In Which Charlie Stross Complains That California Is Insufficiently Terraformed...
Department of "Huh?!": Labor Market Demand and Supply for the Elderly Edition

An Elbow to the Ribs While the Ref Isn't Looking: Macroeconomic Analysis Department

Greg Mankiw, January 10, 2009, in a column written to diminish the chances that the Recovery Act would pass called: "A Dose of Skepticism on Government Spending":

Greg Mankiw: When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand. The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases…

This struck me as the equivalent of an elbow to the ribs while the ref wasn't looking, for Mankiw knew damned well that David and Christina Romer thought not that tax multipliers were bigger than spending ones but that both were bigger than studies like Valerie Ramey's suggested.

Me, January 12 2009:

The Romer View of Tax and Spending Multipliers Revisited: Mankiw's comparison of the 1.4 estimated spending multiplier from Valerie Ramey's study with the 3.0 estimated tax multiplier from the Romers' study is inappropriate…. [t]he Ramey study on the effects of government spending… does not fully control for the tax increases that often accompany spending increases. Thus it is very likely to understate the effects of spending increases alone: her study assesses the impact of the Korean-War military spending increase without taking account of the fact that it was accompanied by a large tax increase.

What Romer and Romer's study (and their earlier work on monetary policy) shows is not that tax cuts are uniquely effective, but rather that failing to consider the reasons for policy changes leads to underestimates of the effects of all types of stimulus. Because these issues of omitted variable bias are likely to be as strong for spending as for tax changes, the most reasonable interpretation of their paper is that all types of fiscal stimulus are more potent than conventional estimates would lead us to believe.

It is somewhat puzzling that Mankiw appears to believe that the Romers do think that tax multipliers are larger than spending multipliers, as they do not, and this is something that he could have very easily checked.

And Mankiw continued to argue that the Obama Recovery Act had been only minimally effective--that the poor state of the economy as the Recovery Act was implemented was not because the Recovery Act was too small but rather that it was the wrong kind of stimulus:

Crisis Economics: The patient, however, returns a few weeks later; this time, her symptoms are worse. What, then, should the doctor conclude? He might decide that he gave the patient the wrong medicine. Or he might determine that the patient was even sicker than he originally thought, and thus that the medicine should be administered at an even higher dosage. Either conclusion is plausible….

To the question of why their patient — the U.S. economy — did not respond as expected, the Obama team's answer is that the patient was sicker at the beginning of 2009 than they had originally thought, not that they administered the wrong medicine. The spending-heavy fiscal stimulus, they argue, was the right approach and did some good; if the stimulus bill had not been enacted, unemployment today would be even higher….

[I]nspired by the view that fiscal policy can prop up aggregate demand, Obama's advisors (and their congressional allies) began to design a stimulus plan heavy on direct government spending…. They determined that the "government-purchases multiplier" — that is, the multiplier for direct spending — would be 1.57, while the tax-cut multiplier would be 0.99. In other words, every dollar spent by the government would yield $1.57 in aggregate demand, while every dollar in reduced taxes would yield only 99 cents in increased demand…. The question for economists now is whether the administration's assumptions, and the model based on them, were correct….

Several studies on government-spending multipliers have been conducted using techniques similar to those used by the Romers. And none has found government-spending multipliers to be so large as to justify assumptions about the inherent superiority of government spending over tax cuts….

[T]he fiscal-policy decisions of the past year and a half have not been implausible or inexplicable — but they have also not been empirically shown to work. The data point to other approaches…

That struck me as much more than an elbow to Christina Romer's ribs--as, rather, a head butt, for Mankiw's argument was simply incoherent: use of Ramey rather than Romer-Bernstein multipliers led one to expect that the Recovery Act would be 50% more effective than the Obama Administration had claimed, and that the Recovery Act medicine was more rather than less potent:

Brad DeLong: Department of "Huh?!" Greg Mankiw Is Not Making Any Sense...: The $787 billion ARRA was about 2/3 spending increases and 1/3 tax cuts. Jared Bernstein and Christie Romer estimated that with a spending multiplier of 1.57 and a tax multiplier of 0.99 that the ARRA would boost production over its lifetime by $787 x 2/3 x 1.57 + $787 x 1/3 x 0.99 = $1,083 billion.

Now comes Greg Mankiw to say that they overestimated the impact of the ARRA because their multipliers were wrong: that he prefers a tax multiplier of 3 (from Romer and Romer) and a spending multiplier of 1.4 (from Valerie Ramey) and that as a result the right estimate was that the ARRA would boost production over its lifetime by $787 x 2/3 x 1.4 + $787 x 1/3 x 3 = $1,521 billion.

But, Greg, $1,521 > $1,083…

This track record seemed to use out here in Berkeley to demonstrate that Mankiw was being neither nuanced nor open-minded but, rather, playing for Team Republican. There is an argument that tax cuts for businesses are more effective stimulus than the hydraulic Keynesian model predicts because they bring the Confidence Fairy with them--but that argument is not buttressed by comparing Ramey kumquats to Romer and Romer oranges. And there is no argument whatsoever that adopting Romer-Bernstein rather than Ramey multipliers led Romer and Bernstein to overestimate the efficacy of the Recovery Act. No argument None. Nada.

This track record was why we out here in Berkeley were amused when Noah Smith saw Greg Mankiw on the teevee analyzing the situation as if it were obvious that the Recovery Act had a substantial effect on the economy--an effect as substantial as Christy Romer and Jared Bernstein had argued it would back in January 2009:

Noahpinion: Greg Mankiw thinks Obama's stimulus worked: Mankiw says:

Fiscal policy is going to be a drag going forward as the stimulus wears out.

And Noah commented:

Note that Mankiw has stated numerous times that he is a "stimulus skeptic." In general, he has been coy on the subject. On one hand, he has never claimed outright (as have many prominent "neoclassical" economists) that stimulus is incapable of boosting growth, and he has extolled the virtue of tax cuts (though he has left it unclear whether he believes they work via demand-side effects). But he has also said that he doesn't think Obama's stimulus was very effective, and he linked uncritically to a paper that purported to show that the stimulus destroyed jobs overall…. As Bob Lucas once said, "I guess everyone is a Keynesian in a foxhole." We're certainly in a foxhole right now…

Today Mankiw protests:

Greg Mankiw's Blog: Coy or Nuanced?: I have never asserted that the Obama stimulus was a complete failure in expanding aggregate demand.  Instead, I have suggested that there might well have been much better ways to promote recovery…. [F]rom a welfare standpoint, "conventional fiscal policy is the demand management tool of last resort."  In other words, in that model, conventional fiscal policy is effective, but it is still not the best tool to take off the shelf when facing a collapse in aggregate demand. Some may think I am being coy.  I consider myself nuanced and open-minded…

Alas! Mankiw's claim back in the summer of 2010 that the Recovery Act was significantly less effective than Romer-Bernstein had originally estimated--that $1,521 billion was less than $1,083 billion--did not strike any of us here at Berkeley as nuanced and open-minded. Nor did his attempt to demonstrate that spending increases were relatively ineffective by comparing Ramey kumquats to Romer and Romer oranges strike us out here as nuanced and open-minded.

More important, it seems to me that the claim that "conventional fiscal policy is the demand management tool of last resort" is neither nuanced nor open-minded when applied to the current situation.

The U.S. government right now can borrow at a nominal rate of 2.24%/year for ten years in an environment where expected ten-year inflation is around 2.5%/year. The short-term nominal interest rates the Fed usually targets are zero, turning its preferred policy tool--open-market operations--into relatively ineffective swaps of one zero-yield government asset for another. Asset prices tell us that our current macroeconomic distress is that the private sector is desperately hungry not for liquidity (which could be provided for the Federal Reserve) or savings vehicles of substantial duration (which could be provided by inducing businesses to invest) but rather for safe assets, which right now can most easily be provided by having credit-worthy governments spend and borrow.

An open-minded and nuanced look at the current situation strongly leads to the conclusion that conventional fiscal policy is, in situations like today, the demand management tool of first resort.

Comments