Eugene Fama's Syllogism

Via Paul Krugman, Eugene Fama offers a syllogism on macroeconomic stabilization:

Again, here is my argument in three sentences.

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

Are any of these statements incorrect?

In his attack on me Krugman implicitly assumes that sentence 3 above is true; that is, the stimulus plan will on balance move resources from less productive to more productive uses. This is indeed the focus of the issue.

One way to understand what's wrong with this is to consider the circumstances under which it might be true. Suppose that we were living in the Kingdom of Coneria and "funds" meant "gold coins." In that case, anything the government does to stimulate the economy requires the acquisition of additional gold coins. You could borrow the gold coins, you could tax the gold coins, you have options, but somehow you've got to get the coins. In this case, due to the objective scarcity of coins the only real issue is whether you're shifting the coins from a low-efficiency use to a high-efficiency one.

But now suppose you swap everyone's coins for little pieces of paper with the king's face on them. Just as before, economic actors need a medium of exchange. And just as before, taxes are due. But instead of paying taxes with gold coins, you pay them with little pieces of paper. This makes the pieces of paper commodities worth having, and thus convenient for use as a medium of exchange. Now the king is riding around one day and he notices that 9.1 percent of the population is unemployed. He also sees that there's a bridge in disrepair. So he prints up some more little pieces of paper, walks over to some unemployed dudes, and says, "I'll give you some paper if you fix the bridge." The dudes are short on little pieces of paper, so they jump at the opportunity. This use of pieces of paper doesn't need to be more efficient than some alternative use of the paper. You just had the paper printed. All that has to happen is that it has to be more efficient for the dudes to be building a bridge than for the to be sitting on the couch scouring the help wanted ads and feeling depressed.