Christina Romer on fiscal policy

Marcus Nunes sent me a new Christina Romer paper, which claims that fiscal stimulus is effective.  I’ll argue that she has some good evidence, but also that there are weaknesses in her argument.

Her best evidence is a study that she did with David Romer, which examined two types of tax cuts; those done to boost the economy, and those done for other reasons, which can be viewed as “exogenous.”

What David and I did was to bring in information on the motivation for tax changes. For every legislative tax change, up or down, there is a huge narrative record about why it was passed. This narrative record is contained in Congressional reports, presidential speeches, the Economic Report of the President put out by the Council of Economic Advisers each year, and other documents.

We read all of those documents and classified tax changes into those taken in response to other factors affecting output and those taken for more independent reasons. We identified a number of tax cuts taken because the economy was slipping into a recession. We also found a number of tax increases taken because government spending was rising; for example, policymakers raised taxes dramatically during the Korean War. This is important because spending increases will tend to increase output, while tax increases will tend to reduce it. So in cases where the tax increase is caused by the spending increase, there are systematically factors going in opposite directions.

At the same time, we also found a number of tax changes taken not in response to current or forecasted economic conditions, but for more ideological or long-term reasons. For example, Ronald Reagan cut taxes in the early 1980s because he believed lower tax rates were good for long-term growth. Bill Clinton raised taxes in 1993 because he thought dealing with the deficit would be good for the long-term health of the economy.

We argued that to estimate the impact of tax changes, we should look at the behavior of output following these tax changes made for more ideological reasons. In other words, we dealt with some of the omitted variable bias problem by excluding from the empirical analysis the tax changes taken in response to economic conditions.

They found that the endogenous tax changes had a modest (but positive) effect on output, while the exogenous changes had a large impact on output.

I favor a pragmatic approach to research, so I applaud the Romers for using the narrative approach.  However what’s being tested here isn’t really “stimulus,” it’s tax cuts.  The traditional Keynesian model says fiscal stimulus will boost NGDP, and will also boost RGDP if there is slack in the economy.  Otherwise you get higher prices.  So there are actually two interesting questions worth testing; does Keynesian stimulus boost NGDP (i.e. spending) and does the higher spending lead to more real output.

To make things even more complicated, supply-siders have suggested an alternative channel through which tax cuts might boost RGDP; increasing the incentive to work, save and invest.  The basic supply-side model doesn’t predict claim any impact of tax cuts on NGDP, indeed it was sold in the late 1970s as a tool for boosting output without boosting inflation.  Even so, if the central bank is targeting interest rates, then supply-side effects could easily lead to more NGDP as well.

So let’s accept Romer’s argument that tax cuts boost RGDP.  Is it a problem that we don’t know exactly how or why?  It could be, because if it is due to supply-side effects then lump sum tax rebates and government spending increases wouldn’t necessarily work.

Romer discusses one such event that occurred in the spring of 2008, when the Bush administration issued tax rebates to boost consumption.  John Taylor later pointed out that consumption did not seem to respond to these tax rebates, despite the temporary spike in disposable income.  Romer replied:

The trouble with this analysis is, Professor Taylor wasn’t thinking about what else was going on at the time. Democrats and Republicans didn’t come together to pass the tax rebate for no reason. This was the heart of the subprime mortgage crisis. House prices were tumbling. Mortgage lenders like Countrywide Financial were in deep trouble.

Economists were worried that consumption was about to plummet. For most families, their home is their main asset. When house prices fall, people are poorer, and so tend to cut back on their spending.

Against that background, the fact that consumption held steady around the time of the tax rebate may in fact be a sign of just how well it was working. It kept consumption up for a while, despite the strong downdraft of falling house prices.

Romer’s right that without the rebates aggregate spending and output might have been somewhat lower during mid-2008.  But Romer doesn’t consider whether that might have led the Fed to move much more aggressively in September 2008.  As it is the Fed met two days after Lehman failed and did nothing (which effectively tightened policy sharply as the Wicksellian natural rate was plunging rapidly during this period.)

The Fed cited an equal risk of recession and inflation (i.e. economic overheating) when it left interest rates unchanged at 2% in September.  It seems highly unlikely that the Fed would have been so passive if Romer’s counterfactual had come to pass.  If so, then John Taylor might be right, but for the wrong reason.  The real problem is that the Fed sabotaged Bush’s tax rebate.  The real problem is that in new Keynesian models the fiscal multiplier is precisely zero if the central bank targets either inflation or NGDP.

This is the biggest weakness in Romer’s paper.  When discussing Taylor’s critique she rightfully talks about the omitted variable problem.  But then she basically ignores the problem of monetary policy counterfactuals when considering what would have happened without the Obama stimulus.  The basic problem here is that she seems to hold three contradictory views:

1.  She agrees with Bernanke that the Fed is not out of ammunition.

2.  Elsewhere she praises Bernanke for acting aggressively in 2008-09, making the recession less severe.

3.  Her three million “jobs created or saved” estimate for the Obama stimulus implicitly assumes that if Obama’s stimulus had not passed, then the Fed would have responded to the deeper downturn with almost criminal negligence.

Now I’m perfectly willing to concede that it’s unlikely a counterfactual monetary policy would have exactly offset any fiscal stimulus reductions.  But I would also insist that monetary policy counterfactuals must be addressed in any multiplier estimates.  And I see one Keynesian study after another completely ignoring this problem.

She also cites the study by Nakamura and Steinsson that looked at the cross-sectional effects of defense spending in various regions.  But as I’ve pointed out many times, these multiplier estimates are completely consistent with the national multiplier being zero.  In other words, models that assume no aggregate multiplier effect (such as the monetary policy offset model) would nonetheless predict that regional defense expenditures would impact regional GDP.

She also cites a study of how individual reactions to rebate checks depend on the date they were received (Jonathan Parker, et al.)   This approach is somewhat better, but still fails to fully address the monetary offset problem.  Stimulus might boost NGDP in Q2, and the Fed might take it all back in Q3.

On a more positive note let me acknowledge that the Romers’ tax cut study is very important.  It suggests that we do know, at a minimum, that cuts in marginal tax rates boost RGDP.  I’m willing to support that sort of fiscal stimulus.  But at this point I’d have to say that’s all we know.  In a world where central banks are targeting inflation (and by implication AD), then all multiplier estimates for demand-side stimulus will be highly uncertain, little more that estimates of monetary policy incompetence in the specific period being examined.



25 Responses to “Christina Romer on fiscal policy”

  1. Gravatar of StatsGuy StatsGuy
    21. November 2011 at 06:29

    “The real problem is that in new Keynesian models the fiscal multiplier is precisely zero if the central bank targets either inflation or NGDP.”

    This assumes the target is symmetric, and specific. If the target (like the ECB target) is “somewhere under 2%” and the current rate is 0.5%, then in those models fiscal would have some traction. In essence, it’s forcing the monetary hand by issuing more debt (and with current rates, debt is approaching money with the drawback that it needs to be rolled).

    “… then the Fed would have responded to the deeper downturn with almost criminal negligence”

    And, your point?

  2. Gravatar of Kevin Donoghue Kevin Donoghue
    21. November 2011 at 07:05

    Scott: “models that assume no aggregate multiplier effect (such as the monetary policy offset model) would nonetheless predict that regional defense expenditures would impact regional GDP.”

    Total expenditure is the sum of regional expenditures. Total GDP is the sum of regional GDPs.

    I’ve tried to make sense of your claims in this regard and at this point I think what you’re saying is that increased spending on missiles in California could depress sales of beer in Florida. That’s certainly a possibility. There may even be some planet on which something of the sort occurs. But I wouldn’t accuse researchers who disregard such effects of falling for a fallacy of composition.

    Is that really the straw at which you are clutching?

  3. Gravatar of Morgan Warstler Morgan Warstler
    21. November 2011 at 07:14

    EMore of this please until the Romero / DeKrugan / Matty crowd GIVE UP on this trick, you haven’t really delivered on your promise… they must chose monetary over fiscal… mutually exclusive.

  4. Gravatar of William William
    21. November 2011 at 07:40

    I would also insist that monetary policy counterfactuals must be addressed in any multiplier estimates. And I see one Keynesian study after another completely ignoring this problem.

    Scott, any suggestion for how one might even attempt this? If they would concede your claim that the Fed has the power to make NGDP anything it wants, what’s the point of even trying to estimate a fiscal multiplier? So to ask my question another way, what assumption would you have them make about Fed behavior so that fiscal multiplier is still something that can be estimated?

  5. Gravatar of Benjamin Cole Benjamin Cole
    21. November 2011 at 08:33

    I agree with this post.

    Perhaps we Market Monetarists, to build political support from the inflation-obsessed right, should always add in that we believe permanent tax cuts are stimulative.

    Of course, taxing luxury consumption would be the best of all, but I don’t dare mention that.

  6. Gravatar of Richard A. Richard A.
    21. November 2011 at 09:22

    “Elsewhere she praises Bernanke for acting aggressively in 2008-09, making the recession less severe.”

    Like the decision to pay interest on excess reserves in the fall of 2008? I suspect that monetary historians of the future will point to this as a big screw up.

  7. Gravatar of ssumner ssumner
    21. November 2011 at 10:00

    Statsguy, Yes, there are many possibilities–I wish Keynesians would discuss them, or at least show some signs of recognizing the problem.

    Kevin, If you simply want to assume the zero multiplier models are wrong, and base your reasoning on a silly anecdote about beer sales, that’s fine. If we assume the multiplier is 1.6, then perhaps it’s 1.6. But if you actually want to engage the issue, you need to consider the predictions of both the zero and positive multiplier models. And if they both predict local effects, then finding local effects doesn’t show anything of value. Everyone knew you’d get that result without even doing the test.

    You seem to think I’ve developed some wacky new approach–but I’m giving you the mainstream NK model, what’s taught in graduate textbooks. You are the heterodox economist. You can’t dislodge a mainstream model with anecdotes about beer sales. There are reasons why more spending in one area might be offset by less spending elsewhere. For instance, the construction worker who moves from Florida to California to build that federal project. Do you think he might reduce his Florida beer purchases if he no longer lives in Florida?

    Thanks Morgan.

    William, You asked:

    “So to ask my question another way, what assumption would you have them make about Fed behavior so that fiscal multiplier is still something that can be estimated?”

    Good question, and very easy to answer. Suppose the Fed has a 2% inflation target, and core inflation is 2% (like right now.) The fiscal authorities decide to do a massive fiscal stimulus to try to raise AD enough so that inflation is expected to rise to 3%. The multiplier they assume will be effective if their action causes the Fed to say “Oh, we see the fiscal authorities are trying to raise inflation to 3%. Well in that case will do what we can to help.”

    That’s certainly possible, as Congress ultimately controls the Fed. But that’s the sort of Fed behavior that would make multipliers positive.

    Ben, Yes, replacing taxes on capital with taxes on luxuries would help a lot.

    Richard, They will if I have anything to say about it.

  8. Gravatar of John Thacker John Thacker
    21. November 2011 at 10:01


    The point is that spending is paid for somehow. If Florida (and the other states) are taxed to pay for missiles in California, surely you would agree that noting that California, which got stimulus, did better than the taxed states proved nothing.

    The Keynesian objection in this case is that it’s not being paid for by taxes, so no problem. But this ignores all kinds of alternative models. There’s the model where people save more because they know taxes will go up in the future, the model where the stimulus creates inflation and everyone is worse off, and then Scott’s model wherever Fed doesn’t do as much monetary stimulus because of the missile spending.

    If Florida gets less QE because of missile spending in California, then California will look better but it won’t mean that the fiscal stimulus helped the country as a whole.

    It seems like a willful blindness on the part of some Keynesians.

  9. Gravatar of ssumner ssumner
    21. November 2011 at 10:02

    William, Poor grammar on my part. It should be “the multiplier that they assume to be effective will be confirmed . . . “

  10. Gravatar of OGT OGT
    21. November 2011 at 10:19

    All in all I take this mostly as an argument that the Fed needs a clearer mandate. As it is fiscal officials (and economists) are left to guess what the Fed will do.

    If they guess that the Fed will act and it does not don’t they are risking wide spread suffering and a worse recession.

    If they guess that the Fed will not act and it does they will needlessly add debt, though there may or may not be additional positive and negative effects. As DeLong points out building infrastructure when real borrowing costs are zero makes sense, especially if you are simply pulling expenditures from the future.

    If the Fed targets NGDP and is seen as effective there is little rational for discretionary stimulus, just like non-liquidity trap situations. I’d still argue that ‘hard’ Keynesian budgeting makes sense, balanced during the upswings with allowances for automatic stabilizers to push it into deficit in downturns but primary justification is not macro economic stabilization.

  11. Gravatar of johnleemk johnleemk
    21. November 2011 at 10:22


    You persist in insisting that since nations are comprised of regions, the fallacy of composition does not apply. You seem to have missed the part of the Wikipedia article that reads:

    “In Keynesian macroeconomics, the “paradox of thrift” theory illustrates this fallacy: increasing saving (or “thrift”) is obviously good for an individual, since it provides for retirement or a “rainy day,” but if everyone saves more, Keynesian economists argue that it may cause a recession by reducing consumer demand.”

    A nation comprises individuals, so why can’t more aggregate saving be always good for the economy?

    As I said to you earlier, the spillover effects are easier to ignore at the national level because national boundaries almost always correspond with large frictions in the flow of goods, labour and capital. But the same rarely holds true for regions at subnational level. They may speak in undecipherable accents, but they still speak English after a fashion throughout the UK. Ignoring the effects of greater government spending in Scotland on the economies of Wales, Northern Ireland and England means the Scottish study has no implication whatsoever for the national-level multiplier.

  12. Gravatar of Kevin Donoghue Kevin Donoghue
    21. November 2011 at 11:08

    Scott: “You seem to think I’ve developed some wacky new approach-but I’m giving you the mainstream NK model, what’s taught in graduate textbooks.”

    I have two modern graduate textbooks on macro (Gali’s and Benassy’s), neither of which tells me that there’s a fallacy of composition involved in Romer’s reasoning (which is also Krugman’s, DeLong’s, Baker’s and many more).

    John Thacker, John Leemk,

    Thanks for the replies. All I really wanted to clarify was that Scott’s view turns on the idea that spillover effects are negative, or at a minimum we should reject any study which rules that out. AFAICT that is indeed what he has in mind. For an economy operating near capacity that’s perfectly reasonable, but when unemployment is high it is indeed wacky.

  13. Gravatar of Mike Sax Mike Sax
    21. November 2011 at 14:19

    Scott I will once again as I did the other day on another points comments, point out that Eggertsson did a study which suggests that while typically fiscal stimulus will be duplicative with Fed policy, during times of deep shocks-depressions-and when the nominal short term rate has it the Zero Lower Bound (ZLB) this will not be the case.

    “Under regular circumstances, these policies are counterproductive. A central bank that targets
    price stability, for example, will offset any inflationary pressure these policies create by increasing the short-term nominal interest rate. In this case, the policy wedges reduces output through traditional channels. The New Deal policies are expansionary in the model because they are a
    response to the “emergency” conditions created by deflationary shocks

  14. Gravatar of ssumner ssumner
    21. November 2011 at 15:29

    OGT, I agree that the budget should swing back and forth with the business cycle.

    Kevin, I meant that the standard NK model says the fiscal multiplier is zero when the central bank targets inflation. That’s why NKs stopped favoring fiscal policy decades ago.

    But I’m quite sure the standard NK model would allow for positive regional multipliers.

    Mike, And again I will point to the fact that the data from 1933 decisively rejects his assertion:

    1. Monetary stimulus clearly boosted prices and output, almost no one disputes that.

    2. Fiscal stimulus was quite small in 1933.

    3. Prices rose 20% from March 1933 to February 1934, despite 25% unemployment.

    Now tell me how that story matches the Keynesian “fiscal stimulus in a depression boosts output and not prices” story.

  15. Gravatar of John Thacker John Thacker
    21. November 2011 at 15:41


    It absolutely is “just wacky” for the Fed to not do more monetary stimulus because of fiscal stimulus when unemployment is so high. Scott and I agree with that.

    And yet, the Fed is doing this wacky thing. How else can we explain the insistence that it can do more and is not out of ammo, yet refusing to do more?

    The Fed is saying that it is satisfied with this level of AD and worries that more attempts to increase it would cause inflation. Crazy and “just wacky” to be sure, but nonetheless.

  16. Gravatar of Mike Sax Mike Sax
    21. November 2011 at 16:32

    Well as you yourself know, Scott, correlation and causation are not necessarily the same thing.

    I mention Eggertsson for two reasons. One is he’s a damn good economist. Two, you yourself have appeasled to him for your view that getting off the gold standard is responsible for the recovery in prices and production of 33-34.

    So he doesn’t deny what “almost no oone denies’ as you know as you sppealed to him back in your post about Skidelsky’s biography of Keynes.

    To say that monetary policy worked in 33-34 doesn’t prove that fiscal doesn’t. As you say the fiscal stimulus at this point was quite small it tells us nothing about whether or not monetary policy will neutralize fiscal policy in a depression. Krugman argues that nobody can really tell if Keynseianism really works because no one has ever really tried it.

  17. Gravatar of John Thacker John Thacker
    22. November 2011 at 06:45


    Except that the fact that the Fed insists it can do more, has done some, and refuses to do more (but hints that it would “if necessary”) DOES tell us something about how the Fed is choosing to neutralize fiscal policy.

    Of course the Fed doesn’t *have* to behave that way, but from both the evidence, its statements, and logic is clearly is.

    Sure, we don’t know if fiscal policy that the Fed didn’t neutralize would help. But who cares? The Federal Reserve is determined to neutralize fiscal policy– in the name of worrying about inflation, despite whatever you may think of AD.

    Be concerned about the world as it is, not according to some theory that ignores what the Fed is actually doing and will do.

  18. Gravatar of ssumner ssumner
    22. November 2011 at 06:58

    Mike, I agree.

  19. Gravatar of Floccina Floccina
    22. November 2011 at 09:46

    which claims that fiscal stimulus is effective.

    To me thus is a moot point because even if it is true the cost is high per job saved/created. Better monetary stimulus and wage subsidy. To me this seems especially true in this downturn because the lower skilled workers are so much more likely to out of work. IMHO for the people at the bottom of skill levels a wage subsidy is a much cheaper way to create jobs than a stimulus which is likely to have quite a bit of crowding out.

  20. Gravatar of TruthTeller TruthTeller
    22. November 2011 at 10:35

    You all, and the Keynesians, are nuts.

    The M&M propositions laugh at all of you.

    You take a bunch of stories (sticky this, aggregate demand that) and shift money (fiscally or monetarily) from one thing to another, and think you’ve done something of consequence…

    There are real things to do. Regulate smarter/less, that’s real. Tax broader/less, that’s real. Redistribute smarter/less, that’s real. Trade freer, that’s real. Do all of it –> get a wonderful economy. Don’t fall back into old habits –> get a wonderful economy forever.

    But rather, do fiscal “stimulus”, i.e., steal from some for others (funneled through some project or other), or some generations for other generations and you accomplish nothing as people are rational and on to you.

    Or do monetary “stimulus”, i.e., shuffle around paper and hope to fool people with, dare I say it, money illusion, and you accomplish nothing real.

    All of you, stop “making pretend” and advocate for real things.

    Silly economists.

  21. Gravatar of ssumner ssumner
    24. November 2011 at 07:04

    Floccina, I agree.

    Truth Teller, If you want a good laugh, look at “real” theories of the Great Depression.

  22. Gravatar of TruthTeller TruthTeller
    28. November 2011 at 14:13

    Yep, because the GD happened, we need to apply every behavioral oddity theory known to man, none of which (e.g., a high multiplier) has decent evidence. Good point.

  23. Gravatar of Scott Sumner Scott Sumner
    28. November 2011 at 18:02

    Truthteller, You do know that I claim the fiscal multiplier is zero, don’t you? If not, you are criticizing something you know nothing about.

    And I’d love to see your “real” theory of the 1921 recession.

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