Last week I guest-taught a class for my friend and colleague at GMU Dr. Colin Doran. The course was Introductory Macroeconomics and the lecture was on fiscal policy. The textbook is Paul Krugman and Robin Wells’ popular book Macroeconomics (5th ed). In the chapter on fiscal policy, after explaining its goals and implementation, Krugman & Wells discuss several common objections. They write (Page 386):
In practice, the use of fiscal policy—in particular, the use of expansionary fiscal
policy in the face of a recessionary gap—is often controversial….But for now, let’s quickly summarize the major points of the debate over expansionary fiscal policy, so we can understand when the critiques are justified and when they are not.
There are three main arguments against the use of expansionary fiscal policy.
• Government spending always crowds out private spending
• Government borrowing always crowds out private investment spending
• Government budget deficits lead to reduced private spending
The first of these claims is wrong in principle, but it has nonetheless played a
prominent role in public debates. The second is valid under some, but not all, circumstances. The third argument, although it raises some important issues, isn’t
a good reason to believe that expansionary fiscal policy doesn’t work.
This post will address Krugman’s & Wells’ (henceforth shortened to “Krugman”) claim that objections 1 & 2 are incorrect on principle; I will ignore point #3 for now. What follows will be a wonky discussion.
Following the above quotation, Krugman writes:
Claim 1: “Government Spending Always Crowds Out Private Spending”
Some claim that expansionary fiscal policy can never raise aggregate spending
and therefore can never raise aggregate income, with reasons that go something
like this: “Every dollar that the government spends is a dollar taken away from
the private sector. So any rise in government spending must be offset by an equal
fall in private spending.” In other words, every dollar spent by the government
crowds out, or displaces, a dollar of private spending.
But the statement is wrong because it assumes that resources in the economy
are always fully employed and, as a result, the aggregate income earned in the
economy is always a fixed sum—which isn’t true. In reality, whether or not
government spending crowds out private spending depends upon the state of
the economy. In particular, when the economy is suffering from a recessionary
gap, there are unemployed resources in the economy, and output, and therefore
income, is below its potential level. Expansionary fiscal policy during these
periods puts unemployed resources to work and generates higher spending and
higher income. Government spending crowds out private spending only when the
economy is operating at full employment. So the argument that expansionary fiscal
policy always crowds out private spending is wrong in principle.
Krugman’s statement isn’t objectionable, per se. But I do think critics of fiscal policy (myself among them) and Krugman are talking past each other. The discussion revolves around the Production Possibilities Frontier (source):
A quick recap: The Production Possibilities Frontier (PPF) is the various combinations of goods X and Y that can be produced in an economy at a given level of technology and resources. Any point along the curve (A or B in the above picture) is where all resources are consumed; therefore wanting to produce more of X would require some sacrifice of Y (and vice-versa). Any point inside the PPF (point C) indicates some resources are sitting idle and more production of X or Y could be obtained without necessarily sacrificing some of the other good. A point like D is impossible to obtain.
Krugman’s point in his above criticism is that if the economy is inside the PPF (Point C), that is to say, if the economy is in a recession, then government spending without any reduction in private spending. Since some resources in the economy (eg labor, capital) are sitting idle and not being used by private actors, they can be used by the government. These resources weren’t being used anyway, so their use by the government crowds nothing out.
The argument itself is quite solid on economic grounds, at least insofar as the PPF goes. However, I object on a more fundamental level. All goods are scarce and most goods are rival (that is, their consumption by one person precludes another from consuming the same). When the government increases its spending in a recession in order to employ the idle resources, it consumes resources that could have been used elsewhere. While the spending doesn’t crowd out current uses of resources, it does crowd out future uses of resources. If the government is employing idle construction workers to build bridges, for example, then it means that fewer construction workers to build potential office buildings in the coming period; any project takes time.
“But wait!” cries the hypothetical Krugman. “Those resources were idle. They weren’t building office buildings at all. What’s the harm in putting them to use building bridges?” This is a legitimate point, one to which I’d respond MR = MC. When the government employs resources, it necessarily bids up the price of using those resources (the government must bid on their use away from their current use, even if that use is sitting idle). In order for people to use those resources in the future, they must also be bid away from their current use, in this case, whatever the government is using them for. This would increase the marginal cost of whatever project those resources could be used for, which would mean the marginal revenue must also be higher before other people decide to bid for those resources. However, it may have been the case if the government never stepped in. The government spending might have, rather than ending a recession, caused it to persist by raising the cost of economic action.
Another question worth asking is even if government spending utilizes idle resources and we move back to the production possibilities frontier (points A or B), is the new allocation of X and Y optimal? Again, at the PPF, a production of more X necessarily means trading off Y. If the government spends resources to get the economy to Point A, where a relatively high amount of Y is produced and a relatively little amount of X is produced, but people prefer to be at B (more X and less Y), then couldn’t one argue that the government spending moves the economy to a point where things are less than optimal?
Consider a real-world example: World War 2. Prior to the US’ entry into the war, the country was in the Great Depression. Lots of resources were sitting idle. Once the war began, those resources (and then some) were poured into the war effort. Unemployment plummeted. Factory utilization skyrocketed. The United States became the Arsenal of Democracy as ships, planes, tanks, firearms, and munitions began pouring off the assembly lines. Across four continents, American armies and arms were engaged. But what of the homefront? People had to do without a lot of little luxuries. Rationing was huge. People had money but nothing to spend it on. Not what one generally thinks of when one thinks of a prosperous economy. The recession was technically over; we were back on the PPF, but were people better off (for a great discussion of this point, see Bob Higgs’ excellent 1992 article “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s“)?
To put the above story in terms of the diagram, let’s assume that Y is “war goods” and X is “literally everything else.” During the Depression, let’s say the economy is at Point C. After 1941, the economy moves to Point A. All resources are utilized but for the war effort. But if people prefer more X to Y, could we say this new state of affairs was better than the Depression? I’d argue “no.”
To be perfectly clear, I do not want to give the impression that Krugman does not understand the arguments put forth here. I do not think Krugman thinks scarcity doesn’t exist even in a recession or that there are still trade-offs. Keynesianism does not overthrow nor ignore scarcity. Rather, the point of this discussion was to provide some more detail into the criticism of fiscal policy and the crowding out effect. Crowding out still happens by virtue that all goods are scarce.