DeLong, "The Effects of Fiscal Policy in 2009 and Beyond_ A Discussion of Cogan-Cwik-Taylor-Wieland" by James DeLong

The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland

6/17/09 9:35 PM

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The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-TaylorWieland STANFORD INSTITUTE FOR ECONOMIC POLICY RESEARCH ANNUAL POLICY FORUM 2009 The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland J. Bradford DeLong

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The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland

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University of California at Berkeley and NBER brad.delong@gmail.com; http://delong.typepad.com/; +1 925 708 0467 May 1, 2009 Last March I got a note from Ward Hanson asking me to come down today and talk about: the impact of the Stimulus Bill on jobs creation… the contrast between the Romer/Bernstein estimates of the benefits of the stimulus plan versus… Cogan, Taylor et. al. that estimate/argue that there will be very little benefit…. I've got agreement from the "Taylor group" to present, as well as Martin Giles of the Economist Magazine to serve as a moderator… So I said yes. And Tuesday afternoon I sat down to reread Romer and Bernstein (2009), which I had read before, and Cogan, Cwik, Taylor, and Wieland (2009), which I had not, and I ran into a problem. On page 2 Cogan et al. 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…. [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). This surprised me. I had talked to Christy. I had talked to Jared. I knew that their intention had been to pull standard models off the shelf and use them--not to push the envelope in economic modeling in any way. 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 push the short-term Treasury Bill interest rate up over time http://delong.typepad.com/sdj/2009/05/the-effects-of-fiscal-policy-in-2009-and-beyond-a-discussion-of-cogan-cwik-taylor-wieland.html

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The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland

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with the Federal Reserve contracting the real money supply to 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. Expanding the money supply on the one hand, contracting it on the other. “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. I am sorry. In Europe, that gets you four red cards. In America, that gets you sent to the showers. The first intellectual responsibility of critique is to accurately present what you are critiquing. When Cogan et al. learn that they can come back into the game. But not until then. Cogan is simply not what it is being sold as--a critique of the argument of Romer-Bernstein. It should not be taken as such. I could stop here. But I have extra time. I think the best way for me to spend the rest of my time is to lay out why right now at this moment someone like Christy Romer--fundamentally a monetarist, a believer in monetary policy, author of papers on how it was monetary expansion that substantially alleviated the Great Depression in the late 1930s--is now a believer in, a designer of, and an advocate for Barack Obama’s plan to give the U.S. economy a fiscal boost to try to cushion the current fall in employment. The analysis I am going to give is essentially that carried out nearly eighty years ago by one of Milton Friedman’s teachers, Jacob Viner, in his analysis of the Great Depression when he called for “large and continuous deficit budgets to combat the mass unemployment and deflation of the times.” Friedman applauded Viner’s analysis and saw it as superior to those of others like John Maynard Keynes: “so far as policy was concerned,” Friedman wrote in the early 1970s, “Keynes had nothing to offer those of us who had sat at the feet of [Henry] Simons, [Lloyd] Mints, [Frank] Knight, and [Jacob] Viner…” Start with Robert Lucas’s observation that in a modern economy you cannot deflate--you cannot have the total nominal volume of spending fall--without having production, sales, and employment falls as well. And also start with the quantity theory of money: PY = MV The total flow of spending in the economy--the amount produced and sold Y times the prices at which goods and services are sold P--is equal to the stock of money in the economy M--bank reserves, cash, checking-account balances, other liquid assets--times the velocity of money V. If PY threatens to fall--threatening a fall in production and sales and a rise in unemployment—then the standard policy Jacob Viner, Milton Friedman, and Christy Romer would recommend would be to boost M. Provided that V does not move in the opposite direction to offset the increase in M, nominal spending will stabilize and deflation and depression and high unemployment will be averted. The loose end is V--how fast households and businesses spend their cash balances. Milton Friedman in Studies in the Quantity Theory of Money maintained that the key determinant of velocity is the (nominal) interest rate: the higher are nominal interest rates, the higher is velocity because the faster you want to spend your money. Holding purchasing power in cash rather than in bonds is expensive when interest rates are high: you would rather either spend it and buy something or move it back into bonds that pay interest rather than keep it around idle. The velocity of money of money is low when interest rates are low because delaying purchases while you comparison shop is not costly: you lose little in foregone interest that you could have been earning. This dependence of velocity on the interest rate puts a limit on the effectiveness of monetary expansion. When you expand the money stock you increase the ratio of money to bonds. By simple supply and demand raise the price of bonds in terms of http://delong.typepad.com/sdj/2009/05/the-effects-of-fiscal-policy-in-2009-and-beyond-a-discussion-of-cogan-cwik-taylor-wieland.html

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The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland

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the money stock you increase the ratio of money to bonds. By simple supply and demand raise the price of bonds in terms of money—and the price of bonds in terms of money is the inverse of the interest rate. So when you raise the money stock, you lower velocity. This matters when interest rates on assets like Treasury Bills get very low, like zero, like they are now. If you hold your money in a six-month Treasury Bill you get essentially no interest--0.3% per year Monday afternoon--and you run the small risk that interest rates might rise over the next month and your Bill might lose a little value. If you hold your money in cash you get exactly no interest and it is safe--FDIC insured. Thus there is no economic incentive pushing you to spend your cash when interest rates are very low. And so there is no economic reason for the velocity of money to be any particular value. When the central bank tries to boost nominal spending through standard monetary expansion it might prove ineffective: interest rates will drop even closer to zero as the ratio of money to bonds rises, and the velocity of money might well drop to offset the boost to the money stock. Guess where we are now? The Federal Reserve is boosting the money supply with extraordinary force, and the velocity of money is dropping like a stone.

In order to ensure that monetary expansion is effective, you need to do something to boost interest rates. What can you? Here is where “large and continuous deficit budgets” comes in. When the government runs a deficit it floods the market http://delong.typepad.com/sdj/2009/05/the-effects-of-fiscal-policy-in-2009-and-beyond-a-discussion-of-cogan-cwik-taylor-wieland.html

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The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland

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Here is where “large and continuous deficit budgets” comes in. When the government runs a deficit it floods the market with bonds. Once again by simple supply and demand more bonds means a lower price of bonds which is the same thing as higher interest rates. The government cannot hold on to the money it gets from selling bonds for that would reduce the money stock, and the whole point of the exercise is to make the increase in the money stock effective. It has to return the money to the private sector by spending it. And it can spend it in four ways: By buying up assets like mortgage-backed securities. By buying up companies like Fannie Mae, Freddie Mac, AIG, GM, Citigroup, and more to come. By refunding the money to taxpayers by cutting taxes. By spending the money directly--boosting government purchases. Which of these ways would be most effective at keeping the velocity of money from falling further to offset expansionary monetary policy? The answer is that we really do not know which of the ways would be most effective--and that is the reason that we are trying them all right now, with Tim Geithner buying GM and mortgage-backed securities with the government’s money and Peter Orszag directing the flow of spending and tax cuts that is the American Recovery and Reinvestment Plan. Will it work? It is hard to see how it could not work. Nobody disputes that in normal times monetary expansion boosts spending, demand, production, and employment. But the worry is that these times right now appear to be not-normal. Nobody disputes that in not-normal times when interest rates are very low--as they are now--there are no strong incentives to spend cash working to keep monetary velocity from falling to offset increases in the money supply. Purchasing insurance against this eventuality--which appears to be a reality outside the building--seems a reasonable thing to do. Is this a good use of the government’s money? It does, after all, saddle us with additional government debt. If we did not spend money on the stimulus program now, we could use that debt capacity for some other, different purpose in the future. But as of 4 PM EDT on Monday, the U.S. government could borrow for seven years at a real interest rate I estimate at – 0.5% per year. Government expenditures on national security, on Medicare, on the Center for Disease Control, on the Interstate Highway System, on research and development into green energy technologies would have to be extraordinarily and uniquely inefficient right now for them not to be worth doing right now when they come with the extra bonus of making monetary policy effective in the current situation. Will it be big enough, or will in two years we wish we had done more? I think the odds are one-in-three that in two years we wish we would have done more, and that the odds are close to zero that in two years we wish we would have done less. Thus my analysis of the stimulus program is quite positive. And this analysis, remember, is not mine alone. It is modeled on the analysis of Milton Friedman’s teachers at the University of Chicago in the 1930s--men of whom he highly approved as having left him nothing to learn at the feet of John Maynard Keynes, men who called for a two-handed approach to the Great Depression: “the Federal Reserve banks systematically pursue open-market operations with the double aim of facilitating necessary government financing and increasing the liquidity of the banking structure…” “the use of large and continuous deficit budgets to combat the mass unemployment and deflation of the times…” That two-handed strategy is the approach we are pursuing now, in a situation that in its level of short-term interest rates has considerable similarities to the Great Depression. It seems a wise and prudent bet. References John Cogan, Tobias Cwik, John Taylor, and Volker Wieland (2009), “Old Keynesian versus New Keynesian Government Spending Multipliers” < http://www.volkerwieland.com/docs/CCTW%20Mar%202.pdf>.

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Milton Friedman (1972), “Comment on the Critics of ‘Milton Friedman’s Monetary Framework’,” Journal of Political Economy. Milton Friedman, ed. (1956), Studies in the Quantity Theory of Money. Christina Romer and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan” http://otrans.3cdn.net/45593e8ecbd339d074_l3m6bt1te.pdf. John Taylor (1993), Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation.

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Comments A couple issues: "If you hold your money in cash you get exactly no interest and it is safe--FDIC insured." I'm confused. Do you mean something like hording the cash at home in (say) your mattress? Or depositing it in a savings account? The former isn't FDIC insured, and the latter isn't exactly zero-interest. Why would the FDIC insure cash horded in a mattress? "PY = MV": I first saw this equation in the context of a critical (newspaper) article: http://www.boston.com/globe/search/stories/nobel/1992/1992n.html "Friedman says the equation has 'the same foundation-stone role in monetary theory that Einstein's E=MC2 does in physics.'" Is this an accurate quote of Friedman? I don't know what it means for Einstein's equation to have a foundation-stone role in physics. The article continues, "There is, perhaps, a difference: Circumstantial evidence suggests the quantity theory is simply an extended analogy smuggled into economics from physics long ago, a dubious appropriation of Boyle's Law, cute, but ultimately not much more revealing than Parkinson's Law (work expands to fill the time allotted for its completion)." Any comments? What might typical values be for the variables, including units, in the equation, "PY = MV"? Posted by: John M 307 | May 01, 2009 at 10:13 AM http://delong.typepad.com/sdj/2009/05/the-effects-of-fiscal-policy-in-2009-and-beyond-a-discussion-of-cogan-cwik-taylor-wieland.html

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....Will it be big enough, or will in two years we wish we had done more? I think the odds are one-in-three that in two years we wish we would have done more, and that the odds are close to zero that in two years we wish we would have done less..... With a first quarter estimate of over 6% drop in GDP as opposed to an Obama estimate of 1.2% GDP drop for the year, it seems pretty clear that the stimulus package is woefully undersized. First, the stimulus spending works out to about $200B per year which is clearly overwhelmed by the drop in state and local government spending. Second, the collapse of Chrysler pushes GM and even Ford closer to collapse through the mechanism of the endangered auto supply network. What is a reasonable estimate of drag created by the virtual shutdown of the "Big Three" (and beyond) this summer? Easily more than the $200B of the stimulus. It is certain that in two years we will wish that more had been done. The consistent underestimating of the nature and scope of this problem has kept this country behind and underwater. Why is that the case?

Posted by: Neal | May 01, 2009 at 10:56 AM "I am sorry. In Europe, that gets you four red cards. In America, that gets you sent to the showers. The first intellectual responsibility of critique is to accurately present what you are critiquing." That is only half right. In Europe you get the red cards, but in America you get offered a cushy think-tank job. Posted by: bigTom | May 01, 2009 at 11:48 AM I understand the rhetorical value of presenting stimulus in monetary terms. And I understand the usefulness of exploring Keynesian and monetarist equivalencies. But to me the usefulness of the monetarist framework turns on the stability of velocity, which after all is simply the ratio of nominal spending to money balances, however the latter is defined. If velocity was stable or rather readily predictable that would be one thing. But instead, Goodhart's Law appears to hold: the relationship between that ratio and any number of observable variables tends to be unreliable. If there's an empirically-based critique of Goodhart's Law, I should like to know about it. Posted by: Measure for Measure | May 01, 2009 at 03:01 PM I agree that a combined fiscal/monetary approach is highly appropriate in the current crisis. But a fret that the fiscal component is too large, even with the prospect that Brad raises of prolonged cheap financing. Milton Friedman added the following two things to the debate. First, there is a lag of at least 12 months from monetary expansion to the full impact on nominal expenditures. On impact, velocity moves reciprocally with the expansion in money to cancel it out. This fact has to be taken into account in judging the extent to which velocity has 'gone slack' in the current low interest rate environment. The other thing that Friedman identified is that interest rates are not a scalar; there is an entire spectrum of maturities from over nightg out to (at the extreme) 500 years in the corporate bond market, or 30 years for treasuries. Quantatative easing still has scope to stimulate expenditure, even when short rates have hit their lower bound. It is true that velocity also depends on these long rates, so some of the quantative easing will reduce velocity, but this does not obviate the basic point, which is that in no way has monetary policy run out of ammunition while there are any positive points on the yield curve. The Fed is doing some quantatatve easing through long bond purchases, but mostly it is being done through failure to sterilize its credit lines, a policy it had adopted de-facto from a little time before it dropped the federal funds rate to 0-0.5%. This is going to make it difficult to forecast the effects of the easing. Making such forecasts would be difficult in any case, since the last time the fed tried anything like this was 'operation twist' under JFK, and there aren't a whole lot of data points to analyse from that era. http://delong.typepad.com/sdj/2009/05/the-effects-of-fiscal-policy-in-2009-and-beyond-a-discussion-of-cogan-cwik-taylor-wieland.html

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The danger, given this uncertainty and the sheer magnitude of the quantatative easing, is that Obama's stimulus and the Fed's quantatative easing will, combined, make the economy rebound too stongly. - Tim Posted by: Tim Peterson | May 01, 2009 at 08:46 PM From my reading of the Cogan, et. al, paper, they did simulate the fiscal expansion with the federal funds rate set to zero throughout 2009 and 2010 (using the Smets-Wouters model). They still got a lower multiplier than the Romer-Bernstein white paper (7). Paper graphically shows the results running the Taylor model, but it also descriptively talks about simulations using other models, partially specificated to the prescriptions of Romer-Bernstein. Professor Delong, would you care to explain why Cogan, et., al are wrong in positing that it is not reasonable to peg the interest rate at zero indefinitely in the Neo-Keynesian model? [That is perhaps the most bizarre thing of all: if you peg the interest rate at zero indefinitely in Smets-Wouters, nominal demand explodes: fiscal policy becomes infinitely powerful...] Posted by: Lance | May 03, 2009 at 05:11 PM

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