Stimulus Denial, Part N - NYTimes.com: Mark Thoma posts about another Cochrane rant, and about what John Taylor really said. Go read. I thought I should point out something else about Taylor’s claim (pdf) that aid to state and local governments had no effect, because they would simply have borrowed the money. Christina Romer (pdf) has already answered this, in devastating fashion:
Cogan and Taylor (2011) present a different view. They show that states had been borrowing heavily before the Recovery Act, and then borrowed less after the receipt of the state fiscal relief. From this, they conclude that the state fiscal relief in the Recovery Act had no net benefit—it just replaced state spending financed by borrowing with state spending financed by Federal aid.
Cogan and Taylor’s analysis shows the importance of specifying the counterfactual. Most states have balanced budget requirements. The requirements leave some room for deficit financing of current spending for a year or two, by running down rainy-day funds or the use of various accounting devices, especially if the deficit is the result of a downturn that was not expected when the budget was passed. But states didn’t have the option of continuing the pace of borrowing they had done in the 2008 and 2009 fiscal years. Absent the Recovery Act, states would have been forced to contract spending greatly. Therefore, relative to the plausible baseline, state spending was substantially higher following the receipt of the Recovery Act funds.
This is just one of those things where you have to ask, what is Taylor thinking? Does he really believe that states and localities could have borrowed all the money that they received from the ARRA, and thus spent at the same rate? Because if he doesn’t believe that — and he shouldn’t — his whole case falls apart. And if states and localities can borrow freely, how do you explain the drastic fall in their spending I have been documenting?
It is a mystery…
But, as Mark Thoma points out, not as big a mystery as John Cochrane. I had thought that we had gotten John Cochrane to admit that the national income identity was not a behavioral relationship--that when the government spent money there was no necessity (or even likelihood) that the people who would eventually pay the taxes to ultimately redeem the debt issued by the government to fund its spending program immediately cut back on their spending by as much as the government increased its. But here we have Cochrane again expressing what sounds a lot like the totally-wrong British Treasury view of the 1920s, again expounding what I call Eugene Fama's fallacy:
The Grumpy Economist: Manna from Heaven: the Harvard Stimulus Debate: Suppose the government pays contractors to… dig a ditch from Fresno to Bakersfield (high speed rail.) Is anyone surprised that GDP goes up in those areas?… When a donut shop relocates from LA, and people spend their salaries on donuts, that counts for more multiplier…. [T]o build the base or rail line, the government had to tax or borrow the money. Cross-sectional studies do not measure the loss of demand in (say) Chicago from the money that got spent in Bakersfield…. Stimulus has to be paid for. In evaluating stimulus for the whole economy, you have to count the loss of demand from the paying-for-it side equally with the raise in demand or employment from the spending-it side…. [Y]ou can't even rely on the magic of borrowed money -- you have to defend the idea that taxing Chicago to dig a ditch in Bakersfield raises output on both places by one and a half times the tax. Not impossible ([Steinsson and Nakamura] try), but not as easy as it seems…
I would say that it is very easy to get to a multiplier of 1.5 in a liquidity trap:
- Government spending goes up by $1 this year.
- Private future tax liabilities go up by $1 this year and private investment spending goes down by about 5¢ this year.
- Higher government spending raises the current price level, and reduces the burden of debt, freeing up risk-bearing capacity to finance investment and leading indebted businesses to spend more increasing their capital stock and indebted households to spend more on consumption.
- The expectation that some of the increased government purchases will ultimately be funded by monetization raises expected inflation and, as long as the economy's interest rates are at their zero nominal lower bound, reduces real interest rates and raises the incentive to spend more now on investment and consumption goods and repay it later.
At the ZNLB--in a liquidity trap--it is very hard to see how the policy-relevant multiplier could possibly be less than 1.5.
And Cochrane's overall rhetorical line--that "stimulus must be paid for" so the fall in spending in Chicago completely (or largely) offsets the rise in spending in Bakersfield--is a complete and false red herring: true in a rigid cash-in-advance economy with a technologically-fixed velocity of circulation, a constant stock of outside money, and an inelastic supply of inside money, but not true in our economy.
No, I have no idea what Cochrane thinks he is doing. It's a red herring. He really ought to stop.
Mark Thoma says:
Economist's View: Did the Stimuus Package Work?: [John] Taylor is not claiming that government spending didn't work, or can't work theoretically. He is saying there is no way to tell…. [Tayor] finds that the second type of stimulus, Federal grants to states and local governments, is ineffective, but it's important to understand why…. [Taylor] is arguing that transfers to state and local governments can work, and work well. Just look at China. If the stimulus package is designed so that state and local governments cannot use the money to finance existing projects, i.e. substitute federal money for state money rather than increasing overall spending, then it will work just as well as it worked in China. Thus, the lesson here is… that state and local governments [must not be allowed to] substitute [federal money] for other types of spending (though I should note, again, that I don't think the empirical evidence is anywhere near as clear as Taylor implies)…