Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Tuesday, March 13, 2012

Fiscal Policy Ineffectiveness in the Interwar Period

Gregor Smith forwards me this paper (coauthored with Nicolas-Guillaume Martineau) that estimates the impact of government spending growth on real GDP growth, using data from a cross-section of countries during the interwar period 1920-1939. Here is their abstract:
Differences across countries or decades in the countercyclical stance of fiscal policy can help identify whether the growth in government spending affects output growth and so speeds recovery from a recession. We use the heterogeneity in the government-spending reaction functions across twenty countries in the interwar period to identify this effect. The main finding is that the growth of government spending did not have a significant effect on output growth, so that there is little evidence that this central aspect of fiscal policy played a stabilizing role from 1920 to 1939.
As usual, a lot depends on the plausibility of the identifying assumptions employed.
The limitations of the data, in frequency and coverage, may prevent us from reaching a precise answer about the efficacy of fiscal policy, but it is still of interest to know whether that is the conclusion. Of course, the answer and its precision depend on an identification scheme. This paper adopts a new one: the main identifying assumption is that countercyclical fiscal policy could have worked in any country but was not tried to the same extent in every country. Identification relies on differences across countries (or over time) in fiscal reaction functions that capture the response of government spending to national income. We use these differences to estimate the effect of this government spending on the growth of income in turn.
The authors conclude (in a rather provocative and un-Canadian manner, I might add), that the evidence over this period fits better the infamous "Treasury view."

If you have some thoughts to share on their identification scheme and/or interpretation of their results, please feel free to comment. I'm sure the authors would appreciate your feedback.


  1. I'm a little confused on their identifying strategy. It sounds like they are using cross-sectional differences in counter-cyclical expenditure. If that's the case, I don't see how this is new. Or do they mean it's new in the study of the multiplier? Because no corporate finance researcher would think this strategy is new and/or suspect.

  2. David, I was surprised (and deeply disappointed) that you mention this paper after reading it.

    Has common sense just jumped out the window? Who would expect there to be any multiplier in countries (German, Italy, Japan, Spain, Portugal, etc. are in the data set) arming and preparing for war or at war? Isn't it self evident that defense spending is going to be a multiplier, if at all, only if people believe the result of the expenditures will be no war (or a war that will yield bountiful returns)?

    In sum, this paper is good evidence about what is wrong with economics, and nothing more. Some bright people have assumed away reality and offer nothing meaningful for the effort.

    1. The Crackpot SpotterMarch 14, 2012 at 7:34 AM

      You might want to leave economics to people who took more than a principles class.

    2. Crackpot

      Economists never took a principles class. If they had, they would see the utter stupidity of this paper (and inferentially of the people who wrote it). That is why economists ought to listen to people like me who have a substantially broader and more rigorous education, to say nothing of experience.

      Now, being a Crackpot, I am sure you think that people working in the shadows of concentration camps (they were opened in 1934, so the German data set includes 5 years of data, a worst for my POV) are more productive.

      My case is very simple. How is data from country with concentration camps meaningful about anything?

  3. John D.

    But so many of the Keynesian ilk point to WWII as evidence that fiscal stimulus 'works,' so to speak. And Spain was neutral in WWII, more or less, as was Portugal. Why would they not have had some benefit, if indeed there was one to be had.

    Note that macro-economists prefer defense spending as an instrument for measuring fiscal policy since it is easily identifiable and arguably exogenous.

    Finally, the destruction shouldn't matter. How is blowing up tanks any different from digging holes and filling them up? Moral difference, absolutely. Economic difference - not much; both are wasteful.

    1. many of the Keynesian ilk point to WWII as evidence that fiscal stimulus 'works,' so to speak

      first, a heads-up. 1) I am a Keynesian 2) WII proves that stimulus works.

      That being said, I am going to try to meet you half way.

      I don't think it worked at all in the simplistic fashion that some argue (or many argue). Just printing money isn't going to be enough, not nearly enough. It would be one of those movies lines the start of the beginning, but we have so much more to do . . .

      My take on Keynes was that, to him, psychology was everything. If people looked at the glass half full you would get an entirely different outcome than if they saw it half empty. No economic model captures that wisdom. Look at FDR and Ronald Reagan. They were leaders who gave people confidence. RR made a million stupid economic choices but his personality trumped. What economic model values such? Obama has done more, but the vision thing he has missed. You can see the result.

      Second, WWII created the opportunity for immense results to scale. IOW, the gov't spent so much that the returns to scale were historic. Again, no model can measure such and it may be a one time thing. Look at what I call the Keynes problem---on what do you spend the money. Specifically, where in our economy can one spend $ 3 or 4 trillion quickly and get returns to scale?

      Third, WWII was to the USA an incredible educational effort. The skills that people acquired between 1940 and 1945 were beyond stunning. We took people off farms and they came back with a world view, able to work in complex organizations and teams, with amazing mechanical skills. Everyone forgets the skills learned to maintain all those ships, planes, trucks, tanks, etc. My Dad was a Marine plane captain. He had 2 year of training in 4 years of service. No economic model measures what they Keynesian spending bought.

      In sum, by 2 cents is that most all thinking today, and all thinking from the right, is shallow and biased. Soros is right and Lucas was wrong. Macro didn't have the answers and the people in the science were lazy and complacent to the horrible damage to all of us.

      You can see this in Krugman's writing. His anger is that he is kicking himself for making a lot of bad assumptions. At least he is trying to make up for past sins, unlike Taylor, Lucas, and Cochrane.

      What would Keynes tell us to do today. I believe he would say we should do two things. First, cut broadband costs to near zero (that is the only return to scale I can see). Second, literally, force feed education to everyone, for free. Had we started in 2009, we could now have 50% of our population with a free but world class BA.

    2. You call that meeting halfway? My word, I don't know where to start. You have repeated all of the nonsense statists and Keynesians want us to believe. I don't even know where to start. Do you honestly believe all this, or are you simply trying to be provocative?

    3. Prof J,

      John D is an idiot -- he proves it every time he speaks. Don't feed the retard troll.

    4. "My take on Keynes was that, to him, psychology was everything. If people looked at the glass half full you would get an entirely different outcome than if they saw it half empty. No economic model captures that wisdom."

      False -- every sunspot model (Roger Farmer's work) has this property. Every time you open your mouth you look dumber and dumber. For the love of the Flying Spaghetti Monster, please, just go away.

    5. Anon @ 7:31,

      Good to know. Thanks.

      Hooka Cat,

      Agreed. Also, excellent handle.

    6. Prof J.

      If I repeated the non-sense that you attribute to "nonsense statists and Keynesians" I would be in the Martin Wolf and Paul Krugman camp, advocating dropping debit cards out of helicopters. Therefore, your attack on me is completely out of place.

      I am not of the drop the debit card mindset and the more consider the subject and especially as time passes the greater become my concerns about how shallow this idea is (and why that shallowness hurts us all).

      In fact, even though I would argue that WWII proves that Keynes was right, that still begs the question, About what? I don't believe the lesson from WWII is to print money? I don't think that is what Keynes would say its lesson is for us, today. His mind had too great a tolerance for ambiguity to be so easily fooled.

      What WWII might prove is that we should not fear a high federal debt to GDP ratio, of and by itself. It must be seen in context. Things actually seemed worse in many ways when Carter was President and we had the lowest debt/GDP ratio since the Great Depression, so there are counterfactuals needing consideration.

      As I said, I don't see the returns to scale and the returns to education being available to us (both were one time events, it seems to me) so I find little or no comfort about what to do today from WWII.

      As for the Hooka Cat, it only takes one reading through Daniel Kahneman's Thinking Fast to come to substantially different conclusions.

      So there you have it. You can either engage or check out.

      Now, given your use of the word "statists" we have pretty good evidence that you are not capable of more than name calling. And, if you want to defend the silliness of saying we should decide what, if anything, to do today based on someones conclusions about Germany in the 1920s and 30s, go for it.

      My two cents is different. I am sure that you are as wrong as I am and that the only way to ever make progress is for you to learn from me where you are wrong and vice versa.

  4. I've always found this a little bit puzzling: If cutting spending reduces GDP (as recent IMF report suggests), why shouldn't the opposite be true?

    - CL

    1. GDP measures take government spending in a dollar-for-dollar sense, so of course a change in G leads to a precise dollar change in GDP. This is not a value-added view of G of course, it's an accounting view. But the real question is how does G affect business investment, since fluctuations in business investment are the main component of the business cycle behavior of GDP. Probably why it's called the business cycle.

    2. But the real question is how does G affect business investment, since fluctuations in business investment are the main component of the business cycle behavior of GDP. Probably why it's called the business cycle.

      Now, if you were a smart business person, would you have invested in Germany at any time after 1918 and before 1946?

      No, so why are we trying to draw lessons from Hitler and Nazi Germany? Hitler was getting 20% of the vote by 1930.

    3. I did find an interesting fact that may explain why Lucas, Cochrane, Taylor, et al will be concerned about this study, as it rebuts their unrelenting assault on working people and trade unions.

      In Germany on 2 May 1933 all trade unions were forced to dissolve and their leaders were arrested; some were sent to concentration camps.

      Thus, the paper shows that if you destroy unions you don't get a positive effect from fiscal stimulus? Did I miss something?

      Sorry David, but the people who wrote this paper are crackpots.

      Seriously people, how to do create a model that means anything when it is the study of countries who are sending everyday citizens to concentration camps?

    4. Well, if anyone knows what a crackpot looks like, it would be John D. As the old saying goes, it takes one to know one.

      Exactly why are you posting incessantly the same crazy nothing? Do you have a disorder?

    5. The Hooka Cat

      You know absolutely nothing about conflict, the purpose conflict, or how to win moral struggles.

      You might read John Boyd. I don't fear giving up him as a resource because I am very comfortable that you will not understand what he says and I know you cannot apply his insights.

      You will note that no one here will now defend this paper. No defense can be made of it, for it is a farce, a parlor game.

      I will stop posting when this attempt at a public voice becomes responsible.

      We have a mother lode of data about the US since Jimmy Carter. Your profession has failed the American people horribly. They trusted Lucas when he falsely promised people knew what they were doing.

      You want me to shut up. Tear into the profession and cut it open. Name all the names that didn't call out deficits don't matter Cheney, the irresponsibility of Bush's tax cuts, how Greenspan let the rise in private debt cover how ill the economy was in 2001 to 2006. I could go on, but there is no need. Everyone knows that, if you name names, you might not get a grant, or get published, or get a chapter in a book or a gov't appointment. You all live in fear of a Google search.

    6. "You want me to shut up."

      I really don't care if you shut up or not. You give me five minutes of entertainment each day, and make so little sense that it really doesn't matter anyway. I'm just curious why you think anyone cares about your nonsensical ramblings.

    7. I believe that people read my comments and realize that they better not write here, especially by name, because I will immediately expose the truth about them.

      David should not have written about this paper--its a silly silly paper. He did it to be nice, which was a mistake. I am sure he saw the flaws apparent to me, and more, but he plays the go along get along game. He has to do that. I don't. We are past being nice.

      We have lots of papers that need writing (like what can we learn from Japan, which looks to be the road for us). But, more than that, we don't need papers, we need action.

      You hate me for exposing how ineffective you and your profession truly our. As being exposed as an emperor with no clothes, you really hate me.

      My purpose is to expose the kinds of thinking that got us into the situation where we find ourselves and to expose the fact that the economics profession is comprised of a great number of people like you who are absolute <<<<

      My questions are good, fair questions and the average reader overtime we see that they cannot be answered and will start to understand the irrelevance of macro. Noah had some great comments on this the last few days.

      the reason that I am effective is that I keep returning to fundamentals---no more studying, papers, bs, What do we do now? You hate me because I have no tolerance for go along get along.

      What helps is that I am extremely moderate in my views. I pay no attention to the right and am extremely skeptical of the left, which just lacks common sense.

    8. "I believe that people read my comments and realize that they better not write here, especially by name, because I will immediately expose the truth about them."

      I believe that Scarlett Johannsen will soon come to her senses and arrive on my doorstep. In other words, we're both delusional, but I know it. You don't see to possess much self-awareness, if you really think people here care about what you write, let alone the profession at large. Notice how I'm the only one that answers you? And I'm only doing it to entertain myself while my programs are busy doing science.

  5. Hmm... I'd like to see the data using just the recessionary periods. Say 1920-1921 in the US, 1929-193? for the other countries etc. I would expect their results if we were just looking at non-recessionary periods.

    I think the effort taken to do this would make the paper stronger, if the results still hold up of course. It would eliminate the obvious criticism that most anyone would instantly use to try and discredit the findings.

    1. Jay,

      I agree that it would be nice to see such a break down, but I think the authors would not be able to do so. There is insufficient data to identify the parameters of interest in such a short time span.

  6. David,

    I've read the paper a couple times now. They spend a lot of time on the identifying strategy, which one can appreciate. Given the paucity of independent variables and the likelihood of endogeneity, there is a fair amount of value-added in being careful to show how you can identify the model. So stylistically, this is a good idea.

    They do mention that omitted variable bias could be a problem, since they're missing output data so can't model productivity shocks directly. I generally agree with them that the bias probably would not change their conclusions very much.

    I think the only real problem I have with the paper is the narrative about the gold standard. The interwar gold standard is not the gold standard of fame and legend. George Selgin has a nice, intuitive discussion of the important differences here:

    And, regarding the force of the conclusion, the co-author is French-Canadian. They have a different manner than Anglos, as you know ;-).

    Now this type of paper doesn't address what I think is really important for results regarding fiscal and monetary policy, and that is the institutional environment. But complaining about that would be like complaining that a Big Mac isn't made of chicken.

    1. the institutional environment

      can you be more specific?

  7. I took the time to read the paper again.

    The authors state they omit Wars (WWI and WII) because they don't know "how to model wartime spending." p.2

    Putting aside there were Wars involving the countries in the data set throughout the 1930s, what fact or facts distinguish "wartime spending" and pre-wartime spending? Does it make a difference to an economy that there was an official declaration of War?

    If the idea of efficient markets means anything, No. You would have to go back and exclude years where the market could foresee the Wars coming.

    What little use there is to this exercise is that it points out that people like Dugger are right. Investment decisions are screwed up when people foresee that the Government out of control. That pretty much explains American economic history since Carter and it really explains why Bush II was a total disaster for us. Investment in plant and equipment went south and private debt exploded.

    Now, how about a paper with useful information about what we can do, now?