Scott Sumner and Paul Krugman have been going back and forth about fiscal multipliers, in a debate with many other participants. (Here are the first post and the latest post by Sumner on the issue.) For those of you who have not followed the debate, the fiscal multiplier is the change in output resulting from an additional dollar of government spending. If the multiplier is greater than one, $1 of additional government spending results in more than $1 of output.
What has been missing from the debate is the concept of the structure of production. Resources, including human abilities, are not just a homogeneous lump. They have a structure: some are less scarce than others, some are easier to switch to new purposes than others, some require less know-how to work with than others. The idea of a fiscal multiplier from spending makes me uneasy because it is basically a supposed case of something for nothing: the government, which almost everywhere in the world cannot even deliver the mail at a profit, steps in to fix a situation that the private sector cannot. How does it happen? The answer has to be that somehow the government is able to put resources to a higher-valued use than the private sector can. Given the specificity of resources and the knowledge that must be applied to use them efficiently, it is hard to imagine how such a thing can happen unless resources are so abundant that is little risk from wasting them.
An early critic of John Maynard Keynes, W.H. (William Harold) Hutt wrote a book on precisely this point in 1939, called The Theory of Idle Resources. Hutt carefully explained how many resources that seem idle to the unpracticed eye are in some kind of use — perhaps not the most active use we can imagine for them, but one that has considerable economic value. Considers cars. Most car owners use their cars for just an hour or two per day. Are the cars idle the rest of the day? True, they are parked, but they not idle in the economic sense. They are held in inventory, set aside by their owners for whatever need may arise to use them. People who don’t wish to hold a car in inventory can ride the bus or hail a taxi to get them where they want to go. (George Selgin or Steve Horwitz, both of whom have used Hutt’s ideas to help develop their own conceptions of the relationship between money and business cycles, may want to chime in with their own posts to say more about Hutt.)
If some resources are so abundant that there is little risk from wasting them, something is restraining the private sector from using them. Either millions of experienced businessmen can find no opportunities for converting something abundant into something more valuable, or government is somehow preventing the private sector from taking the initiative.
I lean to the latter explanation. Why should government, which eats profits (through taxes) rather than generating them, know how to turn resources to more profitable use than the people in the private sector who spend their whole careers trying to do just that?
As Scott Sumner has discussed on his blog, when monetary policy has gone so wrong that it is impeding trades that people would otherwise make, to their mutual benefit, there is a case for certain kinds of fiscal policy as a clumsy work-around. The simpler course, though, is to change monetary policy. And so I wind back up at free banking. Because free banking applies principles of competition that we observe at work in other markets, and that historically have worked in the issuance of money and credit as well, free banking is less likely than central banking to result in economy-wide failures to use resources efficiently. I do not think free banking would eliminate credit booms and busts, but I think they would be less severe than they are under central banking because the scale for making mistakes in monetary policy would be smaller. Then there would be even less reason to debate fiscal multipliers.