Paul Krugman is trying to get us to understand that depression economics is different from the economics of good times, that "normal rules don't apply."

Let me try to illustrate this point by looking at some objections to depression economics policy measures, in particular two recent objections to fiscal policy.

Tyler Cowen says that when it comes to fiscal policy, new research shows that deficit financed tax cuts are far more powerful than increased government spending at stimulating the economy.

But when I read the paper, I didn't think the results applied to depression economies because of the following sentence:

Furthermore, we find that deficit spending weakly stimulates the economy, that it crowds out private investment...

As I'll explain below, it's the claim of crowding out that raised red flags for me.

At Environmental Economics, John Whitehead has a series of posts on "Green jobs are bogus":

Environmental policy can change the mix of jobs but not the overall number of jobs. ... Green government fiscal policy doesn't create jobs in the long run.

That may or may not be true, but it misses the essential point. Green fiscal policy may not have any impact in the long-run, but we are concerned with stabilization, not growth, and it may very well create jobs and stabilize the economy in the short-run. As for the long-run, more on that below, but it's possible for there to be long-run effects on jobs as well. The claim is that there is no empirical evidence to justify the assertion that environmental policy can create jobs in the long-run, but I don't think the empirical evidence necessarily says much about the current situation - again, more on that below.

Let me explain through an example why I don't think these objections do not apply to depression economies.

Imagine a town with a widget factory that provides employment for workers in the town. There is full employment so that everyone who wants a job at the going rate of compensation has one, save for the unavoidable frictional unemployment as people voluntarily change occupations, move, etc.

The town also has infrastructure needs, in particular there is a bridge that is essential to commerce that can no longer support the weight of loaded trucks, and this is forcing trucks headed to and from market to take a much longer, much more expensive route.

If the government tries to build a new bridge or fix the old one, and there is full employment, it will be forced to bid those resources away from other uses. There is no labor or other resources sitting around idle waiting for something to do, so if the government wants to employ the labor, raw materials, and equipment to repair the bridge, it will have to bid these resources away from other uses. A crane working on the bridge cannot be building a new factory at the same time, labor to build the bridge must be bid away from the widget factory, and so on. In such a case, we will see substantial crowding out. That crane on the government bridge project could and would have been used on a private investment project, the labor building the bridge would have made more widgets, and the raw materials would have been used in the production of other private goods.

 It is correct to say that government spending crowds out private investment in this case, and that all government spending can do is change the mix of jobs, it can't change the number. In the example above labor moved from widgets to bridges, but there was no change in the overall quantity of labor.

But let's change the situation. Suppose that for some reason - maybe a housing bubble leads to the collapse of the financial system - a recession hits and the demand for widgets falls nationally. Because of this, a large number of workers are laid off. They would work at pretty much any wage, and they have looked and looked, but there's nothing available for them.

In this case, government spending does not crowd out private investment, and it creates jobs, it doesn't just change the mix. Let's suppose, to make it easy, that the the number of laid off workers is just the number needed to build a new bridge (if not, then adjust the list of projects and add more or less until there is a match).

When the government steps in and hires workers to build the bridge, it doesn't take the workers away from other employment. This is a recession, firms aren't building new factories, new buildings aren't needed, or not needed to the same degree as at full employment, and there are cranes sitting in the yard waiting for something to do. Resources, like labor are no longer fully employed, and putting them to work does not mean having less of something else. In depression economies - when there are idle resources that are involuntarily unemployed - crowding out is not the problem.

Notice that there's another benefit here too. The bridge workers who formally had no income are now being paid, and when they use that income to buy widgets, the widget factory suddenly perks up, and it can hire more workers (who buy more widgets, etc., and this could lead to more private sector investment and higher future growth, though I wouldn't expect the investment effect to be large).

When we talk about crowding out, we mean that government spending, by using the crane, labor, etc., to build the bridge, displaces private investment. If we believe that private investment is more productive than government investment (which isn't completely clear for a bridge if the bridge is essential infrastructure), then future growth will be lower because of the lower level of private sector investment.

But in depression economies, things are different. The choice is not between a new bridge and a new factory, the choice is between a bridge and no bridge (you could try to induce the private sector to build a factory through tax incentives or other means, but good luck with that in a depression).

And here's the thing. If we build the bridge, growth will be higher, not lower in the future (returning to the point above about green jobs, this could just as easily be investments in energy infrastructure, etc.). With the new bridge in place, loaded trucks can use it again so that instead on only being able to make, say, 6 trips to market per day per truck using the long route around the bridge, the producer on the other side of the river can make 10 trips to market - they are no longer limited and production is higher, employment is higher, etc. So I don't necessarily agree that there is no long-run effect on employment. The important thing, though, is to stabilize the economy in the short-run and that happens even if there is no long-run benefit from the bridge (this would happen if, when the economy recovers again, workers move back from the bridge to the widget factory, but there are no new jobs on net overall).

Both of the objections above cite empirical evidence in support of their claims. Free Exchange deals with this objection, but let me add a bit more. We have very little U.S. historical data for time periods when the economy is in a depression, so we don't know a lot about the effectiveness of policy in this framework. It's hard to find decent data about the economy prior to 1947 (and make that 1959 for data on money), and we haven't had that many recessions in that time period. And more importantly, we haven't had the deep kind of recession that depression economics is intended to address. When most of your data (half in any case) is from good times, it is not surprising that the empirical evidence finds that crowding out is an important consideration. If we had lots of episodes like the current one to look at, then I would have more confidence in these results, but we don't. Parameters such as the responsiveness of investment and money demand to changes in the interest rate, the marginal propensity to save, etc., can all change drastically in deep recessions, and that means that the results from empirical investigations covering other time periods won't be very informative. I don't think we know much at all from the econometric evidence about the success of fiscal policy in deep downturns. We'll know more in the future because we'll be able to look back at this one, but for now policymakers are flying pretty blind. What we can examine is the experience of the Great Depression, and when you do, the case for fiscal policy is strong.

Let me end with a few comments about the choice between spending and tax cuts. Let's go back to our example where a national recession has caused workers to be unemployed. But this time, instead of hiring the workers to build a bridge, let's give a tax cut, perhaps a payroll tax cut, or a tax cut of some other type.

How will this help the unemployed workers? Assuming the extra income is not saved, or used to pay off debt, it will be spent to buy widgets. Then, the widget maker, seeing the increase in demand, will hire the workers back to the widget factory. So, if this works, you get more widgets instead of a new bridge. (But this may not be what you want if consumption has been to high and must be ratcheted down to a new level as part of the long-run adjustment process. This is part of what Robert Reich is worried about, Krugman too.)

Thus, if everything goes right, the tax cut will trickle down to the unemployed workers, but they aren't helped directly by, say, a payroll tax cut. This doesn't have to be the case, it would be possible to target a tax rebate or other program directly at the unemployed workers, but the point is that many tax proposals rely upon the hope that first, the money will be spent instead of saved, and that second, it will then trickle down to help the unemployed. These policies might work, but if we do pursue tax instead of government spending options, my preference would be to target the transfer payments directly at the unemployed workers. More generally, though, I prefer simply putting them to work directly through fiscal policy rather than hoping they'll find employment through a tax cut, even more so when there are high value infrastructure projects that can be used to provide the employment.