Cyclically adjusted measures of the stance of fiscal policy

by on November 1, 2012 at 2:15 am in Economics, Uncategorized | Permalink

These cyclically adjusted measures are useful information and should not be discarded, but I don’t wish to use them as the sole or main or dominant source of information about the stance of fiscal policy.  Here are a few reasons why:

1. The cyclically adjusted measure relies on a measure of potential output.  That is not a big problem when potential output is clear, but in a lot of today’s cases the very debate is over the size of the output gap.

Let’s take the current UK.  If the output problems all resulted from supply and productivity failures (not the case, just a hypothetical), the numbers would indicate that the current fiscal policy stance is quite expansionary with high budget deficits.

Alternatively, if you take a more Keynesian view, the potential output gap is much larger and, cyclically adjusted, the stance of fiscal policy looks much more contractionary by the cyclically adjusted measure.

Very often the key question is something like the following: how much are the current UK problems demand-side and how much supply-side?  I see economists addressing this question by invoking cyclically-adjusted measures of the stance of fiscal policy.

This is has a significant element of circularity.  If you assumed a big output gap to begin with, the demand-side crunch is measured as very large.  If you assumed a very small output gap to begin with, the measure gives you a very small demand-side crunch in this case.

Maybe you have seven other reasons for believing it was a large demand-side crunch, but that doesn’t make this a good measure.  Your results depend very much on the assumption — about potential output and thus demand — which you put into it.

Furthermore this point is far from transparent yet I don’t exactly see proponents of the cyclically adjusted measure tripping over themselves to remind us of it.

(As an aside, the IMF, before this issue became so politicized, expressed precisely this reservation about cyclically adjusted measures and in fact did not appear to favor them as a general approach, while admitting they do provide some interesting information.)

2.  There is a big difference between two cases: “the government drove an AD collapse by massive net spending cuts” and “big problems happened and government didn’t fill the gap nearly enough.”  These cases have different economic and political causes, may involve different remedies, and very likely will yield different multipliers, both for initial effects and when it comes to potential remedies.  I want my metrics for the stance of fiscal policy, and my commentators on fiscal policy, to disaggregate them, rather than to blur them together.  Cyclically adjusted measures blur them together.  There simply is not one big multiplier for “austerity” as a general concept.

3.The cyclically adjusted measures are an abstraction, and furthermore an abstraction based on estimating a modal quantity, namely potential output.

To give an analogy, I get uneasy when I read sentences such as “inequality caused X.” “Inequality” didn’t cause anything.  Inequality is a statistical residue of some other actual processes.  It is better to say what caused X (say “the rage and poverty of inner city residents”) and, if relevant, connect this to inequality as well.  Except that the cyclically adjusted deficit is an even more problematic causal concept than “inequality” because it relies on measurement of a modal, namely potential output.

The word “austerity” is a political concept and it does not belong in rigorous economics.  Let’s just say what happened.  Note the simple causal language in my point #2.

4. The mainstream literature on fiscal policy, starting at least with Blinder and Solow (1973), slots “G” and “Gdot” into the model as the measure of fiscal policy.  Paul Krugman pieces do this too, as do hundreds of other economists.  Models are there to give us some discipline, so let’s use that discipline.  Why is it that so few of these classic models used the cyclically adjusted deficit measure to express the stance of fiscal policy?  Because many of those economists know that, in the causal sense, that is a whacky measure and best used with caution.  It simply is not “the standard measure of the stance of fiscal policy.”

5. These days there is a sudden near-moratorium on citing open economy models of fiscal policy in smallish open economies with floating exchange rates (it may not matter nearly as much as you think for AD).  This should be incorporated into the discussion more, yet oddly it suffers from relative neglect.  Note also that a) the UK hasn’t the whole time been at the zero bound, and b) you still can depreciate your currency at the zero bound.

6. Let me sum up where we (at least many of us) agree.  British policy should have been much more countercyclical than it was and indeed I have thought this from the beginning.  But I still see many commentators, writing on British fiscal policy, giving us an exaggerated sense of its potency, an exaggerated sense of the causes of the British downturn in the AD/fiscal policy direction, and cloaking all of this under non-transparent terminology, while keeping the various important qualifications rather silent.

I have further points to make about UK austerity in particular, and the Wren-Lewis blog post, but I’ll save those up for another day.  On some details of the UK economy, Matt’s simple treatment makes a lot of sense and he is also (correctly) a major proponent of the relevance of AD analysis.

DocMerlin November 1, 2012 at 4:40 am

‘The word “austerity” is a political concept and it does not belong in rigorous economics. Let’s just say what happened. ‘
“I have further points to make about UK austerity in particular”

FAIL! The entire time you don’t actually say what the UK government actually did, or what actually happened.

Sam November 1, 2012 at 12:31 pm

It is also worth noting the difference between the tone of what politicians say they are doing, and the content of what they actually do. Both things, of course, can affect the way that people behave.

Michael Heller November 1, 2012 at 6:03 am

“On some details of the UK economy, Matt’s simple treatment makes a lot of sense and he is also (correctly) a major proponent of the relevance of AD analysis.”

By the length and tone I judged this to be a serious piece by a top economist. But the last sentence spoiled it. According to wikipedia Matt graduated only 10 years with a philosophy degree. There’s no mention of a master’s degree let alone economics. “Major Proponent” of a complicated economic theory? Tyler sometimes you take this blogging lark too seriously.

Claudia November 1, 2012 at 6:36 am

And you are taking economists too seriously? You don’t need an advanced degree in economics to say something intelligent about the economy…for some it’s even a hindrance. I was happy to see austerity called out as a slippery term.

W.E. Heasley November 1, 2012 at 6:48 am

What if the political term “austerity” is related to the movement from a government privilege based economy to an economy based on economics? Stated alternatively, if politicos through the mechanism of government purposely create, over time, an economy based upon government privilege and a new set of politicos attempt to reverse the process, then the undoing means a disenfranchised recipient class (the end product of constituent building exercises through taxpayer money).

The reversal process affects those politicos who’s past, present and future political constituency base hinges upon political constituency building exercises through tax payer dollars. Further, the existing political constituency built through taxpayer dollars, the flesh and blood recipients, are then disenfranchised from receipt of other people’s money.

Hence the process itself is basically reversing Milton Friedman’s famous fourth category of spending i.e. other people [politicos] spending other people’s money [the spongy conduit of taxpayer dollars] on other people [recipient class]. Removing the spongy conduit of taxpayer dollars means “austerity” to the politico as it interrupts the process of political constituency building exercises through tax payer dollars and it’s also “austerity” to the current political built constituency as the spongy conduit is closed.

Hence the term “austerity” is cast in a negative political light as it interrupts and/or reverses the process of building a government privilege economy.

“The government has nothing to give. The government is simply a mechanism which has the power to take from some to give to others. It is a way in which some people can spend other peoples’ money for the benefit of a third party – and not so incidentally themselves”.

- The Invisible Hand in Economics and Politics, Milton Friedman, Institute of Southeast Asian Studies, 1981, p11.

Andrew' November 1, 2012 at 7:53 am

I guess noone has to answer my question, but I’ll say it again, overcapacity, or a potential output gap is the reason for price drops. We can certainly build more houses, but it was the fact that we could build so many houses and nobody wanted them that precipitated the housing crash.

DocMerlin November 1, 2012 at 7:58 am

Bingo. Output gaps are a symptom, not a cause.

GiT November 1, 2012 at 4:37 pm

There’s a Marxist economic historian (eww, ickk, boo, hiss, mood affiliation!) who focuses a lot on overcapacity’s relation to the housing bubble and the crisis and the general problems proper to “the great stagnation.” Perhaps of interest to the curious: http://solidarity-us.org/pdfs/BrennerLongDownturnNewAmerica20102.pdf

DanC November 1, 2012 at 8:20 am

What happens if a large percentage of the drop in potential output is because of government policy – increased regulation, uncertain future taxes, potential increase in size of government (some crowding out), etc.

Also “austerity” that substitutes government mandates (or regulations) for direct spending could be more distorting to economic activity then fiscal spending.

derek November 1, 2012 at 10:31 am

A mixture of regulations an Fed policy are making it more profitable for US banks to buy Treasuries than to lend to businesses and individuals. This is real austerity. The government borrowing over a $trillion more than they take in and the efforts to keep the fiscal situation from collapse is causing serious problems in the economy.

Benny Lava November 1, 2012 at 8:45 am

An economist admits error? Very refreshing.

“The word “austerity” is a political concept and it does not belong in rigorous economics”

So this means you will never link to De Rugy again?

GiT November 1, 2012 at 4:37 pm

We can dream, can’t we?

UKGB November 1, 2012 at 9:55 am

great post

In terms of missing qualifications, the greatest is the Sumner Critique. Chris Giles today in the FT gets this bang on

Nick Rowe November 1, 2012 at 10:44 am

Tyler: agreed. But the concept is even worse than you think. Suppose one government is a “hands on” government that likes to increase G and cut T in a recession. A second government is a ‘fire and forget” government, that sets up some rules so that G automatically rises and T automatically falls in a recession. But G rises and T falls by exactly the same amounts for both governments. The first has a “structural” deficit, and the second doesn’t. My old post: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/01/what-is-a-structural-deficit.html

Brian Donohue November 1, 2012 at 11:01 am

+1.

‘The distinction between automatic and discretionary fiscal policy, and hence between cyclical and structural deficits, is a political distinction, not an economic one.’

Like austerity?

Hakan November 18, 2012 at 12:13 am

Dear Bill,Thanks again, I hope to make it to DC and learn something from the Teach-in.My sieogstugn would be to include some mano-a-mano to the Peterson Groups five major arguments.Actually, a lot of that.I want to raise another point here, perhaps nit-picking in the $Trillions to one of the basic tenets of chartalist thinking.This is not an argument, rather something I think needs addressing. It’s partly that self-imposed constraint thing the actual lack of the government being the monopoly-issuer of currency in our sovereign, non-pegged exchanging world.The first part may be simple in that it is not the government that is issuing the currency here in the US. Our self-imposed constraint is the creation through the law of the land of the supposedly-PRIVATE, supposedly-monopoly currency issuer that of the (non)Federal Reserve Bankers.Simple enough remove the self-imposed restraint and make the Fed part of the government where we the sovereigns take over, and in your generally presented view, control the money system through issuance of monetary reserves (hot money) to manage the currency. Simple. Repeal or amend the Fed Act.But what about the other $Trillions? What about the powers of the Shadow-Investment bankers to create $USD-denominated thingies, or vehicles’, that create $-denominated financial debt obligations that serve the exact same function as currency so to me they are currency. It was well stated defensively by almost every Fed official at the Minsky Conference last week that MOST of the money created during the entire last generation was NOT created by the (non) Federal Reserve commercial banking system.I guess my point is that the self-imposed restraints go further than bringing the central-banking function back under the government. It must include a broad prohibition against the ability of any private leveraging up of base money with financialized debts.My solution to the present inevitable debt-money deflation cycle is the same as proposed by Dr. Fisher a move to real, honest full-reserve banking. What do we do about the money-creation power of the shadow bankers?Thanks, Bill.

Donald Pretari November 1, 2012 at 1:42 pm

Good points. However, since I was a Philosophy Major in college, you shouldn’t care what I think.

ChrisA November 1, 2012 at 8:28 pm

Personally I don’t care if “government austerity” is causing slower measured GDP in the UK. I don’t believe that the measured GDP growth resulting from Government activity is real anyway, it may appear in statistics but it really doesn’t add to the value of peoples lives. In fact in many cases ceasing government funding activities improves peoples lives. For instance one of the activities scrapped by the coalition government was the national identity card scheme. I am sure that measured GDP would have increased had this scheme proceeded, but I am glad to swap the lost GDP for more freedom. Statist economists, such as Krugman and Wren-Lewis, who perpetuate the post war establishment view that Government is always the answer, and the more the better, will never understand this.

Phil Perspective November 3, 2012 at 4:02 am

Statist economists, such as Krugman and Wren-Lewis, who perpetuate the post war establishment view that Government is always the answer, and the more the better, will never understand this.

Proof? You make a big mistake. No one, I repeat no one, ever says Government is always the answer.

Justin Boland November 2, 2012 at 9:52 am

Just curious — are you really saying that “the rage and poverty of inner city residents” is a “cause” unto itself, or was that just awkward grammar?

Hugh November 2, 2012 at 11:39 am

When talking about the UK it is worth bearing in mind that public spending is now around half of total GDP (44.5%). How does this play into the discussion?

To my way of thinking (and I am not an economist) it means:

1) Any real cut to G will have an effect on GDP, just because it’s such a large part of GDP. However, please note that government spending in the UK is not declining, it is merely increasing at a greatly reduced rate;

BUT

2) Any attempt to meaningfully increase G as Keynesians wish becomes prohibitively expensive for the private sector that must, at the end of the day, pay the bill.

I have no simple answer to this quandary, but my gut tells me that the best course of action would be to freeze G and not to implement tax increases (the UK government has increased both VAT and income tax).

I agree that simply talking about “Austerity” does not help us understand the situation any better.

Phil Perspective November 3, 2012 at 4:07 am

If you are called a racist, just look at # 3 and you’ll see why they do.

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