Questions from Russ Roberts, Part 1

He poses three questions to Krugman and me (and those of you who agree with me should feel free to jump in). Some I think take more thinking than others, and I've got a few other things to do today so I'll probably trickle the answers out. I'll start with the last one, the easiest one, and in a lot of ways the most frustrating one to see Russ asking:

"Third, does the failure of the Keynesian models using multipliers from past economic experience to accurately predict the effect of the 2009 stimulus package give you any uncertainty about your claims?"

I could just say "I reject the premise" and move on, but if someone with a platform like Russ is repeating the claim it's worth walking through what's wrong with it again (we've discussed this many times here and actually I discussed it a lot when I used to comment at Russ's blog too). My short answer is "I am always uncertain about my claims, but nothing in the data since 2009 has made me more uncertain about my fiscal policy claims (I'm not sure whether I should revise my priors on monetary policy)" - for the long answer, read on.

Russ is not being particularly forthright about what he's saying here. What he's actually asking is "why did the Romer-Bernstein prediction get it so wrong?". That version of the question is an excellent question but by skipping from that question to his question about "the Keynesian models" Russ is sneaking in a claim that people need to be aware of.

He is implicitly claiming that the problem with the Romer-Bernstein prediction was the multiplier and not the forecast, because forecasts have very little to do with Keynesianism. What Romer and Bernstein did was estimate a forecast of how the economy would behave with no change in fiscal policy (in their case, how the unemployment rate would behave) and then they subtracted off how much unemployment would have been eliminated by the stimulus package (I think it was a little higher than what was passed, but roughly the same).

I find Russ's implicit claim (and it would be nice if he confirmed that he thinks that so everyone is clear on where the disagreement is and where it isn't) to be entirely implausible. The economy is not a car... the economy is organic. It's a complex system. Forecasting a complex system is extremely challenging - particularly when you're doing it so far into the future (like a meteorologist, our short-term forecasts are decent enough). On top of the normally challenging task of forecasting you have to remember that Romer and Bernstein were forecasting at a time when credit markets were in turmoil and they had no idea how that would be sorted out. So in arbitrating between whether I trust the multiplier half of the prediction which has been carefully worked on and argued over for decades or the forecast half of the prediction which is weak by its nature and done quickly and largely done in the dark I unequivocally trust the multiplier half and am leery of the forecast.

Aside from the normal problems posed by forecasting a complex system, we have very good reason to believe that the forecasts in this particular crisis weren't up to the job because of the problems in the financial sector. I assume something like a DSGE was used to generate the forecast although it might have been even simpler than that, but even DSGE models don't take finance into account. Noah Smith had an excellent post on this issue a few weeks back summarizing research at the New York Fed (Mark Thoma also has thoughts here) that concludes that when you incorporate finance into DSGE forecast models (even without calibration - a critical point), the model does a lot better. Nobody used to use DSGE models in this way, though, because financial crises haven't played such a big role in macroeconomic fluctuations lately.

So trusting that forecast seems like a bad bet to me, but it's critical to understand that if Russ wants to cast doubt on the multipliers it's a bet that Russ is making. It's up to him to explain why - I couldn't tell you that.

So what about multipliers?

We don't actually have real-time estimates of the multiplier associated with the Recovery Act or the changes in state and local spending during that time. We need to "identify the model" to get that, which basically means we need find a way to deal with the fact that causality runs in both directions*. Fiscal policy has some effect on output, but output also determines fiscal policy. For certain components of fiscal policy that vary automatically with changes in the economy like unemployment insurance, taxes, and food stamps (we call these "automatic stabilizers") the causal link from output to fiscal policy is very tight. This means that if we just look at the raw data there is a natural tendency (because of the causality running from the state of the economy to fiscal policy) to observe a negative relationship between fiscal policy and output or at least to underestimate any positive causality running from fiscal policy to output.

I won't go into the details here about how we "identify the model" here (search my archives - we talk about this stuff a lot), but suffice it to say that that is the principal obsession of empirical economists, whether they're doing micro or macro work. These are estimated and argued about in the literature, and if Russ wants me to rethink my views he needs to dig up that literature and tell me why I'm wrong in my assessment of it.

As it stands if I had to choose between (1.) the Romer-Bernstein consensus on multipliers, and (2.) the DSGE forecasts that Romer-Bernstein presumably use, I have considerably more faith in (1.).

Why am I wrong?