“A Line in the Sand”

If you look on the sidebar, you will see a link to “Bailouts and Stimulus Plans – Fama/French Forum,” at least until it rolls off the list. It’s a link to a post at a new blog by financial economists Eugene Fama and Kenneth French. However, if you look at today’s daily links, you will see that the link to this post is not there. That’s because I took it out, I didn’t want to send people to read the post without explaining what was wrong with it first, and I didn’t have time to explain.

Here’s why I removed the link, and something that’s worth taking a few moments to understand:

Eugene Fama Rederives the “Treasury View”: A Guestpost from Montagu Norman: Back in the 1920s and 1930s–in the days that overly-clever bisexual academic dilettante John Maynard Keynes was trying to persuade us that if only we got the government to spend more money the unemployment rate might go down–by far the silliest argument against his position was the one put forward by the staff of the Chancellor of the Exchequer: the so-called “Treasury View.”

The Treasury View was that nothing could boost employment: not government spending, not tax cuts, not private business decisions to expand their capacity, not irrational exuberance on the part of entrepreneurs–for the unemployment rate was what it was.

Back on Christmas Eve Paul Krugman whacked Caroline Baum of Bloomberg on the nose for rediscovering the Treasury View. Now Eugene Fama of the University of Chicago has rederived it from scratch (apparently without knowing anything of its history):

Bailouts and Stimulus Plans: There is an identity in macroeconomics… private investment [PI] must equal the sum of private savings [PS], corporate savings (retained earnings) [CS], and government savings [GS]….

(1) PI = PS + CS + GS….

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt…. The added debt absorbs savings that would otherwise go to private investment…. [S]timulus plans do not add to current resources in use. They just move resources from one use to another…. I come back to these fundamental points several times below….

The Sad Logic of a Fiscal Stimulus

In a “fiscal stimulus,” the government borrows and spends the money on investment projects or gives it away as transfer payments to people or states. The hope is that government spending will put people to work…. Unfortunately, there is a fly in the ointment…. [G]overnment infrastructure investments must be financed — more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount….

Suppose the stimulus plan takes the form of lower taxes… we can’t get something for nothing this way either… lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes…

Fama’s reasoning is dead wrong–and embarrassing. Fama’s reasoning is dead wrong for an elementary reason. The accounting identity that savings are equal to investment is true only under a particular definition of investment–one that counts unwanted growth in inventories as part of investment–and under a particular valuation of unexpected inventory accumulation–that which values unwanted inventory accumulation at its cost.

In general, the value of unwanted inventory accumulation can’t be equal to its cost–the inventory accumulation is unwanted and unexpected, meaning that they tried to sell it at a normal price and failed, and it is now sitting in a corner of a warehouse somewhere. …

Moreover, unwanted inventory accumulation and decumulation today affects incomes and savings next week. Let’s tell a story. Suppose that it is Friday, January 2, 2009, and all of a sudden the federal government borrows some money–reducing savings–and buys some extra stuff. Savings is still equal to investment on January 2: savings went down because the government ran a bigger deficit but investment also went down because firms sold extra and so their inventories dropped.

What happens on Monday, January 5? Over the weekend the firms mark the value of the goods in their remaining inventory up: inventories are now scarce. They revisit their production plans. Sunday night they call some extra workers and tell them to show up on Monday–that they are expanding production because they are now short of inventories. So when Monday rolls around more people are at work. Thus incomes are higher on Monday than they were on Friday. And in all likelihood savings will be higher as well, for consumers on Monday probably won’t raise their consumption spending by as much as their incomes rose. Maybe on Monday purchases will be back in balance with production, and there will be no more unwanted inventory changes. Maybe it will take until Monday January 12 before the change in inventories is back to its desired level. Maybe it will take until … 2010. But when the change in inventories does come back to its wanted level, production, employment, income, savings, and investment will all be higher than they were on January 1: the stimulus will have worked. Yet every single day savings are equal to investment according to the accounting conventions of the National Income and Product Accounts. Fama’s conclusion–that stimulus programs cannot work–has nothing at all to do with his premise–that savings always equals investment in the NIPA framework. …

Fama does not know enough national income accounting to know that that is what he is assuming. He does not understand the identity he deploys as equation (1). He thinks that “investment” means “growth in the value of the capital stock.” He simply does not understand what the NIPA investment concept is, or that what he thinks of as “investment” is not in general equal to savings.

All of this is part of the undergraduate sophomore economics curriculum. It is gone over again very quickly in graduate school–for example, David Romer (2006), Advanced Macroeconomics 3e, p. 224:

If one treats goods that a firm produces and then holds as inventories as purchased by the firm, then all output is purchased by someone. Thus actual expenditure equals the economy’s output, Y. In equilibrium, planned and actual expenditure must be equal. If planned expenditure falls short of actual expenditure, for example, firms are accumulating unwanted inventories; they will respond by cutting their production…

These mistakes are, literally, elementary ones. They were elementary when R.G. Hawtrey and the other staffers of the British Treasury made them in the 1920s. They carry the implication not just that government cannot stimulate or depress the economy, but that no set of private investment or savings decisions can stimulate or depress the economy either, and thus that there can be no business cycle fluctuations from any source whatsoever–because every action that shifts savings or investment simply moves resources from one use to another.

What is extraordinary is that these mistakes are being rederived today, at the end of the 2000s, without any consciousness of their past or of the refutations of them.

I think it is time to draw a line in the sand.

I, the ghost of Montagu Norman, have risen from my grave to do so.

I hereby warn all awards committees of all prizes whatsoever that a minimum, a minimum requirement for awarding any prize in economic science to anybody whatseover is that they know enough national income accounting to understand that the savings-investment identity is an accounting identity, not a behavioral relationship: the fact that this equation is always satisfied by definition has no implications for what the impacts of various changes in government policy are.

Jeebus save us…

Update: Two follow-up posts: Fama’s Fallacy: Predecessors and Fama’s Fallacy, Take III.

Originally published at the Economist’s View reproduced here with the author’s permission.

4 Responses to "“A Line in the Sand”"

  1. Brian Shriver   January 15, 2009 at 1:36 pm

    This savings = investment “identity” is really crap. For one thing, it leads to goofy conclusions like: since net exports = savings – investment, our trade deficit is caused by inadequate savings (ignoring for example the more immediate impact of the forex rate).More important, savings = investment conflates three fundamentally independent processes. First nodes in the economy may have surpluses or deficits, with the constraint that in aggregate surpluses equal zero. Second, some of those surpluses are forwarded via primary flows to borrowers. A portion of this flow is used to support investment, but other portions (as recent history makes obvious) are used to support deficit spending and leveraged investment. Finally, some firms actually do depend on borrowing to finance investment, but much of it is financed out of profits.I suppose you could assume savings = investment and/or define your terms so that they must equal, but that’s the problem with modern macro in a nutshell – overly and arbitrarily stylized models with little concern for descriptive realism.