17 Jan 2009

Fama vs. DeLong

All Posts No Comments

Von Pepe has been peppering me to address the skirmishes generated by Eugene Fama’s critique of fiscal stimulus. Fama wrote:

There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),
PI = PS + CS + GS.

The quantities in the equation are not predetermined from year to year, and government actions affect them. The goal of government policy is to expand current and future incomes. When I analyze the auto bailout and the stimulus plan below, I judge them on whether they are likely to achieve this goal.

Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: 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. They just move resources from one use to another.

Now this sounds very compatible with my critique of the “idle resources” argument for stimulus, but actually I don’t think it is the same. (I should note that I didn’t read Fama’s whole post, just the beginning.) In my article, I was making the point that even if government deficit spending pulled resources into use that would otherwise have remained idle, it still makes the economy poorer because it locks them into inferior uses, when they eventually would have found a new home in the truly productive private sector.

In contrast, it seems that Fama is making an argument from accounting, rather than making an economic point about the “social function” (if you will) of idle resources in a market economy. He is literally saying that deficit spending can’t make unemployment budge, whereas I am saying that if it does, it is a bad thing. (I.e. the goal is not to reduce unemployment per se, but rather to get those unemployed people into useful occupations.)

It is with great sadness, then, that I must side with Brad DeLong. (My endowment of honor is second only to Optimus Prime’s.) When Greg Mankiw politely disagreed with Fama (by conceding the possibility of short-run Keynesian effects), claiming that Fama was wed more strongly than him (Mankiw) to a classical model, Brad DeLong was outraged:

No, Greg. It’s not an endorsement of any model. It’s just a mistake. Fama mistakes the NIPA savings-investment accounting identity for a behavioral relationship that constrains the behavior of investment: when the government deficit goes up, Fama says, private investment must go down by the same amount.

When the government deficit goes up, private savings could go up by more–and private investment could increase. Private savings could go up by less–and private investment would fall by less than the rise in the government deficit. Private savings could remain unchanged. Or private savings could fall. Determining which of these is most likely to happen would require a model of the economy of some sort–and Fama does not have one: all he has is an accounting identity that he does not understand.

To this, Mankiw gave the cool cat reply:

This post reflects a fundamental difference between Brad’s approach to the world and mine. When I read others’ work, I try to read between the lines and put it in the best possible light. In particular, when I read the work of an economist as distinguished as Eugene Fama, I am reluctant to jump to the conclusion that I am vastly smarter than he is.

But as I say, as hilarious as this is (for those of us who are not members of the Brad DeLong fan club), I think DeLong is right in his analysis, though not his manners perhaps. I basically had the same reaction when a guy at National Review took the opposite tack, and argued that accounting identities proved that the government needed to run a deficit in order to allow private households to save. (If you aren’t familiar with that one, you should check it out. I had forgotten how nuts the guy was, and I am still amazed “conservative” NR ran the piece.)

Comments are closed.