BRUCE BARTLETT'S latest piece in the Fiscal Times reminds us that today's deficit problems are to a great extent the legacy of the Reagan and second Bush administration's "starve the beast" philosophy: the belief that if you cut taxes, spending will automatically come down. In fact, both administrations revved up spending at the same time they were cutting taxes, in the political equivalent of an overweight person who rewards himself with an extra helping of ice cream because he has just purchased a membership in a gym. And Kevin Drum adds the well-recognised point (on the left, at least) that this is precisely what we should expect:

[B]asic economic principles, of the kind that Republicans are endlessly lecturing the rest of us about, predict the same thing. If you raise taxes to pay for government programs, you're essentially making them expensive. Conversely, if you cut taxes, you're making government spending cheaper. So what does Econ 101 say happens when you reduce the price of something? Answer: demand for it goes up. Cutting taxes makes government spending less expensive for taxpayers, which makes them want more of it. And politicians, obliging creatures that they are, are eager to give the people what they want. Result: lots of spending and lots of deficits.

I think this is true, and both the current moment and the previous moment of deficit-cutting frenzy, in the early Clinton administration, suggest the public tends to develop an openness to tax hikes and spending cuts at the same time. (The hard right, of course, is different: it's never open to tax hikes, but that's another story.) But Mr Drum's way of looking at this (and my own) does contain a hidden assumption. The assumption is that when you raise taxes, people view it as making government spending "expensive", but that when you cut taxes, people don't look at the extra debt you've created, raise their expectations of future taxes needed to repay that debt plus interest, and consider government spending even more expensive. A lot of hard-money conservatives, however, believe that people act in the latter fashion. And this is the same reason why they've been arguing for the past year or two that government fiscal stimulus doesn't work.

The clearest expression of this thesis I've read was in a note written by John Cochrane entitled "Fiscal Stimulus RIP". I'm not an economist, and don't really have any authority to weigh in on a fundamental debate between the very small group of economists, including Mr Cochrane, who believe that fiscal stimulus has a multiplier of zero or less, and the much larger group of economists, including Martin Feldstein, Ben Bernanke, Paul Krugman, Simon Johnson, Christina Romer, John Hall, Martin Eichenbaum and so forth who disagree with this belief. But at this point you sort of have to have an opinion on this question in order to have an opinion on what's been happening in the American economy over the past two years, and on what political responses make sense. My basic opinion on this point is simply derived from the fact that all the economics I'd ever read presented the majoritarian view that fiscal stimulus has some effect. But having read the challenge presented by Mr Cochrane, I had to have some reaction. So here, for what it's worth, is my layman's explanation of why I found Mr Cochrane's challenge unconvincing, beyond the fact that most economists don't seem to agree with him.

Here's the crux of Mr Cochrane's argument:

[T]o borrow today, the government must raise taxes tomorrow to repay that debt. If we borrow $1 from A, but tell him his taxes will be $1 higher (with interest) tomorrow, he reduces spending exactly as if we had taxed him today! If we tell both A and B that C (“the rich”) will pay the taxes, C will spend $1 less today. Worse, C will work less hard, hire a bunch of lawyers, lobby for loopholes, or move to Switzerland. A will hire a lobbyist to get more stimulus. All this is wasted effort, so we're worse off than before! The question for the “multiplier” is not whether it is greater than one, it's how on earth it can be greater than zero? (Conversely, so far my arguments for the ineffectiveness of spending apply equally to tax cuts. But tax cuts can cut rates, which improves incentives.) These statements are a theorem not a theory. I'm explaining (in very simple terms) Robert Barro's (1974) famous “Ricardian Equivalence” theorem. “Theorem” means that if a bunch of assumptions, then borrowing has exactly the same effect as taxing. That doesn't mean it's true of the world, but it means that if you want to defend stimulus, you have to tell us which of the “ifs” you disagree with. That discipline changes everything. Thoughtful stimulus advocates respond. Well, maybe people don't notice future taxes. Does the man or woman on the street really understand that more spending today means more taxes tomorrow? That's an interesting position, but at this point, most of the battle is lost. Stimulus is no longer an “always and everywhere” law, it's at best a “if people don't notice that deficits today mean taxes tomorrow” idea. This qualification has deep implications. First, it means that a “stimulus” policy can only work by fooling people. Is wise policy really predicated on fooling people?

Anybody catch the key rhetorical confusion here? It should be familiar to anyone who saw the animated movie "Sinbad". Okay, here it is: if stimulus works, then the policy wasn't fooling people. If stimulus works because most people (though not John Cochrane) have no reason to believe it doesn't work, then most people were right and John Cochrane was wrong. This might be a tricksy way to justify an economic policy, except for the fact that our entire economy, like every economy dependent on fractional reserve banking, which is to say every modern economy in the world, is run on the basis of a series of similar confidence games. If everyone became more conscious of the fact that there isn't enough money in the bank to pay back all the depositors, then everyone might rush to the bank to take their money out, causing the bank to fail. Do we then say "banking can only work by fooling people. Is wise policy really predicated on fooling people?" Of course not. We get the government to backstop the banks, so the largest possible institution, the one with ultimate control over the money supply, can sustain the confidence needed to keep the incredibly productive system of capitalism running.

I'm not saying Mr Cochrane doesn't have an argument here. I'm just saying that his phrasing of his argument is a (possibly inadvertent) rhetorical sleight of hand. To phrase this in a more concrete fashion: unemployment is running over 9%. The argument of stimulus proponents is that if we borrow a few trillion dollars and spend it right now, there will be more demand for goods and services, some of those people who are now sitting around doing nothing will be put to work creating goods and services that otherwise wouldn't exist, that will result in a bigger, wealthier economy, this in turn will prompt businesses to begin investing on expectation of greater demand rather than sitting on piles of cash, and over the medium to long term we'll be able to pay down our debt faster than we would if we hadn't borrowed and spent the money, leaving all those people idle and poor. And all of this will happen unless people are so unwise as to listen to Mr Cochrane, have an anxiety attack and decide to save as much money as the government releases into the economy. But why should they do that?

This is now getting too long, but what becomes clear here is that Mr Cochrane's argument is predicated on ignoring the entire question of the preference for holding money. Again, if you're caught in a liquidity trap, then (the argument goes) the simple act of getting money flowing will decrease people's preference for holding money over their preference for purchasing goods. This results in more growth, which makes people's lives better in the short term and, if there's enough of it, makes it easier in the long term to pay off your debt. This pro-stimulus argument may be wrong, but it's not predicated on "fooling people".

To get back to Mr Drum's point about whether people view government spending as more "expensive" when they're being taxed for it than when the government is incurring debt to pay for it, I agree that people think it's more expensive when they're being taxed for it. The simplest way to ground that belief rests on the time value of money: I'll be able to do a lot with that money by the time the government gets around to taxing me for it in ten years, particularly if I'm unemployed right now. Mr Cochrane might argue that this is shortsighted, since the government will need to charge interest as well, to me or someone richer than me. But I think the average person would be right to put much more weight on $1 now, in the midst of hard economic times, than on $1.33 in 2020 (nominal, at current ten-year bond rates of 2.87%). Much of that increase will almost certainly be wiped out by inflation. The latest CBO estimate, which explicitly addresses the "general equilibrium" models Mr Cochrane subscribes to, discounts them because of the often unlikely assumptions they rest on; it finds the stimulus led to an economy between 1.4% and 4.1% larger in the third quarter of 2010.

Basically, I think people don't much reduce their spending based on assessments of how large a deficit the government is running, and whether that will mean higher or lower taxes in ten years. Moreover, I think they're right not to do so. Because who knows what the heck's going to be happening in ten years? It's perfectly reasonable to think that putting lots of idle people to work, at a moment of high unemployment, will more than pay for itself in the long term. So people base their views of the likelihood of tax hikes not on the uncertain expected economic effects of debt, but on their expectations of the predictable tax behaviour of government. If people see that the government generally raises taxes to pay for spending, they'll be hesitant about approving more spending. If people see that taxes always go down in recessions (2001) and recoveries (2003), they'll figure, what do I care how much the government spends? Maybe the private sector will somehow generate mind-boggling growth and it'll all get paid for somehow or other. And it didn't help that in the mid-2000s, the government was telling them exactly that.