Permanent vs. temporary increases in government spending, a Keynesian approach

by on February 2, 2009 at 7:52 am in Economics | Permalink

Let's say government can spend $100 billion today or spend the present expected value of $100 billion, stretched out over time so it is a commitment in perpetuity.  Both spending programs are financed by bonds.  So that's the same net present value of spending and the same method of finance.

The Keynesian boost to aggregate demand arises because people consider the resulting bonds to be "net wealth" even when they are not, in the sense outlined by Robert Barro (1974).  People are tricked by the government's fiscal policy, but of course the extent, timing, and nature of the trickery is hard to predict.

Is it easier to trick people "a lot all at once" or "a little bit by bit over time"?  It depends.  If you try to trick them slowly over time, temporal learning and adaptive expectations may work against the policymaker.  But if you try to trick people a lot all at once, the trick may rise over their threshold of attention, perhaps because of media coverage.  We don't know which "trick" to aggregate demand will be greater, the temporary boost to spending or the permanent boost.

One way to get a clear answer — in favor of Krugman's hypothesis that the temporary spending is more potent — is to assume that bonds as net wealth fails for a policy rule but not for a single period policy surprise (the temporary boost in spending).  In contrast, the traditional Keynesian view is to think that bonds are also net wealth in the medium run and perhaps the long run too and then we are back to not knowing whether the permanent or temporary spending boost does more for aggregate demand.  Or you might think, as I have suggested, that whether bonds are viewed as net wealth in the short run will depend on the size of the spending boost.  Many different assumptions are possible and thus many different results are possible.

Alternatively, you might compare $100 billion today (and no more) to $100 billion each year, every year.  You could call that "temporary" vs. "permanent" although I suspect the dominant effects will fall out of "small" vs. "large."

The latter, permanent boost to spending will give a bigger boost to aggregate demand overall (unless again you neuter it by applying Ricardian Equivalence to the rule but not the single period policy).  It also will lead to more crowding out.  Do note that in the early periods of this policy taxes need not rise by $100 billion for each year but rather the early installments can be paid off over time.

It is less clear whether the permanent spending boost leads to a bigger AD shift only for today.  It will if you apply the same degree of bonds as net wealth to the rule and single period policy, and if you think that the later periods of government spending will add net value, thus creating positive feedback through the long-run wealth effect.

It is also unclear if the larger, permanent spending boost creates more "stimulus per dollar" (as opposed to more stimulus in the aggregate or more stimulus for the single period).  That will depend on whether we are in the range where the stimulus has increasing returns to scale (maybe a certain critical mass is needed, as I believe Mark Thoma has suggested), constant returns to scale, or diminishing or even negative returns to scale, because of eventual crowding out. 

Overall the Keynesian effects can mean either the permanent or the temporary spending boost has a bigger effect and there are also a number of ways of defining what a "bigger effect" might mean.  This analysis has more variations than does the Poisoned Pawn Sicilian.

DK February 2, 2009 at 8:13 am

so if media coverage of the trick reduces its effectiveness, does this mean you are hurting the chances of the stimulus working by writing about it?

Jyotirmoy Bhattacharya February 2, 2009 at 8:19 am

Ricardian equivalence is not relevant here. Ricardian equivalence tells you that it does not matter how a given stream of government spending is financed. It does not tell you what happens when you make changes to the stream of spending. Even if people do not consider government bonds as net wealth, an increase in government spending may raise incomes if you are in a demand constrained state, as the world is right now. And in this case since the effect on output is based on the government’s demand for goods and services, $100 today will have a greater impact than $100 spread over time.

Marc February 2, 2009 at 8:33 am

This assumes the spending is temporary and I see no indication of that, other than the tax cuts.

Health IT, look at the FBI IT projects (or most any government IT project), they are black holes.

Add to that anytime funding is not increased year over year at least as much as inflation the media calls it cut in funding, there is no way the other funding will be temporary.

mickslam February 2, 2009 at 9:40 am

A few days ago you were talking about placebos, and having a large, one time shock probably counts as a placebo in addition to the effects you talk about above. I think the reason for this is the cost is spread across a society but the stimulus will hit individuals who will spend it, most people have little or no future time reference, and even businesses have time horizons of only a few years. The taxes will not be considered by the participants in any of these scenarios.

a student of economics February 2, 2009 at 10:09 am

Tyler, Paul Krugman reads your blog and today says, in essence, that you misunderstand that government spending counts as part of GDP and employment. Is that right? (That seems to be the belief of some of your commenters, e.g. ‘assman’ in comments on your last post.)

Or are you assuming that, even when their are slack resources, then, because of Ricardian equivalence, people instantly will cut back on consumption and/or investment by 100% of the amount of government purchases. I.e. when they hear that gov’t is spending a 127 billion on new bridges in 2009, everyone will buy less food, housing, TV sets, etc in the 2009 so they will save enough to fully offset their share of all the future financing cost of the bridge. Such behavior doesn’t strike me as rational (why not save a bit every year, instead of all at once?), let alone plausible.

pgl February 2, 2009 at 10:24 am

Tyler – while you are correct that variations in net taxes (taxes or
transfer payments) will not impact consumption and hence aggregate demand
in a Barro-Ricardian model, not all variations in government spending have
to be changes in transfer payments. A one-shot increase in government
purchases in a Barro-Ricardian model of consumption has only a very small
offsetting effect on consumption and hence will significantly increase
aggregate demand – as Krugman and others (e.g., me( have pointed out
repeatedly.

mk February 2, 2009 at 10:53 am

To me one thing that pops out of Tyler’s analysis here is the utter futility of settling this issue theoretically.

There are plenty of models one might use, and they presuppose different models of the human. Are economists on either side of the debate really sure that they have the correct model of a human? Doesn’t that seem presumptuous, in advance of firm empirical evidence?

Further, any policy based on “fooling human beings” has serious moving target issues. Human beings learn, and adapt their behavior. The extent of fooling in a given case will depend on technological and social circumstances like media saturation, education level, etc. which are different in every situation.

So basically, there is some serious model uncertainty going on. Unfortunately the model-parameter-confidence-weighted “policy blend” approach will probably not appease those who feel a giant package based on their model is absolutely necessary.

Yancey Ward February 2, 2009 at 12:01 pm

Student,

How is that different in assuming they will save the entirety of a one time tax cut? I still don’t get the Keynsian reluctance to simply borrow a vast amount of money and give every citizen an equal stipend for the stimulus. That way you don’t have to worry about having politicians coordinating the spending.

LabDancer February 2, 2009 at 12:49 pm

To Bob Murphy: There was a portly third baseman for Atlanta by that name; I do hope you aren’t him, because it would affect my image of him. I’m keeping my hopes up, because, having read the 3 posts [at what I gather is your own blog] your response to Stevehar linked to, it’s apparent that the issue Stevehar raised is more serious than he might have known heretofore: It is not that you misundertood Mr Cowan’s blog here for a site comparable to Little Green Footballs or Ace of Spades H.Q., where readers’ ad hominem attacks are not just tolerated but encouraged, often by opening posts of unsurpassable venom; it is that you are not able to distinguish between ad hominem attacks and high level economic theory.

[There is one other possibility, being that you are actually part of a concerted disinformation and propaganda effort to dissuade Americans from accepting advice from J.M. Keynes. I discount that primary on the basis that your first name is “Bob” [here], & “Robert” [on your blog], but in neither case is it suggested to be “Dick”, no matter how much more in keeping with the content of your posts here and there.]

notsure February 2, 2009 at 1:16 pm

Barkely,

The tax part of the Ricardian equivalence result is about lump sum taxation, not tax rates. Tax rates may well have other effects. Maybe you are talking about lump sum taxation though.

Weren’t the Reagan and Bush cuts changes in rates?

Yancey Ward February 2, 2009 at 2:00 pm

Oh, so the goal is simply to up the headline GDP in the near term? So, why not simply redefine the tax cut as the buying of 5 minutes of people’s time it takes to deposit the check. We count the entire tax cut as government spending, GDP goes up the 100% of the tax cut, and we get the multiplier effects from the second order spending of the stimulus check recipients.

Yancey Ward February 2, 2009 at 2:35 pm

student,

I don’t have to believe it has zero value. I would just like to see the support from the Keynesians that the government spending proposed has greater value than which would accrue from the citizens in their collective spending/saving of the same amount of stimulus checks. So far, no one has actually shown a cost/benefit for the proposed government spending outside the simple-minded argument that it adds 100% to the GDP number.

Anonymous February 2, 2009 at 4:41 pm

Barkley,

I agree with much of what you say.

My point was simply that Ricardian equivalence does not mean that all taxation is irrelevant–it strictly applies to lump sum taxes, and taxes that feedback to spending plans.

I am reading now that putting lump appears to be lump sum tax rebates into the stimulus is a good thing. And those statements seem to be made by politicians who have argued for Ricardian equivalence in the past.

There seems to be a lot of confusion out there about this. Your statement mixes rates with lump sum taxation–the thing in the actual Ricardian models. As soon as the rates are changed, the we will get an effect of taxation on output.

Ricardian equivalence is that the timing of lump sum taxes doesn’t matter. Tax rate changes are not neutral in the Ricardian models because the rates may matter for marginal decisions.

Hence the tax rate cuts are evidence about Ricardian equivalence if you add some other statement, such as ‘the incentive effects of taxes are small’ Perhaps a fine statement, but it is not what you wrote. And the key to interpreting the evidence I think.

Sorry to be picky, but these are big issues-and are going to matter a lot going forward. We need to be precise exactly because people will take the evidence out of context.

notsure February 2, 2009 at 5:16 pm

feedback to GOVERNMENT spending plans.

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