I have yet to see what I would consider to be a persuasive argument in favor of this belief.
Bruce Wilder (see his response to my earlier post) suggests that most economists do not believe that this is true universally; but that it is true only under "special" circumstances like a large negative "aggregate demand" shock. According to Bruce:
The case for fiscal stimulus rests on the belief that macroeconomic circumstances are such that the economy is not near, and is not headed in the near-term toward, a full-employment equilibrium, and that the price matrix is seriously out-of-whack.
I think that his view reflects accurately how many economists feel about why a massive fiscal stimulus is currently needed. The question I have for non-believers is the following: Do you find Bruce's argument persuasive?
Personally, I do not. He makes no attempt to justify his belief that the price-system is seriously out-of-whack. And even if it is out-of-whack, he makes no attempt to explain to us why this is the product of market malfunctioning, rather than government regulation. Moreover, he does not tell us what "the full-employment" level of employment is in the U.S. Nor does he identify other episodes in economic history where the policy has worked under similar "special" circumstances. No...instead we are asked simply to believe. Indeed, the non-believers are asked to explain why they do not believe!
I have stated earlier that I believe that fiscal stimulus can "work" as a redistributive mechanism. The only semi-clear evidence I see where fiscal policy has "worked" to stimulate aggregate output and employment is in the U.S. during WW2. But this policy was also associated with a significant decline in private consumption. In short, people were willing to make sacrifices to support the war effort. A similar policy today would not likely be viewed as welfare-enhancing by a population not currently facing a large threat to national security.
Where else can we find examples of economies subject to Bruce's special "deflationary" shock? How about Japan? Why did Bruce not mention the "success" that Japan has had in overcoming its troubles with fiscal stimulus. Let me explain to you why. Because the evidence clearly does not support the hypothesis; see my earlier post here. (Actually, if memory serves, perhaps Bruce mentioned that the Japanese case simply shows that fiscal stimulus is "not enough." But even so, this is hardly a persuasive argument to make in favor of fiscal stimulus).
But then, there are a lot of really smart people out there that believe that it works. Take Brad DeLong for example in his debate with Michele Boldrin; see my post here. DeLong, being the economic historian that he is, even goes so far to give us examples that purport to show why fiscal stimulus will work. What are his three examples? Here they are:
[1] The 2003-2005 housing boom, facilitated by loose monetary policy;[2] The 1996-1998 internet boom;[3] The post 1982 boom following the easing of monetary policy, the Reagan tax-cuts, and increase in military expenditure.
Now are you persuaded?
Perhaps we should believe on the basis of what some econometricians report to be fiscal multipliers above one? No one will be persuaded; this "evidence" is simply not compelling. (Among other things, we know that based on the manner in which fiscal purchases are accounted for in NIPA, the "true" contributions to GDP are by definition overstated).
Where is the evidence? Somebody please tell me. I need something more than a thinly-veiled belief that the private sector is screwed up and that therefore "something" must be done by the government to correct this screw-up.
Let me repeat what I have said in earlier posts: if a case is to be made for fiscal stimulus, it should likely be framed in terms of its desired effects as a redistributive mechanism. Here, I think the evidence is much clearer and can be made much more persuasive. One may question why it is socially desirable to keep construction workers or auto workers employed when there is clearly too much product on the market, but at least it is clear how such a policy benefits these unfortunate workers.
I suspect that this argument is not made for two reasons. The first is political; i.e., it is much more politically palatable to sell a fiscal stimulus package on the grounds that "everyone" will be made better off. The second has to do with the way most conventional macroeconomic models are structured; in particular, they are usually one-sector models so that economists trained in these models have not often thought about how, in practice, fiscal policy is usually directed to specific sectors. Who knows...this is largely conjecture on my part.
David, I was wondering if have any comments on this speech given by Thomas Woods. He discusses the depression of 1920 that nobody talks about. It's essentially a speech about the ineffectiveness of fiscal stimulus.
ReplyDeletehttp://www.youtube.com/watch?v=czcUmnsprQI
David:
ReplyDeleteI will bite, though I am definitely less than 100% confident a fiscal stimulus will have desirable effects.
This is why I think it might work:
I believe it on the basis of the following theoretical view of the world.
1. Fiscal policy shifts the AD curve (in the "normal" directions)
2. Shifts in the AD curve (whether caused by fiscal, monetary, or other causes) cause real output and employment to change in the short run.
3. The AD curve is currently shifting to the left, so we will be to the left of the LRAS curve.
My reason for believing 1 is mostly theoretical, but seems to fit the empirical world. And I can look at empirical cases in support of 1 where output was either at, above, or below the LRAS curve. And I can look for evidence of price changes as well as real output changes in support of 1.
My reason for believing 2 is mostly empirical. Prices seem to adjust slowly, and real output and employment adjusts, when there seems to be a change in aggregate demand, whatever caused it.
My reason for believing 3 is the financial crisis, the general air of panic, the falling levels of output and employment.
The biggest difference between my reasons for believing fiscal policy may work is that I rely more on a theoretical framework in which it can work, and my empirical evidence for that theoretical framework can therefore extend outside of cases where we look only at fiscal policy and only at cases of "underemployment".
I don't believe my reasons are really different from most people's underlying reasons. I just think I have presented the reasons differently, and have come closer to identifying the reasons they also believe what they do.
I could (probably) expand on any of those 1,2,3. Econometric evidence (especially VARs etc.) has little bearing on it. It is more whether I can make sense of the world around me by thinking in those terms.
Hi Nick:
ReplyDeleteSo, if I understand correctly, your belief is basely largely on the simple Econ 101 model of the macroeconomy, supported by empirical evidence that prices appear to be sticky.
If so, then I offer the following reply.
First, the simple Econ 101 model provides us with no meaningful social welfare function. It does not tell us whether a shock to AD should be offset by an increase in G.
Second, we have more sophisticated models that can interpret what we see in the data that explicitly suggest that a change in G is welfare reducing. (Of course, there are models that suggest the opposite too).
Third, while few would argue that prices are sometimes slow to adjust in the short-run, empirical evidence shows that they adjust much more quickly than is commonly believed.
Fourth, even Keynes (1936) did not believe that sticky prices were a problem (in fact, he thought that the opposite was true). And how does one explain 15 years of stagnation in Japan as the product of sticky prices?
Fifth, you provided no example of where you believe that an appropriate fiscal stimulus actually helped an economy recover from a financial market collapse.
I therefore remain unconvinced by your argument.
Hi David:
ReplyDeleteI wasn't really trying to convince you. I don't know if I could. And anyway, I'm not entirely convinced myself. I was just trying to explain the reasons why I believe what I do.
Yes, it is based largely on the ECON1000 model (Carleton course number!). But the many macro models I have seen, to the extent that I believe them in part, add nuance and qualifications to that model, but don't change much of the basic message about fiscal policy.
Let me try to answer your points:
1. The basic macro model doesn't have a SWF, but when I build or see a similar model which does have a SWF, or, more importantly, try to understand what such a world would look like which both gave those results and how it would effect people's welfare, I think the same way. In fact, my intuitive understanding of what is going on with SW in such a model is much more important than any explicitly modelled SWF.
2. Which models do you have in mind? A RBC model with wasteful government spending?
3. I dunno. The slowness of inflation to fall in response to tighter monetary policies in the 1970's and 1980's made me think that CPI inflation is slower to change than I had previously expected. Plus the way that financial markets respond to interest rate policy wouldn't make sense to me if prices adjusted quickly. Plus my observations of micro-pricing in even my local supermarket.
4. As I interpret him, Keynes thought that increased price flexibility, in some circumstances, might make things even worse, by increasing expected deflation. It's the trade-off between the slope of the AD curve (if any), vs the shift caused by changes in expected inflation. Japan's experience I see as evidence of very slow downward price adjustment, coupled with a near-vertical AD curve. It might even slope the wrong way, with debt-deflation effects.
5. Agreed. We don't observe the counterfactual. We don't see the disasters that didn't happen because policy saved the day. Maybe everything would have been OK anyway.
These, by the way, are my biggest reasons to fear that fiscal policy might NOT work:
1. Governments will screw it up. Buy the wrong goods, too late, with too great an administrative cost, and in a way that's too hard to reverse.
2. Because aggressive monetary policy could have been used instead, and used better.
3. Because fear of the future distorting tax implications of the increased debt (this is not a Ricardian Equivalence argument, because I'm talking about distorting taxes) may harm investor confidence, and actualy reduce AD.
4. Because there's always something I haven't thought of.
But if you had to make a positive case against fiscal policy, what would it be? What harm do you think it would likely do?
Nick:
ReplyDeleteBills and Klenow have a nice empirical piece on micro price adjustments. They show that the average duration of price-changes is about 9 months; and that there is a lot of heterogeneity across product classes.
An RBC model appended to allow for "national security concerns" would rationalize the fiscal policy of the US during WW2. It could also be welfare improving, although material living standards would fall. Do not think this is applicable in current circumstances.
Any RBC model appended to allow for public goods externalities could also rationalize a Pareto-improving role for fiscal policy; but I'm not sure that the optimal policy would be countercyclical (it may well be procyclical).
The case against? All the concerns you listed. But even more. I would say that any society concerned with protecting civil liberties should be wary of govt interventions. A strong case should be made based on empirical observation. A case could be made in the case of war (Lincoln made the case for "appropriations" to finance the war to maintain the Union; but he was well aware of the dangers involved). To this point, I have not seen anyone make a persuasive case which suggests that fiscal policy of the sort suggested has worked in the past in similar circumstances. Should this not be enough to be wary of the promises being made?
Cheers,
David
David, That's an excellent concise description of why fiscal stimulus may have 'worked' during WW II.
ReplyDeleteThe Detroit 'Little 3" are being supported in part because of its key strategic importance to the North American Defence Industrial Base (NADIB).
Others are supporting auto-sector bail-outs fearing that a sudden collapse would help accelerate the recession with snowball effects well beyond the component suppliers. Warranted? I dunno.
Suppose that fiscal stimulation isn't what 'stimulates' the economy but fiscal stimulation is simply correlated with or signals effective social coordination and economic cooperation. That would explain the effectiveness of WW II fiscal stimulation in the face of substantive threats that helped form an effective and robust social consensus to help defeat the Axis enemies.
That might explain why the US economy stagnated in the 1970s following an extremely controversial proxy war against Soviet communism fought with nationalistic Vietnamese peasants that highly polarized American society.
That might explain this recession that follows on the heels of controversial colonial wars of conquest in the Mid-East. Clearly there was no consensus in American society as to the need or desirability of these wars. Americans emerged from the Bush II years highly polarized compared to the Reagan or Clinton years.
Given the large number of North Americans (including Canadians) who believe that more killing and taking is absolutely necessary in the Mid-East and the perhaps larger number who strongly oppose such a strategy, this 'social co-ordination' approach suggests economic recovery will be slow and painful.
Evidence that fiscal stimulus works, look for aggregate hours worked going up during periods of heavy fiscal stimulus (I haven't done this, but would be interesting to look at).
ReplyDeleteGovernmental spending, most straightforwardly, aims to increase GDP by putting people back to work.
In normal times, consumption drives the US economy. When there is a massive asset price decline, consumers can no longer drive the economy, so the GDP will go into decline without offsetting factors, ie government spending and/or other factors other than depending on consumers. (GDP = GDI = GDC, in the US Gross domestic consumption traditionally has driven overall GDP (agg hours worked*productivity) and GDI)
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ReplyDeleteIt is informative and fascinating to see, three years later, how wrong your comments were.
ReplyDeleteFirst, you wholly failed to understand the cause of the Lesser Depression, in which we remain and will remain until real fiscal stimulus is applied (more below). As show by Keen, Mian, Sufi, and others, the cause of the Lesser Depression was a private debt bubble and an underlying very sick economy. The private debt bubble fueled consumption (now investment).
The 33% plus drop in home prices more than satisfies your condition "that the price-system is seriously out-of-whack." Home prices should be like bonds. As interest rates fall, they should rise. Instead, even as rates have fallen, house prices have fallen.
Second, when we had a healthy economy, Fed spending as a % of GDP on research was more than double today's rate. Put all of this together and we need a massive "fiscal" intervention, whether you call such a debt jubilee, helicopter drops, whatever.
We have been at this long enough now to come to understand we are the new Japan. The second and third order effects are killing our future.
Munger said in his speech, Academic Economics:
http://www.tilsonfunds.com/MungerUCSBspeech.pdf
This shows how all-human systems are gamed. Another example of not thinking through the consequences of the consequences is the standard reaction in economics to Ricardo’s law of comparative advantage giving benefit on both sides of trade. Ricardo came up with a wonderful, non-obvious explanation that was so powerful that people were charmed with it, and they still are, because it’s a very useful idea. Everybody in economics understands that comparative advantage is a big deal, when one considers first order advantages in trade from the Ricardo effect. But suppose you’ve got a very talented ethnic group, like the Chinese, and they’re very poor and backward, and you’re an advanced nation, and you create free trade with China, and it goes on for a long time.
Now let’s follow and second and third order consequences: You are more prosperous than you would have been if you hadn’t traded with China in terms of average well-being in the United States, right? Ricardo proved it. But which nation is going to be growing faster in economic terms? It’s obviously China. They’re absorbing all the modern technology of the world through this great facilitator in free trade, and, like the Asian Tigers have proved, they will get ahead fast. Look at Hong Kong. Look at Taiwan. Look at early Japan. So, you start in a place where you’ve got a weak nation of backward peasants, a billion and a quarter of them, and in the end they’re going to be a much bigger, stronger nation than you are, maybe even having more and better atomic bombs. Well, Ricardo did not prove that that’s a wonderful outcome for the former leading nation. He didn’t try to determine second order and higher order effects. If you try and talk like this to an economics professor, and I’ve done this three times, they shrink in horror and offense because they don’t like this kind of talk. It really gums up this nice discipline of theirs, which is so much simpler when you ignore second and third order consequences.
Your thinking about fiscal stimulus shows you do not understand the importance of its positive second and third order effects.
For example, you don't see that WWII was a massive on the job training effort: those 20 million service people returned from the war with personal skills many multiples of where they were 4 years before.
I could go on and on but, you have Kahneman blindness
.