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June 22, 2009

Economist's View - 4 new articles

FRBSF: Fighting Downturns with Fiscal Policy

Sylvain Leduc of the San Francisco Fed reviews several studies on the effectiveness of fiscal policy and concludes:

The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output. Nevertheless, the uncertainty regarding those estimates remains high. ...

This brings up a point about tax cuts I've been meaning to make (again). The effectiveness of tax cuts depends, in part, on how hard the recession hits household balance sheets. In a recession where balance sheets are relatively unaffected, a tax cut may very well translate into spending, and do so fairly quickly.

But when balance sheets are hit hard, the result is different. In this case tax cuts may be used largely to rebuild balance sheets - to recover what was lost - rather than for new spending. Thus, in this recession the stimulative effects of tax cuts may not have as large of an immediate effect as in the past (there are also reasons to suspect the government spending multipliers shown in the table below are underestimated due to the fact that this recession is not like those in the data used to produce the estimates, e.g. for one, the historical data may overestimate the crowding out effect, but for now I want to focus on taxes).

The fact that in this recession tax cuts may not have as large of an immediate impact as in the past should not necessarily lead us to conclude that the tax cuts were a waste. That is, households will not turn back to consumption until they have saved enough to make up for what has been lost, at least in part, so how long it takes for the recession to end depends upon how quickly household balance sheets are refilled (once this is over, I expect saving rates to be higher than in the past, but I also expect that saving will fall some from where they are now once balance sheets are in better shape). The faster they are refilled, the sooner people begin to spend more, and the sooner this thing ends.

So in that sense, the tax cuts were not a waste at all. Unfortunately, however, during the time when the balance sheets are being refilled it will look like the stimulus package is not having any effect - all you see is higher savings rate - but again, the higher saving rate brings the end of the recession nearer in time, and that is important in and of itself. That's a hard effect to estimate, even if you are looking for it after the fact, but again, it shouldn't be dismissed as inconsequential.

Finally, because tax cuts are likely to be saved more than in the past, and hence have a smaller impact than tax multipliers from historical data suggest, and because there is reason to think that government spending multipliers rise as recessions get more severe (e.g. even if interest rates go up, investment is likely to be insensitive when conditions are bad), the logic of using both tax cuts and spending to stimulate the economy is sound.

Here's more:

Fighting Downturns with Fiscal Policy, by Sylvain Leduc, FRBSF Economic Letter: Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals. The main argument is that monetary policy can act quickly when output falls below an economy's potential or when inflation varies from its optimal rate, and that these actions can be reversed quickly as conditions change. By contrast, modifications to the fiscal code take a long time to enact and implement and can be very difficult to undo.

However, the current recession is clearly not a typical downturn. In particular, unlike other post-World War II U.S. recessions, monetary policy has run out of its usual ammunition to boost economic activity. The federal funds rate, the principal tool that the Federal Reserve uses to stabilize the economy, is now hovering near zero. Because interest rates cannot be negative in nominal terms, monetary policymakers are unable to lower the federal funds rate further. In this situation, the Federal Reserve has turned to unconventional tools to get around this barrier, commonly called the zero lower bound.

Because of the severity of the recession and the uncertain effects of unconventional monetary policy tools, Congress and the Obama Administration have also enacted a fiscal stimulus package. The $787 billion program approved by Congress in February includes a mix of tax and spending measures aimed at creating jobs and boosting output. Yet, economists and political leaders heatedly debate whether tax cuts or increased spending are more effective, a dispute that's hard to resolve because of the difficulty of determining the precise magnitude of fiscal policy's impact on real GDP. This Economic Letter examines some recent empirical studies analyzing data on the relative effects of higher spending and lower taxes on output.

A simple theory of the effects of fiscal policy

Basic Keynesian theory suggests that the effect of a change in fiscal policy on real GDP is more than one-for-one. For instance, since government spending is one component of GDP, an increase in government purchases, by putting idle resources to work, boosts income one-for-one when the money is initially spent. In addition to that, though, since consumption is a function of current after-tax income in this framework, households also increase their consumption in line with their higher incomes, multiplying the effect of the initial government spending on GDP. The "multiplier effect" of government spending on GDP is thus greater than one.

This simple framework also predicts that the multiplier effect of a tax cut on GDP will be less than that for government spending. This is because a change in government spending affects GDP one-for-one, while part of a tax cut will be saved and will, at least initially, translate into a less than one-for-one increase in GDP.

Clearly, these results hinge on many underlying assumptions. One is that households are not assessing their future income when deciding how much to consume. Instead, they are assumed to spend a lot as long as their current income is high. However, households may be concerned about the impact of fiscal measures on their future tax bills. Households may not decide to consume as much if they expect taxes to rise and their future after-tax income to be lower. Moreover, this framework assumes that investment and net exports are insensitive to the change in fiscal policy. However, the response of investment will clearly depend on the behavior of interest rates, which in turn will depend on monetary policy. If monetary policy changes in response to fiscal policy, investment would be affected.

Large-scale econometric models often used in policymaking institutions make adjustments for household behavior and investment (see, for instance, Elmendorf and Reifschneider 2002). Nonetheless, the relative size of their fiscal multipliers is in line with this simple framework's predictions. For instance, earlier this year, Christina Romer, the chair of the Council of Economic Advisers, and Jared Bernstein, an advisor to Vice President Biden, estimated that the effects of permanently increasing government purchases by 1% of GDP would be to raise output by 1.5% two years after. At the same time, their model predicts that a tax cut of 1% of GDP would increase output by only 1% two years down the road.

Challenging the model

In a recent paper, Cogan et al. (2009) challenged the Romer/Bernstein estimates using an alternative New Keynesian model in which households and firms are more forward-looking than in typical large-scale econometric models. Using this model, the authors argue that a 1% increase in government spending would produce a mere 0.5% rise in output two years later.

In this framework, household and firm decisions to spend, invest, and produce are heavily influenced by their expectations of the future. Households anticipate that higher budget deficits will ultimately be financed with higher taxes, and they consume less as a result. Higher government spending thus crowds out consumption. Moreover, Cogan and his coauthors assume that, as the economy recovers following the increase in government spending, monetary policy becomes more restrictive, choking off investment. In contrast, Romer and Bernstein assume that the Federal Reserve keeps the federal funds rate constant, thus mitigating the adverse effect on investment. The crowding out of consumption and investment is relatively strong in the New Keynesian framework, offsetting much of the stimulatory impact of higher government spending.

In other words, the effects of fiscal policy on real GDP are quite sensitive to underlying modeling assumptions regarding the behavior of households, firms, and monetary policy. This creates fertile ground for good empirical work.

Recent empirical work

Empiricists interested in calculating the impact of movements in government spending and taxes on real GDP face multiple challenges, but the biggest hurdle is distinguishing fiscal policy changes that are fundamental from changes that are responses to economic conditions. Many influences other than tax and spending policy determine the trajectory of economic output. And taxation and spending vary over the course of the business cycle. The difficulty is to make sure to capture the effect of a change in fiscal policy on the economy and not the effect of changes in the economy on fiscal policy. Those fiscal policy changes that are independent of economic circumstances are called exogenous, and those that are reactions to economic conditions are called endogenous.

This is a particularly relevant issue because government spending and taxes respond endogenously to economic activity via automatic stabilizers--features built into the fiscal system to stimulate or depress economic activity automatically. Taxes automatically fall in recessions as household incomes decline. Transfer payments, such as unemployment insurance, rise. Moreover, government spending and taxes may have complex relationships with each other. For example, the payroll tax increased in 1965 to offset the costs of the new Medicare program on the federal budget (Romer and Romer 2008).

Typically, empirical studies adjust for the automatic stabilizers built into fiscal policy by taking into account movements in GDP when measuring government spending and taxes. Recent empirical analyses have taken a number of additional approaches to separate endogenous from exogenous factors.

Romer and Romer address the impact of tax changes by performing a narrative analysis of U.S. tax policy since 1945. Using the historical record, they try to isolate exogenous tax changes by identifying the key reasons underlying each modification to the tax code and rejecting those that were clear responses to economic activity. Alternatively, Blanchard and Perotti (2002) use a timing restriction to identify changes in government spending and taxes that are exogenous to unexpected movements in output. They argue that, because it takes time for legislators to understand a sudden movement in activity and then pass legislation to address it, it is reasonable to assume that, at high enough frequency, changes in taxes and government spending are independent of current output.

In contrast to these studies, Mountford and Uhlig (2005) use a mix of economic theory and time series analysis to identify exogenous movements in government spending and taxes. They build a small empirical model of the U.S. economy and look at the behavior of different "shocks" to that model, that is, disturbances that are unrelated to other variables in the system. They identify as exogenous movements in government spending those disturbances that end up raising government spending in the empirical model for a defined period of time. Similarly, exogenous movements in taxes are classified as those disturbances that end up raising tax revenues.

Table 1: Tax cut multipliers (on level of real GDP)
Table 2:

An interesting aspect of this new literature is that, notwithstanding their vastly different methodologies, they reach surprisingly similar conclusions. Regarding the impact of tax cuts on the level of real GDP one year after the change in taxes, the three studies predict a multiplier of roughly 1.2, as shown in Table 1. Moreover, Table 2 shows that, in contrast to theoretical predictions from the simple Keynesian framework, the analyses found that government spending had less bang for the buck than tax cuts. For instance, one year after the increase in spending, the impact on the level of real GDP is less than one-for-one, partly reflecting a decline in investment. There is more disagreement, however, about the effects of tax cuts on output two years after they are implemented, as Table 1 indicates. The analyses of Romer and Romer and Mountford and Uhlig find very large tax multipliers, while Blanchard and Perotti continue to find effects similar to those occurring after one year.

The stimulus package: Will it work?

Earlier this year, Congress passed a $787 billion fiscal stimulus package spread over 10 years. Of that total, $584 billion are spent in 2009 and 2010, with 19% of the funds allocated toward increases in government spending, 33.4% in transfers to the states, and 47.6% toward tax cuts. The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output.

Nevertheless, the uncertainty regarding those estimates remains high. Several economists remain skeptical that fiscal multipliers--whether from spending or taxes--are very large (see, for instance, Barro 2009). Moreover historical relationships may prove much less reliable during this downturn. Faced with a large decline in wealth and tight credit availability, households may very well respond differently to tax cuts today than they have in the past.

References

[URL accessed June 2009.]

Barro, Robert J. 2009. "Government Spending Is No Free Lunch." Wall Street Journal, January 22.

Blanchard, Olivier, and Roberto Perotti. 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output." Quarterly Journal of Economics (November) pp. 1329-1368.

Cogan, John F., Tobias Cwik, John B.Taylor, and Volker Wieland. 2009. "New Keynesian versus Old Keynesian Government Spending Multipliers." Unpublished manuscript.

Elmendorf, Douglas W., and David Reifschneider. 2002. "Short-Run Effects of Fiscal Policy with Forward-Looking Financial Markets." National Tax Journal 55(3, September) pp. 359-386.

Mountford, Andrew, and Harald Uhlig. 2005. "What Are the Effects of Fiscal Policy Shocks?" SFB 649 Discussion Paper 2005-039.

Romer, Christina, and Jared Bernstein. 2009. "The Job Impact of the American Recovery and Reinvestment Plan." Manuscript.

Romer, Christina, and David Romer. 2008. "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks." Manuscript.


Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.


Paul Krugman: Health Care Showdown

What's with the Blue-Cross Dogs?:

Health Care Showdown, by Paul Krugman, Commentary, NY Times: America's political scene has changed immensely since the last time a Democratic president tried to reform health care. So has the health care picture: with costs soaring and insurance dwindling, nobody can now say with a straight face that the U.S. health care system is O.K. And if surveys ... are any indication, voters are ready for major change.

The question now is whether we will nonetheless fail to get that change, because a handful of Democratic senators are still determined to party like it's 1993.

And yes, I mean Democratic senators. The Republicans ... role ... is ... shouting the old slogans — Government-run health care! Socialism! Europe! — hoping that someone still cares.

The polls suggest that hardly anyone does. Voters, it seems, strongly favor a universal guarantee of coverage, and they mostly accept ... that higher taxes may be needed... What's more, they overwhelmingly favor precisely the feature ... that Republicans denounce most fiercely as "socialized medicine" —... a public health insurance option that competes with private insurers.

Or to put it another way, in effect voters support the health care plan jointly released by three House committees last week... Yet it remains all too possible that health care reform will fail...

I'm not that worried about the issue of costs ..., we can afford universal health insurance... Furthermore, Democratic leaders know that they have to pass a health care bill for the sake of their own survival. One way or another, the numbers will be brought in line.

The real risk is that health care reform will be undermined by "centrist" Democratic senators... What the balking Democrats seem most determined to do is to kill the public option, either by eliminating it or by ... replacing a true public option with something meaningless. For the record, neither regional health cooperatives nor state-level public plans, both of which have been proposed as alternatives, would have the financial stability and bargaining power needed to bring down health care costs.

Whatever may be motivating these Democrats, they don't seem able to explain their reasons in public.

Thus Senator Ben Nelson of Nebraska initially declared that the public option — which, remember, has overwhelming popular support — was a "deal-breaker." Why? Because he didn't think private insurers could compete: "At the end of the day, the public plan wins the day." Um, isn't the purpose of health care reform to protect American citizens, not insurance companies?

Mr. Nelson softened his stand after reform advocates began a public campaign targeting him for his position on the public option.

And Senator Kent Conrad of North Dakota offers a perfectly circular argument: we can't have the public option, because if we do, health care reform won't get the votes of senators like him. "In a 60-vote environment," he says (implicitly rejecting the idea, embraced by President Obama, of bypassing the filibuster if necessary), "you've got to attract some Republicans as well as holding virtually all the Democrats together, and that, I don't believe, is possible with a pure public option."

Honestly, I don't know what these Democrats are trying to achieve. Yes, some of the balking senators receive large campaign contributions from the medical-industrial complex — but who in politics doesn't? If I had to guess, I'd say that what's really going on is that relatively conservative Democrats still cling to the old dream of becoming kingmakers, of recreating the bipartisan center that used to run America.

But this fantasy can't be allowed to stand in the way of giving America the health care reform it needs. This time, the alleged center must not hold.


Mishkin: How to Get the Fed Out of Its 'Box'

Frederic Mishkin is worried about the long-run budget and how it constrains what the Fed can do:

How to Get The Fed Out Of Its 'Box', by Frederic Mishkin, Commentary, WSJ: When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma.

Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around ... 0.70%,... the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates ... has the potential to choke off economic recovery and lead to further deterioration in the housing market. ... Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?

To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause ... is the more positive economic news..., particularly in financial markets. The bad news is ... the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. ...

Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, ... be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.

The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy... The fiscal situation argues against this policy action, because it would weaken the Fed's inflation-fighting credibility.

How can the Fed get out of the box and pursue the expansionary monetary policy that is needed...? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions..., fiscal stimulus to promote economic recovery ... in a severe recession is a sensible prescription.

However, the failure to take steps to get future budgets under control is a recipe for disaster. Not only does it make it difficult for the Fed..., but it may even make the fiscal stimulus package less effective. After all, if you know that the government is issuing a lot of debt ... you can expect to pay much higher taxes in the future. With the prospect of higher taxes, you will be less likely to spend today.

How can the Obama administration and Congress help the Fed do its job and help the fiscal stimulus package work? It needs to address exploding spending on entitlements -- Social Security and particularly Medicare -- which are causing future deficit projections to be so bleak.

One possibility is to establish a nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s. ... Another is taxing health-care benefits as part of any package to reform health care. Taxing health-care benefits would ... generate large amounts of revenue. It would also increase the incentive for people to lower the costs of their health care. There are surely many other ways to promote more fiscal responsibility.

The Fed can assist this process. It could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past. In the current extremely difficult economic environment, we surely need such a deal now.

As has been pointed out here many times, the inflation and interest rate concerns are likely overblown, as is the worry that consumption will suffer significantly due to the expectation of taxes in the future, and hence the motivation to attack entitlements is not as strong as suggested. Also, there is also at least some question about the Fed's ability to control long-term interest rates.

But beyond that the projected increase in health care costs is the biggest problem with the long-run budget by far, and the Obama administration is trying to reform the health care system. So the administration is attempting to "address exploding spending on entitlements," at least the one that is actually exploding - there's no sense in which the projected increase in the deficit due to Social Security can be described as "exploding" - and if the Fed, Mishkin, or anyone else wants to assist with that effort with deals or op-eds that promote the necessary reform, I'm sure the administration would welcome their help.


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