Is Freshwater Skepticism on Fiscal Multipliers Rooted in Theory?

Abstract:

Since the 2008 financial meltdown, opposing camps of mainstream macroeconomists have debated fiscal policy measures, and have expressed opposing views on the size of the fiscal multipliers—about which there is an abundance of empirical evidence. However, empirical evidence has not been enough to resolve these debates about multipliers: the “freshwater” macroeconomists have continued to express skepticism about claims of their “saltwater” counterparts that government spending multipliers should be large and positive. This paper makes the possibly surprising claim that the fiscal multiplier skepticism of “freshwater” macroeconomists is not rooted in specific macroeconomic modeling assumptions. Freshwater macroeconomists certainly have tastes for a particular set of modeling assumptions, but these assumptions are insufficient to guarantee that multipliers will be zero, let alone negative.

Keywords::

• Macroeconomic controversies
• fiscal stimulus
• fiscal austerity
• spending multipliers
• Reinhart–Rogoff controversy
• macroeconomic methodology
• “freshwater” macro ideology

Notes

During a visit to the London School of Economics in November 2008, the Queen asked why economic experts failed to see the financial meltdown coming (see Pierce 2008). In a response sent eight months later, an eminent group of British economists blamed “a failure of the collective imagination of many bright people, to understand the risks to the system as a whole” (see Stewart 2009).

The terms “freshwater” and “saltwater” are now widely used to label different macroeconomic camps in the United States, with freshwater economists giving greater emphasis to the self-correcting properties of markets and saltwater economists viewing themselves as more Keynesian in outlook.

For a detailed treatment of the modern macro tastes of freshwater macroeconomists presented by an advocate, see Athreya (2013).

Keynes (1936: 120) himself acknowledged the relevance of “confidence” as a minor factor in judging the impact of an increase in government purchases, and stated: “With the confused psychology that often prevails, the Government programme may, through its effect on ‘confidence,’ increase liquidity-preference or diminish the marginal efficiency of capital, which, again, may retard other investment unless measures are taken to offset it.”

See Krugman (2013b) and Blyth (2013).

Of course, in other theoretical frameworks and in actual practice, the necessity of paying off debt in the future is often not so clear.

David Ricardo (1888) was the first to propose this possibility in the early nineteenth century; however, he was unconvinced of it. Barro (1974) took the question up independently in the 1970s, in an attempt to give the proposition a firm theoretical foundation.

This point has been made by, among others, Paul Krugman (e.g., 2011a, 2011b).

Wynne Godley (2000) popularized (if not pioneered) the use of such accounting identities (since the mid-1970s; see Godley and Lavoie 2012: xxxvi) and his work has long been influential amongst post-Keynesian economists. More recently Martin Wolf of the Financial Times and Paul Krugman of Princeton University, for example, have employed these identities in fiscal policy debates.

Our notation here is standard: C = consumption spending, I = private-sector investment spending, G = government purchases, T = net taxes, X = exports of goods and services, and IM = imports of goods and services. But we let Y = GNP rather than GDP; otherwise Equation (2) does not hold without adding the complication of net factor income flows.

Some presidents of Federal Reserve Banks and some freshwater economists disputed whether this characterized the situation around 2009 (and beyond). For example, Charles Plosser and Narayana Kocherlakota, presidents of the Philadelphia and Minnesota Federal Reserve Banks, respectively, and the Chicago economist turned Reserve Bank of India governor Raghuram Rajan (2011).

Incidentally, we believe that empirical evidence is important for judging the size of fiscal multipliers, and regard Nakamura and Steinsson (2014) as an exceptionally solid effort to estimate fiscal multipliers for the United States. We cannot survey the vast empirical literature here but wish to mention Gechert (2013), a meta regression analysis of 104 studies.

Additional information

Notes on contributors

Tony Myatt

Tony Myatt and Brian MacLean are, respectively, Professors of Economics at the University of New Brunswick, Fredericton, Canada, and Laurentian University, Sudbury, Canada. The authors would like to thank, without in any way implicating, Richard Lipsey for encouraging comments on an early presentation of this paper, Simon Wren-Lewis for an instructive e-mail exchange, two anonymous referees of this journal for constructive evaluation of two drafts, and Akhter Faroque for helpful suggestions

Brian MacLean

Tony Myatt and Brian MacLean are, respectively, Professors of Economics at the University of New Brunswick, Fredericton, Canada, and Laurentian University, Sudbury, Canada. The authors would like to thank, without in any way implicating, Richard Lipsey for encouraging comments on an early presentation of this paper, Simon Wren-Lewis for an instructive e-mail exchange, two anonymous referees of this journal for constructive evaluation of two drafts, and Akhter Faroque for helpful suggestions