Real problems, nominal solutions?


Two of my favourite macroeconomists online are Scott Sumner and Arnold Kling. Both have blogged about the OECD's chief economist's statement that the UK should slow the rate of government cuts if growth doesn't pick up soon. Sumner, who wrote a report for us earlier this year on The Case for NGDP Targeting (PDF), says this idea is:

Pain without purpose. Let’s make the UK budget deficit even larger, imposing crushing future tax obligations on an already over-taxed economy, and do so in a way that is assured of having absolutely no positive impact on growth. That’s conventional macroeconomics circa 2011. . . .

. . . it is still quite revealing that a prominent macroeconomist thought the solution to a growth slowdown is more government spending, rather than slowing the expected pace of monetary tightening.

Arnold Kling says that most British economics commentators are practicing "folk economics":

In textbook macroeconomics, aggregate demand is aggregate demand. It does not matter whether nominal GDP goes up because of monetary expansion or fiscal expansion.

Sumner points out that in the UK they are experiencing inflation without real GDP growth. According to textbook macroeconomics, that means that there is a problem with aggregate supply, not with aggregate demand. Instead, commentators are willing to blame the inflation on loose money while blaming the low real GDP growth on fiscal austerity. My guess is that very few textbook authors will bother to correct the commentators, because the textbook authors are hostile to the conservative government in the UK. . . .

Folk macroeconomics consists of spending and an aggregate production function. When the government spends more, output goes up, and employment goes up. End of story. Money is just voodoo. Oh, the central bank can jigger interest rates, but that does not really do anything. [Emphasis mine.]

Most economic critiques of government cuts (see Ed Balls' "too far, too fast" claim) argue that the cuts will hurt aggregate demand. But, as Sumner points out, these criticisms miss the other part of aggregate demand – money supply. If cutting government expenditure hurts demand, then increase the money supply to maintain nominal GDP.

As both Sumner and Kling argue, criticising the government cuts is silly from the textbook macro view. Any loss in demand from government cuts can be offset by a monetary expansion. Textbook macro isn't a perspective that I subscribe to, but it's fairly standard and surely what Balls and other critics of the cuts are basing their arguments on.