Paul Samuelson on where he disagreed with Milton Friedman on macroeconomic policy

Paul Samuelson on where he disagreed with Milton Friedman

via Samuelson vs. Friedman, David Henderson | EconLog | Library of Economics and Liberty and An Interview With Paul Samuelson, Part One — The Atlantic.


Deflation and Depression: Is There an Empirical Link?

Deflation has a bad reputation. People blame deflation for causing the great depression in the 1930s. What worse reputation can you get as a self-respecting macroeconomic phenomena?

The inconvenient truth for this urban legend is empirical evidence of deflation leading to a depression is rather weak.

The most obvious is confounding evidence, is up until the great depression, deflation was commonplace. In the late 19th century, deflation coincided with strong growth, growth so strong that it was called the Industrial Revolution.

For deflation to be a depressing force, something must have happened in the lead up to the Great Depression to change the impact of deflation on economic growth.

Atkeson and Kehoe in the AER looked into the relationship between deflation and depressions and came up empty-handed.

Deflation and depression do seem to have been linked during the 1930s. But in the rest of the data for 17 countries and more than 100 years, there is virtually no evidence of such a link.


Analyse Economique

Deflation and Depression: Is There an Empirical Link?

Andrew Atkeson, and Patrick J. Kehoe, 2004.

Are deflation and depression empirically linked? No, concludes a broad historical study of inflation and real output growth rates. Deflation and depression do seem to have been linked during the 1930s. But in the rest of the data for 17 countries and more than 100 years, there is virtually no evidence of such a link.

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Eugene Fama and the simulative effects of fiscal policy

Eugene Fama argues that government bailouts and stimulus plans seem attractive when there are idle resources – when there is unemployment such as in a recession or depression including in the 1930s.

Fama counters that:

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

Fama noted that there was just one valid negative comment in response to this argument  that appears  to be valid which was made by Brad DeLong.

Fama thinks Delong’s point about involuntary inventory accumulation is consistent with Fama’s initial arguments about the need for the stimulus to work through moving resources to higher value uses.

For me, the notion that a fiscal stimulus is a negative productivity shock is a good starting point for analysis. The method of financing the stimulus is important too.

Economic agents know that a temporary expenditure program has no lasting effect on employment but has lasting effect on disposable income and taxes. Indeed, massive public interventions to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead to a depression.

In Australia,  there was a  massive fiscal contraction from late 1930 onwards called the Premiers’ Plan. In 1931, unemployment rates was 25% or more.

  • The Premiers’ Plan required the federal and state governments to cut spending by 20%, including cuts to wages and pensions and was to be accompanied by tax increases, reductions in interest on bank deposits and a 22.5% reduction in the interest the government paid on internal loans.
  • The Premiers’ Plan was complementary to the Arbitration Court’s 10 per cent nominal wage cut in January 1931 and the devaluation of the Australian pound. Most countries had abandoned the gold standard by 1931 and 1932 and devalued by about 10% including the UK. These competitive devaluations were called currency wars. Most countries below started to recovery before they left the gold standard, a year or two before they left the cross of gold.

Maclaren (1936) dated the Australian economic recovery from the last months of 1932. It was to take another three years before unemployment rates fell below 10 per cent — the rate it had been during most of the 1920s.

The June 1931 Premiers’ Plan of fiscal consolidation had time by late 1932 to become credible and take hold given the usual leads and lag on fiscal policy. Unemployment data  for the time show a rapid fall in the high twenties unemployment rate in 1932 to be below 10 per cent by 1937.

Robert Lucas explained his support for U.S. monetary policy in 2008 as follows

  • There are many ways to stimulate spending, but monetary policy was the most helpful counter-recession action because it was fast and flexible.
  • There is no other way that so much cash could have been put into the system as fast, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.
  • There is no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These were important virtues.

Repeat after me: fiscal policy is ineffective when there is a flexible exchange rate!

New Zealand, Australia, and most other economies are small open economies. Any expansion in the budget deficit will drive up the exchange rate because of the higher interest rates. This appreciation of the local currency in response to the capital inflow will make imports cheaper. Any increase in so-called aggregate demand will simply result in an decrease in net exports. There will be no increase in local production or employment.

IS-LM-BP-Perfect capital mobility-Flexible exchange rate-Fiscal policy


  1. a fiscal expansion puts upward pressure on the domestic interest rate
  2. But this immediately invites a massive capital inflow.
  3. This appreciates the nominal exchange rate.
  4. This will decrease net exports, since we are able to import more goods and services with less money  because of the currency appreciation, while foreigners will import less of our products because of our appreciated domestic currency
  5. The exchange rate appreciates and the trade balance worsens until the initial increase in government spending is completely offset.

Under a floating exchange rate and high capital mobility, fiscal policy is ineffective in stimulating the economy because of exchange rate crowding out. The appreciating exchange rate will increase imports and reduce exports to render fiscal policy impotent or at least to shadow of its former closed economies self.

What did fiscal policy do in World War II?

It is ironic that both camps use World War II as evidence that the fiscal policy might work (Keynesian macroeconomics) or it does not work (Barro and Ohanian).

The nature of the new spending and how it was financed both matter, as does whether the new spending was a public good, a private good or a general or contingent income transfer matter, and whether the new spending was tax or bond financed all matter to the income and substitution effects of taxes and the additional public debt.

World War II was a temporary increase in government military purchases that will be followed by a long period of primary budget surpluses and perhaps surprise spikes in price inflation to pay down the massive wartime debt.

  • A military build-up financed by debt lowers consumer wealth which induces households to consume less leisure and work more while the temporary nature of the fiscal shock increases labour input through inter-temporal substitution of labour into the period of lower taxes.
  • The increase in the supply of labour leads to a fall in productivity and real wages. Inter-temporal substitution of labour also raises the real interest rate and lowers private investment.

Barro found that World War II U.S. defence expenditures increased by $540 billion per year at the peak in 1943-44, amounting to 44% of real GDP.  this increased real GDP by $430 billion per year in 1943-44  – a multiplier was 0.8 (430/540). The main declines were in private investment, non-military government purchases, and net exports. Wartime production was  a dampener, rather than a multiplier.

The war-based multiplier of 0.8 overstates the multiplier that would apply  to peacetime government purchases. Public spending crowds out private spending wartime because of intertemporal substitution of labour and consumption smoothing so private investment falls substantially.

People expect the added wartime spending to be temporary so consumer demand will fall by less. Consumers saving less to smooth out the changes in consumption relative the changes in their current after-tax income if the war is expected to last no more than a few years and no major destruction of capital stock and population is anticipated.

Korean War expenditures were financed mostly by higher taxes resulted in a much lower output and welfare compared to the tax smoothing policy for World War II.

The US borrowed heavily to finance World War II as did  for most of its previous wars. This means the tax rises necessary to pa for the war debt were spread over a much longer period of time and would in consequence have less effect on labour supply and investment.

In the Korean War, taxes were increased immediately  to finance the war. In consequence,labour supply and investment dropped immediately during the period of high taxes

Britain taxed capital income at a much higher rate than the United States during the war and for much of the post-war period. Lee Ohanian explains what happened:

British capital income tax rates rose substantially during the war—they approached 90 per cent—and remained high after it.

Not surprisingly, savings and investment were close to zero over this period, reflecting the very low after-tax return to savings.

In time, London reduced tax rates on savings and investment—and, as a result, savings and investment began to rise, increasing from about 3 per cent of British GDP in the early 1950s to 20 per cent of GDP in the 1980s.

But before its capital income tax rates fell, the United Kingdom was among the slowest growing countries in the industrialized West.