Friday, 7 December 2012

Igniting the recovery? Fiscal policy and aggregate demand

From David Beckworth comes the following graph on the effect of fiscal policy (fiscal contraction) in the crisis and its effect on aggregate demand:

Source: David Beckworth's blog: Macro and Other Market Musings
HT: Tyler Cowen
Here's what he concludes:
"This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010. Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures."
It seems to me that even before the crisis there hasn't been a clear correlation between the two variables. Based on this graph (and on the other one he shows in his text) it's far from concluding anything on the effects of counter-cyclical fiscal policy or its low multiplier. And this was the center-point behind Beckworth's argument that fiscal policy is ineffective in igniting the recovery. As the regular readers of the blog will know, I agree with the point that fiscal policy is ineffective, but this graph is far from proving that point. 

Observing only the given series of federal government expenditures relative to NGDP (blue line), their decline since 2010 can be attributed to the restoration to its pre-crisis levels. We can see a strong peak in 2009 following the Obama stimulus (rising from another high point after the Bush bailout), so everything afterwards is simply restoring the pace and size of government spending to its previous levels. This is why a fiscal consolidation is necessary. Fiscal stimulus responses to the crisis shock in 2007-2009 in both the US and particularly in Europe are the reason behind the unsustainability of public finances in many of these countries (particularly Ireland and Spain which didn't have problems with debts and deficits before the crisis). In order to resolve these unsustainable issues arising primarily because of a faulty welfare state model (which still isn't being reformed), structural reforms are necessary.

Generally, the graph above is an argument that fiscal policy was ineffective from 2010 onward so the US should engage in a monetary stimulus, presumably target its NGDP growth rate at 5% (a full percentage point above its current growth rate, by building up inflation, thereby increasing the value of currently produced goods and services simply by increasing their price). Once again I fail to see how this strategy will do any good for the US recovery. 

Noah Smith makes a good point on that perspective in his critique to Beckworth's arguments:
"Also, note that if fiscal policy is effective (i.e. if the multiplier is high), then aggregate demand will depend not just on current deficits but on expectations of the response of deficits to future external AD shocks. This is a central tenet of the "market monetarism" that Beckworth espouses, but there's no reason that forward-looking expectations can't be applied to fiscal policy as well as monetary policy."
And this is exactly why I don't align with market monetarism arguments. There is no reason that forward-looking expectations of a favourable fiscal policy won't result in a similar effect as expectations over accommodative monetary policy. If you believe that one policy response is effective because of forward-looking expectations than there is no reason not to believe that the other policy won't work. I, for one, don't believe that forward-looking expectations of any of the two policy alternatives will be effective in increasing current confidence. The overview of business and consumer confidence (particularly following monetary stimuli) as well as the policy uncertainty in the economy suggests otherwise.

8 comments:

  1. The only thing that this graph proves is the effectiveness of the Obama stimulus in 09. There was a huge increase of GDP after the stimulus following a time lag of 6 months.

    As for the effect afterwards one can make several conclusions.. like that there was no stronger recovery of GDP because the economy was expecting another fiscal expansion but got a contraction instead. Basically growth would have been faster with less austerity and more spending.

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    1. I will refer you to Greg's and Kyle's comments below. And add that aggregate values such as these can very well point into several directions, all opposite to one another, which is why I avoid conclusions based on such variables.

      Another good way to show why you cannot conclude that the stimulus of 09 was successful, at least not from this graph, is in the measurement of the variables. In 2009 it is only obvious that total spending grew more than NGDP, which is why the hike is there. The time lag you mention that supposedly took the stimulus to draw some effect makes little sense in this case, since it is a clear case of an omitted variable bias. This means that there was something else that caused the NGDP to recover, not the stimulus.

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  2. doesn't the chart show spending to ngdp? if ngdp grows at 4% and spending by 2% this would make the ratio fall, right? so how does this prove anything on the effects of austerity to ngdp?

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    1. exactly, good spot! Essentially this only means that NGDP is growing faster than federal spending. It is certainly not a proof of austerity. It only makes it more confusing to conclude on the real effects, and can stand to support both hypotheses or neither.
      You can play with graphs as much as you want until you find something to support your point of view.

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  3. Anonymous, can you be more naive? Why don't you check out any typical NGDP chart following every other recession in world history? You will see a similar rise, quite independent of any government policy. After every economic shock there is a period of rebound, the question is will the rebound return to where we were before or will it stop short of full recovery? The only thing the stimulus did was create a lot of debt and uncertainty.

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  4. I want to take a longer term view. In my opinion there is no future for the world's western style democracies until they create a strong legal frame work inhibiting the central government from excessive debt.

    In the USA it would have to mean a constitutional amendment. Until this happens I see no hope for the future. The politicians are incapable of spending less, and nearly every major western economy is on the verge of either debt default or hyperinflation.

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    1. you're suggesting a fiscal rule of some sort right? I recommend this very good paper by Wyplosz - it's more on constraining the budget deficit, not government debt (which is essentially very similar and actually more effective and economically sound). He goes through a lot of historical examples on how fiscal rules can be effective and suggest some of his own amendments. But yes, this can only be effective if it were a constitutional rule.

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  5. The chart is faulty as it shows only the ratio of spending to NGDP, not aggregate spending by itself..

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