Monday, October 27, 2014

Ideology, theory and investment

Krugman is basically correct in today's New York Times to argue that investment is low because of ideology. In his words, the "inability to invest doesn’t reflect something wrong with 'Washington'; it reflects the destructive ideology that has taken over the Republican Party", which ultimately is based on "an overwhelming hostility to government spending of any kind." And he is also correct that the solution would be the "obvious policy response to this situation: public investment."

The graph below shows Gross Capital Formation (investment) as a share of GDP. It is at a low level indeed. And the recovery since the Great Recession has been moderate at best.
Krugman in his post seems to suggest that, since "America has been awash in savings" and there is a "mismatch between desired saving and the willingness to invest", then this is what "has kept the economy depressed." Notice that this diagnostic would be perfectly compatible with the confidence fairy that he argues always against. If the government didn't cause investors to be unwilling to invest, everything would be okay, or so the argument would go (remember that Krugman likes his fairies too; in his argument the Fed has to increase the expectations of future inflation and that would lead to investment), since savings are large enough to finance investment.

Note that, as discussed several times in this blog, investment basically responds to income growth (in all fairness sometimes Krugman remembers this, and his column today says correctly that "Corporations are earning huge profits, but are reluctant to invest in the face of weak consumer demand"). The accelerator works. So investment is low because the recovery is weak. That's why government spending is the solution. Because the Federal government can inject autonomous spending. That also means that savings is the endogenous variable (autonomous spending, which includes public investment, determines income, and the part not consumed of income would be saved).

It is important to get this right to avoid the confidence fairy argument. Not just ideology has been a problem, but also the reluctance of reasonable mainstream economists to part with the neoclassical theory of investment, in which the latter depends on its productivity and, hence, its remuneration (or expected remuneration). In this sense, as I have said before, Krugman's arguments would be more coherent, and stronger from the point of view of evidence, if he parted with neoclassical theory. On the ideology front he is fine, he knows that sometimes government is the solution.


  1. How to measure the size of the confidence fairy: the area between the two curves in Figure 5 here:

  2. Adam Smith used the expression "there is much ruin..." he stated that profits are highest when a nation is going fast to ruin and that wages are the cause and reason for the prosperity of a nation.


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