A Keynesian Free Lunch?

In the newly-revised edition of his book The Return of Depression Economics, Paul Krugman writes that

The quintessential economic sentence is supposed to be “There is no free lunch”; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch … because there are unemployed resources that could be put to work.

Is there a Keynesian free lunch with respect to government revenues? The idea is that heavy government expenditures and/or large temporary tax cuts will increase demand and thereby invigorate the economy. This will produce larger tax revenues several years down the road than would otherwise have been the case, helping to offset the deficits incurred now.

This seems plausible. But it sounds suspiciously similar to the claim made by “supply-side economics” advocates: a reduction in tax rates will increase investment and hence growth and thus government revenues, offsetting the short-run loss in revenues due to the tax cut. If you don’t buy the supply-side free lunch claim, and relatively few serious analysts do these days, why should you believe its Keynesian counterpart?

One distinction lies in the hypothesized magnitude of the effect. The Keynesian version I’ve seen suggests that a large government deficit will be partially recouped by the resultant spur to economic growth, whereas the supply-side claim tended to be that the revenue loss from a tax cut would be fully or more-than-fully offset.

Another difference lies in attention to context. If the current tax rate is high enough that it really does impede investment, the supply-side free lunch exists: reducing the tax rate will yield little or no loss in government revenues. Put another way, the so-called “Laffer curve” is a reasonable depiction of reality. But its proper application requires asking where the current tax rate lies on the curve — whether, in other words, the current tax rate actually is impeding investment. Few supply-siders bothered to take this question seriously, and the notion became a blanket rationale for continued tax cuts. The experience of the past several decades has not been kind to the claim (see here and here).

As best I can tell, few contemporary believers in a Keynesian free lunch view it as context-independent. The hypothesis is that in conditions of a significant shortfall in demand and limited potential for further help from monetary policy, such as our present situation, an increase in the current government deficit is likely to stimulate enough growth to partly offset the cost.

8 thoughts on “A Keynesian Free Lunch?

  1. Keynesian free lunch is free in theory. In practice, government has to find those underutilized resources to spur demand for them and it has do so in time for it to have an impact (i.e. before those resources reallocate themselves in the usual, but painful, process of creative destruction). Not to mention the political system has to work fast enough to authorize Keynesian spending in the first place.

  2. Regarding the supply-side claim to a free lunch, Austan Goolsbee pretty thoroughly debunked that line quite a while ago (http://faculty.chicagogsb.edu/austan.goolsbee/research/laf.pdf). To quote from his conclusion:

    “The notion that governments could raise more money by cutting rates is, indeed, a glorious idea. It would permit a Pareto improvement of the most enjoyable kind. Unfortunately for all of us, the data from the historical record suggest that it is unlikely to be true at anything like today’s marginal tax rates. It seems that, for now at least, we will have to keep paying for our tax cuts the old fashioned way.”

  3. I think you’re leaving out the potential productivity boost of Keynsian deficit spending. Lots of the spending in the new stimulus bill is designed to both increase demand and productivity. Infrastructure improvements are a good example. They create jobs which gives people more money to spend while eliminating things like supply bottle necks or traffic jams or other kinds of limits on productivity. In fact there’s a parallel argument in supply-side theory- that tax cuts will lead to investment, which will enhance productivity and then create jobs and demand.

    I also think there’s an argument to be made that the economy runs a demand deficit more often than people think, and that it’s not just during depressions or recessions. In the 40s, 50s, and 60s it was basically conventional wisdom among mainstream liberals that government had to keep spending more to prevent recessions and promote growth.

  4. quick follow up- i meant that productivity improvements can be a free lunch too- that essentially they’re an investment that will produce larger tax revenues down the road.

  5. I don’t agree with Lane’s claim that Keynsian deficits are “suspiciously similar” to the “supply side economists’”claim that tax cuts stimulate the economy. The two are quite different.

    The text book explanation of deficits is that they are an injection into an economy (or a net increase in aggregate demand). I.e. deficits work for much the same reason as increased demand for a country’s products would raise demand in the country concerned.

    In contrast, the supply side argument, as I understand it, is that reducing personal taxation, particularly on the rich or on entrepreneurs, gives everyone (particularly entrepreneurs) added incentive to create jobs, produce more, seek out orders, sell more etc etc. A “supply sider” would argue that a personal tax reduction would work even if aggregate demand is initially not affected (e.g. if the reduced personal taxation were matched by reduced government spending).

  6. I wonder when economics will add up to logical math. Spending money to stimulate the economy, what a horrible concept if one spends poorly. There is no free lunch here. I am dumbfounded by the notion that all one has to do is out think 300Million people and the economy is better off. Sorry the data over time does not support that. Try some Austrian economics for a change.

  7. Terry G: No one claims that the road to riches consists simply of printing bits of paper with “$100” inscribed on them. At the same time, economies need a money supply. It is a reasonable assumption that this supply will need to expand in line with the expansion of the economy in real terms.

    Moreover, if households decide to hoard the bits of paper (i.e. deleverage) rather than spend them, the fact is that this means unemployment.

    This is not to deny that Austrians have a point, i.e. that without a money supply expansion the economy will in the long run self correct. But I suspect Keynes was right when he said that “in the long run we are all dead”. Nor is this to deny that there are risks in a money supply expansion: the risk is that governments and central banks are so incompetent that they will fail to take anti-inflationary measures when the expanded money supply begins to stoke inflation.

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