IV estimate of fiscal multipliers

I'm usually skeptical of instrumental variable models, but this seems more convincing. I'd have to look closer at it, but I imagine this isn't some tiny independent variation they're trying to hang a result on. I'm guessing Congressional seniority and the number of representatives per person has a big effect on spending decisions (and not much effect on economic performance).

The results pretty much predict what I would expect. This is the abstract:

"We use state and county level variation to examine the impact of the American Recovery and Reinvestment Act on employment. A cross state analysis suggests that one additional job was created by each $170,000 in stimulus spending. Time series analysis at the state level suggests a smaller response with a per job cost of about $400,000. These results imply Keynesian multipliers between 0.5 and 1.0, somewhat lower than those assumed by the administration. However, the overall results mask considerable variation for different types of spending. Grants to states for education do not appear to have created any additional jobs. Support programs for low income households and infrastructure spending are found to be highly expansionary. Estimates excluding education spending suggest fiscal policy multipliers of about 2.0 with per job cost of under $100,000."

Big multipliers on non-grant, non-education stuff, modest multipliers on the whole shebang. A couple thoughts:

1. Krugman notes that this is going to still underestimate multipliers because of spillover. If New Jersey stimulus boosts New York and New York stimulus boosts New Jersey this will cancel that out and miss the effect because the model is identified off the variation between states.

2. So the education multiplier was small, but this also seems like it would be the component of spending where the instrument is weakest. I don't know how the sausage-factory that is the Congress works on these things, but I would guess grants to states are likely to be far more formulaic (and therefore less correlated with Congressional seniority, and therefore biased downward in these IV estimates) than spending on other grants and projects. I'm guessing there's some kind of per-student or per-Medicaid beneficiary or per-dollar-state-budget-shortfall calculations that go into that. So while the low education multiplier isn't especially surprising compared to infrastructure spending, it may still be an underestimate.

3. This goes for support programs for low-income families as well, many of which are run through the states. These programs were already found to have high multipliers. If the disbursements were formulaic rather than based on politics, then the actual multiplier is likely to be even higher.

UPDATE: So for those not familiar with my typical unease with IV models, I should probably say why this is more convincing, otherwise it seems a little self-serving. This instrument does two things that a lot of instruments don't that makes me more confident in it. First - the causal relationship between Congressional representation/seniority and fund disbursements is very real and very clear. There's no subtlety to it - you can take this relationship to the bank. It's not like Angrist and Krueger's birth cohort schtick where you were taking a very, very subtle causal relationship and identifying a model off of it. This relationship is clear and there's no clear alternative channel through which this could be affecting state growth besides through federal spending that even comes close to the effect on spending. The second thing that encourages me about this is the expected direction of the bias. In studies on the returns to education, the endogeneous processes people worry about bias estimates upwards. So when you get a positive result from an IV model on those studies, you're always secretly wondering "is this a real positive effect or not?". In fiscal multiplier analyses, the endogenous process people worry about biases estimates downwards. Unlike returns to education studies, empirical multiplier estimates (not calibration of Keynesian models with various MPC estimates - but actual empirical studies like this) are always conservative estimates. When you get a positive result on one of these, you can be more confident in it (if anything it's an underestimate).

UPDATE 2: Scott Sumner does not agree on this paper. I think he's wrong on at least one point, but I think he makes an additional very interesting criticism of the paper that has some validity. One way to look at this (as Sumner does) is that it is a "micro study" because it is not a "national study". This isn't exactly right (what would constitute a "macro" study in the EU these days? A national study? An EU-wide study?). The difference between macro and micro is an aggregation of economic activity across all markets. It doesn't matter at what level that aggregation is - if you're discussing the behavior of aggregates, you're discussing macro. But it does raise some important questions. A lot of fiscal policy is supposed to operate through the bond market - and that is a national market (and thus it is differenced out in this analysis for the same reason that spillovers across state lines are). I'll try to post more on it this weekend, but if I don't that should give you a flavor of my thoughts on Sumner's critique.

Trying to Get in Touch with My Inner Keynes

It's no secret that I'm a Keynesian. I feel like I have eclectic interests, an open mind, and great respect for many non-Keynesian thinkers, but I am decidedly in that camp and have only found myself more firmly under the sway of the old Cambridge don since the beginning of the Great Recession. Moreover, I personally feel like I was ahead of the curve. I first read his magnum opus, The General Theory of Employment, Interest, and Money (1936) in 2006 - way before it was cool. It was this reading that confirmed my earlier suspicions about my own affiliation.

But lately I've been doing quite a bit of introspection on the nature of my inner Keynes, namely: am I a Post-Keynesian or a New-Keynesian? Specifically, do I think that nominal wage cuts are effective at fighting depressionary conditions? It's the sort of school of thought sub-sub-classification internecine struggle that seems somewhat appropriate to this blog (particularly now that I know we have at least a couple economics-inclined readers). However, like most who engage in these internecine struggles, I'm personally convinced of the importance of the question. Millions of livelihoods and perhaps trillions of dollars are on the line, after all! Why haven't I decided!

Well, because it's a very tough question. Standard theory says that wage cuts should raise the employment level, and some very smart people have highlighted rigid or sub-optimally high wages as the source of involuntary unemployment. That's the New Keynesian position, and if pressed that's what I'd call myself. It's a safe and respectable default. The problem with that is, standard theory often breaks down in unstandard times - and we're living through very unstandard times in the economy right now. Markets are gumming up and failing to function normally all over the place. It's important to recognize that it's not just a hard period - things are not really working how they're supposed to work. The government borrows around a tenth of GDP and interest rates on short-term government debt are bumping around at 0%?!?!? The money supply shoots through the roof and we're seeing exceptionally low inflation?!?!? For an economist, this is the equivalent of a Salvador Dali painting. But we've been here before, and one of the most prescient thinkers on these problems the last time we were here was John Maynard Keynes. And Keynes (1936) said that nominal wage cuts in depressions would worsen depression.

So what motivated this blog post? What do I have to share with you besides my own soul-searching? Well, there has been quite a bit of chatter on other blogs over this very question that I wanted to share. Because some of the recent posts reference back to it, we can start with a year-old op-ed by Paul Krugman, arguing the classic Keynes position on the issue. Krugman is interesting - he's always been in the New-Keynesian camp, but he's been sounding a lot like a Post-Keynesian lately. Bryan Caplan responded at that time. A recent heated exchange between Brad DeLong (New Keynesian) and Steve Horwitz (Austrian School) over a somewhat different (but related) question turned up this comment by DeLong on David Henderson's (ummm... I guess Austrian School) blog. This is when the real nominal wage discussion begins.

Henderson responds to DeLong's comment. Menzie Chinn (I suppose also a New Keynesian) responds to Henderson's head scratcher of an attempt at ad hoc empiricism. Caplan responds to Henderson and DeLong. And as usual, Scott Sumner makes me wonder if I have everything wrong and should just become an unrepentant Monetarist. Then again, Scott Sumner is sort of out in left field... by which I mean the parking lot. I don't mean that as an insult at all - he just has a very different perspective on things from most people.

So there's a bunch of links to wade through - and my guess is there will be more today. The other reason why I mention this is because the back-and-forth mentions the last time nominal wage cuts did decidedly lead us out of a recession: the 1920-21 Depression, to be exact. I'm currently about half to two thirds of the way through a paper critiquing the Austrian School interpretation of the 1920-21 Depression, so that caught my eye in a big way. Throughout the last year, several Austrians and libertarians have argued that the quick exit from the 1920-21 Depression vindicates the Austrian school and proves that active fiscal and monetary policy only makes depressions worse. I point out that the 1920-21 Depression was very unusual. It was a manufactured depression - the Federal Reserve created it. Moreover, they justified their quite deliberate actions with arguments that Keynes himself put forward in 1923. Depressionary conditions that necessitate a Keynesian response (liquidity trap, low interest rates, high savings, depressed aggregate demand) were not in force through 1920-21, so a Keynesian response was entirely unmerited. And the coverage the 1920-21 in the recent blog debate only drives home that point (which is nice... makes me more confident in my thesis) - if Keynesian depression conditions don't hold, then we shouldn't be surprised that wage cuts got us out of depression in that case. If Keynesian depression conditions did hold, then successful wage cuts would lead you to question Keynesian prescriptions. So anyway, as a result of this work I'm officially obsesssed with the 1920s now. It was a fascinating time. Perhaps look for more on that in the future.

By the way - I found a piece by F.A. Hayek on the 1920-21 depression and its aftermath that he wrote in 1925. If anyone knows of anything that Ludwig von Mises wrote about the post-war downturn, I would be very, very interested in hearing about it. I don't know von Mises very well.

Reform and Recovery - A Word of Caution from Keynes

From John Maynard Keynes's Open Letter to President Roosevelt

"You are engaged on a double task, Recovery and Reform;--recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range Recovery, that you will have the driving force to accomplish long-range Reform. On the other hand, even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. It may over-task your bureaucratic machine, which the traditional individualism of the United States and the old "spoils system" have left none too strong. And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once."

Health Reform and the Reconciliation Process

Washington was buzzing Friday with news that health care reform would likely be pushed through the Senate this Fall during the reconciliation process, making it immune to the risk of filibuster. Normally, the famously "collegial" Senate has sensibilities that are far too delicate to countenance interrupting a given Senator when he or she is speaking. To close debate on a bill, 60 out of 100 Senators must vote for cloture. The end result of this procedural rule is that any given bill actually needs 60 votes to pass, not 51, so long as some Senator cares enough to filibuster it*. Filibustering is good insofar as it requires Senators to produce a more bipartisan bill. However, it opens the possibility that the minority will be able to dictate to the majority in a variety of occasions. The House does not have this rule.

However, budget bills can be submitted as "reconciliation bills", which cannot be filibustered. A reconciliation budget will specify certain legislative committees that need to bring certain pieces of legislation into alignment with the budget bill. So for example, this year's budget bill may say "we will spend X amount of money on health care", and specify that the committee that deals with health care bring the law in line with the spending requirements. These changes in health care law will then be passed without the risk of filibuster as well. This means that health care reform may be passed this year with 51 votes (which the Democrats easily have), rather than 60 (which they can't count on). It may come as a surprise to most Americans that this is even a major piece of news - isn't the majority always supposed to rule? Yes... except in the United States Senate.

Republicans are predictably suggesting that this is heavy handed and inappropriate. Why is this response predictable? Because it's exactly how the Democrats responded when the Republicans used the reconciliation process to push through the Bush tax cuts.... and most of Clinton's budgets... and most of Reagan's budgets. The false outrage over the reconciliation process is old hat in Washington. I personally have no problem with the Democrats using the reconciliation process - I wouldn't mind seeing filibusters eliminated from the Senate entirely. They have some moderating benefits, but they are inherently undemocratic. Republicans shouldn't be ashamed for using them to pass tax cuts under Bush, and they shouldn't be outraged that Democrats are using them now. But let's get past all this... why do I start by quoting a note of caution that Keynes offered to Roosevelt in the 1930s?

Reform and Recovery

The reconciliation process essentially guarantees that we will see some sort of health care reform this year. It may be a monumental overhaul, or it may be a first step towards a monumental overhaul. Right now we don't know. Health care reform is desperately needed in this country, no matter what side of the aisle you're on. We pay far more for the care we receive than any other country, and tens of millions of Americans don't have any health insurance. Higher costs and lower coverage are an explosive combination. These rising health care costs are also a burden on U.S. businesses who provide most of the coverage in the U.S.. Whatever the failings of the health care systems of our peer nations, they have been more successful at keeping costs down, which means that their businesses can operate that much more efficiently than ours can. Health care reform is unambiguously an imperative right now.

But another imperative is recovery from the current recession. Despite the upbeat talk of President Obama and Fed Chair Bernanke recently, most analysts think that we have not bottomed out yet, and when we do the recovery will be drawn out, rather than rapid. The ubiquitous Depression analogies aren't made to scare people, but they are made for a reason - this downturn will end up being substantial, and like the Depression there is no real prospect that the recovery will be swift. Those who write off double digit unemployment are fooling themselves. The "real economy" hasn't even bottomed out yet, and unemployment won't stop rising until well after the "real economy" has reached it's trough and started climbing again for at least a couple quarters.

Many people see the problem as steering deftly between the Scylla of a broken health care system and the Charybdis of a once (more likely twice) in a lifetime economic downturn. I think this understanding of the situation is incorrect. Health care is obviously a problem in this country - but is it a problem that throws millions out of work in a matter of months? Is it a problem that destroys a third of a family's savings? Is it a problem that will grow exponentially worse if it is allowed to fester for another year or two or three? No. If we are still at the bottom of this hole in 2011 or 2012, history will remember this as the Second Great Depression, and the future prospects of capitalism will truly be in jeopardy. If we maintain the current health care system through 2011 or 2012, how will history remember us? Perhaps as lazy. Perhaps that we missed an opportunity. Perhaps even that we are uncaring and primitive. It will probably look at us the same way that we look back to the sluggish adoption of Social Security and unemployment insurance in this country; unnecessarily slow, but since the change was inevitable, the delay is ultimately just remembered as an artifact of history. We have had somewhere around 40 to 50 million uninsured for years. It is a burden and it is a crisis, but that crisis clearly lacks the immediacy or urgency of the economic crisis.

We did elect Obama for a double task: reform and recovery. But his mandate for reform and recovery doesn't mean that both need to be done within ten months of taking office.

What is to be done?

I, like the vast majority of Americans, am suspicious of what's called a "single payer", public health insurance system. Thankfully, Barack Obama and the United States Congress also seem to be wary of such a course. We know that the market is too efficient to completely abandon. But there are problems that public policy can help to address. While Americans shouldn't be required to purchase government health care, we can think about making some sort of subsidized public insurance available to the 50 million people who are uninsured. The externalities of public health may justify mandating health insurance coverage, either from a public or private source - much like many states already do with car insurance. We can think about eliminating the tax privileges currently afforded to employer provided health benefits, which encourage sub-optimal over-consumption of health care and hide the true costs of care. We can imagine the benefits of a system of electronic health records, and we can conceive a potential role for government in jump-starting this process. There is a lot we can potentially do, but there are no silver bullets. I think this suggests that we act, but also that we discuss and deliberate. The "experts" have discussed our options for years - at least since the aborted attempt at health care reform spearheaded by the current Secretary of State in 1993. But our elected representatives have not had a real debate on the finer points of health reform, probably since that debate on the Clinton plan fifteen years ago.

If we don't act immediately to address the economic crisis, we could easily slip into a cycle of deflation, rising debt burdens, rising unemployment, and further deflation. A moment of hesitation could make this recession much worse. Can we say the same for health reform? Of course not? A moment's hesitation - even a year's hesitation, or two year's hesitation will probably find us about where we are today: with a health care system that could be vastly improved on a number of measures, but that generally keeps Americans healthy. What would a rush to reform health care risk? It risks leaving us with an equally poorly conceived system that we're likely to be stuck with for years or even decades to come.

I will note, this is not meant to suggest that there is no risk associated with rushing a program of economic recovery. Hindsight will certainly show us that there were major problems with TARP, TALF, ARRA, and every other "rescue" that's been rolled out since the summer of 2008. We will pay a price for these problems. But I would argue that these problems are far outweighed by the problems that would have emerged if we had waited longer to do something. I think the risks are flipped when it comes to reforms in general, and health care reforms in particular. Prudence and careful consideration will pay off. Obama should not rush into this (nor should he rush into education reform, finance regulatory reform, etc. etc.).

*The Washington buzz of Tuesday, the 28th (which absolutely swamps the events of last Friday in overal buzziness) largely negates the buzz on reconciliation of Friday, the 24th. Republican Senator Arlen Specter announced that he is changing his affiliation to Democratic, virtually assuring that by the Fall (when Al Franken will in all likelihood be seated), the Democrats will have a filibuster-proof majority anyway.