It won’t come as a great shock to anyone that the current state of the financial markets shows that we’ve still quite a bit to learn about economics. While there were indeed those observers (some of them even economists!) who pointed to the housing bubble, its unsustainable nature and the oddity of funding it by borrowing back the money we’d sent to China for our iPods and other shiny gew gaws, few if any thought that the unwinding would lead to a collapse of the entire financial system. Even amongst those few that did the precise mechanism by which it happened escaped them: it wasn’t, for example, credit default swaps that caused it, nor other complex derivatives. A good old fashioned credit crisis though, one driven it appears by a massive loss of trust in the system itself. We thought we’d managed to get rid of that possibility by having such as the FDIC, SEC and so on, the alphabet soup of regulators installed after the last such collapse of confidence in the 1930s.

As I say, turns out we didn’t know as much about economics as we thought we did. But this ignorance isn’t restricted to to what went wrong in the past, it’s also relevant to what we ought to be doing now. We’re still finding out things about what were done last time, in the ‘30s, and perhaps not fast enough to stop making the same mistakes as last time. We’ve still got people saying that the solution is to raise the minimum wage for the poor spend all of their money rather than save it: entirely ignoring the fact that Roosevelt’s policies of trying to raise real wages prolonged the Depression. It’s not rocket science to point out that if you raise the price of something people will purchase less of it, after all, and this applies to labor just as much as anything else.

But much the most interesting area of disagreement to me is over the fiscal stimulus. Yes, I know, it’s rather a cornerstone of conservative economic thought that if we can’t actually have a balanced budget, can we at least have some logical relationship between the amount being taxed and the amount spent? It’s also a similar cornerstone that small government is better than big for as Adam Smith pointed out, the money should be allowed to fructify in the pockets of the populace. Rather than, say, be allocated by bureaucrats and politicians to their favoured groups and activities. But if a fiscal stimulus there is going to be and for political reasons I can’t see that there won’t be, there’s still the argument over how this should be done.

Keynes himself (something that has been forgotten by many of his modern followers) pointed out that if other things were equal that there are two ways to have such a boost, such a stimulus. For to him the basic point was that government needed to be spending more than it was collecting in taxes, funding the gap by borrowing or printing. This can be done in two ways, by increasing spending while keeping taxes static (in the present, for most assuredly they will have to rise in the future) or by reducing taxes and keeping spending constant. Either will provide that fiscal boost assuming, as above, that other things are equal.

It was a refinement of this that has led so many to assume that a rise in spending is better, a refinement that depends upon something called the “multiplier.” Simply, how much economic growth, how much extra GDP do we get for each $ of government spending? Is this higher than the extra growth we get for each $ of tax cuts? If so, assuming that we do indeed want a fiscal boost, then spending is the way to go, it’s a more efficient way of getting what we want. The general Keynesian assumption has been that the spending multiplier is indeed higher than the tax cut one. However, recent research seems to show that this is incorrect, it is actually the tax cuts which produce more growth than the spending rises.

Paul Krugman (yes, I know, but it’s his political view that is objectionable, not his economics) puts the spending multiplier at about 1.1. That’s a pretty low estimate as such go, but there’s almost no one who thinks that it is above 2 in the current US economy. That tax multiplier has always been assumed to be lower than this, an assumption made in error, it seems.

The strong negative relationship between tax changes and investment also helps to explain the size of our estimated overall effect on output. Recall that we find that a tax increase of one percent of
GDP lowers real GDP by about 3 percent, implying a substantial multiplier. An important part of that effect appears to be due to the procyclical behavior of investment.

Yes, we do expect that tax rises and tax cuts have equal and opposite effects and that seems to be telling us that the tax multiplier is in fact 3. That is, much higher than the spending one. This doesn’t come as much of a surprise to any of us: we already believe that people spending their own money on their own desires produces a better result than bureaucrats spending other people’s money on what politicians think people desire. It does come as something of an unwelcome surprise to those who consider themselves Keynesians. For decades the assumption has been the other way around, that the spending multiplier is larger than the tax one.

As I’ve said above, we really don’t know as much about economics as we thought we did and are finding out new things all the time. In this case, contrary to received wisdom, that tax cuts are the best and most efficient method of providing a fiscal boost to the economy. Something we have always insisted is true, yes, but now we’re using impeccable Keynesian logic to prove it. Of course, you can find an economic paper to argue just about any point you want but I have a feeling that this one I’ve quoted is going to have a rather larger effect than most. For it was written just last month by Christina Romer along with her husband. Yes, that Christina Romer who has just been appointed Chair of Obama’s new Council of Economic Advisors.

That Congress and the White House are now Democratic controlled is a bitter pill to swallow, of course, but if it becomes the received wisdom that tax cuts, not growth of government, are the way to combat recessions, then I for one will take that as a consolation prize.