Suppose there was a huge stock market crash that destroyed lots of wealth. Would it reduce AD? One would think so, and some might cite the 1929 crash. But the Fed reduced the monetary base between October 1929 and October 1930 at one of the fastest rates of the 20th century. So perhaps tight money caused NGDP to fall.
Sometimes I point out that a virtually identical stock market crash in 1987 had no significant impact on AD, not even a tiny slowdown followed the crash. But it’s hard to convince people, as you’d think a crash would reduce AD. Some people argue that 1987 was different, because Greenspan eased monetary policy to prevent a fall in AD. But when I hear that argument I think to myself; ”That just proves my point, monetary policy drives NGDP.”
In 1981 we had a rare exogenous fiscal policy shock. Reagan was elected and took office in the midst of a business cycle expansion. During 1980:4 and 1981:1 NGDP was soaring at an 18% annual rate. He quickly introduced an expansionary fiscal policy; big tax cuts and huge military spending increases. And a few months later NGDP growth plunged sharply.
Once again, people will point to the fact that it wasn’t a fair test–Volcker was simultaneously engaged in squeezing inflation out of the economy. (Of course Keynesians weren’t using that excuse in 1981, when they predicted the Reagan deficits would lead to high inflation.) But when I hear that argument I think; “That just proves my point, monetary policy drives NGDP.”
I do understand why fiscal stimulus has a powerful intuitive appeal, and would concede that one can find episodes that seem to support that assumption (like 1940-41.) But I also think that people may sometimes let this intuitive appeal overcome their better judgment.
This past February I criticized (here and here) a paper by Feyrer and Sacerdote that used regional data to estimate the fiscal policy multiplier. A number of prominent Keynesians like Brad DeLong, Dean Baker, and Paul Krugman cited this evidence favorably. But it doesn’t really tell us what they thought it did, as even those models that predict no fiscal multiplier at the national level, would predict a fiscal multiplier at the regional level. If the federal government pours $10 billion into a nuclear weapons base in North Dakota, then North Dakota’s GDP will rise. We all get that. The question is whether America’s GDP will rise.
So while this paper claims to show the effect of military expenditures on output, it really shows that military expenditures create jobs and attract capital (they have an IV but as far as I can tell it doesn’t address this issue).
But can we salvage the overall message of the paper? Isn’t creating jobs and attracting capital exactly what we’re trying to do with fiscal stimulus? Yes, but not if it means that labor and capital is coming from other States. GDP is increasing in the States that have more military expenditures but is necessarily decreasing in the States that are losing workers and capital. Because these two effects cancel each other out, the “true” fiscal multiplier is less than the 1.5 estimated by this paper.
NGDP normally grows 15% over three years. Since mid-2008 it’s up just over 4%. How much less would the growth have been if there had been no ARRA? How should I know? It depends on what the Fed would have done if all the responsibility for stimulus had been put in their hands. I could easily see the number being less than 4%; the Fed might not have made up for the shortfall. Or maybe they have a 0.6% floor in core inflation (as in 2010), and we would have ended up in the same place. Or maybe they would have been very aggressive and done level targeting of the price level in the absence of any fiscal stimulus, and we’d actually be a bit ahead of where we are now.
I’m not saying the fiscal stimulus advocates are wrong; I lean toward the view that the net effect on NGDP is probably slightly positive. But anything more seems like an act of faith to me.
BTW, I do know that Bernanke talks like fiscal stimulus works. And I also know that he’s uncomfortable pushing monetary stimulus, because of opposition within and outside of the Fed. But I also know that he does move when NGDP growth is clearly unacceptable. So his discomfort at monetary stimulus, and his wish that fiscal stimulus would do more, may not tell us all that much about counterfactuals. Level targeting is much more powerful than QE, but might well be less politically controversial.