Kudlow Fails to Grasp the Keynes-Ramsey Rule

I voted earlier today after waiting through a fairly long line of what appeared to be enthusiastic Los Angeles neighbors. It was easy to pick which Presidential candidate to vote for as whether national security or economic issues received the higher weight for me, my view is that Kerry would be better than Bush on either big issue. If you have not voted, do so and make your own best judgment.

But now, it’s time to get back to the strange writings of the National Review’s “economic editor”, Lawrence Kudlow, whose Stock Market Tea Leaves is subtitled “The latest indicators say the call is for Bush”. His “evidence” that a mere 1.5% increase in the stock market is a sign that Bush will be declared the winner after today was ably rebutted by Brad DeLong.

Kudlow had a second purpose in mind for this oped:

Kerry, on the other hand, proposes to raise taxes on capital formation and he opposes tax-free savings accounts. He believes the economy is weak because Americans don’t consume enough. A recent paper by University of Chicago economist Casey B. Mulligan strongly disputes this obsession with consumer spending. Prof. Mulligan argues that less taxation of saving and investment capital will actually spur consumer spending over time…It is highly doubtful that your average investor-class member has read Mulligan’s paper. But it is also likely that investors intuitively understand that you can’t have income-producing jobs without a healthy business, and that the nation will not produce strong businesses by taxing the very seed corn those businesses require. Investors may well know what John Kerry doesn’t – that you can’t have capitalism without capital.

It is odd that Kudlow failed to tell us which one of Mulligan’s papers he refers to but I suspect he meant What Do Aggregate Consumption Euler Equations Tell Us About the Capital Burden. The abstract notes:

Aggregate consumption Euler equations fit financial asset return data poorly. But they fit the return on the capital stock well, which leads us to three empirical findings relating to the capital income tax burden. First, capital taxation drives a wedge between consumption growth and the expected pre-tax capital return. Second, capital taxation is the major distortion in the capital market, in the sense that most of the medium and long run deviations between expected consumption growth and the expected pre-tax capital return are associated with capital taxation. Third, consumption growth appears to be pretty elastic to the after-tax capital return (i.e., capital is elastically supplied), even while it appears inelastic to returns on various financial assets. Capital income taxes are passed on through reduced capital accumulation, or higher markups, or some combination.

The Keynes-Ramsey Rule for optimal savings has as its objective function the maximization of consumption per capita in the steady state. Economists have long recognized that taxation of capital would to a lower steady state level of consumption per capita, so Mulligan’s paper seems to be treading on similar grounds. While Kudlow may have read Mulligan’s paper, did he really understand its significance in the fiscal policy debate?

First of all, he misrepresents what Kerry’s fiscal plan seems to be but then when has he been honest about Kerry’s economic plan? But secondly, Kudlow is forever confused between the role of fiscal policy and long-term growth, which is what Ramsey and Keynes were discussing in the late 1920’s versus the role of aggregate demand and maintaining full employment in the short-run, which was the subject of the Keynes’s General Theory a few years later. Note his own expression “spur consumer spending over time” as an illustration. The goal of aggregate demand policy now should be to increase some form of spending now. Most economists accept the classical premise that economies eventually get back to full employment. And all economists recognize the need for more savings (not less) in order to generate investment for long-term growth, which is really how lower tax rates on capital are supposed to generate the Ramsey-Solow growth effects. Yet, Kudlow’s brand of free-lunch economics does not get the fact that “giving people their money back” along with more government spending (Bush’s fiscal policy) results in less savings and investment not more. As such, a policy of fiscal stimulus over the long-run lowers economic growth.

Of course, anyone who actually understood modern macroeconomics would grasp this distinction between the short-run aggregate demand considerations of Keynes’s General Theory and the long-run Solow-like consideration embodied in the Keynes-Ramsey rule. Since the economics editor of the National Review has yet to grasp this crucial distinction, might I suggest this piece from Josesph Stiglitz. Or maybe the National Review should simply have its economic editor finally learn Econ 101 before the next time he so embarrasses himself.