Does fiscal policy work?

The military buildup or World War II is often cited as a successful prediction of Keynesian economics. Usually forgotten is what happened at the end of the war. David Henderson summarizes:

In a 2010 study for the Mercatus Center at George Mason University, I examined the four years from 1944, the peak of World War II spending, to 1948. Over those years, the U.S. government cut spending from a high of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP. The result was an astonishing boom. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But between 1945 and 1948, it reached its peak at only 3.9 percent in 1946. From September 1945 to December 1948, the average unemployment rate was 3.5 percent.

There was a sharp decline in real GNP at the end of the war, but Henderson says that is an artifact of the ending of price controls. The price controls hid what the actual prices were, so the jump in the price index was not capturing a real rise in prices. But that illusion of a jump resulted in a decline in reported real GNP. (An implication of this is that real GNP was overstated during the war because the price index was not capturing the rise in prices.)

How does Henderson explain the boom?

But why did this postwar boom occur? The answer, in a nutshell, is that the U.S. economy went from being centrally planned, with price controls and government allocation in large sectors of the economy, to being much more free market. During the New Deal, Franklin Roosevelt had many advisors who were hostile to free markets. But during the war, Roosevelt, although he centrally planned the economy for the duration, kicked out most of his anti-market advisors, people like Ben Cohen, William O. Douglas, trust-buster Thurman Arnold, price controller Leon Henderson, and Felix Frankfurter. In 1945 and 1946, Harry Truman got rid of the remaining New Dealers, including two of the most prominent ones: former Vice President Henry Wallace and Harold Ickes.

The stimulus and jobs

From Greg Mankiw's blog, a summary of a paper trying to determine the effects of the 2009 Obama stimulus bill:

Our benchmark results suggest that the ARRA created/saved approximately 450 thousand state and local government jobs and destroyed/forestalled roughly one million private sector jobs.

Keynes vs Hayek 2

The sequel to the best economics video ever.

Will fiscal policy return to hibernation?

Sometimes the only way to diminish an idea is the try it, to see what happens when it is implemented. Keynesianism was largely irrelevant from the 1970s until George W Bush revived it in his administration, and the Obama administration is crowded with Keynesians. But is this revival supported by the evidence? Michael Boskin said "No" in the Wall Street Journal more than a week ago:

These empirical studies leave many leading economists dubious about the ability of government spending to boost the economy in the short run. Worse, the large long-term costs of debt-financed spending are ignored in most studies of short-run fiscal stimulus and even more so in the political debate.

Only time will tell if we will see Keynesianism again recede. 

One attraction of Keynesian policy is that it lets the government do something and people want the government to do something when there is a problem. There is, however, an asymmetry in how the results are judged. The Obama economists projected a path for unemployment with and without the stimulus program that Congress enacted shortly after Obama became president. Unemployment did not follow the projected path; on the contrary, it has greatly exceeded the path predicted if there were no stimulus. The Keynesians have not acknowledged that this is evidence that their program did not work. Rather they argue it shows that the program was not big enough. They are taken seriously in this response. However, consider what things would look like if the stimulus had not been enacted and unemployment had taken the course that it has taken. Would anyone take seriously the response that the initial shock was bigger than we had realized? Everyone would have concluded that we made a mistake in not passing a stimulus.

There is an incentive for politicians to "do something" in the way the media and the public react to failure. They are more willing to forgive failure or explain it away when the government acts than when the government does not act.

Another youtube video of Hayek and Keynes

Found on Division of Labor:

The coming fiscal crisis

The Congressional Budget Office put out an amazing document on July 27, 2010 titled "Federal Debt and the Risk of a Fiscal Crisis " The purpose was not to say that there was no risk of a fiscal crisis. On the contrary, the document outlined how fiscal crises come about and said that the U.S. will eventually have a fiscal crisis unless the government greatly reduces the level of deficits:

But as other countries’ experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply. The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the government’s long-term budget outlook, its near-term borrowing needs, and the health of the economy. When fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal policy in response.

The most arresting passage in the piece, though, was this one:

According to the Congressional Budget Office’s (CBO’s) projections, federal debt held by the public will stand at 62 percent of GDP at the end of fiscal year 2010, having risen from 36 percent at the end of fiscal year 2007, just before the recession began. In only one other period in U.S. history—during and shortly after World War II—has that figure exceeded 50 percent.

The Democrats want to blame Bush for this, but there is an inconvenient truth that they have to ignore to do that: they captured control of congress in the 2006 elections and have had control the purse strings since then.

You can find a link to the document on Greg Mankiw's blog here, or get the document directly here.

Bad ideas

I liked this line in a Wall Street Journal editorial:

Like many bad ideas, the current Keynesian revival began under George W. Bush.

What economists do not know

Reuters reports on "Obama Counters Republican critics on jobs agenda":

Republicans say Obama's policies have failed to dent unemployment, a political sore spot for the president that has helped drag down his approval rating to 50 percent or lower.

Obama's $787 billion stimulus package approved last year by the Democratic-controlled Congress was largely rejected by Republicans. However, many independent economists have said the measures helped avert an even deeper recession.

Recalling the stimulus fight, Obama said he refused at the time to give in to "partisan posturing."

Why did the reporter throw in the sentence that I have highlighted? Why not put in this sentence: "However, many independent economists have said that the measure did little or nothing to fight the recession"? Economists are divided on the effect of the so-called stimulus package, with some believing that it helped and others believing that it did nothing or even made the recession worse. The only information this sentence contains is that the reporter believes the president and the Democrats are the good guys in this dispute and the Republicans are the bad guys.

Economists do not and cannot know what would have happened if the stimulus package had not been passed. Economists are not using current events to test their theories, but are using their theories to interpret current events. Those economists who believe that the stimulus measure helped hold that belief because their theory tells them that fiscal policy works. Hence, they conclude that without the stimulus the economy would have done worse. However, there are other economists who believe that fiscal policy is either ineffective or unpredictable in its effects, and they see no reason to believe that the economy would have done worse without the stimulus package.

Because economists cannot re-run history several times to see what would have happened with various policies, macroeconomics has long been an area of considerable disagreement among economists. However, the field is not totally without progress. Occasionally the results of policies are so dramatic that a theory loses plausibility. For example, the unemployment and inflation results of the 1970s killed the idea that there is a stable Phillips Curve. Sometimes examination of data from many years shapes what is plausible. For example, no one still believes that fiscal policy multipliers are anywhere near what the economists of the "New Economics" thought they were in the 1950s and 1960s. Even the Obama administration's economists were using government spending multipliers that were under two.

On a non-economic note, when has this president ever refused to give in to partisan posturing? Campaigning is the one thing he does really well.

Barro on the spending multiplier

From his piece in the Wall Street Journal:

I estimate a spending multiplier of around 0.4 within the same year and about 0.6 over two years. Thus, if the government spends an extra $300 billion in each of 2009 and 2010, GDP would be higher than otherwise by $120 billion in 2009 and $180 billion in 2010.
....
When one factors in the typical relationship between tax rates and tax revenue, the multiplier is around minus 1.1. Hence, an increase in taxes by $300 billion lowers GDP the next year by about $330 billion.

Few economists think that the velocity of money is stable enough to predict with any accuracy what would happen if the money stock increased by10%. Why should the multiplier be any more predictable?

Update: More here and here.

What works in fiscal policy.

In the New York Times Greg Mankiw reviews empirical evidence that suggests tax cuts work as fiscal policy, while increases in government spending do not.

The results are striking. Successful stimulus relies almost entirely on cuts in business and income taxes. Failed stimulus relies mostly on increases in government spending.
All these findings suggest that conventional models leave something out. A clue as to what that might be can be found in a 2002 study by Olivier Blanchard and Roberto Perotti. (Mr. Perotti is a professor at Boccini University in Milano, Italy; Mr. Blanchard is now chief economist at the International Monetary Fund.) They report that “both increases in taxes and increases in government spending have a strong negative effect on private investment spending. This effect is difficult to reconcile with Keynesian theory.”

You might almost think that the supply side people were on to something. 

fiscal policy or economic development

Found here:
http://www.zerohedge.com/article/other-side-chinas-8-gdp-growth-ghost-cities
http://www.youtube.com/watch?v=0h7V3Twb-Qk



Does it illustrate the problems of fiscal policy or of economic development?

(It is a bit unsettling that Al Jazeera has better youtube clips on the world economy than any of the American networks.)

The error on the debt

The Obama administration says that they underestimated the amount of debt that the U.S. will incur over the next ten years by about $2 trillion dollars. That error is about as much as the federal debt held by the public grew during the second Bush Administration. It is also much less than the numbers others are suggesting.

Paul Krugman says not to worry, that it is "bad but not horrific." Does anyone think he would say the same thing if it were a Republican administration piling up the debt?

What will stop the recession?

A few days ago Carpe Diem had a post on two views of what is bringing us out of recession. One view said it was the self-stabilizing nature of markets aided by massive Federal Reserve action, the other argued big government, especially automatic fiscal stabilizers. One of the weaknesses of macroeconomics is that it is so hard to test different theories.

I could not resist the temptation to add a couple comments, but forgot that the word "data" is plural.

How well is that stimulus working?

President Obama (or his speech writer) has a column in the Washington Post defending his economic policies. He uses one of his favorite rhetorical devices:

They favor an incremental approach or believe that doing nothing is somehow an answer. But that is exactly the thinking that led us to this predicament.

His critics are not impressed. Here is Stephen Spruiell on The Corner

We should not allow Obama to take credit pre-emptively for any future recovery when there is such a strong case to be made that his policies created a level of uncertainty that prevented the recovery from starting sooner.

Keith Hennessey does an almost sentence-by-sentence critique:

This did not have to be a two-year program. Congress could have front-loaded the stimulus had they instead given the cash directly to the American people, as they did on a bipartisan basis in early 2008. We would have saved much of it, paying off our mortgages, student loans, and credit cards (which would not be a bad thing). We would have spent the rest much more quickly than the federal and state government bureaucracies now stumbling through their usual corrupt, slow and inefficient processes. Instead the President handed the money and program design over to a Congress of his own party, who saw it as a big honey pot rather than as an exercise in macroeconomic fiscal policy. The President’s primary macroeconomic policy mistake was allowing Congress to pervert a rapid Keynesian stimulus into a slow-spending interest-based binge.

Finally, Ed Morrissey at hotair.com:

Note too that Obama has quietly dropped the promise to “save or create at least 3 million jobs by the end of 2010,” as Romer’s support of Porkulus claimed. Nowhere in this essay does Obama put a number on jobs. Suddenly, Porkulus has stopped being a jobs project — the entire basis on which Obama pushed Congress to pass it — and has become instead a foundational, long-term rebuilding of the American economy.

Fiscal policy as placebo

Robert Frank makes a placebo-effect argument for fiscal policy, something I have not seen before:

John Maynard Keynes once compared investing in the stock market to picking the winner of a beauty contest. In each case, it's not who you think will win, but who you think others will pick. It's the same for those trying to sort out the stimulus debate. The argument of stimulus opponents hinges on their belief that consumers and businesses will predict that stimulus won't work. The fact that stimulus opponents are far less numerous, have less distinguished academic credentials, on average, and are far less ideologically diverse than their counterparts does not guarantee they're wrong. But these factors should make rational consumers and investors less likely to side with them. And since this is really an argument about expectations, that's probably enough.

If we believe it will work, it will work.

(If he is consistent, he should be very harsh on the talking-down of the economy before the stimulus package was passed in February.)

Will the third time be the charm?

There has been buzz about the possibility of a another stimulus package since the first Obama package does not seem to be curing the recession. I was wondering why they were not calling it a third stimulus, but Donald Marron made that point before I could type anything. (The Bush stimulus package of 2008 would be the first one, a stimulus package that was actually properly timed.)

How does fiscal policy work

The rise of long-term interest rates since the beginning of the year has drawn notice. Niall Ferguson notes that he predicted the rise while Paul Krugman, relying on textbook Keynesianism, did not:

Of course, Mr Krugman knew what I meant. “The only thing that might drive up interest rates,” he acknowledged during our debate, “is that people may grow dubious about the financial solvency of governments.” Might? May? The fact is that people – not least the Chinese government – are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.

Over at Econlog Arnold Kling also notes the rise:

Greg Mankiw reports that the yield curve is steep, meaning that long-term interest rates have risen. In my view, this is perfectly rational, and it shows that the short-run effect of the fiscal stimulus is negative, as Jeff Sachs predicted.

This is all based on a Keynesian type of macro analysis. As we know, most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy.