Effects of fiscal policy – Seperating ideology from empirics

A nice paper/speech from Team Obama’s ex chief economist – Christina Romer. This has been blogged about much. Krugman, Gulzar and John Taylor (responding to his criticism in the paper) have blogged about it.

Tons of research is to follow on whether fiscal policy worked or failed in this crisis. All I can say with 90% confidence is despite so much research, we can never be sure whether fiscal policy worked in this crisis.

However, this paper is a very good one (in plain english) and explains the basic problems with research on fiscal policy.

These days, the Recovery Act isn’t very popular. A lot of politicians and pundits assert with great confidence that the Recovery Act was useless. If you are a Republican candidate for President, you probably describe it as $787 billion of pork that did nothing.

If you press people for why they think this they will probably say something like, “It’s not rocket science—all you need are two good eyes to look around you. We spent all of this money and the economy is still terrible. It obviously didn’t work.”

Well, the theme of my talk this evening is that it is not that easy. Estimating the effects of fiscal policy may not be rocket science, but it is incredibly hard. The reason that it is hard is that fiscal actions are often taken in response to other things happening in the economy. Separating the impact of those other factors from the impact of the tax changes or spending decisions is very difficult. It requires many of the sophisticated techniques in the economist’s tool kit—along with a big dose of creativity, and plenty of plain old-fashioned hard work.

This leads peopel to wrongly assess the impact of fiscal policy. What are the problems?

First, there has been limited research before crisis on the fiscal policy. Second, there are some interesting cases of omitted variables. So you see the impact of first because of second and ignore the impact of third variable which could have been more important.

To illustrate why estimating the effects of fiscal policy is hard, let me start with an example. In February 2008, the Bush Administration and Congress came together to pass a tax cut—the Economic Stimulus Act of 2008. This was before the collapse of Lehman Brothers, but just after what we now date as the start of the recession in December 2007. The total budgetary cost of the bill was about $130 billion. Most of it came in the form of tax rebate checks mailed between April and July of 2008.

John Taylor, one of the economists saying loudly that fiscal stimulus doesn’t work, has a short paper saying this tax rebate wasn’t effective…

What Taylor does is to estimate the impact on consumption post rebates and sees it is the same as pre-crisis and calls it a failure. However, what we need to understand is in a crisis consumption should have fallen sharply. As it did not, this was a success of fiscal policy:

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.

She calls this omitted variable analysis which leads to wrong conclusions. Taylor responds saying he did look at this saying it is a case of Omitted Facts in a Speech on Omitted Variables.More fireworks could follow..

She goes on to point some critical problems with omitted variables. Basically, things like taxes / govt. expenditure are done in different times. So you see different impact:

The usual way that researchers had looked at the impact of tax changes was to estimate the relationship between output (real GDP) and the change in government tax revenues. In measuring tax revenues, they had tried to control for the fact that revenues naturally tend to go up in good times and down in bad times. They used the change in something called cyclically-adjusted revenues.

The finding was the expected negative relationship: lower taxes went with higher output. Tax cuts tend to cause the economy to grow, at least in the short run. But the estimated impact was not very large and the estimates were not very precise. The computer thought that tax cuts increased output, but it wasn’t very sure.

But there was a problem of omitted variable bias in these studies. Some tax cuts—like the 2008 tax rebate we talked about earlier—were taken because output was tanking. In those cases, we wouldn’t expect output to increase, even if the tax cuts were very effective. If such observations were common, the studies might go very far astray.

 She points how she addressed this bias in her research with her hubby David Romer. They looked at why tax rates were changed following policy narratives:

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.

Hmm. Superb. This helped doing away with some of the omission bias and they found the multiplier around 3..

She points to some recent research on impact of fiscal policy both before and during crisis. Most research shows the fiscal policy does have some impact.  She says people accuse her being a Keynesian but she is an empiricist economist and believes in analysis and not ideology.

She looks at the recent austerity debate and says why it has not been a success. Economies in distress need stimulus not austerity. She says though difficult US also needs a fiscal stimulus to raise more jobs. There is a problem that stimulus will further worsen debt crisis but what we need to worry more about is today’s growth and longer term debt issues:

The research on the impact of fiscal contractions, however, suggests that we need to be smart about dealing with these deficits. Aggressive moves to immediately lower the deficit will cause unemployment to rise. Indeed, as I have described, we have already seen this happen in a number of countries that have either chosen or been forced by debt crises to shrink their deficits immediately. And the true problem children of Europe—Greece, Portugal, Spain, and Italy—have such unsustainable deficits that financial markets have already lost confidence in their ability to repay.

The resulting high unemployment just makes the deficit problem even worse. Right now, countries like Greece and Spain are in a vicious circle, where fiscal austerity leads to higher unemployment which leads to higher deficits and more austerity.

A much more sensible way forward is to pass aggressive plans that will shrink deficits gradually over time. We should make the decisions right now about what spending to cut and whose taxes to raise. But then we should phase these measures in as the economy recovers. In the United States, such a forward-looking deficit reduction plan might include things like gradually raising the eligibility age for Medicare, or gradually phasing out some of the biggest deductions in the tax code.

A must read paper on fiscal policy in simple english. Even if you do not agree to the findings, this is how one should be writing on economics..