This is a *demand side* argument in favor of Fama’s claim that deficit spending crowds out private spending one for one.
My earlier effort was to argue that the aggregate supply curve can be vertical (real aggregate supply is not affected by nominal aggregate dmeand) even when there is involuntary unemployment. I think I get bonus points for appealing to Stiglitz in defence of Fama, but now I want to go alllll the way.
So I will assume that the aggregate supply curve is horizontal (increased demand causes increased supply and has no effect on the price level).
Now it is clear that we have, at least, a communication problem here. Fama does finance not macro and no one can argue that he used standard Macro notation in all of his blog posts. In his first post [link needed] he presented an argument using the symbols S and I. He treated S as a state variable. In standard notation S is a flow variable — disposable income minus consumption. It is, therefore, not predetermined. It can jump. Depending on when you consider people to have earned income it is either very very high at 2 am or very very low on weekends.
Ooops. Now Brad DeLong had a theory that the problem was I and that Fama didn’t know that unsold goods count in I as inventory investment. Most people thought Fama was confusing S with the accumulated wealth (confusingly called savings leading to a standard warning in all introductory undergraduate macro texts which I have read).
Then a commenter at Brad’s blog [link needed (first comment or search for pedro)] came up with another theory. Fama wasn’t talking about S he was talking about M. He was asserting that the velocity of money is constant. Indeed, Fama’s follow up post definitely referred to a stock (“the same funds”) and might be interpreted as a reference to M1, M2 or something. So maybe Fama thought that velocity — the ratio of nominal GNP to the money stock — is constant.
The problem is that we have data on money and that ratio is not constant. It pretended to be a constant (really a predictable declining exponential trend) until Milton Friedman won the Nobel Prize (for unrelated work) then it began changing unpredictably. It is currently falling like a stone. Asserting that monetary velocity is constant is admitting that one hasn’t read or hasn’t understood a Newspaper at least since the crisis began.
Now I think only two kinds of people are interested in these issues 1) people who enjoy the humiliation and suffering of others and want to see Fama and his disciples squirm and 2) gluttons for punishment. I say enough with S&M.
The point is that Fama did not specify what stock he was talking about when he wrote “the same funds”. Money is not the only nominal stock in the economy. In fact, it has been argued that the quantity with stable velocity (just means a stable ratio between it and nominal GNP) is not money but “Total Credit.” Now that has declined for sure. It is not blindingly obvious how government spending would cause it to increase. If the velocity of total credit is constant, then there will be crowding out. No one has proven, in response to Fama, that this ratio (nominal GNP)/(total credit) is not constant. Nor has anyone explained why it should depend on safe short term nominal interest rates (most credit is for sure not safe these days).
Now the best part. The author of the total credit theory is Friedman, not Milton, Benjamin Friedman. He is the saltiest of salt water economists. I think that he and he alone is the focus of the most intense disdain of the fresh water school (what’s in a name and think about what you think of Robert Samuelson).
Oh what joy it was to use Stiglitz to defend Fama, but to appeal to Benjamin Friedman to heal the self inflicted wounds of the Chicago school is very heaven.