Archive for November 18th, 2009

Fiscal Multipliers in Depressions

November 18, 2009

Barry Eichengreen et al have another paper which is bound to fuel controversy in the fiscal multiplier debate. Voxeu summary is here.

The Great Depression of the ‘Thirties and the Great Credit Crisis of the “Noughties had similar causes but elicited strikingly different policy responses.  It may still be too early to assess the effectiveness of current policy responses, but it is possible to analyze monetary and fiscal policies in the 1930s as a “natural experiment” or “counterfactual” capable of shedding light on the impact of recent policies.

We employ vector autoregressions, instrumental variables, and qualitative evidence for a panel of 27 countries in the period 1925-1939.  The results suggest that monetary and fiscal stimulus was effective – that where it did not make a difference it was not tried. 

The results also shed light on the debate over fiscal multipliers in episodes of financial crisis.  They are consistent with multipliers at the higher end of those estimated in the recent literature, consistent with the idea that the impact of fiscal stimulus will be greater when banking system are dysfunctional and monetary policy is constrained by the zero bound.

The authors find the fiscal multiplier at about 2.  Voxeu summarises the findings as:

They show that where fiscal policy was tried, it was effective.

Our estimates of its short-run effects are at the upper end of those estimated recently with modern data; the multiplier is as large as 2 in the first year, before declining significantly in subsequent years. (Figure 1 shows this in the case of the panel VAR estimates with the conventional ordering assumptions.) This is, in fact, what one should expect if one believes that the effectiveness of fiscal policy is greatest when interest rates are at the zero bound, leading to little crowding out of private spending. It is what one should expect when households are credit constrained by a dysfunctional banking system.

Monetary policy is not ineffective in zero interest rates:

This result is notable, given the presumption, widespread in the literature, that monetary policy is ineffective in near-zero-interest-rate (liquidity trap) conditions. On the contrary, in the 1930s it appears that accommodating monetary policy helped, by transforming deflationary expectations (Temin and Wigmore 1990) and by helping to mend broken banking systems (Bernanke and James 1991). Given the prevalence of both problems circa 2008, we suspect that the results carry over.


The paper is different as looks at fiscal multiplier from 27 countries. The Great Depression was not limited to US but spread across economies. However most studies look at US and conclude whether fiscal multiplier worked or not. Eichengreen et al look at fiscal multiplier across 27 economies with each in recession. So this is more like a global fiscal multiplier when several economies are trapped in a recession.

Therefore settings of this paper apply more closely to today’s times. In this recession we see many countries in a recession and many adopting fiscal policies. Then we also have near ZIRP in many countries. The authiors say:

The IMF estimated in October that world output would contract by 1.1% in 2009. In its October World Economic Outlook it estimated that the G-20 would implement crisis related fiscal stimulus equivalent to 2 per cent of GDP during 2009. It also estimated that worldwide government fiscal balances would deteriorate by the equivalent of 4.6 per cent of world GDP (comparing 2009 with 2008). OECD (2009b) has estimated that OECD governments are embarking on an expenditure stimulus equivalent to 1.7 per cent of GDP during 2008-10, and on a total fiscal stimulus of 3.4 per cent over the same period. Fiscal stimuli of this size, and fiscal multipliers of the size we have estimated in this paper, together suggest that the world economy would have contracted by a great deal more than 1.1 per cent in 2009 if we had seen the same passive policy response that characterised the years after 1929. 

What would Barro et al say to these findings? Let us wait for the answers. Exciting stuff. Fiscal Policy is surely getting a lot of research coverage. Krugman finds it difficult to understand why we cannot understand these depression basics.

Recession of 1937 – a preview

November 18, 2009

François Velde of Chicago Fed has written an insightful paper on the Recession of 1937. The recession of 1929 and 1937 made the entire crisis as Great Depression.


Velde explores the reasons why the crisis of 1937 occurred. There are wide views:


The recession of 1937 has been cited as a cautionary tale about the dangers of premature policy tightening on the way out of a deep downturn. In contrast, some authors have downplayed the role of monetary policy suggested by Friedman and Schwartz (1963). In particular, Cole and Ohanian (1999) dismiss the role  of reserve requirements in the 1937 recession for two reasons. One is timing: “we would expect to see output fall shortly after” the changes in reserve requirements; but, they write, industrial production peaked in August 1937, 12 months after the first change (Cole and Ohanian, 1999, p. 10). The other is that interest rates did not increase: Commercial loan rates remained in the same range, and rates on corporate bonds “were roughly unchanged between 1936 and 1938” (Cole and Ohanian, 1999, p. 10).



What does he find?


I find that monetary policy and fiscal policy do not explain the timing of the downturn but do account well for its severity and most of the recovery. Wages explain little of the downturn and none of the recovery.


Read the paper for another peek into economic history. It mostly has something different and new to offer.



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