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Fiscal Cliff: Is Heritage Inconsistent?

Posted By Salim Furth, Ph.D On December 13, 2012 @ 10:12 am In Ongoing Priorities | Comments Disabled

Menzie Chinn took to the blog Econbrowser [1] last Thursday to accuse conservative economists in general – and The Heritage Foundation in particular – of being inconsistent, since we did not share his optimism about the benefits of the 2009 stimulus, but we’ve warned of the danger of the fiscal cliff.

Chinn and other Keynesians argue that fixed relationships exist between large aggregate numbers—for example, that a dollar more in wages always leads to 70 cents more consumption. This approach was pioneered during the 1920s and 1930s, most notably by John Maynard Keynes. A modern macroeconomic approach, in which macroeconomics is modeled on microeconomics, is the only theoretical framework taught in most PhD programs today, including at Chinn’s University of Wisconsin [2].

The substance of Chinn’s blog post is as follows. He quotes former Heritage Foundation analyst Brian Riedl, who wrote in 2010 [3]:

Spending-stimulus advocates claim that Congress can “inject” new money into the economy, increasing demand and therefore production. This raises the obvious question: From where does the government acquire the money it pumps into the economy? Congress does not have a vault of money waiting to be distributed. Every dollar Congress injects into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely redistributed from one group of people to another.

Chinn then shows that Heritage’s view is consistent with Chinn’s favored 1930s-era model only under the condition that the economy is at full employment, which was clearly not the case in 2009 or 2010. Using the same model, Chinn thinks it is contradictory of The Heritage Foundation to be worried about the fiscal cliff after having opposed the “stimulus” bill of 2009.

But the contradiction only exists inside Chinn’s model: He ignores the fact that Heritage Foundation economists, like most academic macroeconomists, have put away the old Keynesian model in favor of modern alternatives.

In a neoclassical framework, the stimulus increased expected future taxes, diminishing capital accumulation and lowering expected take-home wages. In addition, as Casey Mulligan has shown recently [4], the stimulus made work less attractive for millions of low-wage Americans.

With the fiscal cliff, the threat of the stimulus may be realized: higher taxes—especially on capital—both now and in the future. All government spending must eventually be paid for through either distortionary taxation or inflation.

A revealing quote from Chinn’s post shows how little he understands of the viewpoint he is mocking:

If the stimulus was ineffective because each dollar spent by the government was a dollar taken away from the private sector, then we should rejoice when each dollar no longer spent on defense…is released to the private sector for purchases of yachts and mansions.

As Chinn would learn if he read Heritage Foundation research [5], our analysts argue that defense spending should be maintained for the sake of defense, not because it has magical effects on the economy. Thus, we propose $150 billion in annual savings elsewhere in the budget.

Chinn’s characterization of private spending as “yachts and mansions” is revealing. Chinn apparently believes that all marginal private spending is for (frivolous) consumption, not for investment. In Chinn’s equations and graphs, where are the changes in investment? Nowhere. By assumption, Chinn’s Keynesian model keeps investment spending constant and capital stock constant in both the short and long run.

When the government borrows a trillion dollars on global financial markets for a stimulus package, does Chinn believe that zero dollars of that is diverted from investment? When the government raises taxes on dividends to 43 percent from 15 percent, does Chinn believe that has zero impact on investment?

We are not the first to correct Chinn’s mischaracterization of Heritage research. Paul Krugman [6], an unlikely ally in this case, notes some of the many famous and recognized economists who share The Heritage Foundation’s views.

Thus, conservative economists have been quite consistent: We believe that when higher taxes lower the return on work and investment, people work and invest less. When unemployment insurance is extended from 26 weeks to 99 weeks, the unemployed spend more time looking for work. In other words, we believe what economics and common sense tell us: People respond to incentives.


Article printed from The Foundry: Conservative Policy News from The Heritage Foundation: http://blog.heritage.org

URL to article: http://blog.heritage.org/2012/12/13/fiscal-cliff-is-heritage-inconsistent/

URLs in this post:

[1] took to the blog Econbrowser: http://www.econbrowser.com/archives/2012/12/why_worry_about.html

[2] including at Chinn’s University of Wisconsin: http://www.econ.wisc.edu/grad/fields.html#Macro

[3] who wrote in 2010: http://www.heritage.org/research/reports/2010/01/why-government-spending-does-not-stimulate-economic-growth-answering-the-critics/

[4] as Casey Mulligan has shown recently: http://www.nber.org/papers/w18591.pdf

[5] Heritage Foundation research: http://www.heritage.org/research/reports/2012/11/150-billion-in-spending-cuts-to-offset-defense-sequestration

[6] Paul Krugman: http://krugman.blogs.nytimes.com/2012/12/08/heritage-chicago-and-the-fiscal-cliff/

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