Fiscal policy and the burden of proof

by on December 18, 2008 at 12:52 pm in Economics | Permalink

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.

1 floccina December 18, 2008 at 1:11 pm

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.

2 Robin Hanson December 18, 2008 at 1:27 pm

A good challenge; do add links to posts that respond to it; let’s see the best they’ve got.

3 Warren December 18, 2008 at 1:46 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).

4 Noel Johnson December 18, 2008 at 2:17 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.

5 Michael Foody December 18, 2008 at 2:49 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.

6 spencer December 18, 2008 at 4:04 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.

7 Isaac December 18, 2008 at 4:09 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?

8 Sebastian December 18, 2008 at 4:12 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…

9 guy in the veal calf office December 18, 2008 at 5:06 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.

10 mk December 18, 2008 at 5:38 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?

11 glh December 18, 2008 at 6:56 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.

12 Mike Moffatt December 18, 2008 at 7:21 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.

13 Cyrus December 18, 2008 at 7:31 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.

14 libertarian December 18, 2008 at 7:57 pm

To put $1 trillion in perspective it’s worth noting the recent article about health care cost decisions in Britain. The British statisticians, economists, and doctors worked it all out and decided that saving 6 months of life was worth about $25k. If we equate destroying a life with removing 40 years, then wasting a million dollars is about the same as wasting a life. So when the government wastes $1 trillion this is about the same as sacrificing a million lives.

This kind of calculation justifies much stronger criticisms of massive government intervention than most people are willing to issue. Wasting $1 trillion is nothing less than a crime against humanity.

15 Hal December 18, 2008 at 11:22 pm

Shorter Tyler Cowen

Don’t just do nothing… stand there!

16 MichaelG December 19, 2008 at 12:07 am

Independent of whether government spending really is a stimulus, and whether these projects would happen in time to provide a stimulus, I’m not really impressed by what’s been leaked about the Obama Plan. It all strikes me as consumption, not investment.

You might get some economic return from construction that reduces traffic congestion. You might get a small return for giving broadband internet to the small percentage of the population that wants it and can’t get it. You might get an improvement on health care with electronic records (though I still think if doctors would print clearly, most prescription errors would end.) If school buildings are so run down they interfere with learning, replacing them might give you a better educated group of students, and more economic return years later. And you’ll save a bit of money with energy efficient government buildings.

But will any of this return a trillion dollars of value, plus the interest necessary to pay back the debt? I don’t think so.

As a category, you are looking for expensive projects that will return value, but that no company or state has done, because they couldn’t afford it, or couldn’t capture the returns. A tall order.

17 a December 19, 2008 at 1:24 am

Bless you!

“What, then, is his prescription for what will work?” Always, always, ask the ontological question first: *is* there a prescription which will work? Approaching a problem and assuming that there naturally must be a solution, is a fool’s errand.

18 Russell Nelson December 19, 2008 at 1:29 am

Huh? Keynsian economics has been PROOOVEN to work, because a highly regulated financial system which we call a “free market” system has failed. Since it failed, then Keynes must be right rather than any other school of economics, e.g. all the ones which say that the government is incompetent to regulate and that regulation should be left up to consumers in a free market.

You’ve got to belieeeeve, brother! Have faith! Keynes — not just a Nobel Prize winner, he’s English, and had a really great accent. Krugman — not just a Nobel Prize winner, he’s got a really great beard, so his defense of Keynes MUST be right. How can you doubt someone with such great faith in a dead charlatan?

19 Roland Buck December 19, 2008 at 3:49 am

Having grown up in a blue collar household that suffered involuntary unemployment during various recessions, I have first hand experience of what it is like to face such a situation, losing your main source of income (my mother also worked part time) and having to be afraid that you are going to lose your home because you cannot afford to keep up the mortgage payments. During a recession, the mantra needs to be “jobs first.” If the expenditures can be made in such a way that they will also increase real income, fine, but that is a secondary consideration in evaluating the effectiveness of fiscal policy.

20 Roland Buck December 19, 2008 at 4:45 am

One of the factors that kept national governments from engaging in expansionary fiscal policies was the “treasury view” that increases in government expenditures would just crowd out an equal amount of private expenditures. This helped keep the economies mired in the great depression until military expenditures finally got the countries out of the Great Depression. The increase in military expenditures did bring about major increases in GDP and reduction in unemployment rates in all the European countries who did it.

21 Roland Buck December 19, 2008 at 5:27 am

A cursory look at the Mountford and Uhling paper immediately shows 2 major flaws her is the first and most serious one:

The data is for 1955-2000. This means that data were used for periods 1. during which the U.S. economy was not only below potential output, which is the time for which fiscal stimulus is advocated, but also 2. for periods during which the ecomomy was approximately at potential output, and 3. periods at which it was above potential output. Now virtually no one would argue that expansionary fiscal policy should be used during the later 2 periods. The relevant question is whether expansionary fiscal policy is effective in restoring the economy to potential output when it is below it, and, if so, which approach is best under such conditions. The results in this paper are totally irrelevant to this question. For example, if increases in government spending are the most effective during perod 1, but ineffective or countereffective duing periods 2 and 3, the results in this paper would not show it.

22 Roland Buck December 19, 2008 at 6:01 am

Actually, the above point can be generalized. When fiscal policy is made in a democratic government, no fiscal policy that depends on beign a suprise can be implemented. However, in economies where prices of many goods and inputs are not only sticky, but are changed sequentially, rather than simultaneously, fiscal policy changes that are not surprises can affect output and unemployment.

23 Adolpho December 19, 2008 at 8:31 am

I still think Randall Wray deserves a response.

24 Andrew December 19, 2008 at 10:54 am

You are going to have a lot of unemployed people sitting around. Our society is not going to just let them starve and get thrown out of their houses. We can give them unemployment payments and other sorts of transfer payments and have them sit around waiting for the private sector to pick them up. Or we can put them to work on infrastructure etc. Putting them to work on infrastructure may not stimulate the economy, but it’s surely better than letting productive resources sit idle.

25 RGB December 19, 2008 at 1:12 pm

The New Deal doesn’t count because fiscal policy wasn’t very expansionary then.

No, the New Deal doesn’t count because it didn’t succeed. The US was in a depression when FDR took office, and it remained in a depression when he died.

If anything, the Nazis helped the US and Britain by snatching most of the 20-something males off the employment rolls and convinced the rest of the populace to take even larger pay cuts in order to build infrastructure to fight the war. But all that did was obscure the fact that the country hadn’t recovered from the depression. We still needed massive injections of government credit and deficit spending like the GI Bill to provide the illusion of prosperity when the war ended.

Fact is, neither the US nor Britain have recovered from the crash of 1929 yet. Most of their “wealth” post-WWII has come from infrastructure development from the late 40’s to the early 70’s and from financial engineering afterward. Infrastructure development can’t go on forever; any infrastructure-based stimulus is either hokum or an inability to see that it has already run its course.

Some people like to pretend we spend less money on infrastructure today than we did 20 years ago, but the facts are otherwise. The reality is that we are still paying for the infrastructure spending of 20 years ago through bloated government pensions and the financial engineering and deferrals that made such infrastructure possible.

26 RGB December 19, 2008 at 1:23 pm

For an involuntarily unemployed worker, getting a job, even if his real income has not increased over what it was before he lost his job, this is a bigger increase in his standard of living than an increase in his real wage.

LOL!!

Lots of involuntarily unemployed Jews saw no increase in the standard of living.

27 Cliff December 19, 2008 at 5:50 pm

So I guess that bridge to nowhere is starting to look good to the stimulus advocates..?

28 Ben Kuhner December 20, 2008 at 1:42 pm

For Obama this is only secondarily an economic maneuver. Primarily it is a maneuver to put his politacal agenda in place from day one, to rush it through in the name of the “need to do something fast” for the economy. But the stimulus reaches into most of the areas where he has a politcal agenda: global warming, labor policy, health care, education, coporate intrusion. Think about it.
Ben Kuhner

29 sparkles plenty December 22, 2008 at 3:11 am

The economy is a measurement, not a thing to be measured (or “stimulated”).

A carpenter following Obama’s logic would be hoping to see his 25-ft Stanley tape measure begin to dance.

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