A Poor Critique of Fiscal Stimulus

While I am no defender of fiscal stimulus — “Government Spending is Bad Economics” —, I call it like I see it: Anthony Davies’ recent empirical case against fiscal stimulus is not particularly persuasive. Here is the short video, taken from a lecture,

[youtube http://www.youtube.com/watch?v=Zo0h_AR_lJM]

The data Davies uses is available in .pdf format. Rather than reproduce the graphs here, I’ll refer to pages within the .pdf.

In a nutshell, Davies argues (p. 2) that a +∆ in fiscal stimulus should have a positive impact on ∆ in GDP. This is, under the condition of ceteris paribus, fair and non-controversial. But, in the real world there is no such thing as “ceteris paribus.” Nobody disagrees with me, no doubt, but I feel Davies doesn’t fairly consider the implications of this truth.

Take a look at the graphs on pp. 4, 6, 8, 10, 12. I’m not a good statistician, or maybe even a good interpreter of scatter plots, but the lack of clear correlation on the first three graphs (of those listed in the previous sentence) is not particular damning. A fiscal stimulus advocate could just as easily argue that a lack of fiscal stimulus would have achieved a lower growth rate in %∆ in GDP. In fact, as displayed, there might be some empirical support for this kind of defense: countries with –%∆ in fiscal outlays have comparatively lower %%∆ in GDP than others. We don’t even know what countries each point plotted represents (although, I suppose we can look at the relevant BEA databases). The graphs on pp. 10 and 12 show a negative trend, but this could be caused by changes in economic fundamentals — the kind of fundamentals that take 1–2 years to impact the economy —, unrelated to fiscal stimulus. Finally, again, without knowing the countries it’s impossible to interpret the data.

To put the ambiguity of “faceless” data into perspective, suppose that that the point on the graph on p. 10 corresponding with, roughly, (1.25, –0.9) represents the fictional country of “Spreece.” On average, Spreece’s government practices relatively high levels of fiscal stimulus. But, inter alia, it also has restrictive labor laws, a dysfunctional financial sector (private credit freeze), and domestic violence issues (e.g. rioting) and thus a relatively high degree of regime uncertainty. It’s conceivable that the effects of fiscal stimulus can be outweighed by relevant factors outside the State’s direct control (Ilzetzki, et. al., [2010]).

[Edit: Thanks to commenter “M.H.” I now realize that the points don’t represent countries, but different historical episodes in the United States. My general argument in the above two paragraphs still applies, however. Change “countries” for “episodes.” The impact of fiscal stimulus may be contingent on other factors.]

The bar graph on p. 18 is no less misleading. Which recession matters. Most were “solved” (smoothed over) by changes in monetary policy — viz. loose credit policies —, and most recessions between 1945 and 2007–08 have been “mild” (what some like to call “garden variety”). To put it straight, one could argue that the need for fiscal stimulus is contingent on the magnitude of the fluctuation, the effects of countercyclical monetary policy, and the status of the banking sector (whether it’s in a position to respond to Fed stimulus). But, I think this graph is better than the others.

Like I wrote above, I’m no fiscal stimulus (or monetary, for that matter) advocate. But, we should avoid weak arguments, because these are the ones that many well-known advocates focus on when they try to discredit their opponents. I think the best case against stimulus is theoretical, but few people tend to be persuaded by pure theory. If we must go to the evidence, then I think the best argument against fiscal stimulus is to look at past recessions with similar traits and make an exhaustive empirical case for what did push the recovery. A good example is the work, over the past two decades or so, on the impact of World War II on the U.S. economy. Hasn’t persuaded everyone, but I think the skeptic’s case against World War II as fiscal stimulus has gained a lot of ground.

4 thoughts on “A Poor Critique of Fiscal Stimulus

  1. M.H.

    Of course, it was a bad critique, because one should not use empirical data alone to discredit/confirm a theory. Instead, empirical data combined with a theoretical attack is much more convincing.

    If I had a critique to make, I would say that there is no reason to assume that investment would necessarily increase. Subsidized firms could realize that the injected funds keep their activity afloat for a short period of time, until the economy recovers from recession. If so, these firms would know that the actual demand for their product is temporary. They will not increase investment.

    Also, there are still phenomena of creative destruction at work, regardless of the business cycle. Some industries naturally disappear due to a shift in consumer preference. Clearly, these obsolete industries were destined to disappear due to technological advances, even in the absence of recession. Government cannot distinguish between the obsolete industries and the slack industries which result from the recession. He will inevitably inject funds into industries that do not need it.

    One of the biggest flaws of keynesian economics is to assume that government spending during a recession would not cause a crowding out effect until the economy reached full unemployment. The assumption, therefore, states that the fiscal stimulus would only affect idle resources (including unemployed workers). But in reality, there is no guarantee that the money will be spent exclusively on unemployed workers. There is no way to avoid this dilemma. When slack industries will be finally able to hire some workers, skilled or non-skilled, thanks to the injected funds, part of them are likely to come from anoter job. See Jones (2011) for empirical evidence of the crowding-out effect.

    And I would add one more thing. Most projects are probably not “shovel ready” (refer to the above papers) which means that most of them will require engineers and other specific skills to do the planning. To make things even worse, if the projects require some qualified and specific skilled workers, the problem arises when the skills offered by the unemployed do not match the skills demanded by the firms, because the unemployed have not these qualifications or because there is lack of unemployed with these qualifications, the subsidized projects will fail to obtain the kind of labor they need. This would unavoidably delay the stimulus projects. But even if stimulus did work in stimulating private consumption, the process could operate only at the expense of the stages of production furthest from consumption. You know what this implies. Stimulus would destroy the stages furthest from consumption, and the jobs located here. The economy would become poorer than before, not richer.

    Now, regarding the first 3 graphs, I see no clear correlation. And when you say :

    “The bar graph on p. 18 is no less misleading. Which recession matters.”

    It’s not what he really meant, I think. After reading his paper (a while ago) :

    His argument is that “historically” the governments have failed to stimulate the economy, for whatever reasons. So, even if you were right in saying “Most were “solved” (smoothed over) by changes in monetary policy”, Davies’ argument still hold.

    (I would like to comment more often than I actually do, but my english is not very good and needs to be improved.)

  2. M.H.

    Oh. And this :

    “without knowing the countries it’s impossible to interpret the data.”

    At first glance, those graphs are the ones he has presented in his paper “The U.S. Experience with Fiscal Stimulus. A Historical and Statistical Analysis of U.S. Fiscal Stimulus Activity, 1953–2011”. In this case, the data focuses on the US experience with stimulus.

    1. JCatalan

      Yea, you’re right — it’s all U.S. data; my mistake (I’ll make a correcting edit).

      Regarding the bar graph on p. 18, it shows that during the initial quarters of a recession government spending tends to contract the most. Yet, 50%+ of recessions end by this time. What he intends to imply is that the evidence does not favor a case for fiscal stimulus. My point is that this is misleading, because most New Keynesians don’t think that fiscal stimulus is always appropriate. That other means have led to recovery during certain kinds of recessions doesn’t mean that fiscal stimulus can’t work under more severe conditions.

      And thanks for the link. I’ll have to read the paper.

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