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.