Wednesday, February 11, 2009

More Keynesian Destruction Worship

Mark Thoma links to a New York Fed paper that argues that under a zero interest environment, tax cuts will have a contractionary effect. It is presented using the standard method that academic (neoclassical) economics uses to hide sloppy economic reasoning, which is to say the use of Greek letters and mathematical equations, but that won't work here because I am not impressed by that and instead translates it back to English so he won't be able to hide, and the assumptions behind these equations are essentially these:

-Tax cuts will boost aggregate supply.

-Higher aggregate supply will mean lower prices.

-Lower prices means that real interest rates will be increased (as nominal interest rates can't be cut below zero).

-Higher real interest rates will lower output.

There are several fallacies here: first of all, it overlooks how point number one will in itself mean a higher output. And it also appears to assume that tax cuts unlike spending increases do not affect demand. And finally, it falsely assumes that an increase in real interest rates caused by higher supply will have a negative effect on output, which is not true for reasons that I elaborated upon here.

The absurdity of his argument can be illustrated by using a Bastiat-style reductio ad absurdum: If it were really true that reducing aggregate supply is good, why not then bomb Silicon Valley into dust (preferably using large quantities of conventional bombs rather than nukes to avoid radiation) after having evacuated everyone working and living there first, and then have the federal government compensate all asset owners and workers fully for any losses with newly printed money. That would leave aggregate demand unaffected, while reducing aggregate supply, and so boost inflation and so lower real interest rates and so according to the Keynesian model boost output!

Absurd idea? Indeed it is, but I don't think there's anything in those Keynesian models used by the New York Fed that could really be used to argue against this plan, so what this illustrates is the absurdity of those models.


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