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Monday, May 21, 2012

Fiscal Policy Works

Paul Krugman:

None So Blind: As those who will not see.
Eddie Lazear has an op-ed in the WSJ on the fiscal cliff that, among other things, pooh-poohs any concerns that sudden cuts in spending might hurt the economy. He weasels a bit, but basically conveys the impression that there’s no evidence for Keynesian effects.
What this signifies to me is the politicization and corruption overtaking the economics profession. I’ll give Eddie the benefit of the doubt; he is probably just going by what his friends say. But it’s truly awesome: in the midst of a crisis that has both provided overwhelming evidence for Keynesian views of fiscal policy and inspired a great deal of empirical work that also confirms the case for a Keynesian view, the right wing of the profession is just covering its ears and yelling “La, la, la, I can’t hear you.”

The question of where the moderate, reasonable, rational voices within the Republican Party have gone certainly needs to be examined, but for now let me focus on Lazear's remarks on fiscal policy. What does the evidence actually say? David Romer examines the empirical work on the effectiveness of fiscal policy, notes that there is compelling evidence that fiscal policy works in a major crisis, and says "I think we should view the question of whether fiscal stimulus is effective as settled":

...Given the magnitude and persistence of the demand shortfall in a major crisis and the limited possibilities for policies that shift intertemporal incentives, much of discretionary fiscal stimulus is likely to take largely conventional forms, such as broad-based income tax cuts, increased transfers, and higher government purchases. My second lesson is that the evidence that has come out of the crisis has made the case that such conventional fiscal actions stimulate the macroeconomy even more compelling than it was before.
Because we have had to turn to fiscal tools, the crisis has sparked a great deal of work on the short-run effects of fiscal policy. As Robert Solow stresses in his remarks in this session, we should not be trying to find "the" multiplier: the effects of fiscal policy are highly regime dependent.
One critical issue is the monetary regime. Consider estimating the effects of fiscal policy over the period from, say, 1985 to 2005. Central banks were actively trying to offset other forces affecting the economy, and they had the tools to do so. Thus if they were successful, one would expect the estimated effects of fiscal policy to be close to zero. But this would tell us nothing about the effects of fiscal policy in situations where monetary policymakers are unable or unwilling to offset other forces. Fortunately, there has been a great deal of new research that sheds light on the effects of fiscal policy in settings where monetary policy does not respond aggressively. Some of it uses evidence from the crisis itself, but much does not; some focuses on a particular country, usually the United States, but some uses larger samples; and a considerable body of the work looks at evidence from different regions within a country, again usually the United States. One particularly appealing aspect of this last set of studies is that because monetary policy is conducted at the national level, it is inherently being held constant when one is looking at within-country variation.
Collectively, this research points very strongly (though, I should say, not unanimously) to the conclusion that when monetary policy does not respond, conventional fiscal stimulus is effective. And a careful examination of the evidence gives no support to the view that when monetary policy is constrained, fiscal contractions are expansionary (International Monetary Fund, 2010).
Even so, I find two types of evidence that predate the crisis even more compelling. The first comes from wars. The fact that the major increases in government purchases in the two world wars and the Korean War were associated with booms in economic activity, and that those booms occurred despite very large tax increases and extensive microeconomic interventions whose purpose was to restrict private demand, seems to me overwhelming evidence that fiscal stimulus matters.
The other type of evidence is more general evidence about the functioning of the macroeconomy. We know that monetary policy has powerful real effects, which means that aggregate demand matters. We know that current disposable income is important to consumption. And we know that cash flow and sales have strong effects on investment.It would take a strange combination of circumstances for those things to be true but for fiscal policy, which one would expect to work through those channels, not to be effective. Given this wide range of evidence—not to mention the large body of pre-crisis work on the effects of fiscal policy that I have not even touched on—I think we should view the question of whether fiscal stimulus is effective as settled. ...

    Posted by on Monday, May 21, 2012 at 10:03 AM in Economics, Fiscal Policy | Permalink  Comments (47)


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