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Fed Historic Mistake Watch

What People Might Mean When They Say: "the Fiscal Policy Multiplier Is Zero"

Daniel Kuehn reminds us of Noah Smith from a year and a half ago:

Noahpinion: Actually, I don't think David Romer is batty at all...: I was responding to this quote of Sumner's:

Keynesian economists have never been able to accept my assertion that the fiscal multiplier is roughly zero because the Fed steers the (nominal) economy.

Now, I do admit that this sentence could mean several things! Let's consider three claims that could be represented by this statement:

Possible Claim 1: Because monetary policy can act in opposition to fiscal policy, the effect of fiscal stimulus depends crucially on how the Fed reacts to a stimulus.

Possible Claim 2: The data show that, in practice, the Fed does act to negate the effects of fiscal stimulus.

Possible Claim 3: Because the Fed can, in theory, counteract any fiscal stimulus, the effect of any fiscal policy on output should be considered to be zero.

So, let's look at these possible claims. Possible Claim 1 is… theoretical claim… says that monetary policy is always capable of counteracting fiscal policy. That claim is… certainly not batty.

Possible Claim 2 is… empirical claim. Therefore, it can't be logically inconsistent or "batty"; only the data will tell us…. I'm certainly willing to entertain the possibility that it is true (though I must say I am skeptical).

Possible Claim 3… says that (3a) when we talk about the "multiplier" associated with fiscal stimulus, we should include the Fed's reaction function in the model that we use to estimate the multiplier. This is the argument made by David Romer in some remarks cited by Sumner:

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… if [central banks are] successful [at offsetting the effects of fiscal policy], one would expect the estimated effects of fiscal policy to be close to zero.

This is just saying that there are several ways to define "the multiplier" - you can talk about the multiplier while holding monetary policy constant, or you can talk about the multiplier in the context of a model that includes the Fed's reaction function. If we look in the data and see that a fiscal stimulus was followed by an increase in nominal output, we could say that "The stimulus increased output," or we could say that "The Fed increased output by choosing not to counteract the stimulus." To borrow an old NRA slogan, it's a question of whether guns kill people or people kill people.

BUT, aha! Possible Claim 3 also involves a theoretical claim. This is the claim that (3b) the Fed's reaction function is invariant to fiscal policy! To see why, consider a world in which the Fed targets a 3% growth rate for NGDP if there is no stimulus, but raises the growth rate target in the event of a stimulus. In this case, it would make perfect sense to say "fiscal stimulus increased NGDP growth," in the sense that we normally think of causality. It would make no sense to attribute the growth increase to the Fed. That would be like saying "You think you put butter on that piece of toast, but actually it was I who put butter on that piece of toast, since I could have clobbered you on the head and stopped you from putting butter on the toast, and I chose not to. Thus, you are incapable of buttering toast; only I can butter your toast." That would be a truly batty claim!

And it was this claim, Possible Claim 3, that I believed Sumner to be making…. When I go back and read that sentence again, it still sounds like Claim 3b, but that could be my minsinterpretation. Perhaps Sumner was only making a combination of Possible Claims 1, 2, and 3a…. And if this was the totality of what he was saying, then I was indeed mistaken in bringing out Bat Boy…. So perhaps I was too quick to say that Sumner's claim was batty. It was simply the case that the claim I thought Sumner was making would, in fact, be batty.