How the Keynesians miss the bigger picture

Another day, another data point suggesting a zero fiscal multiplier:

The number of Americans filing new claims for unemployment benefits dropped to its lowest level in nearly 5-1/2 years last week, signaling labor market resilience in the face of fiscal austerity.

On the other hand, Matt Yglesias points out that most pragmatic economists are at least partly Keynesian:

A meta-point that is a little underappreciated here is that private sector macroeconomists all use models that embed broadly “Keynesian” assumptions about the behavior of the economy. Government economists at the OMB and CBO do it too, but they’re really just following the lead of what you would find at any bank or consultancy. Obviously that doesn’t prove that these models are correct—in fact that record of forecasting accuracy isn’t stellar—but I don’t hear much from anti-Keynesian types about why their preferred models have failed the market test.

If I were going to treat Yglesias the way he recently treated Alex Tabarrok, I’d say he’s attacking a strawman.  But Yglesias (and Tabarrok) obviously understand the opposing argument.  Nonetheless I find many people do misunderstand what “monetary offset” is all about.

It’s quite possible to write down a model where, ceteris paribus, fiscal austerity reduces output, and monetary stimulus (such as the recent actions of the Fed) raise output.  You can call that model “Keynesian,” and attach a positive multiplier to fiscal policy if it makes you feel good.  But what matters are counterfactuals.  And if more fiscal stimulus leads to less monetary stimulus (as the Fed claims!), then the fiscal multiplier estimates will be nearly worthless.  This is a subtle game theory problem, which as far as I can tell hasn’t even been considered by many Keynesian economists.

One can talk all one wants about Keynesian forecasters predicting that fiscal austerity would have a sharp contractionary impact in 2013.  But the fact of the matter is that the consensus forecast for 2013 from all these supposedly Keynesian economists was about the same as for 2012, despite a much higher level of fiscal austerity in 2013.

By the way, the real “market test” isn’t what forecasters think, it’s what markets think.  And as I’ve pointed out numerous times, the markets are market monetarist.

PS.  Here’s the sort of slowdown expected by The Economist:

Screen Shot 2013-03-13 at 8.52.49 PM

Yes, this could still happen.  Market monetarism says fiscal stimulus estimates are nothing more than estimates of central bank incompetence.  And central banks are far from perfect.  But I continue to believe that 2% RGDP growth should be the baseline forecast for 2013.  Now we’ll just have to wait and see just how incompetent the Fed actually is.


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22 Responses to “How the Keynesians miss the bigger picture”

  1. Gravatar of jknarr jknarr
    9. May 2013 at 09:08

    Scott, why is the private sector totally ignored in the fiscal-monetary policy framework? Both the public- and private- economy deal with the same monetary landscape — every dollar extracted by the public sector comes out of the private economy, and every dollar kept in the private is not available to the public. Yet monetary policy applies to both.

    You seem to be painting a picture where the public sector runs deficits (borrowing from the private sector), and the monetary authority tightens policy (for both the private and public economy) — doesn’t this strip the private sector of capital twice over?

  2. Gravatar of TallDave TallDave
    9. May 2013 at 09:10

    Good post. I would only add no discussion of “austerity” is complete without the caveat that fiscal profligacy has consequences; while no one’s ever quite sure where the edge of a sovereign Plank curve begins, you definitely don’t want to find out!

    A bit O/T but I had not realized just how deflationary some aspects of TGD really were:

    Wholesale price of wheat in 1920: $2.45 per bushel
    … in 1921: $1.30 per bushel
    … in 1932: 49 cents per bushel

    Wholesale price of cotton in 1920: 42 cents per pound
    … in 1921: 10 cents per pound
    … in 1932: 5 cents per pound

    Wow.

  3. Gravatar of ssumner ssumner
    9. May 2013 at 09:32

    jknarr, It would be helpful to use more precise language in your assertion. For instance, what does “strip the private sector of capital” actually mean?

    Not saying you are wrong, but it’s hard to evaluate the argument.

    TallDave, I haven’t focused on that issue as I don’t see it as a big problem for the US right now. But yes, it is another factor.

  4. Gravatar of John Thacker John Thacker
    9. May 2013 at 09:32

    To be fair to Matt, when he refers to “anti-Keynesians” he is presumably also referring to those who claim that fiscal stimulus would be ineffective under their preferred monetary tightness / deflation / gold standard as well. That’s not precisely a straw man argument, as there are definitely quite a lot of people who believe that, both ordinary people and policymakers. At the same time, it’s not engaging with the best arguments of those who view fiscal stimulus as useless and counterproductive.

    At the same time, I can’t help but notice that many of the private sector macroeconomists are employed by the same type of firms that Matt (rightly, IMO) scoffed at for encouraging things like active fund management and frequent trading as good ways to manage your money. Advocacy of active fund management and frequent trading does seem to me (and Matt) like rent-seeking. The macroeconomic models that have lots of overly precise estimations of multipliers and predict strong changes in the economy based on the progress of fiscal stimulus would support and encourage a lot more active and frequent trading than a MM model with no net multiplier, no?

  5. Gravatar of Geoff Geoff
    9. May 2013 at 09:39

    Speaking of counter-factuals, it’s too bad Dr. Sumner doesn’t make those explicit when he addresses more market oriented policies than his own. Then counter-factuals take a back-seat to appeals to “pragmatism”, as if that is even an argument rather than an evasion.

    “And as I’ve pointed out numerous times, the markets are market monetarist.”

    Translation: An inflation distorted capital structure that is dependent on inflation, responds well to inflation.

    For a time.

    The markets are actually not any iteration of monetarism. Monetarism is grounded on central banking, and central banks are not market institutions, but state institutions.

    Or are state created institutions now market institutions, and non-MMs didn’t get the memo?

    The market is about as market monetarist, as respect for private property rights are violations of them.

  6. Gravatar of jknarr jknarr
    9. May 2013 at 09:47

    Scott, what I mean to say is that public- and private- sector funding is a zero-sum proposition. The monetary cake, so to speak, is divided between the two. The monetary authority decides the size of the cake.

    If the public sector has strong borrowing needs — let’s say to fund consumption via transfer payments — and the monetary authority tightens policy and reduces NGDP proportionally, doesn’t this reduce the volume of lending and investment in the private sector on two fronts?

    Lending capacity is eaten up by government borrowing, and NGDP is suppressed by tight monetary policy. This leaves the private sector with a toxic combination of reduced available borrowing alongside slow NGDP. Consider Greece as an extreme example of this general case.

    Sorry for the imprecision, but I’m trying to understand the private sector’s relationship to the fiscal-versus-monetary zero multiplier. It strikes me that monetary policy affects private and public economys both, while public versus private is zero-sum.

  7. Gravatar of Don Geddis Don Geddis
    9. May 2013 at 10:10

    The Keynesian “prediction” is annoyingly unfalsifiable. “The economy will have 2% less growth, because of austerity, than … it otherwise would have.” That’s not a prediction about anything that could possibly be measured in the real world. It’s almost like an astrologer or psychic. No matter how the world turns out, there’s always a plausible rationalization about how this “confirms” the prediction. How can these people be taken seriously?

  8. Gravatar of ssumner ssumner
    9. May 2013 at 10:11

    John, You said;

    “To be fair to Matt . . . ”

    Yes, and I was fair to Yglesias. But was he fair to Tabarrok?

    jknarr, Yes, but it depends on whether you mean “real cake” or “nominal cake” etc. That’s why precision is important. As for the zero sum game question, it all depends . . .

  9. Gravatar of Mike Sax Mike Sax
    9. May 2013 at 10:20

    “And if more fiscal stimulus leads to less monetary stimulus (as the Fed claims!), then the fiscal multiplier estimates will be nearly worthless.”

    The Fed says something else too: that the sequester has hurt growth-after the jobs report Friday.

    “Things are so grim that the Federal Reserve’s policy-setting Open Market Committee, nobody’s idea of a left-wing shop, felt the need to put out a statement Friday after the jobs numbers came out warning bluntly that “fiscal policy is restraining economic growth” and suggesting that inflation, if anything, is too low. The Fed vowed to keep interest rates extremely low, and suggested that the executive and legislative branches should take their feet off the brake. It’s quite a situation when the Federal Reserve is the most fiscally left-wing outfit in town.”

    http://diaryofarepublicanhater.blogspot.com/2013/05/the-fiscal-multiplier-sumner-vs-bernanke.html

    Most economists also don’t think that the sequester is wholly offset. As it isn’t then we’d be better off without it.

    “The nation’s unemployment rate would probably be nearly a point lower, roughly 6.5 percent, and economic growth almost two points higher this year if Washington had not cut spending and raised taxes as it has since 2011, according to private-sector and government economists.”

    “Fiscal tightening is hurting,” Ian Shepherdson, chief economist of Pantheon Macroeconomic Advisors, wrote to clients recently. The investment bank Jefferies wrote of “ongoing fiscal mismanagement” in its midyear report on Tuesday, and noted that while the recovery and expansion would be four years old next month, reduced government spending “has detracted from growth in five of past seven quarters.”

    http://diaryofarepublicanhater.blogspot.com/2013/05/the-facts-dont-seem-to-have-market.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+DiaryOfARepublicanHater+%28Diary+of+a+Republican+Hater%29

    As the inflation rate is much close to 1% than to 2%-Bernanke said that QE Infinity will stay until 2.5% inflation- we would seem to have plenty of room for fiscal stimulus. Yet no one is even talking about fiscal stimulus but simply getting rid of austerity-the sequester.

  10. Gravatar of Mike Sax Mike Sax
    9. May 2013 at 10:26

    Even David Wessell at the WSJ is against short term austerity. When you lose the Journal you’ve lost the message war on austerity’s positive good.

    “The Federal Reserve is increasingly explicit in saying that U.S. tax-and-spending policy is hurting, not helping. “Household spending and business fixed investment advanced, and the housing sector has strengthened further,” the Fed’s policy committee said recently, “but fiscal policy is restraining economic growth.”

    http://online.wsj.com/article/SB10001424127887324059704578470590270528844.html?KEYWORDS=david+wessel

  11. Gravatar of Jacob A. Geller Jacob A. Geller
    9. May 2013 at 10:31

    The problem is the assumption of ceteris paribus. If you assume no change in monetary policy, then you have assumed into existence the fiscal multiplier. And Keynesian can tell a story about the ZLB all they like to justify the assumption, that’s fine, but it’s still an assumption.

  12. Gravatar of jknarr jknarr
    9. May 2013 at 10:36

    Scott, when we’re introducing a new variable, yes, we should define the terms precisely, but why can’t we just use the same fiscal multiplier question assumptions, but swap public-for-private? In other words, does the private economy have a multiplier in the same way that the public sector has/has not?

    Does the Fed tighten into private activity the same way as we assume it does for public activity? (The monetary cake is always nominal, no?)

    Monetary policy should not be set exclusively against the public Keynesian fiscal question, but also needs to consider the interaction with the private sector as well. This is a three-way game, not a two-way game as commonly assumed.

    What if Fed policies reduce the private economy multiplier to zero? Would Keynesian policies then have a positive multiplier? If the Fed creates an endogenous zero multiplier for Keynesian policies, then doesn’t this have an exogenous effect on the private sector as well?

  13. Gravatar of dbeach dbeach
    9. May 2013 at 10:54

    Jacob, yes, that’s right. But in this case the Fed have basically said that they’re not able (though what they mean is willing) to do more than they are already doing to offset the fiscal drag, so I think we can in fact assume no change in monetary policy. But I still see no plausible way that “austerity” could cost 1.8% of GDP, as the Economist’s chart shows.

  14. Gravatar of Mark A. Sadowski Mark A. Sadowski
    9. May 2013 at 15:42

    Scott,
    The estimates of the effect of fiscal austerity evidently come from the Scowcroft Group and don’t make much sense to me.

    According to the April 2013 IMF World Economic Outlook (WEO) the the U.S. increased its general government structural (cyclically adjusted) balance by 0.8%, 1.3% and 1.7% of potential GDP in 2011, 2012 and 2013 respectively. So there was an increase, but not a doubling of fiscal austerity this year. (Unless they are assuming differing economic effects due to fiscal multipliers being different because of the composition of the fiscal changes.)

    Similarly, the IMF estimates that the eurozone has increased its general government structural balance by 0.9%, 1.5% and 0.8% of potential GDP in 2011, 2012 and 2013 respectively. So the effect in 2011 seems too large and the diagram implies that the eurozone has done more fiscal austerity than the U.S. which it has not.

    And finally, the IMF estimates that the UK has increased its general government structural balance by 2.1%, 1.1% and 1.1% of potential GDP in 2011, 2012 and 2013 respectively. So there was a big reduction in fiscal austerity from 2011 and 2012 and that seems understated in the diagram.

    The bottom line is I wish I knew where those numbers were coming from because they don’t really match the publicly available data.

  15. Gravatar of ssumner ssumner
    10. May 2013 at 05:32

    Mike, Saying that other people think I am wrong is not an argument.

    And the news page of the WSJ is not right wing.

    Would you agree that the evidence so far this year suggests that I am right?

    Jacob, Good point.

    jknarr, Yes, I believe monetary offset also applies to private sector multipliers (say from a big investment project like Keystone.)

    dbeach, You said;

    “But in this case the Fed have basically said that they’re not able (though what they mean is willing) to do more than they are already doing to offset the fiscal drag, so I think we can in fact assume no change in monetary policy.”

    This is wrong–the Fed recently indicated that they are contemplating an increase in QE.

    Mark, No one has any idea how big the output gap in Britain really is, and hence the estimates are very imprecise.

    I’m reacting to what Keynesians have been saying, and am trying to hold them to account.

  16. Gravatar of Mark A. Sadowski Mark A. Sadowski
    10. May 2013 at 06:48

    “I’m reacting to what Keynesians have been saying, and am trying to hold them to account.”

    Yes, but that diagram isn’t really helping your case. The U.S. did about as much fiscal consolidation as the eurozone in 2011 and your diagram implies that it did about half as much. The U.S. did more fiscal consolidation than the U.K. and almost as much as the eurozone in 2012 and your diagram implies it did about half as much as either.

    The point isn’t so much that the U.S. economy isn’t collapsing this year under fiscal tightening, as it didn’t collapse in 2011 or 2012 either.

  17. Gravatar of jj jj
    10. May 2013 at 07:50

    The “market” for private sector macroeconomists isn’t deep or liquid, so looking at how many of each type is hired is a very poor way to gauge the market’s judgement of model accuracy.

  18. Gravatar of ssumner ssumner
    10. May 2013 at 16:12

    Mark, OK, I accept you point. Now where is the diagram that everyone agrees shows the actual amount of austerity in each region?

    jj, Agreed.

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    10. May 2013 at 16:58

    I have a bar graph that shows the changes in the structural deficit between calendar years 2010 and 2013 for the four major currency areas. I can change it to show annual changes if you want it.

  20. Gravatar of Bill Ellis Bill Ellis
    11. May 2013 at 07:40

    Scott says….” And if more fiscal stimulus leads to less monetary stimulus (as the Fed claims!), then the fiscal multiplier estimates will be nearly worthless. ”

    But if the Fed (as they do now! ) promises to tolerate higher inflation caused by fiscal stim… then the Multipliers (given that they exist) will be effective.

    The “Sumner Critique” a political argument disguised as an economic argument.

  21. Gravatar of Marcus Nunes and the Decade Long Labor Market Malaise « J.uris D.ebtor Marcus Nunes and the Decade Long Labor Market Malaise « J.uris D.ebtor
    19. May 2013 at 12:15

    [...] Scott Sumner has used similar data to support his arguments, but that was more to disprove the Keynesian fiscal multiplier than to tout MM as the ultimate economic panacea.  Nunes, on the other hand, is willfully ignoring the bigger picture.  I posted the following data in the comments section on his blog, which has not been posted, so I’ll post it here.   The decline in initial unemployment claims is a highly misleading metric (again, when someone points to one metric to prove or disprove, it’s best to peer behind the curtain).  To look behind that current we see that while unemployment indicators are improving, they might be declining because more workers are leaving the workforce, not looking for work, and not applying for unemployment insurance: [...]

  22. Gravatar of When Good News Goes Bad: Labor Market Update « J.uris D.ebtor When Good News Goes Bad: Labor Market Update « J.uris D.ebtor
    31. May 2013 at 08:18

    [...] employed by pundits as evidence of an improving labor market, one prominent market monetarist, Scott Sumner, has pointed to the declining intial unemployment weekly claims as evidence that monetary stimulus [...]

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