There’s no experiment capable of showing whether fiscal stimulus works

A recent paper by Gordon and Krenn argues that the fiscal multiplier during 1939-41 was about 1.8.  Paul Krugman argues that this time period was almost ideal for considering the impact of stimulus:

Although they don’t quite say so explicitly, the paper is to an important extent an answer to Robert Barro’s claim that the World War II experience shows that multipliers are low, because private spending actually fell during the war; as I and others have tried to point out, this was because it was, you know, wartime, with rationing of consumer goods and sharp restrictions on private investment.

What Gordon and Krenn point out is that we actually have more information than a simple comparison between the depressed peacetime economy and the war economy after Pearl Harbor: there was a period of more than two years when the United States was gearing up for war but not yet engaged in combat “” the Arsenal of Democracy era. Rationing was not yet in effect, and for at least part of this period the economy still had excess capacity despite a very large rise in government spending.

What they find is that when there was still excess capacity, there was a quite large multiplier on government spending; that is, fiscal policy worked.

So far so good.  And Krugman overlooks another advantage that he has discussed elsewhere, the short term interest rate was close to zero.  This is important because when rates are positive, an inflation targeting central bank will tend to neutralize the impact of fiscal stimulus.  Krugman concludes:

But in the prewar buildup you had a clear-cut expansion of federal spending on the order of 14 percent of GDP. That’s a real experiment with the economy. And the results were clearly Keynesian.

I agree with that, but for completely different reasons.  What’s most important is that monetary policy was very passive during those years.  The Fed was quite content to let the wholesale price index trend downward from 1937 to mid-1940.  The monetary base was determined by gold inflows.  Under this sort of passive monetary policy regime fiscal stimulus can boost NGDP, and it seems to have done so in 1939-41.

But . . . this natural experiment has no implications for the efficacy of the recent fiscal stimulus.  Unlike in 1939, our Fed is not content to let the US economy slide into a Great Depression.  Any doubts on that score were erased by the recent Fed meeting, which strongly implied they would not allow inflation to fall below about 1%, and were seriously considering policies such as aggressive QE, in order to prevent that from happening.  I won’t repeat all the evidence; my previous post discusses this in a bit more detail.

And in a sense we’ve known this all along.  As far back as March 2009 the Fed responded to the sharply falling NGDP growth expectations with a substantial bond purchase program (albeit nowhere near as much as was needed.)  We don’t know exactly where the “Bernanke put” is, but we can be pretty sure that we were close to it in March 2009.

Many pro-Keynesian commenters will defend the fiscal stimulus, despite its apparent failure, with two arguments:

1.  It was too small.

2.  At least it prevented the economy from sliding into a depression.

I agree that from the perspective of the standard Keynesian model it was too small.  Nonetheless, it did far less than its proponents expected.  The other excuse is much more doubtful.  There is no evidence that the Fed would have allowed things to get worse than they did.  Is it possible?  Sure, anything’s possible.  It’s also possible that in the absence of aggressive fiscal stimulus the Fed would have done much more, and the recovery actually would have been faster.

I’m even willing to concede that it’s more likely the stimulus boosted NGDP in 2009, than reduced it.  But I hope everyone understands that with modern inflation targeting central banks, there is no such things as a “natural experiment” for fiscal stimulus, there is no scientific evidence pointing to how much fiscal stimulus boosted output, as compared to the counter-factual where there was no fiscal stimulus.  In grad school I recall they’d say “it’s a game theory problem,” which translates as “who the hell knows.”

This appears in the Gordon and Krenn abstract:

Only the 1.80 multiplier is relevant to situations like 2009-10 when capacity constraints are absent across the economy.

I love economics, but I’m frustrated that many economists have an excessively narrow or linear way of thinking about policy issues.  Their study has no relevance for 2009-2010.


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33 Responses to “There’s no experiment capable of showing whether fiscal stimulus works”

  1. Gravatar of foosion foosion
    25. September 2010 at 08:08

    There was no fiscal stimulus for the latest recession. Increased spending at the federal level was offset by decreased spending at the state and local level.

  2. Gravatar of JimP JimP
    25. September 2010 at 08:11

    Again on the Fed statement:

    http://www.ft.com/cms/s/0/91aa2366-c809-11df-ae3a-00144feab49a.html

    At least this guy gets the general idea:

    begin quote
    There are ways the Fed could do this, however. It could promise to keep loose monetary policy in place until the economy grows to a certain size, or allow just enough extra inflation to make up for slower price rises during the recession. Mr Bernanke, at least, is confident. In a speech at Jackson Hole in August he made an unusually definitive statement for a central banker. “The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do,” he said. There is no reason to doubt him. But the time to use all those tools is now at hand.
    end quote

    “There are ways the Fed could do this, however. It could promise to keep loose monetary policy in place until the economy grows to a certain size, or allow just enough extra inflation to make up for slower price rises during the recession.”

    Exactly. And “grows to a certain size” = NGDP targeting

  3. Gravatar of JimP JimP
    25. September 2010 at 08:16

    And “promise” = promise. Say it our loud Ben. That might well be all you actually have to do.

  4. Gravatar of JimP JimP
    25. September 2010 at 08:27

    But:

    Here we have Ben hoping (for the best I hope) – but hoping is not your job Ben. Your job is to set expectations – we will do the hoping – you do the setting. Ok?

    http://www.reuters.com/article/idUSTRE68N4T920100924

  5. Gravatar of ssumner ssumner
    25. September 2010 at 08:34

    JimP, Yes. How can he be surprised the recovery is slow, when NGDP is growing at 4% vs 11% in the Volcker recovery. And slow NGDP grwoth is monetary policy, not financial problems. AAAAGH!

    BTW, I think you’ll like my new post.

  6. Gravatar of scott sumner scott sumner
    25. September 2010 at 08:42

    foosion, I don’t agree. The S&L cutbacks were much less than $787 billion. And even if you are right, it wouldn’t change my argument at all, as the fiscal authorities claimed unemployment would only rise to 9% if there were no fiscal stimulus at all. So by any measure it was a big disappointment. Of course S&L governments always do cut back in recessions–anyone should put that in their model. Are you saying the Obama people didn’t expect that?

    Plus, I conceded the fiscal stimulus was too small to work in the Keynesian model–so it doesn’t change my argument even if all the above were wrong.

  7. Gravatar of JimP JimP
    25. September 2010 at 08:56

    Scott:

    Where is Roosevelt when we need him? Both Obama and Bernanke evoke Roosevelt in their speeches, but then they act like Miles Davis. Very cool – detached – laid back. As if all of this were happening only in the abstract – to people they don’t actually know or care about.

    We need some passion – that big Roosevelt smile and the cigarette holder would be real nice. A taste of optimism and confidence.

    I never understood this – but they call depressions depressions because everybody is depressed. Both Obama and Bernanke act like depressed people – people who believe there is just not much they can do about anything. It is just making me crazy.

    But but but. As we saw from George Bush – fake optimism is the worst thing there is. So if Obama and Bernanke really do think they are managing American decline – and that is sure how they act – then they are acting as they should – and we will just have to decline right along with them. Expectations are really all there is – or so i think.

    Unless we toss both of them out – right on their ass.

    But do the Republicans have anything better to offer? Not to me they dont.

  8. Gravatar of scott sumner scott sumner
    25. September 2010 at 09:11

    JimP, Exactly my thoughts.

  9. Gravatar of Greg Ransom Greg Ransom
    25. September 2010 at 09:22

    Everyone complains about the fake science nature of most academic economics — but no one does anything about it.

    When are folks going to stand up to the fake science proponents?

    When are academics going to be honest with the voting public about the product being sold by academic economists?

    David Colander made a start in his House testimony last year.

    Who else is going to step up to the plate?

    Scott writes,

    “I love economics, but I’m frustrated that many economists have an excessively narrow or linear way of thinking about policy issues.”

  10. Gravatar of Morgan Warstler Morgan Warstler
    25. September 2010 at 10:26

    “But do the Republicans have anything better to offer? Not to me they dont.”

    I do.

    1. GOV2.0 Productivity Gains saving $300B in annual spending. Cut $400B in Public Employee expenditures, and put $100B into privatization – technology and service companies – mostly start up newcos.
    2. Progressive Corporate Taxes – no taxes on first $10M in profits.
    3. Unwinding Obamacare.

    All of these are VIABLE political plays that will do wonders for the economy. The trick is keeping Republicans on track with policies that have real returns…. shit has to WORK.

    I’d LOVE a 4th: give anyone who buys a house a green card, but I think it is too out there for most to deal with. The implications are great though for remaking corrupt dying Democrat controlled cities very, very quickly.

    These are strong plays JimP – start demanding them!

  11. Gravatar of Mikko Mikko
    25. September 2010 at 10:28

    Scott, is game theory how commonly part of graduate economics? By the way, the Fed as a last mover in NGDP game would make for a perfect example or problem in a suitable game theory course.

  12. Gravatar of Benjamin Cole Benjamin Cole
    25. September 2010 at 10:33

    Another excellent and insightful blog from Scott Sumner.

    I would like to somewhat echo foosion’s comment: Often, the actions of the 50 states are ignored.

    What if the 50 states are busily erecting structural barriers to growth? It takes forever to get a permit to do anything? What if the 50 states are running surpluses, cutting outlays?

    Conversely, what if the 50 states have been streamlining procedures in the last 20 years, going online (I just renewed vehicle reg online–a snap). And borrowing to make infrastructure improvements?

    Cumulatively, the 50 states could have an impact–we don’t know which way.

    When a Richard Fisher declares that Obama taxes and regs are the final straw, and now monetary expansionism will only result in inflation (a specious comment at best) he is ignoring whatever has been happening in the 50 states. Also, he seems to suggest that all of Europe is a dead zone for monetarists, as they have worse regs and taxes than we do.

    In general, however, I am more than willing to give full-throated monetarism and QE a big long try. With inflation plunging towards zero (remember, the CPI overstates inflation) and the economy feeble, and the federal government fabulously wasteful (Iraqistan anyone?), let’s go all in on monetarism.

    $100 billion a month in QE, and wake me when we hit 4 percent inflation.

  13. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    25. September 2010 at 12:43

    Scott, your idea that fiscal multiplier depends on monetary policy is correct. But there are two interesting cases:

    1. Multiplier of quasi-fiscal actions of monetary authorities can be very high, this was already recognized by Bagehot. One example – in May 2010, ECB’s “no sovereign defaults” policy lost credibility, and markets started pricing in large probability of default, this could have caused an unintended tightening of monetary policy in the eurozone. ECB started quasi-fiscal intervention in sovereign debt markets, and monetary conditions were pushed back to the state that was intended by ECB. This intervention had a huge cost/benefit ratio.
    Another more important example was in September 2008, when the Fed lost credibility, and monetary conditions became much tighter than intended by FOMC. According to 3 month LIBOR, market participants feared that the effective fed funds rate will be much higher than intended by FOMC during next three months. To return monetary conditions to levels intended by FOMC, Bernanke had to expand quasi-fiscal credit easing programs, these quasi-fiscal expenditures had a huge multiplier (unfortunately it took a very long time until monetary policy regained credibility).

    2. Monetary authorities are subject to various risks and costs, including to risks of political interference. As Bernanke said in Jackson Hole: “As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.” This effect can also create a fiscal multiplier, because Treasury-driven stimulus can reduce risks to monetary authorities. To some extent this also applies to Obama stimulus – Bernanke was a supporter. In the absence of fiscal stimulus the Fed would have done a bit more monetary stimulus, but not enough to fully offset the lack of fiscal stimulus.

  14. Gravatar of Joe Joe
    25. September 2010 at 13:35

    Professor Sumner,

    Can there be an experiment that will show that monetary stimulus works? Worth a shot…

    Best,

    Joe

  15. Gravatar of Pró & e Con estímulos fiscais « Historinhas Pró & e Con estímulos fiscais « Historinhas
    25. September 2010 at 13:45

    […] Con: Scott Sumner (aqui) […]

  16. Gravatar of Lorenzo from Oz Lorenzo from Oz
    25. September 2010 at 14:13

    Unlike in 1939, our Fed is not content to let the US economy slide into a Great Depression. I suspect a typo :)

  17. Gravatar of Keith Keith
    25. September 2010 at 19:38

    It seems to me that a nation generates income via the successful exchange of goods and services produced. Income is the monetary accounting for those goods and services. Governments spend money obtained by taxes or borrowing, both of which originate from current income. To argue that a government employee generates more economic growth by spending a nation’s income than the private citizen who created the goods and services doesn’t hold water. Although I’m sure Ceasar would have made such an argument.

    Economic growth is driven by investment: spending that increases our productive capacity. The only logical argument that I see for government spending “stimulating” an economy would be to argue that government employees are more likely to invest income than private citizens and their investments would be of higher value. I see no evidence for this, none.

    Government borrowing competes with private investment for a nation’s limited savings. This is certainly true with the current recession. BEA data on private investment indicates that private investment dropped pretty much dollar for dollar as government borrowed to finance spending.

    Consumption spending cannot grow an economy — and that is what the vast majority of government spending is. The act of shifting the spending to a government employee cannot possible stimulate the economy as a whole. It can change what parts of the economy thrive and shift the timing a little, but that’s it.

    The current recession is not the great depression. Money was likely the cause of the great depression but that is not the case for this recession. The economy suffered real losses in its ability to generate real income and the only way out that is investment.

    Yes, more money might help, but not without investment. More money in early 2008 might have helped a great deal. But the mechanism by which money helps is by lowering the real value of wages — essentially spreading the pain across all workers and not just the unemployed. That should be stated more openly in the monetary debate.

    The conservation of mass (income) holds true in the economy just as it does in the physical sciences. Government’s spend our income not tinkerbells.

    For those who want to play around with the possible impact of monetary policy, go here:

    http://forio.com/simulate/simulation/keubanks/macro-economics-101

  18. Gravatar of Benjamin Cole Benjamin Cole
    25. September 2010 at 19:52

    Morgan:

    How about a green card to anyone who buys a farm, and promises never to take subsidies on that farm, for 20 generations?

  19. Gravatar of Josh Josh
    25. September 2010 at 19:54

    Was the stimulus too small? I’m not a big believer in fiscal stimulus, but I think that the problem has more to do with the amount of transfers than with the size of the package.

  20. Gravatar of Stephan Stephan
    26. September 2010 at 03:30

    “I love economics, but I’m frustrated that many economists have an excessively narrow or linear way of thinking about policy issues.”

    Hmmm … given your almost reflexive attitude to dismiss fiscal policy as ineffective and your religious belief into monetary policy as a cure for all I’m wondering who das an excessively narrow focus?

  21. Gravatar of Rebecca Burlingame Rebecca Burlingame
    26. September 2010 at 05:43

    About the “linear thinking on policy issues”. Even if more non-linear thought was going on in the present, I wonder if some of the important measures are being missed that could be monitored. Specifically, points of pricing “guidelines” that lie along economic flow continuums of all kinds, that point to the ability of economic players to maintain survivability (or not). Perhaps no one wants to look at such blockages of flow, because of fears someone might try to “plan” an economy. Is this why the public does not have ready access to studies showing how restricted labor access (limited medical schools) distorts prices along the entire continuum of economic flow? Every business owner, and a few other ordinary folk instinctively know that this happens and yet there are no models or statistics to prove it as far as I can tell…at least from the economics books that most of us would hope to find in a Barnes and Nobles store.

  22. Gravatar of scott sumner scott sumner
    26. September 2010 at 06:10

    Greg, Good question—the system is hard to attack because so many economists benefit from it.

    Morgan, Interesting ideas, but the Republicans won’t do them.

    Mikko, Game theory wasn’t emphasized when I went to school in the 1970s–but it is now.

    Thanks Benjamin, I have a feeling we’ll be getting some QE soon. But it really needs to be combined with something else to have a strong impact. My $100 billion a month figure was combined with ending IOR and setting an explicit p-level target. W/O those I’d rather see $200 billion a month.

    Your first point is a good one. Of course if there was a law against fiscal authorities bailing out banks, then the Fed and ECB would have thought it necessary to do much more QE.

    I can’t agree with your second point. I just don’t think Bernanke is willing to see inflation fall below 1%, with or w/o fiscal stimulus. And we are at 1% right now. So either way we’d be right here.

    Joe, Both can work on a ceteris paribus basis. The problem with fiscal stimulus is that we don’t know whether the ceteris paribus assumption will hold in the real world.

    We all agree monetary policy can work in a technical sense. the question is whether an expansionary move by the Fed would be offset by fiscal tightening. I think that’s very unlikely, so I don’t even see a need to do an experiment. And I’m not sure how an experiment can be done. As I said, both fiscal and monetary can work in a technical sense, and that’s really all an experiment can show. It can’t show how the game theory problem gets solved.

    Lorenzo, Thanks, I should have said “in the 1930s” Of course we slid in during the early 1930s, and in 1939 I meant the Fed was content to let us stay there, or more accurately recover at a rather slow pace. The modern Fed wouldn’t be so passive if the depression was deep and prices were falling.

    Keith; You said;

    “The current recession is not the great depression. Money was likely the cause of the great depression but that is not the case for this recession.”

    I disagree, money hoarding (the monetary base) caused both the GD and this recession.

    You make good points about the long run growth in the economy, but right now we are trying to address the business cycle.

    You said;

    “But the mechanism by which money helps is by lowering the real value of wages “” essentially spreading the pain across all workers and not just the unemployed. That should be stated more openly in the monetary debate.”

    This is a good point, but there are some counterarguments. I’ve had a steady job all through the recession, but would have benefited from a much easier policy as my investment losses in my pension plan greatly exceed my real wage gains. Also, far more than 9.5% of workers have been under employed or unemployed at one time or another during the recession. When you have a severe recession it isn’t a zero sum game, the total losses greatly exceed the gains.

    Josh, You may be right.

    Stephan, You said;

    “Hmmm … given your almost reflexive attitude to dismiss fiscal policy as ineffective and your religious belief into monetary policy as a cure for all I’m wondering who das an excessively narrow focus?”

    1. In this very post I said the fiscal stimulus of 1939 seems to have worked. Would a Robert Barro have said that?

    2. I argued that the actual outcome in the real world is a game theory problem. Yep, that sounds like a religious nut who who allows no uncertainty to creep into his beliefs.

    3. I have argued the monetarists are wrong about money, it’s hard to predict what will happen if the money supply increases by X%. It depends on expectations. More rigid religious faith.

    4. I am adopting the standard new Keynesian model circa 2006, monetary policy is much more effective than fiscal policy. Yes, that sounds like a nutty monetarist.

    5. I argued in the post that the 2009 fiscal stimulus more likely than not had some positive impact on NGDP. More religious nuttiness.

    6. I have argued that the cause of unemployment was partly the housing shock, partly bad supply-side policies, and mostly a monetary shock. Yes, more single-minded focus on money.

    So, do you actually have any arguments against the ideas presented in this post, or do you wish simply to engage in name-calling?

  23. Gravatar of scott sumner scott sumner
    26. September 2010 at 06:15

    Rebecca, I agree there are a lot of labor market rigidities, but they aren’t to blame for the current recession.

  24. Gravatar of Stephan Stephan
    26. September 2010 at 10:05

    Scott,

    Sorry for only replying now. I’m on a high-speed train your president wants yesterday for the US travelling from Cologne to Vienna. My remark on that: Be careful what you are wishing for. You might get it. I’m travelling this route now for 30 years. Indeed it’s faster now. About 2 hours. Given the cost I would prefer Deutsche Bahn would have hired models serving me champagne and foie gras for free on the ride for the next 30 years while the ride takes 2 hours longer.

    But I disgress. I’m not name calling. I just started to read your blog some weeks ago and thought about your enthusiastic believe in monetary policy. I’m not sharing this believe. The FED can do whatever it wishes to do but at the end of the day this money sits idle in bank reserves accounts. Banks lend if there are credit-worthy borrowers who wish to borrow. There are not. Why? Because they don’t need to given that there’s no demand justifying any borrowing.

    I’m thinking more along the line of modern monetary theory (MMT). The best thing right now would be for the federal government to offer a job to anyone who wants a job. Simple solutions for big problems. But I do understand: this smells like socialism and is hard to swallow for a libertarian.

  25. Gravatar of Keith Keith
    27. September 2010 at 06:20

    Scott,

    Q1: What exactly do you mean by money hoarding in the current recession?

    Here’s why I ask.

    I see from the data that the flow of savings into private investment dried up by about half in 2009. However, I read the data as indicating this savings flowed into treasuries, not cash in the vault. Savings have obviously flowed into gold and other commodities too (given the prices).

    I see the increase in reserves but this is largely accounted for by the Fed’s quantative easing: new money?

    Is the flow of savings into treasuries what you are calling hoarding? If savings are flowing into deposits which are buying treasuries, I can see that definition. Note, I think funneling savings into treasuries has the same effect as hoarding cash: it diverts savings away from productive investments.

    Q2: Business cycle?

    I see the current recession as a little different from a normal business cycle (although very much related). It seems to me that the housing boom lasted so long, that we not only over-built an inventory of houses but also over built the capacity to produce them. Because of this, the housing sector has lost much of its ability to generate prior levels of income.

    For example, last year a friend of mine took a tour of a wall board manufacturing plant (relatively new ~ 5 yrs). When built this plant ran 3 manufacturing lines, 3 shifts a day, 7 days a week. Last year, they were running 1 line, 1 shift, 3 days a week. It will be a long time before this plant is running full out again, if ever. This means this sector of the economy cannot return to its prior income generation for a long time (real income).

    It seems to me that the fastest way to get real income back is to invest in new areas. New products, new widgets, new services: whatever it is that people would be willing to buy. We are not doing this.

    My opinion is that the reason is not monetary but regime uncertainty?

    Note, I believe that more money in mid 2008 might have avoided the banking crises and subsequent regime uncertainty. But, not the underlying housing industry problems; it took over a decade to create that and possibly a decade to clear it. I believe unemployment might have stayed below 7 or 8% without the regime uncertainty.

    Note 2: because I believe monetary policy initiated the great depression, I think monetary policy could have easily reversed it in the early days. I don’t think mal-investment was the cause. However, I think over-investment was the root cause of the current recession. In both cases, I think government policy made things worse.

    Q3: if the government had not increased spending, where would savings have gone? perhaps gold would be $3000/oz, perhaps private investment wouldn’t have dried up so much.

  26. Gravatar of scott sumner scott sumner
    27. September 2010 at 07:42

    Stephan, Well at least we agree on high speed rail. I’m afraid I don’t have time to completely address all the issues you raise–I have long blog posts that discuss these issues. Banks will hoard reserves only if the Fed wants them to, they can always lower the interest rate on reserves to the point where banks disgorge them. (negative interest on reserves if necessary)

    In all of world history, no fiat money central bank that wanted to inflate ever failed. That’s the least of my concerns. And your comment about loans is not relevant. Monetary policy does not work by encouraging banks to make loans, it works by changing NGDP expectations by altering the supply and demand for base money. That doesn’t require banks to make additional loans. it’s all about excess cash balances.

    Keith, You said;

    “Q1: What exactly do you mean by money hoarding in the current recession?”

    You are looking at the wrong data, the purchase of Treasuries has no impact on money hoarding. I am talking about the monetary base, which in real terms has more than doubled. The main reason is the Fed’s policy of interest on reserves.

    You said;

    “I see the current recession as a little different from a normal business cycle (although very much related). It seems to me that the housing boom lasted so long, that we not only over-built an inventory of houses but also over built the capacity to produce them. Because of this, the housing sector has lost much of its ability to generate prior levels of income.”

    This is a common misconception. If you look at the data you see almost all the decline in home building occurred between mid-2006 and mid-2008, and yet unemployment only rose slightly. Housing is just not that big a share of the economy. Only when AD fell sharply in late 2008, and manufacturing and services shed millions of jobs, did unemployment rise sharply. Every recession people say “this one is different” and almost every time they are wrong (except 1974.)

    I don’t think the increased government spending had much effect–if it hadn’t occurred the Fed would have done more.

    I agree there was mal-investment, and I agree it caused a modest rise in unemployment during 2007 and early 2008, but I think you greatly overestimate its importance.

  27. Gravatar of Keith Keith
    27. September 2010 at 10:19

    Scott,

    Ok, so the rise in reserves is what your calling hoarding. I can buy that. But this seems to be where much of the QE went rather than a steady flow of monthly income?

    “I don’t think the increased government spending had much effect”

    I’m educated as an engineer, with a specialty in feedback control systems. I view the economy as a complex feedback system. Real income flows are conserved. Prior to the banking crisis, there was a monthly flow of savings into private investments. When the government started borrowing, some of this flow was diverted into TARP, stimulus and general gov spending. This had to have caused an enormous disruption to the economy.

    While national income contracted after Q3 2008, government spending rose. Private savings also rose, yet private investment dropped. In a very short period of time, we shifted income from the private sector to the government (100s of $B). That shift alone had to have created disruption and unemployment.

  28. Gravatar of ssumner ssumner
    27. September 2010 at 20:06

    Keith, Most economists think fiscal stimulus creates jobs. A few think it has no effects. I’ve never heard anyone claim it reduces employment. I’m not saying your argument can’t possibly be right, but your going to need a lot more reasons that what you provide in the comment. What about the extra spending associated with government programs and tax cuts?

  29. Gravatar of Keith Keith
    28. September 2010 at 07:53

    Scott,

    I’ll start this comment a little off center. Inflation has the ability to alter economic performance because not all prices change with the same speed, correct? Specifically, wages changes tend to lag other prices, perhaps on a relatively long time scale — as in a year or two or three. In other words, it is the transient response of the economy to changes in the value of money that enable inflation to lower real wages and potentially promote employment and real economic growth.

    Over a short time span, weeks to months, national income is a relatively fixed pie. In comparison to the time it takes to grow that pie, the increase in government borrowing from the end of 2008 to the end of 2009 was very fast. What I’m saying is that the speed with which income was shifted to the government created a very large disruption in the private sector and created unemployment in the private sector.

    If this increase in government borrowing occurred over several years or a decade, we would gradually shift employment away from the private sector to the government sector. There might be long term effects on unemployment but it would not be immediately observable. Do this in a day or week or month or six months and it is very much observable.

    Last year, the government dipped into the credit markets in a very big way, very quickly. The flow of income being set aside each day, week and month for savings is only so big. This flow is all that is available to borrow on a daily, weekly, and monthly basis. When the government stepped in to borrow a large chunk of this, the areas of the economy that had been borrowing this flow of savings lost it, and they had to cut back in a very big way, very quickly.

    The transient response of the economy is very important. In my opinion, the economy is never really in equilibrium, it is always transiting toward equilibrium. It seems that very little economic research is focused on the transient?

    Anyone that argues that a $100 billion can create a lot of jobs would have to recognize that the loss of a $100 billion would destroy jobs. The speed with which the government entered the credit markets meant that someone lost that flow of savings.

    As an analogy, think of a river. A state wishes to re-direct the flow of water in this river to a new channel. On the day the new channel is opened and the old closed, a great deal of distruption occurs: fish die, local environments change, property values change, business changes. After a few years, everything settles out to the new conditions.

    I build simulation models for a living. Let me re-phrase that, I try to make a living with my model building skills: some years have been very lucrative, some not. In an effort to better understand our recent economic behavior and how government and monetary policy might be affecting that, I built a relatively simple economic growth model to explore how government borrowing and monetary policy might affect capital accumulation, production, income and employment. It was from this effort that I concluded your NGDP policy had merrit. The logic is certainly there. Another conclusion is that our economy is doing exactly as one might expect with such a large increase in government borrowing. The transient response of the economy to such a large increase in government spending is to hestiate for a few years. If government spending remains at it current levels, growth will resume but per capita wealth and income will have suffered a permanent loss.

    Our economy is a very dynamic place: thousands of jobs are created and lost every day. Growth or decline depends upon the relative value of very large flows. Investment is important not only for the long term but the near term. Shift a large portion of our savings around in a very short period of time and the transient effects to the economy will be very large.

    Does this make sense?

    Note: in response to your comments, I posted a simplified interface to the growth model I developed: 4 inputs, lots of outputs, no diagrams. Obviously, the first pass could not be used to communicate. That may be true of the second too, but maybe not.

    http://forio.com/simulate/simulation/keubanks/macro-economics-101

  30. Gravatar of ssumner ssumner
    29. September 2010 at 12:33

    Keith; You said;

    “Over a short time span, weeks to months, national income is a relatively fixed pie. In comparison to the time it takes to grow that pie, the increase in government borrowing from the end of 2008 to the end of 2009 was very fast.”

    You can’t hold national income constant, and you certainly can’t hold national income constant while making an argument that fiscal stimulus reduces national income.

    The proponents of fiscal stimulus will argue that w/o the stimulus, NGDP would have fallen much further.

    You said;

    “When the government stepped in to borrow a large chunk of this, the areas of the economy that had been borrowing this flow of savings lost it, and they had to cut back in a very big way, very quickly.”

    This is not clear, because saving rose very sharply just as government borrowing rose.

    You said;

    “The transient response of the economy is very important. In my opinion, the economy is never really in equilibrium, it is always transiting toward equilibrium. It seems that very little economic research is focused on the transient?”

    I think this is your problem. You are trying to criticize the standard model w/o having really studied it. There is a massive amount of research into transitions. I think it’s fine for outsiders to criticize economics, but don’t think it is easy, don’t think that economists haven’t thought a lot about transitions.

  31. Gravatar of Keith Keith
    29. September 2010 at 18:04

    “You are trying to criticize the standard model w/o having really studied it.”

    To some degree, perhaps a large degree, that would be true. It takes a lot of years to accumulate experience and knowledge. There will always be more un-read than read, more un-known than known.

    But the objective is not to criticize, it is to understand.

    Thank you for taking the time to comment.

  32. Gravatar of ssumner ssumner
    30. September 2010 at 06:05

    Keith, You’re welcome. Because my time is limited, I can’t really provide a complete reply, but I do my best.

  33. Gravatar of A Natural Experiment in the Making : Invest My Money A Natural Experiment in the Making : Invest My Money
    26. October 2010 at 23:32

    […] providing accommodation via lower interest rates and/or a currency depreciation.  Scott Sumner made a similar point a while back.  He argued it is nearly impossible to estimate the true size of […]

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