Measuring fiscal policy and evaluating its results

There are two measures of fiscal policy: the sum total of everything a government does and the "ramp-up-the-spending-quickly" component which gets labeled "stimulus" by politicians and the media.

In the blogosphere, economists argue mostly about the latter yet it is the former which is more important.  (On this question, among others, I credit Yglesias for being ahead of most of the economists.)

The most important, most effective, and least controversial forms of fiscal policy are the automatic stabilizers.  Let's say you have two countries, A and B.  In country A government spends 50 percent of gdp, mostly on a well-designed welfare state.  When the downturn comes, there is only enough extra borrowing to make up for the lost revenue, and there is no designed "stimulus" per se.  In country B, government spends 25 percent of gdp, mostly not on a well-designed welfare state.  When the downturn comes, country B does an extra three, four, or even five percent of gdp "ramp-up" borrowing and spending.

Which country has a better, more active, and more AD-stabilizing fiscal policy?  Well, it depends on the details and the numbers but I would encourage you to consider country A for this honor.

I don't agree with Krugman's recent interpretation that "Korea and China both engaged in much more aggressive stimulus than any Western nation – and it has worked out well."

In South Korea the welfare state is smaller and more of the government spending is corporate and military, compared to Western Europe, plus government spending is lower overall.  In China central government spending is 19.9 percent of gdp (beware those numbers, though) and the social welfare state institutions, and automatic stabilizers, are very weak, both in terms of quantity and quality. 

For purposes of contrast, in Germany government spending is about 44 percent of gdp and you'll find similar or higher number across Western Europe.

I think of Korea and China as having more "ramp-up" stimulus to make up for what is initially a weaker fiscal policy all things considered (you can add Russia to that list, which also has a high measured "ramp-up" stimulus).  Overall, despite the bigger "make-up." it is quite possible Korea and China are doing less with fiscal policy to stabilize aggregate demand than are the more substantive welfare states.  (Also see Sumner's comment on Krugman here.)

Or think about the fiscal variation within Europe.  "Ramp-up" spending measures of zero vs. 1.5 percent of gdp are portrayed as big differences, but as a chunk of the broader metric — the variation in AD-stabilizing properties of the public sector – it's not such a big deal, especially once you take "crowding out" into account.  Whichever quantity of ramp-up spending you prefer, it's not reason to preach doom and gloom for the welfare state countries with the smaller ramp-up plans.  (Have I mentioned that ramp-up spending is often of lower quality?)

The best fiscal policy — for cyclical and not just growth reasons — is a steady stream of permanent and high-quality government expenditures.  That's true no matter what you think the absolute size of this flow should be.

Sometimes you will see this point acknowledged, such as when U.S. federal transfers to the states are praised as the most effective part of ARRA (which they were).  But again, that's just a constant stream of spending.  And that's in the particulars, not just the aggregate, and it matters because you don't want the federal spending having to rehire the people the states laid off.  The praise is correct, but rarely are its complete implications thought through and presented.

Let's say we measure the efficacy of fiscal policy correctly.  The countries with the most stabilizing fiscal policies would be the big government welfare states with high quality governments.  That means Sweden, Denmark, Germany, Netherlands, and so on, the usual list.  In addition to their relatively high quality governments, they also have relatively strong real economies and healthy institutions.

When this whole episode is over, I would not be surprised to see that same list of countries as having had relatively good recoveries (of course we don't know yet).  A regression could positively correlate "good final outcomes from the crisis" with "total fiscal policy, properly measured."  Such a regression also would be picking up the quality of the institutions and of the real economy.

One way of reading those (potential) numbers would argue that strong real economies, strong governments, and healthy institutions all go together and that such combinations help drive healthy recoveries.  That's actually not so far from real business cycle theory, a favorite whipping boy but in its more sophisticated forms alive and well.  

In the blogosphere, most of what you hear about "fiscal policy" — pro or con — is misconceiving and mismeasuring the concept and then drawing incorrect conclusions.  There's no good reason to focus our economic attention, or perform the informal (or formal) econometrics, on the "ramp-up spending" component.  The ramp-up spending attracts a lot of symbolic interest in the more partisan political debates because it has Obama's or Merkel's or whosever name on it, but it is better to see through such labeling.

Keep your eyes on the ball(s): high quality governments, stabilizing long-run expenditures, well-designed welfare states, robust real economies, and healthy institutions.  In principle there's plenty of room for those concepts in Keynesian economics, but right now they're getting…crowded out…in the intellectual debate.