Temporary vs. permanent increases in government spending

by on March 18, 2012 at 4:04 pm in Economics, History, Political Science, Uncategorized | Permalink

Not long ago Paul Krugman wrote:

To a first approximation, in other words, the effect of current fiscal policy — whether stimulus or austerity — an [on?] the actions of future governments is zero.

He makes further points at the link, although there is not a citation to the literature.  I thought we should look at the evidence a little more closely.  Some of it contradicts Krugman as read literally, though it is not all bad news for his larger point.

Here is an abstract from Brian Goff:

In spite of Peacock and Wiseman’s 1961 NBER study demonstrating the “displacement effect”, simplistic theoretical and empirical distinctions between temporary and permanent spending are common. In this paper, impulse response functions from ARMA models as well as Cochrane’s non-parametric method support Peacock and Wiseman’s conclusion by showing 1) government spending in the aggregate displays strong persistence to temporary shocks, 2) simple decomposition methods intended to yield a “temporary” spending series have a weak statistical foundation, and 3) persistence in spending has increased during this century. Also, as a basic “fact” of government spending behavior, the displacement effect lends support to interest group and bureaucracy models of government spending growth.

There is persistence to spending, although this study does not create a category for stimulus spending per se, however that concept might be defined.  The work of Robert Higgs also provides a clear look at ratchet effects on government spending, control, and regulation, although Higgs focuses on war rather than spending.  State governments also seem to exhibit a ratchet effect, whereby good times bring about permanently higher budgetary demands, if only through endowment effects, lock-in, and status quo bias.

That said, the federal debt/gdp ratio seems to show mean reversion, as does the measure of primary surplus.  That would mean that fiscally troubled situations are followed by improvements, though not necessarily from spending decreases.  In fact there has been  considerable reliance on a “growth dividend.”  And here is Henning Bohn from the QJE:

How do governments react to the accumulation of debt? Do they take corrective measures, or do they let the debt grow? Whereas standard time series tests cannot reject a unit root in the U. S. debt-GDP ratio, this paper provides evidence of corrective action: the U. S. primary surplus is an increasing function of the debt-GDP ratio. The debt-GDP ratio displays mean-reversion if one controls for war-time spending and for cyclical fluctuations. The positive response of the primary surplus to changes in debt also shows that U. S. fiscal policy is satisfying an intertemporal budget constraint.

In other words, we make up for first-temporary-then-permanent spending boosts by a mix of growth and higher taxes.  Krugman might well be happy with that scenario, but the data do show intertemporal interdependence for budgetary decisions, with a mix of persistence on one variable (spending) and mean-reversion on another (debt-gdp ratio).  And if you think a lot of government spending is inefficient, you should still be troubled by apparently “temporary” spending bursts.

As with much of macroeconomics, I would apply a good dose of agnosticism to these results (noting that agnosticism is not the same as assuming zero effect), but still the correlations are consistent with my intuitions more generally.

Karl Smith March 18, 2012 at 4:32 pm

The key question is whether government ratchets down or not.

If not then the both these results are easily closed by positing an underlying trend towards a higher fraction of government spending and taxes. The spending trend is suppressed by in bad times but the tax trend is suppressed even more. Thus Debt-to-GDP rises. Then in good times the tax trend plays catch-up meaning that spending ratchets up but taxes ratchet up more and debt-to-GDP declines.

Mike C. March 18, 2012 at 5:59 pm

Governments spend tax revenues, debt and future tax revenues. The first is fine, but the other two equate to the pulling forward of demand so we can talk all we want about filling in the hole of aggregate demand but we have done so with future plaster of Paris. We have taken a ton of future prosperity and smeared it all over the pig like so much lipstick.

We are going broke and that’s all there is to it. Private debt per capita is rocketing upwards as is muni debt, sovereign debt etc. the only thing to be done is massive austerity and that is not poltically feasible and so we will kick the can until we break our foot and can kick it no longer.

Noah Smith March 18, 2012 at 7:25 pm

Hmm, then how come tax rates have gone down as debt/GDP has gone up?

mulp March 19, 2012 at 5:30 am

Because Reagan proved deficits don’t matter.

Before 1980, debt and deficits were a major concern to liberals and conservatives alike. After all wars, the focus was on reducing the debt burden as rapidly as possible, and the debt burden increased only in times of crisis.

Before 1980, debt was incurred for capital projects, just as a growing business does. Wal-Mart’s debt is much greater today than when it was three stores in order to buy the working capital of the much larger enterprise. While the debt burden was falling rapidly post WWII, the nominal debt stayed constant, but the war debt was replaced by debt funding massive infrastructure investments – water and sewer plants, roads and bridges and ports, aircraft carriers and a 100,000 nukes, bombers, missiles. Some of those investments made the US economy more efficient and productive than any other, others were a waste, but the wasteful spending drove developments of new technology that were quickly redirected for private profit and benefit. The number of missile launches to get rocketry down to a science that created thousands of engineers giving Elon Musk the ability to form a space vehicle manufacturing company for a mere $100 million of his own money, with other investors backing him, of course, to challenge dozens of aerospace companies around the world who got a good chunk of the $1 trillion debt prior to 1980.

But since 1980, most of the debt has come from deficits in operating budgets while capital investment has shrunk.

The depreciated value of the well over half trillion in infrastructure is today near zero. The productive value of the roads and bridges and water and sewer and ports is far greater than a trillion, but estimates that are always too low for such things in both the private and public sector, to restore the infrastructure to a minimal level of health, but that probably does make it as efficient as developed Asia or Europe.

The policy on debt and deficits has been shaped by an increasingly conservative Republican party that has adopted the view that the debt should be run up until the only option is to default on the debt, but that is really just a extremely high tax imposed on those who loaned money to the government.

Clinton tried to restore the ethos prior to 1980, but the fictional budget surpluses, the operating budget deficit was $200B borrowed from excess payroll tax revenue, were used to justify both increased spending and tax cuts. Then the wars were started with the claim “they will pay for themselves and probably turn a profit.”

After what happened when Republicans took control after Clinton devoted 8 years to balancing the budget like from 1945-80 makes it clear that no Democratic president should expend any political capital on balancing the budget – Republicans never spend any political capital to balance the budget any more, so why should any Democrat.

The spending on war was clearly not temporary by 2003, 2004 at the latest, but it was never included in the budget even after Republicans made it clear that military spending needed to increase for at least another decade. Never has a temporary spending on war not involved acting to pay for it in the history of the Constitution. Since 1980, wars hot and cold have been paid for like the Revolutionary War: with debt which had no revenue to back it. The first and second enumerated powers of Congress are the reason for the Constitution because the looming wars could not be funded with debt because promissory notes from the Continental Congress were worthless. Many conservatives explicitly want to erase the first and second enumerated powers of Congress, which means returning to funding wars with worthless debt. (Two-thirds vote to hike taxes and debt when a majority declares an emergency – like war – returning to the powerless Congress pre 1790 that could declare war and fight it, but not pay for it.)

TallDave March 19, 2012 at 12:36 pm

Please, Clinton never wanted to balance the budget. Like welfare reform, that was forced on him by the GOP after much caterwauling about how the GOP wanted poor people to die and likening their efforts to hitman’s “Contract on America.”

TallDave March 19, 2012 at 12:31 pm

Because spending has gone up way too much.

Andrew' March 20, 2012 at 5:08 am

“then how come tax rates have gone down as debt/GDP has gone up?”

Here is my oft-repeated theory:

When the government stopped doing general welfare stuff, it pitted the tax payers against the tax eaters.

Everything else follows, including the solution. Do your f—-ing jobs…GENERAL WELFARE.

Vuk Vukovic March 18, 2012 at 7:52 pm

I agree, the temporary spending boost eventually turns out to be permanent. With such a trend the dependency on the government is easily created (either through public sector jobs or various benefits).

In that perspective, I recommend Kling’s paper (http://www.adamsmith.org/sites/default/files/research/files/PSST.pdf) on Sustainable specialization and trade as an excellent case against a short run (temporary or permanent) fiscal stimulus:
“…government spending is not likely to solve the problem. Government jobs are not self-sustaining. Instead, they require subsidies from present taxpayers or, if the spending is deficit-financed, from savers (and, ultimately, future taxpayers) … The restoration of patterns of sustainable specialization and trade will have to come from the private sector. Short-term so-called stimulus programs may impede the necessary adjustment, rather than hasten it.”

Essentially a short run aggregate supply fiscal shock can only redistribute labour and capital from one industry to another without the necessity to create private sector value, thus slowing down the creative and innovative processes in the economy. A fiscal stimulus can in the end only help an economy retain its pre-crisis status quo.
http://im-an-economist.blogspot.co.uk/2012/03/stimulus-debate-revisited.html

That’s why I like Kling’s work, it provides a well formulated alternative approach to why a stimulus only reallocates resources, mostly efficiently, without having any information on how to obtain a new, technologically improved, equilibrium.

Lord March 18, 2012 at 8:05 pm

Any counter cyclical policy will show up as persistence, so that is not a good measure.

Doc Merlin March 18, 2012 at 9:05 pm

Nope. If you run surpluses in good times, it won’t show as persistence. Persistence is a measure of fiscal policy asymmetry.

Dave March 19, 2012 at 5:07 am

Right, but that never happens. Politicians (and voters) are only foul-weather Keynesians, as fits their incentives.

mulp March 19, 2012 at 5:55 am

Maybe in your lifetime, but not mine. I remember when conservatives and liberals agreed that debt was something that had to be backed with revenue to service it. The difference before 1980 was conservatives fighting investment funded by debt backed by revenue to service it, and liberals pushing investment and debt to the limits of the increased or existing revenue.

After 1980, increasingly conservatives implicitly saw debt not backed by any revenue to be virtuous on the principle it would prevent future debt, but since debt could be incurred without increasing revenue, debt became much easier to use to fund current operating costs while investment was forced to shrink because consumption was starving investment, leading to infrastructure decay and collapses of bridges and cars swallowed up in water main leaks and houses blowing up from leaking gas lines.

I remember when all debt had to be for something concrete and it always required revenue to service it.

But when cutting taxes was more important than anything else, debt no longer meant revenue and that meant nothing concrete resulting from the debt.

TallDave March 19, 2012 at 12:27 pm

Bridges aren’t collapsing due to lack of maintenance; ONE bridge collapsed due to a design flaw duringmaintenance and gas leaks are less, not more common. It’s more likely we’re actually spending too much on infrastructure; we have more paved road per capita than anywhere else in the world.

Your mood affiliation problems aside, what actually happened re debt is that gov’t spending started to become so difficult to control that fiscal conservatives began to accept deficits as a lesser evil than taxes. Whether that was a better choice than insisting on spending cuts is debatable, but remember Republicans tried to pass a Balanced Budget Amendment and couldn’t get enough Democrat support, so the parties cannot be held equally to blame here.

Lord March 19, 2012 at 3:50 pm

Yes, but that requires separating out the bad times. It also requires consideration of political control.

Ray Lopez March 19, 2012 at 1:12 am

I have a question for readers based on my understanding of the short run LM-IS curves (I’m not an econ major). Referring to a Macroeconomics book by Blanchard, it seems *shifts* in the LM and IS curves are only influenced by a handful of variables. In LM, LM shifts, in the short run, are only a function only of interest rates, not Y (real income) while IS is a function only of taxes and government spending, not Y or I (investment). Am I right? For the short run nothing matters save the Federal Reserve and government spending. IMO this is ridiculous, as why should taxes and government spending work faster than investment decisions?

Ray Lopez March 19, 2012 at 1:38 am

So it seems in answer to my question that the Keynesian LM-IS economists solution to “abolishing the business cycle” is to allow the government to become such a big player in the economy that the two variables that can be influenced by government, namely interest rates (for LM shifts), via the Federal Reserve, and taxes and government spending (for IS shifts), via government, are used to change output in the short run. Quite a drastic remedy if you ask me. It ignores the effect having big government will do to your other variables like investment and so on in the long run. Notwithstanding Solow’s model for long term output, I believe big government stifles innovation and diverts resources into non-productive, non-innovative areas, including military spending (pace some people who think war mongering brings about innovation, I disagree, and would argue that the worthy things like Teflon and telecommunication satellites would have arisen without war anyway).

John Thacker March 19, 2012 at 3:09 am

Interesting Washington Post article on the failed “grand bargain” negotiations. In some ways it reinforces the Republican narrative– while there was a framework of a deal, sources on both sides (including notes and emails) indicate that President Obama attempted to alter the terms of the deal after the initial agreement, perhaps wary of his ability to sell it to Congressional Democrats. (Cutting spending is, evidently, considerably more controversial than assassinating Americans on the basis of secret Executive Branch determinations.) Boehner said that he could only sell the original deal. At the last second, President Obama then attempted to go back to the original deal, but apparently the negotiations were poisoned by that point.

What happened? Obama and his advisers have cast the collapse of the talks as a Republican failure. Boehner, unable to deliver, stepped away from the deal, simple as that.

But interviews with most of the central players in those talks — some of whom were granted anonymity to speak about the secret negotiations — as well as a review of meeting notes, e-mails and the negotiating proposals that changed hands, offer a more complicated picture of the collapse. Obama, nervous about how to defend the emerging agreement to his own Democratic base, upped the ante in a way that made it more difficult for Boehner — already facing long odds — to sell it to his party. Eventually, the president tried to put the original framework back in play, but by then it was too late. The moment of making history had passed.

Of course, the exact details of these deals, and what caused the disputes, have not been published.

Eric March 19, 2012 at 4:27 am

Of course ideologically each side is going to read that article how they wish to. However for me, the key passage is:
“. The Republicans wanted Obama to give up plans to raise the tax rate paid by the wealthiest Americans, now set at 35 percent. Instead, they wanted that rate to go down. They also wanted to preserve low rates for investment income — one of the biggest perks for the wealthy in the tax code — and establish a blanket exemption from U.S. taxes for corporate profits earned overseas.

Another key caveat: Much of the $800 billion would have to come from overhauling the tax code — not from higher tax rates.”

Between the lines here – If rates are going down and “overhauling the tax code” is going to generate any noticeable revenue at all, the Republicans are asking for Democratic fingerprints on ending the tax breaks for employer provided health care and mortgage interest. Setting aside weather or not that’s good policy, the R’s are asking for a huge boon for the top 5% in exchange for the D’s dropping the hammer on the 60-80%.

Also this part is just fantasy and shows the Republican’s just monkeying about, and have not come to actually talk with real numbers and math: “The Republicans believed lower rates and a simpler code would generate new revenue by discouraging cheating and spurring economic growth. …. Geithner and other administration officials say …they strenuously deny agreeing to count revenue from economic growth, a process known as “dynamic scoring.””

I have no problem conceding the fact that Obama is a terrible negotiator. However that deal, just like the gang of six and Simpson – Bowles was terrible for everybody from 95% down.

mulp March 19, 2012 at 6:04 am

Except Simpson agrees tax revenue must go up, while Boehner could never sell revenue going up, even if in his heart he knows they must – just not while he gets blamed – if Pelosi takes his place, he will sigh with relief when she hikes taxes and becomes the wicked witch, while he leads the munchins singing about how wicked the witch is.

But the Tea Party faction has a secret hidden tax: just default on all the debt thus taxing those with money invested in Treasuries at 100%.

TallDave March 19, 2012 at 12:29 pm

Or, we could cut spending. No, the world won’t end if we spend only what we’re currently raising. In fact, we could even cut taxes.

Andrew' March 20, 2012 at 5:02 am

Mulp,

We don’t “need” tax increases.

We only “need” tax increases for the Bush tax cuts (again, we don’t really need tax increases).

The catastrophe is the entitlements, for which there can only be entitlement cuts.

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