The Wrong Tool for the Job

Paul Krugman, defending the IS-LM (a/k/a “old Keynesian”) model of the macroeconomy as a non-rigorous but useful “scratchpad”, misses the point by a mile:

It’s a simplified model that more or less gets at what you think are the essentials of an issue, and is easy to work with, so you can use it to reach quick first-pass judgments about policy or whatever.

………

But IS-LM isn’t the prime example of a scratchpad. What is?

The answer is, supply and demand.

It is not easy to derive supply and demand curves for an individual good from general equilibrium with rational consumers blah blah. And it’s definitely not easy to justify consumer and producer surplus as measures of welfare. And there have always been some purists who condemn any use of the S and D curves we all grew up with, the use of triangles to measure welfare loss, and all that.

But for the most part nobody pays attention. The supply-and-demand framework is so convenient, while pretty much getting at what you want to get at, that it’s what almost everyone uses to get a first-pass analysis of economic issues.

Okay, look. Supply and demand (and, especially, triangles of welfare loss, etc) are not entirely rigorous, but they’re good useful simplifications that actually give useful (though approximate) answers to important policy questions. Sort of like Ohm’s Law for electrical circuits.

But IS-LM is not like that at all, because IS-LM does not even address the key policy questions in macroecomics. IS-LM can tell you, perhaps, how to fight a recession, but it can’t tell you whether the recession is worth fighting — not even loosely, because the model contains no individual utility functions and no social welfare function. It therefore does not allow you even to formulate the question of whether a given policy is worth its costs, because it provides no framework for weighing costs against benefits.

Analyzing policy via supply and demand is like analyzing electrical circuits with Ohm’s Law. It answers questions, and over a fairly wide range of situations, it answers them with tolerable accuracy. But analyzing policy via IS-LM is like analyzing electrical circuits with a barometer.

Somewhere in a parallel Universe, there’s an electrician named Paul Krugman who carries a barometer wherever he goes. He uses it to check current flow. Whenever someone says, “Hey, Paul. That barometer is really the wrong tool for the job”, he gets all snarly and says “Hey! Whatcha got against approximations?” Then he goes back to work, muttering something about fools and knaves.

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43 Responses to “The Wrong Tool for the Job”


  1. 1 1 Mike H

    I’m confused – Supply and demand shows a relationship between quantity and price based on “demand”, and another such relationship based on “supply”. You can make useful predictions about the effect on quantity of changes in price, but where are the utility functions and social welfare functions? Perhaps S-D can be derived from utility functions etc, but are they really part of S-D?

    Indeed, mightn’t it be possible for two economists to agree on the S-D curves and on what they predict the effects of certain policies will be, yet disagree on whether those policies are “good” or “bad”?

    IS-LM shows a relationship between interest rates (a price, if you like, of money) and total GDP (something, perhaps, like a quantity of money consumed/produced? Is IS/LM just a special case of S-D??) The IS curve shows how consumers of money react, the LM curve shows how suppliers of money react. You can make useful predictions about the effect of changes in interest rates on GDP, even without knowing the utility functions. Perhaps IS-LM can be derived from utility function and social welfare functions.

    Indeed, couldn’t an economist deduce from IS-LM that fiscal stimulus, applied now, would reduce unemployment, and even perhaps deduce exactly how much unemployment would go down per billion spent? And if so, might this not be useful analysis of policy, even if there isn’t sufficient agreement about the social utility function to determine whether the spending is “worth it”?

    Perhaps Krugman’s argument is a two step one.

    * “From IS/LM, I deduce that $X fiscal stimulus would reduce unemployment by Y%, and raise interest rates and inflation by only small amounts Z% and W%.”
    * “Therefore, it’s worth it.”

    Perhaps you disagree, but perhaps your disagreement is with the social utility function he applies in step 2, but you mistakenly conflate the two steps and blame his IS/LM?

    The IS/LM should be judged on the strength of the predictions it makes, not on the politics or opinions about social utility functions held by its proponents.

  2. 2 2 AC

    I think even that is too generous to IS/LM. What does the model add at all to just saying in words: when in recession, spend more. Does Krugman really need to shift the IS curve to convince himself of that? I really want to know the best case for using it.

  3. 3 3 Steve Landsburg

    AC:

    What does the model add at all to just saying in words: when in recession, spend more. Does Krugman really need to shift the IS curve to convince himself of that? I really want to know the best case for using it.

    I think this is unfair to the model, which does make a great variety of nontrivial predictions. That’s one reason people like to teach it — it lends itself so easily to homework and exam problems with definite answers. See, for example, the first section of Laidler’s book on Demand for Money for a wide array of IS-LM applications.

  4. 4 4 Steve Landsburg

    Mike H:

    Perhaps S-D can be derived from utility functions etc, but are they really part of S-D?

    Consumer surplus is an approximation to an integral of a level curve of a utility function. I don’t see any way to make analogous statements tying the components of IS-LM to any useful notions of utility or social welfare.

  5. 5 5 Keshav Srinivasan

    Steve, I don’t know much economics, but according to Krugman ISLM just involves finding a simultaneous equilibrium in three different markets, where each market has a supply curve and a demand.curve. So can’t you just apply the usual framework for welfare analysis in the context of supply and demand, involving triangles for welfare loss (even if, as you said, it’s an approximation)?

  6. 6 6 Mike H

    “Consumer surplus is an approximation to an integral of a level curve of a utility function. I don’t see any way to make analogous statements tying the components of IS-LM to any useful notions of utility or social welfare.”

    As you pointed out to AC, the IS/LM makes a number of nonintuitive predictions. If it happens that these predictions don’t directly translate into social welfare, does that make the model less useful?

    I’m not entirely sure that Krugman in fact evaluates policy using IS/LM. More likely he uses IS/LM to predict the effects of policy, then evaluates those effects some other how.

  7. 7 7 Mike H

    AC : IS/LM doesn’t say “when in recession, spend”. It says “if you are in a certian kind of recession, and you spend, you will get out of the recession without causing inflation or high interest rates”

    Not just that, it explains *why* spending will not impact interest rates or inflation during that specific kind of recession.

    It also explains how to tell whether you are in that kind of recession or a differecnt kind.

    And if even that seems trivial, keep in mind that
    * many outspoken economists – or at least, political pundits – are making quite different predictions based on quite different models (eg, an IS model with no LM), and getting those predictions wrong, but still not changing their model.
    * many policy makers are making policy that, if IS/LM is well understood, are obviously disastrous. And yet they still make them.
    Therefore, it’s worth harping on this seemingly trivial IS/LM model until people actually get that it works and gives accurate rule-of-thumb answers.

  8. 8 8 Manfred

    Apart from the shortfall that Steve points out, I would add that in the IS-LM model there is no modeling of expectations, of beliefs about the future by the relevant economic agents, there is no modeling of “rules vs. discretion”, no modeling of time consistency/inconsistency issues, etc etc. I agree with John Taylor in his last blog entry, when he says (quoting John Cochrane, in his comments on Taylor’s latest book) that “preference for rules is one of the most important lessons of modern macroeconomics”
    http://johnbtaylorsblog.blogspot.com/2012/07/one-of-most-important-lessons-of-modern.html .
    There is nothing like this in IS-LM.

  9. 9 9 Steve Landsburg

    Mike H:

    I’m not entirely sure that Krugman in fact evaluates policy using IS/LM. More likely he uses IS/LM to predict the effects of policy, then evaluates those effects some other how.

    And as far as I am aware, he has never revealed what that “some other how” might be.

  10. 10 10 Rory Carmichael

    It seems that you are positing that the question of whether or not there is social utility in ending recessions quickly is a controversial one. That may be the case in certain macroeconomic circles, but in terms of the policy debate isn’t even on the radar.

    Furthermore, it seems weird to say that because the tool doesn’t help you understand whether or not you should use it means that the tool isn’t useful. A hammer isn’t useless because it doesn’t tell me how many nails I should use or where to put them.

    So yeah, if you think the main problem in recessions is figuring out whether it would be welfare maximizing to end them, IS/LM isn’t much use. But if you have a prior conviction that ending recessions is good–not exactly uncommon–IS/LM seems to be a tolerable tool for predicting how certain kinds of interventions will act. I don’t see why you would read him as saying anything else.

  11. 11 11 Steve Landsburg

    Rory Carmichael:

    But if you have a prior conviction that ending recessions is good…

    A prior conviction that something is good is not the same thing as a prior conviction that it’s worth its cost. The whole purpose of policy analysis is to figure out which good things are worth their costs and which aren’t.

  12. 12 12 Ken B

    SL:

    Mike H:

    I’m not entirely sure that Krugman in fact evaluates policy using IS/LM. More likely he uses IS/LM to predict the effects of policy, then evaluates those effects some other how.

    And as far as I am aware, he has never revealed what that “some other how” might be.

    Abandoned the idea of expressed preferences have we?

    The ‘some other how’ is whatever will help Krugman’s candidate.

  13. 13 13 Ken B

    Oops, I mean revealed preferences in comment 12. One more joke circles the bowl due to poor proof-reading …

    At least I bid fair to get 13.

  14. 14 14 Bearce

    It therefore does not allow you even to formulate the question of whether a given policy is worth its costs, because it provides no framework for weighing costs against benefits.

    Funny, I always assumed that an economy ought to be operating at equilibrium levels or else you either have higher unemployment, deflation, inflation, stagflation, etc. something the IS/LM model demonstrates. Those seem to be intuitive. Can you show a counter-example as to why its good that an economy might have any of those?

  15. 15 15 Steve Landsburg

    Bearce:

    Perhaps you didn’t see this part of my reply to an earlier comment:

    A prior conviction that something is good is not the same thing as a prior conviction that it’s worth its cost. The whole purpose of policy analysis is to figure out which good things are worth their costs and which aren’t.

    (To be more directly responsive to your comment, this should say “A prior conviction that something — unemployment, inflation, whatever — is bad is not the same thing as a prior conviction that eliminating it is worth the cost”. A different way of expressing the same point, of course.)

    To be even more explicit: Many of the costs of fighting (current) unemployment occur in the future. IS-LM does not provide any way of weighing current benefits against future costs, because people’s preferences about the future are *not even present in the model*.

  16. 16 16 Ken B

    “IS-LM does not provide any way of weighing current benefits against future costs, because people’s preferences about the future are *not even present in the model*.”

    I think in fairness to Krugman he wrote that it’s a good tool for short term things. So can we not in the short term assume the preferences are pretty much the same? So for example if we are willing today to give up X to cut unemployment by 1%, assume that next year we will also be willing to pay X for the same reduction.
    That does not look unreasonabble to me. For a ‘first pass judgment’ tool I ve seen worse.

  17. 17 17 Bearce

    (To be more directly responsive to your comment, this should say “A prior conviction that something — unemployment, inflation, whatever — is bad is not the same thing as a prior conviction that eliminating it is worth the cost”. A different way of expressing the same point, of course.)

    To be even more explicit: Many of the costs of fighting (current) unemployment occur in the future. IS-LM does not provide any way of weighing current benefits against future costs, because people’s preferences about the future are *not even present in the model*.

    It seems to me, Steve, you are using dodgy expressions that create a distinction without a difference. By default, if a benefit isn’t worth the cost of a certain action, it’s proper that the act is labeled ‘bad.’

    My initial question stands, why don’t you provide an example? IS-LM holds that when neither the goods or money market are in equilibrium (or rather, not in equilibrium at potential GDP), the economy faces some type of structural distortion; these include higher unemployment, high inflation, stagflation, or deflation. In order for your objection to hold, I believe you have to somehow demonstrate how any one of these structural distortions could exist as a way of acting as a benefit over the cost of trying to remedy them and return a given economy to equilibrium levels at potential GDP.

  18. 18 18 Steve Landsburg

    Bearce:

    why don’t you provide an example?

    Okay, here’s an example: Suppose it costs a trillion dollars to restore the current economy to full employment, but people would prefer to spend that trillion dollars on other things in the future.

    What, beyond that, are you looking for?

  19. 19 19 Bearce

    Suppose it costs a trillion dollars to restore the current economy to full employment, but people would prefer to spend that trillion dollars on other things in the future.

    That’s rather weak.

    In this scenario, we’re not operating at potential GDP. Aggregate income (before the supposed trillion dollars are spent) is way below potential, and thus consumption is as well. Overall welfare has been significantly reduced and unemployment above its natural rate.

    It takes a really big leap of faith in logic to assume people want to hoard a trillion dollars in order to spend it on something else in the future when immediate ailments are present; high unemployment, which leads to downward pressure on wages, which further exacerbates the problem (perhaps leading to ‘hysteresis’), which dries up savings of poor and middle-class households, etc. I could go on…long run we’re all dead to spend that trillion anyway (if it exists anymore).

    Basically, IS-LM assumes people want the economy to operate at its potential. You’re arguing it’s not a good macroeconomic model because it doesn’t lend itself to a cost-benefit analysis (hence, there could be an instance where, say, fighting a recession may not be worth the cost). I find your example highly unconvincing and special pleading. Thus, I think your claim that the IS-LM doesn’t answer key policy questions for macroeconomics unjustified.

  20. 20 20 Mike H

    @Me: …More likely he uses IS/LM to predict the effects of policy, then evaluates those effects some other how.

    @Steve: And as far as I am aware, he has never revealed what that “some other how” might be.

    Not explicitly. He seems to feel that it’s a bit of a no-brainer that
    * borrowing at 0% to spend on infrastructure,
    * with the side-effect of boosting employment
    * and boosting tax revenue (possibly even enough to pay for the initial investment)
    * yet not causing a sudden increase in either interest rates or inflation until the recession’s over
    * then, when things are rolling along nicely once more, cutting government spending
    is a no-brainer

    In any case, he has plenty of critics with no model or failed models, and very few who agree with him what is likely to happen under various scenarios, yet broadly disagree about the implied best course of action. Perhaps his failure to explicitly state his social welfare function is a supply-and-demand thing. Nobody (but you) really wants to know.

  21. 21 21 Steve Landsburg

    Bearce:

    I find your example highly unconvincing and special pleading.

    You find it highly unconvincing that people might sometimes want to forgo current consumption to finance future consumption? Then how do you explain the existence of savings accounts?

  22. 22 22 Mike H

    He probably finds it unconvincing that real people would make the choice you propose.

    Now, an interesting quote :

    “Now we’re having a crisis that makes perfect sense if you’re willing to accept some real-world behavior that doesn’t arise from intertemporal maxiimization, but none at all if you aren’t”

    So Krugman believes that if you believe people always want to balance future costs and benefits against present ones, you can’t understand what’s going on in this crisis and why.

    Therefore also, he believes that people are not, in fact, intertemporally maximising in this crisis.

    Now, I don’t know exactly what he means by that. I’d love to understand in what ways he feels people are not balancing present and future, but it seems relevant to the discussion.

    Perhaps it’s as simple as this : people would be prefer it if $1 trillion was spent on a job-creating stimulus program, but that $1 trillion is not, in fact, being spent.

  23. 23 23 Ken B

    “You find it highly unconvincing that people might sometimes want to forgo current consumption to finance future consumption? Then how do you explain the existence of savings accounts?”

    Advertising

  24. 24 24 ThomasBayes

    By the way, Krugman recently made one of his favorite claims about consumer demand:

    http://www.nytimes.com/2012/07/20/opinion/krugman-pathos-of-the-plutocrat.html?_r=1


    “There’s no mystery about the reasons the economic recovery has been so weak. Housing is still depressed in the aftermath of a huge bubble, and consumer demand is being held back by the high levels of household debt that are the legacy of that bubble. Business investment has actually held up fairly well given this weakness in demand. Why should businesses invest more when they don’t have enough customers to make full use of the capacity they already have?”

    And Robert Reich recently made a similar claim:
    http://www.huffingtonpost.com/robert-reich/obama-tax-proposal_b_1661908.html

    “The real reason businesses aren’t creating more jobs is American consumers — whose purchases constitute 70 percent of U.S. economic activity — don’t have the money to buy more, and they can no longer borrow as before. Businesses won’t invest and hire without consumers.”

    But this chart seems to show that the consumer demand recession ended a few years ago, and we are now at an all-time high in real personal consumption expenditures:

    http://research.stlouisfed.org/fred2/series/PCEC96/

    Does this chart contradict their claims? If not, can someone explain how consumer demand is the primary concern for businesses when, at the same time, personal consumption expenditures are at an all-time high and rising?

    Reich and Krugman must be aware of this data, so what am I missing?

  25. 25 25 Andy B

    ThomasBayes, here is what you might be missing. Draw a trend line for personal consumption using the slope that existed pre-crisis. It roughly looks like personal consumption would be $1.2 trillion higher than it is now if we had continued on that trajectory.

  26. 26 26 iceman

    Mike H (#20) – I think it’s hard to argue with the neat scenario you describe…of course the same could be said for theories that tax cuts pay for themselves. However some in the real world wonder:

    “borrowing at 0% to spend on infrastructure”
    - perhaps actually finding a trillion dollars of truly needed, “shovel-ready” projects in the SR wasn’t such a “no-brainer”. So by the time much of it actually breaks ground we risk overheating a natural recovery (particularly if we’ve been bidding up input prices in the meantime)

    “with the side-effect of boosting employment”
    - seems similar income / multiplier effects could be accomplished more simply via direct means like extended unemployment benefits? I know the counter is people will lose their skills if we don’t give them make-work jobs, so maybe payroll tax holidays are best? (I’ve heard they have the highest multiplier of all.)

    “and boosting tax revenue (possibly even enough to pay for the initial investment)”
    - sounds suspiciously analogous to the aforementioned supply-side claims, but how does it even work – from taxing the income from the make-work jobs? That just offsets the stimulus so why not just pay the net amount?

    “yet not causing a sudden increase in either interest rates or inflation until the recession’s over”
    - some think we need to be a little more forward-looking than this when analyzing all-in costs and benefits

    “then, when things are rolling along nicely once more, cutting government spending”
    - the very rational fear is that this doesn’t happen, the baseline just gets ratcheted up

    Would appreciate your thoughts

  27. 27 27 Bearce

    You find it highly unconvincing that people might sometimes want to forgo current consumption to finance future consumption? Then how do you explain the existence of savings accounts?

    So we’re playing this game now?

    I don’t deny the existence of forgoing consumption for future consumption, I’m denying your ridiculous claim that people would prefer to hoard a trillion dollars when there is a recession if it would alleviate it. I asked you to provide an example of how there might be a case where people would prefer living in a disequilibrium economy, and you provided a very stupid example. IS-LM, and pretty much anyone in the macro profession, holds that an economy experiencing a depression, recession, stagflation, hyperinflation, etc. is a bad thing that needs to be remedied. You can argue details of how that’s to be the pursued, but you have no real argument against the IS-LM model in saying that it doesn’t answer key policy questions in macro when you can’t even think of a (real) example of why any one of those ailments might be a good thing on a C-B analysis.

    You might as well say Lipitor is a bad medicine because, even though it reduces the chance of heart-attack and stroke, it doesn’t answer the fundamental question of is it worth the cost to reduce a heart-attack and stroke.

  28. 28 28 Bearce

    Woops, forgot to block off the bold quotation. Here’s the modified version of my post.

    You find it highly unconvincing that people might sometimes want to forgo current consumption to finance future consumption? Then how do you explain the existence of savings accounts?

    So we’re playing this game now?

    I don’t deny the existence of forgoing consumption for future consumption, I’m denying your ridiculous claim that people would prefer to hoard a trillion dollars when there is a recession if it would alleviate it. I asked you to provide an example of how there might be a case where people would prefer living in a disequilibrium economy, and you provided a very stupid example. IS-LM, and pretty much anyone in the macro profession, holds that an economy experiencing a depression, recession, stagflation, hyperinflation, etc. is a bad thing that needs to be remedied. You can argue details of how that’s to be the pursued, but you have no real argument against the IS-LM model in saying that it doesn’t answer key policy questions in macro when you can’t even think of a (real) example of why any one of those ailments might be a good thing on a C-B analysis.

    You might as well say Lipitor is a bad medicine because, even though it reduces the chance of heart-attack and stroke, it doesn’t answer the fundamental question of is it worth the cost to reduce a heart-attack and stroke.

  29. 29 29 Mike

    “You might as well say Lipitor is a bad medicine because, even though it reduces the chance of heart-attack and stroke, it doesn’t answer the fundamental question of is it worth the cost to reduce a heart-attack and stroke.”

    No the question is whether the cost of Lipitor is greater than the benefit it provides by reducing heart attacks. If single pill of Lipitor cost 1 trillion dollars and reduced the risk of a heart attack by 1 in 1*E+100, then clearly it would not be worth it. Nobody’s arguing that reducing heart attacks is not beneficial.

  30. 30 30 Steve Landsburg

    Bearce:

    You might as well say Lipitor is a bad medicine because, even though it reduces the chance of heart-attack and stroke, it doesn’t answer the fundamental question of is it worth the cost to reduce a heart-attack and stroke.

    Wrong analogy. The right analogy is that “Take Lipitor because it reduces the chance of heart attacks” is not well-considered advice unless the costs of Lipitor (e.g. potential liver damage) have been weighed in the balance.

    Policy analysis is not analogous to Lipitor; it’s analogous to the process of deciding whether Lipitor is a good idea. As any doctor will tell you, Lipitor has both costs and benefits, and telling everyone to take it because it has benefits, without even attempting to account for the costs, is bad medicine.

  31. 31 31 Sam Viavant

    Is economics a way of making predictions, or passing value judgements?
    I would say economics is very impressive at making predictions, but not particularly helpful at normative judgements. For example, why is efficiency “good?” I always thought economics could only tell us what a policy would do, not whether the effects were good. In that case, why is IS-LM deficient?

  32. 32 32 Mike H

    @iceman

    “borrowing at 0% to spend on infrastructure”
    - perhaps actually finding a trillion dollars of truly needed, “shovel-ready” projects in the SR wasn’t such a “no-brainer”. So by the time much of it actually breaks ground we risk overheating a natural recovery (particularly if we’ve been bidding up input prices in the meantime)

    Perhaps. However, IS/LM predicts that even rather silly forms of spending can help the economy, eg giving cash (or tax cuts) to people likely to spend it. If there are not enough shovel-ready projects, there’s always the possibility of tax cuts and one-off transfer payments to spenders.

    “with the side-effect of boosting employment”
    - seems similar income / multiplier effects could be accomplished more simply via direct means like extended unemployment benefits? I know the counter is people will lose their skills if we don’t give them make-work jobs, so maybe payroll tax holidays are best? (I’ve heard they have the highest multiplier of all.)

    Perhaps indeed. The right approach is probably to figure out the amount of stimulus needed, then start distributing it down the list of projects ordered by multiplier.

    “and boosting tax revenue (possibly even enough to pay for the initial investment)”
    - sounds suspiciously analogous to the aforementioned supply-side claims, but how does it even work – from taxing the income from the make-work jobs? That just offsets the stimulus so why not just pay the net amount?

    if the multiplier is more than 1, some of the improvement in GDP is not directly caused by the stimulus, but is spending triggered by the fact that there is now stimulus money sloshing around the economy. In any case, it’s probably easier to make gross payments than to make net payments and make them tax-free.

    “yet not causing a sudden increase in either interest rates or inflation until the recession’s over”
    - some think we need to be a little more forward-looking than this when analyzing all-in costs and benefits

    “then, when things are rolling along nicely once more, cutting government spending”
    - the very rational fear is that this doesn’t happen, the baseline just gets ratcheted up

    Naturally. However, an independent Fed can keep the lid on an overheated economy with their traditional tools.

  33. 33 33 Ohio Libertarian

    @ Sam Viavant:

    On the contrary, I’ve found economics to be terrible as a forecasting tool; mildly useful when trying to determine what’s going on at the present, possibly best used as tool for historical post-mortems.

    Prime example – how many economists predicted the 2008 financial crisis?

    By definition, normative determinations are beyond the ken of economics. For example – the subject of “externalities” can be argued to be entirely beyond the scope of economics (i.e. strictly normative in nature, political in its solution).

  34. 34 34 Bearce

    Ungh, that Lipitor example had a completely different context. Admittedly, the way I presented it left it open to be criticized as so.

    Nonetheless, it’s already assumed that an economy experiencing some sort of deficiency should be remedied. Arguing that IS-LM is useless because it doesn’t answer whether curing it is worth the cost is nonsensical because it’s already assumed that the structural deficiency is a bad thing that should be combated. Until a (good) example is provided that not fighting whatever problem an economy is facing is preferable to doing something, I remain unconvinced by the argument presented in this blog.

  35. 35 35 Bearce

    On the contrary, I’ve found economics to be terrible as a forecasting tool; mildly useful when trying to determine what’s going on at the present, possibly best used as tool for historical post-mortems.

    Prime example – how many economists predicted the 2008 financial crisis?

    By definition, normative determinations are beyond the ken of economics. For example – the subject of “externalities” can be argued to be entirely beyond the scope of economics (i.e. strictly normative in nature, political in its solution).

    ^You’ve never taken an economics course, have you?

  36. 36 36 Steve Landsburg

    Bearce:

    it’s already assumed that the structural deficiency is a bad thing that should be combated.

    I’d have said that the primary lesson of economics is that one ought never assume that a bad thing ought to be combated without first inquiring into the costs of combat.

  37. 37 37 KS

    I like this post — “It therefore does not allow you even to formulate the question of whether a given policy is worth its costs, because it provides no framework for weighing costs against benefits.”

    However, I am a bit confused as to how you Dr. Landsburg can articulate this point so well, then write such myopic opinion pieces on say, the capital gains tax.

    Correct me if I’m wrong, but your argument typically runs like: (1) investment is necessary for economic growth, (2) a tax on behavior reduces its incidence, therefore (3) a tax on investment is bad for economic growth.

    1. Just because investment is good for economic growth does not mean more investment is always better for economic growth. There is an optimal amount of investment, just like there is an optimal amount of pollution in your house. I do not want to incentivize some Wall Street tool who leverages 30-to-1, for example. I hope 2008 showed us just how dangerous the philosophy of “more investment” can be.

    2. Does a tax on behavior always reduce its incidence? If food becomes more expensive, will I necessarily eat less? If my weights at the gym become heavier, will I lift them less and become weaker? This seems like a very simplistic and linear assumption. Couldn’t it be the case that over a certain range, taxes have minimal effects on behavior, or that taxes may even SPUR behavior? I don’t ever see you cite any evidence to this fact.

    3. Finally, at no point do you consider the flipside of the equation. Yes, the capital gains tax is a TAX. But hey, taxes pay for something. What are the benefits? Are the benefits worth more than the costs? Isn’t there a benefit to redistribution of wealth more the top the bottom, whether or not such an activity is ‘fair’?

  38. 38 38 Steve Landsburg

    KS:

    (1) investment is necessary for economic growth, (2) a tax on behavior reduces its incidence, therefore (3) a tax on investment is bad for economic growth.

    1) This is a terrible argument, for reasons that you’ve clearly explained. (In fact, your explanations are terrific.)

    2) I would be astonished to learn that I’d ever made this argument.

    (More precisely, this is NOT such a terrible argument if you’re trying to prove that at tax on investment will slow down economic growth. But it’s a THOROUGHLY terrible argument if you’re trying to prove that taxes on investment should be lowered.)

  39. 39 39 Martin-2

    KS – Do you accept the argument that it is most efficient to tax all goods at the same rate?

  40. 40 40 Bob Murphy

    Steve, I think the problem you are having with some of your critics here, is that they share what I think is Paul Krugman’s implicit belief that in the aggregate there is *no* opportunity cost to restoring full employment. I.e. we don’t sacrifice anything in the future, by restoring adequate demand in the present. There might be some distributional issues, sure, but those wash out. We can produce more total stuff now, with no consequent reduction in output in any future years.

    Incidentally, this ties in with what Nick Rowe and I kept telling you was Krugman’s faulty position on debt financing, back when we had that fiasco. If the government runs up debt now in order to restore full employment, who cares? In Krugman’s view, that doesn’t impoverish people in the future on net; it just causes some of them to made transfer payments to others of them.

  41. 41 41 Mike H

    @KS – as far as I understand it, Steve’s argument is not at all like the one you presented as his.

    Instead, he says :

    1) for reasons based on utility, different things should be taxed equally. Specifically, as he explained some weeks ago, the tax regime should ensure that prices of different goods should go up by equal percentage amounts.
    2) In particular, taxes should have an equal effect on the prices of present and future consumption.
    3) Imposing taxes on investment income means that future consumption now costs more than present consumption.

  42. 42 42 Kevin Donoghue

    Bob Murphy gets it. The Keynesian claim is that increasing aggregate demand in a slump is a Pareto improvement. In the words of the founder of the school:

    “It is as though two motor-drivers, meeting in the middle of a highway, were unable to pass one another because neither knows the rule of the road. Their own muscles are no use; a motor engineer cannot help them; a better road would not serve. Nothing is required and nothing will avail, except a little, a very little, clear thinking.”

    Clear thinking is not a cost. If you particularly want a utility function, there’s no difficulty about building a model in which the IS and LM curves are derived from explicit functions. But what’s the point of doing that when, by construction (i.e. the preset price and/or wage wage level etc.), those curves are going to cross at a sub-optimal level of output?

  43. 43 43 Paul T

    SL: “Paul Krugman, … misses the point by a mile:”

    Has the Krug ever missed the point by less than a mile?
    I’m not a regular reader of his column, but I’ve seen
    enough. Not only is he obnoxious philosophically, but
    obtuse, more often than not.

    Still, he did snag No Bell. Steve, could you don your
    professor’s hat, and elaborate on his contribution? The
    idea he ever said anything of redeeming value strains
    credulity, but I’ll try to keep an open mind -

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