Christina Romer's speech at the Chicago Booth forum at the University of Chicago:
The Case for Fiscal Stimulus: The Likely Effects of the American Recovery and Reinvestment Act: There are many thrills to my new job:
- Three gates have to open to allow me to park each morning.
- I get to speak frequently with the leader of the free world.
- And, as a courtesy I get to see the Federal Reserve’s Greenbook forecast in real time rather than with a five-year delay.
Actually, the biggest thrill of all is that after more than two decades of studying macroeconomic policy, I had the privilege of helping to craft what is without question the boldest countercyclical fiscal action in American history. ...
Over the past several months, there has been much discussion about whether the act will do enough to get the country back on track. I am extremely optimistic that it will, and thought it would be useful to spend my time today explaining why. In the process, I will explain why I disagree with some arguments that have been made against the recovery plan. ... I will strive to do my CEA best to give a balanced, dispassionate assessment.
The first issue is what it would mean for the policy to work. The President gave a very concrete metric: he wanted a program that would raise employment relative to what it would be in the absence of stimulus by 3 to 4 million by the end of 2010. Some on the blogosphere (such as the best man at my wedding, Greg Mankiw) call this metric meaningless: they complain that because we never observe the outcome under the no stimulus baseline, it isn’t verifiable. But it is, in fact, the intellectually sound and appropriate metric to use. Exactly what any macroeconomist would ask of a policy is what are its effects, holding constant all the other forces affecting the economy. I feel the strongest evidence that the President’s metric is a good one is that it has focused the debate on the right issue. Numerous forecasters, from Mark Zandi to Macroeconomic Advisers to CBO to the Federal Reserve, have looked at what they expect the Act to do. Rather than fighting over the differences in the no-stimulus baselines, which are substantial and largely outside the control of policymakers, the debate has centered on what the policy would accomplish.
Of course, one can also debate the baseline and the question of whether creating or saving 3 to 4 million jobs will be enough to fully heal the economy. But, it is important to acknowledge that creating or saving that many jobs would be a tremendous accomplishment.
This discussion of what the bill is intended to do leads naturally to the more important question of whether it will actually accomplish the President’s goal. This involves two issues. One concerns the effects of a typical fiscal change. What will a quintessential increase in government spending or cut in taxes do to output and employment? The other concerns the particular fiscal changes in this bill. Are there aspects of its structure or timing, or of the economic environment in which it is taking place that would lead us to expect the effects to be different from usual?
Let me start with the issue of the effects of fiscal policy in general. If we cut taxes by 1% of GDP or increase spending by a similar amount, what will that typically do to the economy? I will be the first to point out that estimating these multipliers is difficult and that there is surely substantial uncertainty around any estimate. But, I feel quite confident that conventional multipliers are far more likely to be too small than too large. David Romer and I have argued that omitted variable bias is a rampant problem in estimating the effects of fiscal policy. One good way to illustrate this is to discuss Robert Barro's approach to estimating multipliers. Barro has argued that a reasonable way to estimate the effects of increases in government spending is to look at the behavior of spending and output in wartime. But, consider one of his key observations – the Korean War. If he were using just this observation, Barro would basically divide the increase in output relative to normal by the increase in government purchases relative to normal during this episode. When one does this, one gets a number less than one. From this Barro would conclude that the multiplier for government spending is less than one. But, other things were going on at this time that also affected output. Most importantly, taxes were raised dramatically; indeed, the Korean War was largely fought out of current revenues. The fact that output nevertheless rose substantially is in fact evidence that the effects of increases in government spending are very large.
To address the problem of omitted variables, David and I used narrative evidence to isolate tax changes uncorrelated with other factors affecting output. We read Congressional reports, Presidential speeches, the Economic Reports of the President, and other documents to identify relatively exogenous tax changes. We found that the estimated effect of these changes is very large. A tax cut of 1% of GDP raises GDP by between 2 and 3% over the next three years.
Unfortunately, doing the same kind of narrative analysis for government spending would be very difficult: there are vastly more spending changes than tax changes, and the motivations for them are less easily classified. But, the same issue of omitted variables is surely present. As the war example illustrates, spending changes are often taken at the same time as tax changes that push output in the opposite direction. Also, spending increases are often taken in recessions, where other factors are clearly reducing output. As a result, it is likely that conventional estimates of spending multipliers are also biased downward.
In estimating the effects of the recovery package, Jared Bernstein and I used tax and spending multipliers from very conventional macroeconomic models. We used simulations based on the realistic assumption that monetary policy would remain loose, and on the assumption that people would treat the individual tax cut as permanent. This last assumption is justified by the fact that the President ran on a permanent middle class tax cut and just included it in his budget. In these models, a tax cut has a multiplier of roughly 1.0 after about a year and a half, and spending has a multiplier of about 1.6. As I have suggested, it is very hard to claim that those are excessively large. Indeed, if you want to know why I am more optimistic than some, it is probably because I believe my own research. I think that both the change in taxes and the change in spending may pack more bang than the official Administration estimates assume. Before leaving multipliers, one issue that has come up is the interaction with the financial crisis. A common argument is that fiscal stimulus will have less effect because financial markets are operating poorly and lending is not flowing. I want to offer a different view. I think it is possible that fiscal policy will have even more oomph in this situation. When households and businesses are liquidity-constrained by reduced lending, any money put in their pockets is more likely to be spent.
More fundamentally, there is strong reason to believe that a recovery in the real economy is salutary to the financial sector. When people are employed and buying things, loan defaults fall and asset prices are likely to rise. Both of these developments would surely be helpful to stressed financial institutions. This is, I believe, a key lesson of the Great Depression. In the Depression, the end of deflation, renewed optimism, and increased employment and output were as crucial to the recovery of the financial system as the more direct actions taken to stabilize banks. Thus, real and financial recovery reinforced each other. So, fiscal policy to raise employment may help to restart lending and in that way generate a more durable recovery.
So much for the generic effects of fiscal policy. What about the particular actions called for in the Recovery Act? ...[...entire speech...]