David Romer: Evidence for the Effectiveness of Fiscal Policy
David Romer (March 2011): What Have We Learned about Fiscal Policy from the Crisis?:
As Robert Solow stresses in his remarks in this session, we should not be trying to find “the” multiplier: the effects of fiscal policy are highly regime dependent.
One critical issue is the monetary regime. Consider estimating the effects of fiscal policy over the period from, say, 1985 to 2005. Central banks were actively trying to offset other forces affecting the economy, and they had the tools to do so. Thus if they were successful, one would expect the estimated effects of fiscal policy to be close to zero. But this would tell us nothing about the effects of fiscal policy in situations where monetary policymakers are unable or unwilling to offset other forces.
Fortunately, there has been a great deal of new research that sheds light on the effects of fiscal policy in settings where monetary policy does not respond aggressively. Some of it uses evidence from the crisis itself, but much does not; some focuses on a particular country, usually the United States, but some uses larger samples; and a considerable body of the work looks at evidence from different regions within a country, again usually the United States. One particularly appealing aspect of this last set of studies is that because monetary policy is conducted at the national level, it is inherently being held constant when one is looking at within-country variation.
Collectively, this research points very strongly (though, I should say, not unanimously) to the conclusion that when monetary policy does not respond, conventional fiscal stimulus is effective.3 And a careful examination of the evidence gives no support to the view that when monetary policy is constrained, fiscal contractions are expansionary (International Monetary Fund, 2010).  Even so, I find two types of evidence that predate the crisis even more compelling. The first comes from wars. The fact that the major increases in government purchases in the two world wars and the Korean War were associated with booms in economic activity, and that those booms occurred despite very large tax increases and extensive microeconomic interventions whose purpose was to restrict private demand, seems to me overwhelming evidence that fiscal stimulus matters.
The other type of evidence is more general evidence about the functioning of the macroeconomy. We know that monetary policy has powerful real effects, which means that aggregate demand matters. We know that current disposable income is important to consumption. And we know that cash flow and sales have strong effects on investment. It would take a strange combination of circumstances for those things to be true but for fiscal policy, which one would expect to work through those channels, not to be effective.
Given this wide range of evidence—not to mention the large body of pre-crisis work on the effects of fiscal policy that I have not even touched on—I think we should view the question of whether fiscal stimulus is effective as settled…
[3] For within-country evidence, see Chodorow-Reich, Feiveson, Liscow, and Woolston (2010); Suárez Serrato and Wingender (2010); Shoag (2010); Fishback and Kachanovskaya (2010); and Nakamura and Steinsson (2011). For cross-country evidence, see International Monetary Fund (2010); Council of Economic Advisers (2009); and Kraay (2010). For time-series evidence (as well as simulation-based evidence), see Hall (2009); Barro and Redlick (2010); Fisher and Peters (2009); Coenen et al. (2010); and Christiano, Eichenbaum, and Rebelo (2010). On this list, all but Kraay, Barro and Redlick, and Fisher and Peters implicitly or explicitly try to provide evidence about the case where monetary policy does not act to offset the effects of fiscal policy. With the exception of two of these three (Kraay and Barro and Redlick), the papers all suggest substantial effects of fiscal policy. As I describe below, this brief tour omits all work that predates the crisis.
