates came down, people sucked the equity out of thier home to spend.
This is how the sub-prime loans effected 2nd mortgages. Sub-prime also effected people who
purchased with prime mortgages, and are now underwater.