Abstract
It is argued, first, that fiscal policy was not a neglected and indifferent topic for new classicals, and, second, that their sceptical attitude towards monetary policy was not projected directly upon fiscal policy. By analyzing permanent income hypothesis specified both on adaptive and rational expectations and, then, the Barro–Ricardian equivalence theorem, the crucial assumptions supporting the ineffectiveness of fiscal policy are identified. We come to the point that ineffectiveness of fiscal policy can be considered valid only by presupposing some strong and implausible assumptions. It is argued as well that new classicals did not stress the ineffectiveness of fiscal (and also monetary) policy, but identified precisely the conditions under which economic policy strikes a snag. Starting from the Barro-Ricardian equivalence, the theory of non-Keynesian effects is also reviewed arguing for the fact that new classical macroeconomics put an emphasis on fiscal reforms by which it can be possible for governments to get back the effectiveness of countercyclical policy and to control the economy not only by unanticipated operations. To some extent it is clarified that new classical macroeconomics got considerably close to the theory of Keynes sometimes.
The trouble with the world is that the stupid are cocksure and the intelligent are full of doubt.
(Bertrand Russel)
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- 1.
The different distributions of the same level of employment across sectors may lead to different levels of real national income, so a direct functional relation between employment and real national income should be accepted only as a first and rough approximation (Keynes 1936).
- 2.
Keynes (1936) divided these explanatory variables into objective and subjective factors, assuming the latter to be unchanging (i.e. given).
- 3.
As marginal propensity to consume is a function of income, it follows eventually that average and marginal propensities do not coincide. We expect it to be the general case that average propensity exceeds marginal propensity to consume (cf. Houthakker 1958).
- 4.
The scepticism shown by Keynes regarding the efficiency of monetary policy instruments is not independent of this statement.
- 5.
It is not a mistake to identify the concept of the “consumer unit” mentioned by Friedman with “household”, the extent of which ranges from households consisting of only one member to multi-nuclear households. The definition of household perfectly suits our purposes since it means a social group sharing accommodation and cost of living, consuming together (cf. Andorka 1997; Giddens 1993).
- 6.
At this point, Friedman cited a book by Irving Fisher and another by Kenneth E. Boulding. Fisher laid the foundations of the theory specified for two periods about half a century before Friedman the essence of which is that incomes available for the different periods can be modified through borrowing and lending (Fisher 1982). By the way, Boulding, in his explication, also refers to Fisher (Boulding 1966). This analysis entered microeconomics as “intertemporal utility maximization” (or “intertemporal choice”) (Varian 1999; Kopányi 2003).
- 7.
When studying the mechanisms and effects of automatic fiscal stabilizers (Sect. 5.7), we will see that transitory income does not need to be factor income, it may also come from government transfers.
- 8.
In lack of complete certainty, permanent income should be interpreted as the expected value of a probability distribution, of course.
- 9.
The rate of time preference determines the rate of interest a consumer unit applies to calculate the present value of future utilities.
- 10.
Bird and Bodkin (1965) also stress that the conclusions Friedman drew require the assumption of complete certainty.
- 11.
In other words, actually non-observable permanent income is described on the basis of lagged, actually observed incomes (cf. Bilson 1980).
- 12.
At this point, Gallaway and Smith (1961) raise the possibility of introducing the real balance effect into PIH. As the real balance effect implies, the money stock held by agents is evaluated (in real terms) by the price level (this is real balance itself) and it is true that aggregate consumption is not independent of the price level (a drop in the price level enhances consumption through increasing real balances). Through elaborating the theoretical conception, Arthur Cecil Pigou tried to respond to Keynes’ suggestions according to which a macroeconomic system may get into equilibrium state before full employment is reached, saying that the mechanism of real balances can (and should) be regarded as an automatism directing the system towards full employment. Gallaway and Smith argue that if the value of certain financial assets increases due to a drop in the general price level, this development will affect the ratio between non-human wealth and income, and, eventually, real balance effect can exert influence on permanent income, and hence on consumption. If this change proves to be long-lasting (and, on this ground, agents following the adaptive scheme expect it to survive in the long run), then (planned) expenditures also increase. However, empirical results showed this effect to be only of moderated importance.
- 13.
It has to be mentioned here that (though the initiative was raised by REH) the literature of PIH consists mainly of empirical tests through which authors try to verify or falsify this theory in statistical terms. Among them, the efforts of Chulsoo Kim are very remarkable, putting his emphasis on theoretical-economic significance of PIH rather than on statistical significance. His analysis was aimed at the question of how and to what extent U.S. consumption data deviate from the path predicted by PIH. Although deviations seem to be significant enough for the statistical tests to reject the theory (since a statistical rejection could equally stem from measurement errors or from some simplifying presumptions), Kim infers that PIH still offers the best approximations of data among the alternative theories (cf. Kim 1996).
- 14.
Random numbers are used.
- 15.
Since an infinite lag structure is assumed in which the sum of weights is unity.
- 16.
It is a common practice in the empirical literature to apply the Koyck distributed lag scheme to estimate permanent income, though Friedman (1957) suggested the method of Philip Cagan. In algebraic terms, the Koyck-model is a discrete period analogue of the Cagan-lag (Singh and Drost 1971). However, literature sometimes calls our attention to the fact that applying the Koyck-model to PIH violates some of its assumptions of crucial importance. As it was stressed above, the nature of the relation (correlation) between permanent and transitory components of income and consumption is not ignorable in conceptual terms, however, these required independencies cannot be held when using a Koyck-lag. It has importance with regard to the acceptability of PIH, since the statistical tests built on the Koyck-lag scheme are likely to refuse PIH (cf. Singh and Ullah 1976; Holmes 1970, 1971).
- 17.
On the methodological difficulties related to these stipulations see Bowden 1973.
- 18.
The theory of Holbrook and Stafford (1971) has the same roots: they hypothesized that different marginal propensities to consume out of incomes from various sources can be found.
- 19.
The literature sometimes explicitly stresses that PIH implicitly assumes consumer units to have such an ability (cf. e.g. Pistaferri 2001).
- 20.
The most bothering problem with PIH is that it refers to a macroeconomic variable that cannot be directly observed, as it has been already mentioned in Chap. 1. Consumption and income (or some categories of income) are evidently assumed to be correlated. It follows that it is only the path of consumption that can be compared with the dynamics predicted by the theory, and if a considerable (or, at least, a rough) consistency is observed, we infer the validity of the theory. So, because of the fact that permanent income as a variable is unobservable, researchers are (and were) forced to subject some of the implications drawn deductively to empirical tests. Such an implication is the random walk of consumption.
- 21.
Countercyclical economic policies have to be definitely symmetrical. It means that the cushioning of recessions and the cooling of overheating boosts are equally important goals. It is extraordinarily damaging if an economic policy precludes only contractions, intensifying growth only (for further details see Csaba 2008).
- 22.
In order to eliminate the effects of price changes, data measured in real terms (on a base year) are needed both in the case of actual and potential GDP.
- 23.
Over and above this notion, output gap can be interpreted in a non-ratio form as well, as a simple difference between actual and potential real GDP–though its applicability is limited in this way. The sign is still informative, though makes no comparison possible.
- 24.
This conceptual change is not independent of the concept chosen for potential output. If potential output is a trend around which actual production fluctuates (forming business cycles), potential GDP can be described well through various de-trending techniques. If, however, potential output is linked rather to the supply side, then potential GDP will be that level of production that emerges with optimal capacity utilization (labour force, productive capital, human resource). In this case, numerical estimates require a production function (for further details, see Benk et al. 2005). The difference between these two aspects illustrates well also the bottom-line of the difference between the methods of estimating the potential GDP.
- 25.
For a paramount summary see Carroll (2001). Carroll places Friedman’s seminal innovation (Friedman 1957) with a good sense in the context of the history of economic thought reaching even back to the 1950s. The author’s methodological-empirical efforts deserve our attention because he has a considerable turn for scrutinizing consumption theory with liquidity constraints through simulation techniques. Carroll approaches a traditional research area by using a new method that promises to deliver a great bulk of new insights–similarly to agent-based models.
- 26.
Since, for us, all the reviewed theories are descriptions of living mechanisms working under actual or assumed conditions–hence being completely relevant for theoretical analyses or statistic and econometric researches, and not to be taken as dead relics in the museum of the history of economic thought.
- 27.
Heller and Starr (1979) calls our attention to it because of the liquidity constraints (that is, the limitations of borrowing against future incomes), a tax-cut can trigger a boost in current consumption even if future tax obligations related to bond-financing are fully anticipated. After all, these limitations imply current consumption to be determined by currently available resources (cf. Hubbard and Judd 1986). So, we have to draw a distinction between wealth and liquidity: fiscal policy actions do not affect the former, while the latter definitely responds to tax-cuts. If households are not able to keep their consumption through borrowing on the optimal path, then their additional liquidity resulting from the tax-cut will be devoted to these purposes. Accordingly, current consumption still responds to tax-cuts, that is, the potential of fiscal policy to control aggregate demand is restored.
- 28.
Moreover, actually, it was the relationship between the changes in the policy the fiscal authority follows and the reactions of the real system that form the basis of supply side economics.
- 29.
Here, the relation between permanent income theory and the Ricardian equivalence becomes quite clear. In both cases, agents try to keep consumption at the optimal level (this path is not affected by the chosen fiscal policy mix), and the shifts in disposable income lead to fluctuations in savings. It does not seem to be an oversimplification to sum up the essence of both theories in this single sentence.
- 30.
This is the point where the literature calls our attention to the fact that analyses built on the Ricardian equivalence break with the conclusions of simulations carried out within the traditional IS-LM framework, since it is assumed in the story that the willingness to save and the supply of bonds move hand in hand–however, it follows that no crowding-out occurs, since the rate of interest (if, abandoning the genuine intention of Keynes, regarded as an equilibrium category standing under the influence of loan demand and supply of credit) remains unchanged even after the financial scheme is rearranged. So, if the Ricardian equivalence holds, we do not need to reckon with crowding-out (cf. Seater 1993).
- 31.
Seater (1993) demonstrates this effect with an example that is built on the two-period model of Samuelson (1958). According to it, if taxes that burden producers’ generation of period 1 are reduced, then the later tax increase required by the debt service of bonds compensating lost tax proceeds is going to burden another group of people, that is, the young of the next period. So, workers of period 1 can enhance consumption and they are not forced to provide a cover for later tax increases in advance.
- 32.
The authors claim that the distinction between the cases of only one or more beneficiaries is of high importance. In the former case, the threat may sound incredible (Bernheim et al. 1985), though the parent can run through his savings completely even under this circumstance, realizing the exclusion in this way.
- 33.
It has to be noted that Barro (1974, 1989) also investigated the case of children’s altruism but transfers in his models were always assumed to be non-reciprocal. Accordingly, offsetting future tax liabilities in case of an altruistic child is carried out through appropriate reductions in transfers the child devoted to his parents–however, two-way flows are missing.
- 34.
Feldstein (1988) suggested that an uncertainty about future incomes may discredit the Ricardian equivalence even if both altruism and an accordant bequest are assumed–consequently, present tax-cuts affect current consumption.
- 35.
It is worth stressing the distinction Seater (1993) draws between altruism and the intention of actual bequeathing. Accordingly, altruism maintains the Ricardian equivalence only if altruism is accompanied by the assignment and transference of bequest. However, this slight difference does not invalidate the foregoing comments on altruism–it is only needed (as done implicitly by the authors) to regard altruism as the synonym for the intention of actual bequeathing (the case of an operative bequest motive). However, Barro (1989) notes that altruism can manifest itself not only in bequests transferring at death; inter vivos transfers (e.g. education-related expenditures) are all capable of guaranteeing the Ricardian equivalence.
- 36.
For now, this comprehensive category designates both short-run fiscal consolidation (which is a simple correction actually) and structural reforms also taking long-term concerns into account. We will see, how important this distinction is, as far as real effects are concerned.
- 37.
The importance of quality considerations is also the part of the big picture in a sense that the deficit reduction strategy is far from being irrelevant in terms of efficiency: cutting expenditures back is far more promising than the enhancing of revenues.
- 38.
Later, in Chap. 6, we will return to supply-side explanations of these non-Keynesian effects with regard to the results of supply-side economics.
- 39.
On the ground of the vast literature cited, Afonso (2001) gives a great review of possible interpretations and explanations. For instance, he mentions that, over and above the dimension (size) and permanence of a fiscal correction, its composition is a further significant determinant of starting a non-Keynesian effect and that deficit-reducing fiscal actions focusing on expenditure-cuts promise to be more successful than tax increases. A drop in interest rates also follows from the lower levels of deficit, that, through the wealth effect (in addition to a transmission through the expectations channel), also leads to a rise in consumption expenditures (cf. Giavazzi et al. 1999).
- 40.
It should be added that aggregate demand may also respond to a structural reform along different mechanisms. Up to now, we have scrutinized the case in which the public perceives an initial tax-cut as a rise in permanent income due to a reform process ending up in qualitative changes (as well). However, it is also a possible scenario according to which demand may increase even without an initial tax-cut, if the structural reform triggers improvements in efficiency that turn market participants to expect the tax burden to drop permanently in the near future. In this case, structural reform itself becomes a stimulant of aggregate demand–though it is more urgent to stress that structural reforms are not necessitated by demand management purposes. These favourable demand-side consequences should be regarded as only beneficial by-products.
- 41.
There were conceptualizing efforts to extend the crowding out mechanism to cover not only the effects of budgetary expansions deteriorating private investments but the rivalry of government bonds with different risks in competing for resources, when low-risk papers crowd out high-risk counterparts (Kiss and Mák 2009).
- 42.
It means that though private investment programs may fall victims to a demand-enhancing intervention, but this negative effect may be overcompensated by the boost in real output driven by the fiscal action (cf. e.g. Kőrösi 2009). Of course, all these findings are dependent on the model framework or the structural parameters of a macro-economic system.
- 43.
Since, for instance, the fiscal policy playing-field is narrow and a successful fiscal expansion cannot be even imagined, or since the economy, due to the fiscal policy action, is likely to respond to higher rates of interest through a cut-back in private investments. As far as the final balance of effects is considered, the interest rate elasticity of private investments is of high importance, i.e. (staying within model frameworks) the shape of the investment function built on the rate of interest as an independent (explanatory) variable.
- 44.
Because of this purport, estimations of the structural balance bear a close relationship to measuring potential GDP and output gap. So, we always have a twofold problem: as a first step, we need to judge the cyclical position of the given macro-economic system then, as a second step, structural deficit is calculated on the grounds of data gained in the previous stage. These two phases are connected by those pieces of information that describe the dependency of budget revenues and expenditures on real economic performance.
- 45.
It is interesting that literature sometimes demands too much from the index of cyclically adjusted budget balance. For instance, Muller and Price (1984) argue that fiscal sustainability can also be properly measured on the grounds of the structural balance position, since cyclical correction can separate conjunctural effects from the consequences of discretionary fiscal policy measures. According to them, structural balance is a good indicator of aggregate demand management of fiscal policy as well. Over and above finding the right methodology, it is similarly important to phrase the adequate questions and to find the proper scope for the structural balance (for further considerations, see Blanchard 1990).
- 46.
Because of the close conceptual relationship to core inflation, literature occasionally refers to structural balance as “core deficit” (cf. e.g. Ize 1983).
- 47.
Keep the case of the Friedmanian Phillips curve in mind: agents operating within the adaptive scheme have no information on either the current state of the macroeconomic environment or economic policy responses.
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Galbács, P. (2015). Fiscal Policy and New Classical Macroeconomics. In: The Theory of New Classical Macroeconomics. Contributions to Economics. Springer, Cham. https://doi.org/10.1007/978-3-319-17578-2_5
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