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Fiscal policy and the burden of proof
I'd like to drive home the point that the case for fiscal policy has not yet been made by its advocates (the rest is under the fold)...
I believe that most current advocates of a huge fiscal stimulus have two major arguments in mind. The first is that "when resources are unemployed, in principle government spending can put them back to work, times are dire so we need this." The second is the Galbraithian point that public sector expenditure has been starved for a long time so in principle there are plenty of good ways to spend money through government. In the predominant mental model on this topic, it is believed either of these arguments suffices to justify a large fiscal stimulus. In the debates I sometimes find that when one claim is criticized there is a mental switch back to the other.
Don't let those switches distract you. My point is simple: it is very hard to find examples of successful fiscal stimulus driving an economic recovery. Ever. This should be a sobering fact. The New Deal doesn't count because fiscal policy wasn't very expansionary then. American participation in World War II doesn't count. Nazi Germany during the 1930s doesn't count. (Read Matt Yglesias's response; the point however is that maybe Hitler couldn't have easily spent the money on something else in a rapid and effective fashion; if he could have they why can't we find more examples of a fiscal-policy lead recovery elsewhere?). I'll cover Japan in the 1990s and other examples soon.
Don't be mesmerized by a static, aggregated AD-AS diagram into thinking surely it must be easy. Whether the government can target unemployed resources effectively, and deliver the right stimulus in time, is a major question and so far the evidence isn't so convincing. Keep in mind there are good reasons why truly major fiscal stimulus hasn't been tried very often.
Here's Free Exchange on the research behind fiscal policy. They write:
Today, Mr Cowen links to a(nother) piece of macro research on stimulus multipliers that finds in favour of tax cuts before declaring that "the science isn't there", to support deficit spending as stimulus.
The point is not that I think tax cuts are much better than government spending as stimulus; I don't. The NBER piece I cited considers the possibility that tax cuts bring a multiplier of as large as five. I say no way. The point is not to argue for tax cuts. The point is to note that this is the best research that the highly reputable NBER can come up with on the topic. What does that say about prevailing standards of evidence and proof in the area as a whole? It means they are very weak and that we know very little. This is not "the evil and corrupt WSJ Op-Ed page," this is the NBER and the researchers have done as good a job as others on this topic or maybe better. And what they have produced still isn't very believable.
The bottom line is this: we are being asked to believe that a big, trillion or even multi-trillion fiscal stimulus can boost the current macroeconomy. If you look at history, there isn't good reason to believe that. Any single example, such as the Nazis, can be knocked down for lack of relevance or lack of correspondence to current conditions. Fair enough. But the burden of proof isn't on the skeptics. It's up to the advocates of the trillion dollar expenditure to come up with the convincing examples of a fiscal-led recovery. Right now we're mostly at "It wasn't really tried." And then a mental retreat back into the notion that surely good public sector project opportunities are out there.
So what you have is the possibility of faith -- or lack thereof -- that our government will spend this money well.
And that is under "emergency" conditions, with great haste ("use it or lose it"), with a Congress eager to flex its muscle, and with more or less one-party rule.
For me, that's not enough.
Posted by Tyler Cowen on December 18, 2008 at 12:52 PM in Economics | Permalink
Comments
Is this then the perfect time to welfarize social security. Eliminate the FICA tax let the businesses keep their portion and the employee his portion. This would simultaneously provide encouragement to hire and to spend. Then you can latter lower everybody to the same payout and raise the age to collect because the fraud of SS being a retirement fund is gone.
Posted by: floccina at Dec 18, 2008 1:11:53 PM
good post. i'd prefer infrastructure projects be done at times like this because prices for inputs are lower. thrift is a good argument for doing things now rather than at economic peaks.
Posted by: oops at Dec 18, 2008 1:12:33 PM
A good challenge; do add links to posts that respond to it; let's see the best they've got.
Posted by: Robin Hanson at Dec 18, 2008 1:27:59 PM
Maybe in line with "oops", I'd ask about things we think we'll really have to do anyway. Is "time shifting" justified? This has come up on other discussions with respect to "green jobs." I'd take Alex's smart grid proposal as possibly that kind of time shift. If it helps solve a problem that we think we'll have to solve anyway, if it's a good program in its own right, and it can be done in times of high unemployment ... why not?
Posted by: odograph at Dec 18, 2008 1:43:33 PM
When people talk about fiscal spending and the New Deal I think of the Anderson and Tollison article that shows spending was allocated on a political basis, not strictly on a basis of need. Any fiscal spending in the future I suspect will be more of the same, despite what Obama or anyone else says.
(Congressional Influence and Patterns of New Deal Spending, 1933-1939, Gary M. Anderson and Robert D. Tollison, Journal of Law and Economics, Vol. 34, No. 1 (Apr., 1991), pp. 161-175)
This article is similar:
Gavin Wright, The Economic Determinants of New Deal Spending, 40 Rev. Econ. Stat. 26 (1974).
Posted by: Warren at Dec 18, 2008 1:46:13 PM
Good post, Tyler. I second Robin's suggestion of following up with links to responses. (Hopefully there are responses!)
In fact, they should have invited you to the TPMCafe roundtable.
Posted by: mk at Dec 18, 2008 2:00:08 PM
At the risk of being repetitive, I'm re-posting some of my comment on the Nazi Germany post yesterday.
Regarding the effectiveness of fiscal policy, I'm sure you've taken a look at the work by Price Fishback, Shawn Cantor, and William Horace on New Deal expenditures (http://www.nber.org/papers/w8108). It is very carefully done. Their point is basically that the New Deal was multifaceted, and that some of the programs were much better at stimulating economic activity than others. For example, spending on public works stimulated economic activity in the communities in which it was spend as well as in surrounding communities. By contrast, work relief programs stimulated the counties that received the relief at the expense of neighbor counties.
The Fishback et al paper is particularly nice in that it uses highly disaggregated data and deals with the endogeneity of economic outcomes and fiscal expenditures (e.g. more money was spent by the government in areas that were harder hit by depression, thereby biasing downwards estimates of the effectiveness of the spending). Also, it seems very reasonable to acknowledge that the structure of spending matters, and to measure the effects of different kinds of programs separately.
So, doesn't this imply that government spending can be an effective economic stimulus, if done right? I don't see why this evidence, on the community level impact of government spending, should be dismissed because at the national level, simply because there wasn't enough of it to pull the country out of the depression. At the very least, a claim of that sort seems to push us towards some sort of public choice claim that the government could not possibly have engaged in enough of the right sort of spending. I don't quite see how that follows.
Posted by: Noel Johnson at Dec 18, 2008 2:17:45 PM
Randall Wray in the TPM Cafe points out why one should advocate fiscal spending to boost economic GROWTH (yeah, he´s talking about the long run, not only about a mere short run recovery).
"Paul Krugman provides 4 plausible factors for the early postwar success: pent-up demand, baby boom, moderate inflation, and big government. To these I would add (again, in no particular order):
5. High wage/high consumption bias: strong unions pushed up wages, allowing growing domestic consumption based on income (not debt); this also promoted labor-saving innovation, technological advance, and all of that good stuff.
6. High government debt ratios/low private debt: we emerged from WWII with private balance sheets stuffed full of very safe government debt; in Minsky's terminology we had a "robust" financial sector with highly liquid assets (note this also is related to Paul's "pent-up demand" point).
7. External markets for US output: thanks to the Marshall Plan that provided the financial where-with-all to purchase US exports (as well as some destruction of productive capacity in war-torn Europe and Japan), the US could sell abroad.
8. Government spending "ratchet": government spending grew faster than GDP, supplementing private sector demand and thereby keeping labor, plant, and equipment operating near to full capacity."
What´s Tyler´s opinion on that?
Thanks a lot.
Cheers.
Posted by: Adolpho at Dec 18, 2008 2:33:33 PM
I disagree with the claim that the burden of proof is on the fiscal policy advocates. This isn't a case where fiscal policy has been repeatedly tried and failed and the advocates claim that it was just handled improperly previously. In fact fiscal policy and things like fiscal policy have been attempted and the more similar these things have been to the sort of fiscal policy being advocated the better they have worked. If we followed your burden of proof claim as a categorical imperative we would never be able to know whether fiscal policy worked because prior to trying it we would be unable to prove that it worked. This is not a trial, circumstantial evidence is admissible. The New Deal, Germany prior to WWII, our own involvement in WWII. Does it make sense that there is something about military spending that makes it suitable for fiscal stimulus where domestic spending would be unsuitable? Unless the answer is yes I don't think it makes a whole lot of sense to throw out that example.
Posted by: Michael Foody at Dec 18, 2008 2:49:10 PM
I think it is not so much that people are confident that it will work, but they are afraid of what will happen if it doesn't, or if we do nothing, so they are willing to gamble another trillion dollars on the chance we can avoid what they see as a path to another depression. If you believe we are going to have just a normal recession, you could provide extended unemployment benefits over the next year or two for a lot less money.
Posted by: joan at Dec 18, 2008 3:01:11 PM
I have trouble accepting your claim that fiscal expansion did not work in 1930s Germany.
It did generate an expansion of output and the counterfactual would be that Germany would have remained mired in depression without it. Just because the primary beneficiaries of the expansion were groups you have moral qualms about does not mean that the policy did not work. The only relevant question is did the German economy do better because of the policy than it would have done without it. You have not answered that question to the negative. You have only pointed out that certain groups were the main beneficiaries.
Posted by: spencer at Dec 18, 2008 4:04:30 PM
I agree with Joan: the key question is what will happen if we do nothing.
Tyler argues that there's no reason to believe fiscal stimulus will work. Fine. What, then, is his prescription for what will work? Would he suggest lowering the interest rate to below zero?
If it is do nothing (which I would guess is his default position), then he should say so.
Posted by: lxm at Dec 18, 2008 4:08:02 PM
Regardless of whether a fiscal expansion would actually help, I think it's fair to say that the marjority of the American people think it will. If this is indeed the case, I think there's a third argument for a fiscal expansion that I haven't heard anyone mention. The mere announcement of a fiscal stimulus could then boost consumer confidence enough to make it worthwhile even if the projects themselves don't do much. This also seems like a good rebuttle to the argument that many of these projects, particuarly the infrastructure ones, will take some time to begin. Any thoughts on why I haven't heard this mentioned by the stiumuls proponents?
Posted by: Isaac at Dec 18, 2008 4:09:15 PM
There is an argument that military spending does not have the same negative psychological impact in the business and capitalist community that other types of
government spending may have.
But you have not attempted to make that argument.
Posted by: spencer at Dec 18, 2008 4:11:42 PM
"In the predominant mental model on this topic, it is believed either of these arguments suffices to justify a large fiscal stimulus. In the debates I sometimes find that when one claim is criticized there is a mental switch back to the other."
This has also been my problem in Social Security debates:
A) It is kind of like a pension system.
A1) Isn't it kind of a crappy pension system?
B) No, no it is essentially an anti-poverty program with some pension attributes.
B1) Why do we spend more than 70% of what is essentially an anti-poverty program on the middle and upper classes?
C) Because it is really a pension system.
It is actually more like a 3 step waltz in the stimulus discussions:
A) We need a massive fiscal stimulus to stop the economy from cratering.
A1) Isn't the evidence really thin that such things work? Isn't it pretty likely that instead of working this will be a waste of money?
B) Well public spending has been so low that there are lots of good projects to do.
B1) But lots of those take too long to give stimulus.
C) But they are really good projects.
C1) If that is true they should stand on their own merits. Lets take some time and investigate each of them individually on their merits.
D) We can't do that. We need to pass this as a huge package now because we need a massibe fiscal stimulus or the economy is going to tank...
Posted by: Sebastian at Dec 18, 2008 4:12:27 PM
Adolpho,
I am a huge Randall Wray fan.
Also, I would point to the huge deficits run by Regan during his term as successfully stimulating the economy.
Posted by: mickslam at Dec 18, 2008 4:22:44 PM
Plunder was a large source of Nazi funding, so yes, we could increase government spending without increasing taxes or debt by stealing from select US ethnic groups and some neighboring foreign countries, but that's not the Change Hoped for.
Posted by: guy in the veal calf office at Dec 18, 2008 5:06:20 PM
haha, I love Sebastian's post.
So if I'm reading Tyler correctly, Keynesianism is essentially bogus, and to the extent that we try to manipulate the business cycle, we should do so with the Fed.
Posted by: John H at Dec 18, 2008 5:20:43 PM
It is interesting to see the normally-cautious Tyler express such full-throated skepticism. Although it is a skepticism of spending a trillion dollars, and the reason for the skepticism is caution. So I guess it's not that out of character.
What say you, Mark Thoma and Brad Delong? And Greg Mankiw?
Posted by: mk at Dec 18, 2008 5:38:38 PM
I'm curious. The history books, or history amateurs, often say "FDR instituted the new deal; we don't know how much it really helped directly, but it 'got things going again,' it got people feeling optimistic and less defeatist."
This is basically a psychological or sociological argument in favor of massive intervention during a crisis. You could call it a "placebo effect" argument. What do economists think of it? Could an inspiring leader, who tells us everything will be OK, and who brings gov't to bear on the problem, however vainly, cause people to have more optimism that their problems will be solved?
Actually, if that's all it took, then what's the difference between optimism and a bubble? But that's a question for another day.
Posted by: mk at Dec 18, 2008 5:49:46 PM
If a combination of tax cuts and spending increases doesn't provide for some expansion under existing conditions, we need to burn our textbooks and give a couple of generations of students a tuition refund. Personally, I would like to see the effects of a $750B-$1000B stimulus over a couple of years. I think it would provide the ultimate test of Keynesian economics. If Keynes doesn't work here, I don't see where it would work anywhere.
Posted by: glh at Dec 18, 2008 6:56:21 PM
And the most recent fiscal stimulus did nothing. (See figure ten in a recent paper by John Taylor. http://www.stanford.edu/~johntayl/FCPR.pdf )
Posted by: mgunn at Dec 18, 2008 7:07:52 PM
"A good challenge; do add links to posts that respond to it; let's see the best they've got."
I linked to it and responded to it here:
http://economics.about.com/b/2008/12/18/fiscal-stimulus-is-bunk.htm
Unfortunately(?) I agree with Prof. Cowen, so my comments are not particularly interesting.
However, I also agree with Issac and mk that the most compelling argument for fiscal stimulus is the placebo effect.
Posted by: Mike Moffatt at Dec 18, 2008 7:21:23 PM
Psychology works both ways. Shocked with evidence that they have been spending beyond their means, people will reduce consumption, at least for a while, and be skeptical of their ability to afford large expenditures.
But insofar as people identify with the collective 'we', they may also be skeptical of 'our' ability to afford large expenditures, and public largesse may drive personal asceticism to compensate.
Posted by: Cyrus at Dec 18, 2008 7:23:43 PM
Is there any evidence for a fiscal placebo effect? If times are so hard that the government spending a trillion dollars on stimulus, maybe I should tighten my belt and prepare for even worse.
Posted by: Cyrus at Dec 18, 2008 7:31:35 PM
