I’m excited, because today I get to
catch Paul Krugman red handed criticize Paul Krugman, which is a very rare occurrence, indeed! In responding to John Cogan and John Taylor’s op-ed in the Wall Street Journal today, Krugman has this to say:
Ugh. And I say that advisedly. John Cogan and John Taylor have a piece in the WSJ (where else) arguing that the latest Ryan budget would actually be expansionary, because confidence! It’s as if all the experience of recent years, in which the confidence fairy has yet to make an appearance, hasn’t happened.
Unfortunately, the model in question, which you can take a look at here, has precisely zero role for policy uncertainty. Taylor’s result is driven by the assumption of:
- Heavily distortionary taxation, as Cogan and Taylor et. al. lay out here:
The budget constraint includes a number of different tax rates so that changes in fiscal policy have a direct effect on the consumption-savings choice, the labor supply, investment decisions and the other variables the household members use to maximize their expected life-time utility. Households pay taxes on consumption purchases, on wage income and on capital income. Furthermore, they pay social security contributions, a lump-sum tax and receive transfers. The household members take their decisions in a forward looking manner so that not only changes in fiscal policy today, but also anticipated future changes can have an immediate effect on households’ decisions today.
- Monetary policy is unconstrained. Which is, of course, much closer to reality than a model that assumes the zero bound binds.
- Cogan and Taylor achieve their savings (and thus, reduce future expected tax distortions, and by way of expectations, increase each agents’ income/consumption and savings immediately) through cuts in transfer payments (not purchases — and important distinction), which is outlined in the WSJ article here:
The reductions in the growth rate of spending are to be achieved primarily through entitlement reforms. The Affordable Care Act would be repealed. Medicaid and food-stamp administration would be turned over to the states. Medicare would be fundamentally reformed. Anti-fraud measures would be applied to federal disability programs. Among the major entitlement programs, only Social Security would remain unchanged; this is a deficiency in the plan. As for discretionary spending, the House budget plan would provide for only slight reductions from the levels that are set by the budget sequester.
The existence of number two above makes me stop and scratch my head for a second. This is, after all, the same John Taylor who has been vehemently opposed to the Federal Reserve’s “expansionary policies” over the last few years. He surely understands that the monetary policy offset (being unconstrained by the zero bound) drives most of his result?
In any case, Cogan and Taylor don’t play for Paul Krugman’s team, or else I assume he’d be more charitable. He closes with this:
In fact, the only interesting question here is why their results are so different from Woodford’s. My guess is that they have slipped in some assumption that won’t stand scrutiny, like the notion that the Fed will raise rates even with the economy deeply below capacity. (They’ve done that before).
Perhaps if he had even glanced at the model, he would have seen the difference between Taylor’s and Woodford’s (from the abstract):
This paper explains the key factors that determine the output multiplier of government purchases in New Keynesian models, through a series of simple examples that can be solved analytically. Sticky prices or wages allow for larger multipliers than in a neoclassical model, though the size of the multiplier depends crucially on the monetary policy response. A multiplier well in excess of one is possible when monetary policy is constrained by the zero lower bound, and in this case welfare increases if government purchases expand to partially fill the output gap that arises from the inability to lower interest rates.
Update: Daniel Kuehn points out that I’m fudging the distinction between Krugman’s criticism of the column vs the model. Post updated.
Update 2: Paul Krugman discovers Noah Smith’s peice, tacitly acknowledges that policy uncertainty is not driving the result. The real big feature making the model tick is assuming away the zero lower bound…which, as I noted above, is closer to reality than Krugman’s models of a binding zero bound that turns reality upside down.
P.S. You don’t have to believe me! Noah Smith is on Krugman’s team, and has this to say:
2. This is NOT the “Confidence Fairy.”
The “Confidence Fairy” is the idea that uncertainty over future government policy restrains investment, and usually involves the notion that austerity decreases policy uncertainty. However, Taylor’s model doesn’t have policy uncertainty in it.