Policies that Might Work I: Fiscal Policy J. Bradford DeLong University of California at Berkeley and NBER brad.delong@gmail.com http://delong.typepad.com/ +1 925 708 0467 May 12, 2009
How Not to Analyze Fiscal Policy Eugene Fama: There is an identity in macroeconomics... private investment [PI] must equal the sum of private savings [PS], corporate savings (retained earnings) [CS], and government savings [GS].... (1) PI = PS + CS + GS.... The problem is simple: bailouts and stimulus plans are funded by issuing more government debt.... The added debt absorbs savings that would otherwise go to private investment.... [S]timulus plans do not add to current resources in use. They just move resources from one use to another.... I come back to these fundamental points several times below.... The Sad Logic of a Fiscal Stimulus: In a "fiscal stimulus," the government borrows and spends the money on investment projects or gives it away as transfer payments to people or states. The hope is that government spending will put people to work.... Unfortunately, there is a fly in the ointment.... [G]overnment
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infrastructure investments must be financed—more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount.... Suppose the stimulus plan takes the form of lower taxes... we can't get something for nothing this way either... lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes... But the flow-of-funds savings-investment identity is true by definition—whether or not fiscal policy works. You cannot deduce the effectiveness or ineffectiveness of a policy from an accounting identity that is true by definition.
How to Analyze Fiscal Policy Tyler Cowen: with the failure of large-scale Keynesian macroeconometric models, with the failure of rational-expectations cross-equation restriction macroeconomics, and with the failure of real business cycle theories, macroeconomics has been driven back to a combination of accounting identities and common sense… Reasons why deficit spending might not work: 1. The price level might rise—so that increases in niminal demand will not increase real demand. 2. Interest rates might rise and so investment might fall. 3. Savings might rise and so consumption might fall. 4. Foreigners might buy the bonds and so exports might fall. We neglect the first of these: “we wish…”: is the answer. Two roads: flow-of-funds and income-expenditure—should produce the same answer!
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Start with flow-of-funds. Write down the identity: (2)
S − NX = (G − T ) + I
Consider first a tax increase, and take partials: €(3)
S y ΔY + S i Δi + S t ΔT − NX y ΔY − NX i Δi − NX t ΔT = −ΔT + I y ΔY + I i Δi + I t ΔT
So far we are still in accounting-identity land: we have just created a set of boxes into which to throw arguments about potential effects. € Now we pin the interest rate to zero—we are, after all, following as highly stimulative a normal monetary policy as we can here. And let’s neglect the investment accelerator as well. So we are left with: (4) (5) €
(S
y
− NX y )ΔY = (NX t + I t − S t − 1)ΔT
ΔY =
(NX t + I t − (S t + 1)) ΔT
(S
y
− NX y )
The denominator here is the standard Econ 1 Keynesian multiplier, with permanent-income and open-economy considerations tending to make it €2/3 or more, and thus the tax multiplier 1.5 or less. The inner parenthesis in the numerator is a combination of the normal Keynesian tax effect, permanent-income effects, and Ricardian equvalence effects. If a $1 temporary tax cut leaves consumption unaffected—increases current savings by $1—then that term in the numerator is zero. Otherwise not. Does a temporary tax cut affect net exports through the exchange rate? Well, it leads to expectations of future tax increases, which might discourage imports of capital, which would raise goods exports—so if anything the NXt term seems to go in the direction of a bigger tax multiplier (a long as we are not worrying about price level- or interest
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rate-crowding out). And a temporary tax cut that leads to expectations of future tax increases might discourage investment… Now let’s look at the spending side: (6)
(7) €
(S
y
− NX y )ΔY = (NX g + I g − S g + 1)ΔG
ΔY =
(NX
g
+ I g + (1− S g ))
(S
y
− NX y )
ΔG
Again we have the standard Econ 1 Keynesian multiplier on the denominator. On the numerator, there is no reason anywhere to think that €a temporary boost to government purchases will have any appreciable effect on savings. And a temporary increase in government purchases that promises higher taxes in the future will encourage—not discourage—net exports. Once again, crowding-out of fiscal policy is down to the effects of higher debt and future taxes on current investment… The cost-benefit calculation, however, requires that you look not just at short run but also at long-run effects: the fiscal drag from higher marginal tax rates in the future, et cetera…
Cogan et. al. So why do Cogan et. al. say differently? John F. Cogan, Tobias Cwik, John B. Taylor, and Volker Wieland (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers” (Stanford). They write that their Figure 1 shows how Romer and Bernstein think government spending affects the economy alongside: exactly the same policy change… in another study… by one of us [John Taylor]… the results are vastly different….
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[T]he Romer-Bernstein estimates apparently fail a simple robustness test, being far different from existing published results of another model…
Source: Cogan et al. (2009).
So I dug—and found that Cogan et al.’s claim of “exactly the same policy change” was simply wrong. Romer-Bernstein model an increase in government spending with the Federal Reserve expanding and keeping on expanding the money supply in order to keep the short-term Treasury Bill interest rate the same. Taylor (1993) models an increase in government spending with the Federal Reserve contracting the real money supply to
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push the short-term Treasury Bill interest rate up over time as unemployment falls and inflation creeps up. There is no “robustness” problem with Romer-Bernstein at all: the results are different because the policy changes are different. “Geez,” my first thought was, “this is embarrassing—none of four coauthors of Cogan actually read Romer-Bernstein. Sloppy.” Then I got to page 5 of Cogan: “Romer and Bernstein assume that the Federal Reserve pegs the interest rate—the federal funds rate—at the current level of zero…” Cogan et al. know perfectly well that the policy changes are not “exactly the same.” They just say they are. So what is the explanation for their assuming a different fiscal policy? It is this: Romer and Bernstein assume that the Federal Reserve pegs the interest rate—the federal funds rate—at the current level of zero…. [S]uch a pure interest rate peg is prohibited in new Keynesian models with forward-looking households and firms because it produces calamitous economic consequences. As Thomas Sargent and Neil Wallace pointed out more than thirty years ago, a pure interest rate peg will lead to instability and non-uniqueness…. Inflation expectations of households and firms become unanchored and unhinged and the price level may explode in an upward spiral…. This seems to be an argument that a nominal interest-rate peg makes fiscal policy too powerful in its impact on nominal aggregate demand—so powerful that the only admissible monetary policies are ones that enforce crowding-out and so damp its effects. This doesn’t seem to me to be an argument that fiscal policy is ineffective at all… Looking at the guts of their model:
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Consumption spending heads quickly for its permanent-income level as a result of the government purchases increase. Investment spending quickly declines as well because of higher expected future real interest rates from (a) crowding-out and (b) monetary contraction to keep the inflation rate on its target path. These are, in fact, the reasons why, in normal times, economists like Christy Romer are monetarists. But do Cogan et al. really want to matintain that these times are that normal?
Ramey and Perotti on Fiscal Policy Structural VARs‌ Ramey:
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[Perotti] has five countries, three time periods, and two types of shocks… 30 sets of results for each outcome variable. The key to the paper is the identification…. Perotti goes to great effort to make sure his shocks are immune to various possible critiques…. Nevertheless, I am concerned that the structural VARs are incapable of getting the timing correct. In particular, I think that most shocks identified by structural VARs are actually anticipated....
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Blanchard and Perotti (2002): [W]e only need to construct the elasticities to output of government purchases and of taxes minus transfers. To obtain these elasticities, we use information on the features of the spending and tax/ transfer systems… We find that private consumption is consistently crowded out by taxation, and crowded in by government spending… that private investment is consistently crowded out by both government spending and, to a lesser degree by taxation; this implies a strong negative effect on private investment of a balanced-budget fiscal expansion… Our main goal in this paper was to characterize as carefully as possible the response of output to the tax and spending shocks in the postwar period in the United States…. [W]hen government spending increases, output increases; when taxes increase, output falls… multipliers are small, often close to one…. [T]he response of investment, which decreases in response to both increases in taxes and increases in spending, is hard to reconcile... Romer and Romer: “exogenous” tax multiplier of 3 driven by positive response of investment to a tax change… Ramey (2008): 1.5…
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