Forecast: Changing Pessimistic to Obtuse
Robert Barro and the embarrassing accounting of multipliers
Paul Krugman and the conservativism of liberals
Listen to this episode
We need to clear up some more mathematics.
The airwaves are alive with rumors of the so-called second derivatives. The second derivative in calculus is supposed to be showing that the real economy is experiencing a lesser decline in its rate of decay. The second derivative is the rate of change of the rate of change of the various bad news lines. So we can be negative in the first derivative and sooner or later things will turn around as a result of the second derivative. Things are sure to eventually get better, as the function must eventually turn positive.
But consider a simple linear function with a constant. Perhaps we are not slowing down, just getting closer to the bottom. For example, say the base of the employment to population ratio is certain to have a bottom at .... Ooops. Not a good example. The employment to population ratio is going straight down, there is not lessening of the worsening. It started the recession at 61 percent and it is below 59 percent and headed directly for the years before the two-earner family.
All right, hypothetical. A couple of examples. Just agree that if monthly numbers are coming down from 100 to 90 to 81 to 73, the absolute value of the number is coming down, from 10, to 9 to 8, but its relative value is constant at 10 percent per month. Not what we started to show, but a short step from this is to imagine the lower bound is not zero, but a positive number. Imagine, for example, not everybody will lose their jobs. That social programs or just simple provisioning will require at least a skeletal workforce. If that number is, in our example, say 60, then the decrease in numbers is actually an increasing rate of descent. We're losing 25 percent with ten, 30 percent or so with nine, and 38 percent with eight.
Second derivatives are mathematical voodoo designed to let us think there is some self-correcting mechanism out there that is pulling things back to a normal path. A reversion to the mean. An equilibrium state that is naturally attracted to economic activity by, I don't know, the spirits that haunt the Chicago School?
No. We have to build the economy we want. We're getting all too much Hooveristic, "Let things alone now that Wall Street has been saved."
Up today is the new unemployment number. 10.2 percent. With 17.4 percent on the all-in U-6 measure. Demand Side has that U-6 tickling 20 percent with the forces already baked in.
People ask where are the jobs going to come from? They will come with the natural turning of the economy toward the sacred second derivative. Or maybe they need to come from investment. The reason the 2001 recession was a jobless recession is that there was no business investment, only borrowing and buying of housing and ancillary development.
There is no investment left on sufficient scale in the private goods sector. We have plant and equipment and facilities in consumer goods production just standing idle which will absorb workers without new investment. And even if we didn't, the consumer herself is not going to demand production on a scale approaching that of the previous decade, let alone on a scale or with a long-term stability that will be sufficient to produce new investment opportunities. There is just no route to a sustainable recovery that just involves people going back to work in the same factories.
Some optimists point to the absurdly high productivity numbers which have accompanied the disaster in employment. This shows that business is ready to return to profitability, they say. In fact, as we pointed out not too long ago, the short-term productivity numbers respond dramatically and in the opposite direction as in the longer term. In the current calamity, however, the drastic cuts by business were plainly caused not by enlightened cost-cutting, but by the weight of excess debt and the need to cut whatever variable costs they could. Overhead costs and financing costs are not variable. It is just as Minsky would predict. That dynamic -- the excess leverage -- means bad things for investment going forward.
Optimists have similar positive spin for companies who are hoarding cash. But cash is an indication that they need insurance in an illiquid economy. There is no cash being hoarded when the economy is booming. Quite the opposite.
We put out three paths for economic indicators last time. Baseline, Optimistic and Pessimistic. But that was a mistake. It makes us sound like our projections are more vague than they are. What it was meant to deal with was the possible policy regimes from might be forthcoming from the Administration and Congress.
It has always been our explicit position that the economy is not a natural force insulated from policy, but is actually quite sensitive to policy. So rather than assume optimistic, pessimistic and baseline scenarios for policy, we should have simply estimated the economic effects of each policy choice. Then the forecast could be adjusted as each came on line (or did not).
This eliminates our fudge factor. And we can throw in the Cash for Clunkers and First Time Homebuyers programs without appearing to bring things out of left field.
More complicated, but cleaner, and less difficult to deal with later. It will also give us a chance to rank the different policy choices by their impacts.
- Breaking up the big banks
- $200 billion per year surface transportation infrastructure building
- $40 billion per year smart grid
- Self-contained $20 billion start-up retrofitting per Clinton
- financial products safety commission
- Home Owners Loan Corporation
- Aggressive Tax Revenue
Higher marginal rates on high incomes
Higher marginal rates on high incomes
Here we diverge from our progressive colleagues who insist recovery must be deficit-financed. The difference between borrowing from and taxing the high earners escapes me. The reason we allow financial casinos to go on without a per-chip charge, I don't know. And gas taxes are straightforward and understandable. Carbon trading is untried and if it works needs massive international cooperation not to be forthcoming from the current climate.
Talk about unclear on the concept: The embarrassing mistakes of Robert Barro
Sometimes it is better to start with theory, or at least match theory to empirical evidence, before you make loud and public statements. Here it is the claim of Robert Barro that the multiplier for government spending in stimulus programs is less than one. In a recent piece he and his colleague found that for defense spending, the empirically discovered multiplier was between .6 and .8. Less than one.
This means that for every dollar of spending, the economy contracts by between 20 and 40 percent. You'd think somebody would notice.
But I suppose, since defense spending can be overseas and is in nonproductive assets like ... guns, it is conceivable. Barro goes on to say, however, that the likely multiplier for stimulus programs is similarly .6 to .8.
Now if a contractor gets paid for building a road, the government spends one dollar and the contractor receives one dollar. The multiplier is already one. The theory of the multiplier is that part of this dollar will be spent by the recipient, thus increasing the total gain to more than one. Barro's finding suggests that economic activity declines because ... well, apparently this dollar pushes another dollar out of the way, through the evil of taxation, or something.
Yikes! We'd better tell the world that their stimulus money is about to cause a Depression far worse than the Great Depression.
Empirically, we find that the effect on private consumer spending is not significantly different from zero, while net exports are slightly (but significantly) crowded out and private investment falls considerably.
That is, Barro finds the person with the government-paid job spent zero of his income! Private investment actually falls!
This laughable finding is available only if you ignore theory and try to isolate results empirically. First you have to invent a place to stand (and your assumptions have already tainted your findings) and then you have to pretend one or another is a baseline trend. Barro uses variation from a long-run mean. We pour water in the ocean and if the level doesn't go up, it is not because of the tide, it is because the water had no volume.
Now the multiplier is not simply the government spending multiplier. It is also the investment multiplier. One must wonder whether the investment multiplier, which suffers from all the limitations of a government spending multiplier -- indeed, even some of the construction projects are similar -- Does the investment multiplier suffer from the same negative number? That is, when you build a factory, is your investment actually subtracting well-being from the economy?
With the mean variation technique, it is hard to say. It is possible the effect would be enormous, since private investment is most often done in economies that are expanding. I could conceive of Barro finding a private investment multiplier in the 3's or 4's.
Is the factory producing electronics fundamentally more productive than the road that carries the electronics or the water system that serves the consumer of the electronics. Likely not. Definitely not. In terms of well-being, the public goods are no doubt in fact more productive.
And the effect of needing to raise taxes to pay for deficit spending is mirrored in the private sector by the need to pay back debts for private purchases. This painful side of leverage is much of what is now burdening the entire economy and frustrating its attempts to grow. Bankruptcies, foreclosures, and so on are the failures. The successes are those struggling week to week to keep the bills from coming in overdue. I contend in yet to be published material that this leverage is what keeps the multiplier from kicking in with force.
Needless to say, you can't get to the size of the multiplier by measuring the level of the soup into which it is poured. You just have to observe that people spend their incomes. There is a measurement of how much they don't spend. It is called the savings rate. If you then suppose that people who receive that spending may spend some of it, then that increment is added to the multiplier. If you still live in the delusional world of Rational Expectationists, then perhaps people are somehow contracting their spending in the long term. But that is not the real world.
Now I will admit that the multiplier for tax cuts could be far lower than that for government spending on infrastructure or teachers or other real outlays. Why this would be is that the increase in incomes comes in the form of a marginal increase to a current income. Twenty-five dollars per week, two percent per year, or a flat rebate of $300. This increase could well go into savings or to pay down debt and so would not be multiplied. But the employment of a person or a company in the condition where they would not otherwise be employed is already one.
It is theory because it is conceptual. Much like you would not assume a person went nowhere all day because he ended up in the same bed, you cannot assume that there is no activity because from one measurement point to another is not different.
End of story.
Oh, I can't resist. Quote "Conceptually, our measure of the average marginal tax rate corresponds to the substitution effect of taxes on incentives to work, produce, and invest." Unquote.
One wonders how much the government contractors and employees would be incentivized absent their pay. But they work, produce and invest in a universe parallel, but not connected to the Barro dimension.
This is the kind of economics that is the orthodox line. It is starting from less than zero in its conceptual skills. And it is producing far less than it is consuming in insight or useful information.
I'll stop now. The piece is in the transcript. Demandsideblog.blogspot.com. Link as well.
Robert Barro Charles Redlick
30 October 2009
The recent global recession has made the efficacy of fiscal-stimulus packages one of the most prominent policy debates in economics today. This column finds that the multiplier of defence spending falls in a range of 0.6 to 0.8 and argues that non-defence multipliers are unlikely to be larger. It says we should be sceptical when policymakers claim government-spending multipliers in excess of one and suggests tax cuts may be preferable to spending increases.
The global recession of 2008-09, one of the longest and deepest since the Great Depression, has made the efficacy of fiscal-stimulus packages one of the most prominent policy debates in economics today. These packages typically attempt to smooth out business-cycle fluctuations through a combination of increased government purchases of goods and services (to replace falling private demand) and tax cuts or rebates. The spending component of these packages is typically motivated by the belief that the expenditure multiplier is greater than one – in other words, that total output in the economy will expand by more than the increase in government purchases. Unfortunately, the existing empirical evidence on the size of the spending multiplier is limited at best. In ongoing research (Barro and Redlick, 2009), we attempt to estimate the impact of changes in spending and taxation on economic output using long-term macroeconomic data from the US. We hope that our estimates from this project can provide a useful benchmark in thinking about the design and effectiveness of fiscal-stimulus programs.
Previous research has taken a variety of different approaches in attempting to measure the impact of fiscal policy tools on output. One approach, exemplified by Blanchard and Perotti (2002), has been to use vector-autoregression (VAR) models in which identifying assumptions are made on the order in which the variables are allowed to move. Typically, the government expenditure variable is allowed to move first, and the responses of other variables are treated as causal. Another approach comes from Romer and Romer (2008). Their project takes a “narrative” approach, in which they read the legislative record for evidence on the motivation behind tax changes, as well as the size of the intended impact on federal tax revenue. They use this evidence to categorise tax changes as either endogenous or exogenous and then measure the impact on output from the exogenous shifts.
Our own empirical work begins by extending the times series of average marginal income-tax rates in the US constructed by Barro and Sahasakul (1983, 1986). Figure 1 plots the results; details of the computations can be found in Barro and Redlick (2009). Conceptually, our measure of the average marginal tax rate corresponds to the substitution effect of taxes on incentives to work, produce, and invest. This construct differs from the Romer and Romer measure of prospective federal tax revenue (as a ratio to GDP), which captures the income effect of taxes on disposable income.
Figure 1. Average marginal tax rates in the US, 1912-2006
Our empirical analysis treats the dependent variable as the annual growth rate of real per capita GDP, with the change in government defence purchases and the lagged changed in the average marginal tax rate (along with other controls) as the explanatory variables. In samples that include World War II, we find the multiplier effect of defence purchases is precisely estimated (and highly statistically significant) in a range of 0.6 to 0.7. Advocates of fiscal stimulus often claim the multiplier may be higher when there is more slack in the economy, so we also include the interaction between the change in defence spending and the lagged deviation of unemployment from its long-run median. As predicted, the estimated coefficient is positive and significant, with the defence purchases multiplier rising by about 0.1 for every two percentage points by which the unemployment rate exceeds its long-run median of 5.6%. Even by this estimate, however, the defence-spending multiplier would reach one only at an unemployment rate of about 12%. While we note that it would be highly desirable to also estimate the effect of non-defence purchases on output, the absence of good instruments leaves us with no solution to the obvious endogeneity problem. This is an especially thorny issue since state and local outlays have come to dominate non-defence expenditure, and these outlays are particularly sensitive to fluctuations in tax revenue (which are in turn partly determined by aggregate economic conditions).
A further question of potential policy interest is the mechanism by which the expenditure multiplier falls below one. As an accounting identity, in order for total economic output to rise less than one-for-one with increased government spending, some other component(s) of GDP must decrease. A relevant question, therefore, is exactly what gets “crowded out.” We attempt to answer this question by breaking down the impact of increased government expenditure on GDP into its various components. In particular, we consider the impact on private consumer expenditure, gross private domestic investment, and net exports. Empirically, we find that the effect on private consumer spending is not significantly different from zero, while net exports are slightly (but significantly) crowded out and private investment falls considerably.
Increased government spending is often accompanied by tax cuts in most fiscal stimulus packages. Our analysis of the effects of tax changes on output involves entering our newly constructed measure of the average marginal tax rate by itself and in combination with the Romer and Romer tax variable. We believe our research complements theirs and hope that the combination of the two measures may allow us to distinguish between the substitution effect of tax-rate changes and the income effect of total tax liability changes. In a sample beginning in 1950 (using only our marginal tax-rate series), we find that a one percentage point decrease in the first lag of the average marginal tax rate produces a 0.6% increase in the annual growth rate of real per capita GDP. Unfortunately, this effect is harder to pin down in longer samples, particularly when they include World War II and the Great Depression. The fact that the Romer-Romer series and the changes in our measure of the average marginal tax rate from the federal income tax are correlated to the tune of 0.76 from 1950 to 2006 makes separating their effects difficult. It might be that income effects are nil (given the tax-rate effects), but it is also possible that the tax-rate effects are nil (given the effects on government revenue).
Our bottom line from this research is that a healthy scepticism is warranted when policymakers claim government-spending multipliers in excess of one. Our estimates suggest that the multiplier effect of defence spending falls more in the range of 0.6 to 0.8, and we find it unlikely that non-defence multipliers would be larger. Therefore, our conclusion is that total economic output increases less than one-for-one with increased government purchases. However, we do find evidence to support the view that tax cuts stimulate total output, with a one percentage point decrease in the average marginal tax rate leading to an increase of about 0.6% in the growth rate of real per capita GDP. As such, our preference in the design of fiscal stimulus packages would be for more tax cuts and less reliance on increased government spending.
Barro, R.J. and C.J. Redlick (2009). “Macroeconomic Effects from Government Purchases and Taxes,” unpublished, Harvard University, October.
Barro, R.J. and C. Sahasakul (1983). “Measuring the Average Marginal Tax Rate from the Individual Income Tax,” Journal of Business, 56, October, 419-452.
Barro, R.J. and C. Sahasakul (1986). “Average Marginal Tax Rates from Social Security and the Individual Income Tax,” Journal of Business, 59, October, 555-566.
Blanchard, O. and R. Perotti (2002). “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output,” Quarterly Journal of Economics, 117, November, 1329-1368.
Romer, C.D. and D.H. Romer (2008). “A Narrative Analysis of Postwar Tax Changes,” unpublished, University of California Berkeley, November.
This article may be reproduced with appropriate attribution. See Copyright (below).
Ah, Keynesian doesn't mean what it used to. Take Paul Krugman's feud with Edmund Phelps recently in which Krugman said the only reason Keynesians were talking stimulus is because we are up against the zero bound. That is, we cannot cut interest rates any more, so we've got to do something.
This is the "We're all Keynesians, or should be, in a foxhole." A broader approach might allow the Keynesians to have been right over the past thirty years along the lines Minsky described, and the economy to be vulnerable to Minsky's instabilities and to Keynes' casino markets.
Elsewhere Krugman got into it with one of the Chicago School laughers about a spurious claim that growth had accelerated since 1980. Eugene Fama, I think. Well, no. Growth has decidedly not been more robust since 1980, and quite the opposite. Krugman put up some statistics by decade on how this has not been the case.
But here again, we missed the boat. Notice that between 1946 and 1980 the White House was split about evenly -- 18 years for the Democrats, 16 for the Republicans. After 1980, the Republicans were in there for 20 years and the Democrats for 9. And it was during the eight Democratic years of Bill Clinton's presidency that the bulk of the growth was made.
This is not about the virtue of Democrats and the vileness of Republicans. It is about how demand side policies, which arise when politicians attempt to serve a broader constituency, are better for the economy. As it happened, I dropped the research on the subject into the comment queue at Krugman's blog and found it later to have been excised by the moderator. Censored. I was so incensed to have been censored that I put the charts up on the web at economicperformancebypresident.blogspot.com. The assiduous among you will recognize it as Chapter 4 of the first edition of Demand Side, the book. It is now, yikes, Chapter Eleven in the draft of the second edition. No. It's chapter 13!
I am not making this up. These are the standard metrics of employment growth, unemployment rate, real GDP growth, profitability, and investment, plus our exclusive net real gdp number which brings in the deficit. Yes, they all favor Democrats.
This is directly in line with our bias that policy matters, but seemingly outside the conceptual capacity of most other economists, who believe in a kind of natural sphere outside the reach of public policy. A nebulous place I confess I cannot see.