Tuesday, May 21, 2013

Is there any hope of exogenous variation in the sort of fiscal or monetary policy that matters?

I was talking with Bob Murphy last night about some of Scott Sumner's more strenuous claims. I for one have serious doubts about really declarative empirical claims about monetary or fiscal policy as it relates to the current depression (and I'm skeptical of a lot of historical empirical claims as well!). That goes for Konczal declaring a "natural experiment" as well as Sumner latching on every jobs report that comes out.

My point to Bob was that we need exogenous variation to get a handle on this. There is something of a case for exogenous cross-sectional variation. It's probably weak but it's probably there for a bright person to pull out (and many have tried). We don't have exogenous longitudinal variation in this crisis. That got me thinking about the exogenous variation we've used in the past to estimate multiplier, and that started to depress me about empirical macro.

The distinction between cross-sectional and longitudinal variation is a distinction between different data structures.

But an arguably more important distinction is between what we might call exogenous static and exogenous dynamic policy. In the New Keynesian (vs. the Old Keynesian) and the Market Monetarist (vs. the old Monetarist) or really just in the post-rational-expectations world a lot of the interesting policy effects are in the dynamics and in the impact of policy on expectations. So really if you want a meaningful policy multiplier you want not just to find exogenous policy variation - you want exogenous variation in peoples' expectations about future policy.

That is a very tall order, if you think about it. We usually think that peoples' expectations are affected because they know there is an intention on the part of policymakers to continue a particular policy. But the only reason why there would be such an intention is if there was cause for it (i.e., if the policy was not exogenous). This seems by its very nature a lot harder to me.

It's not impossible. One obvious example of trying to do this that comes to mind is Valerie Ramey's use of the "war news" variable in her work precisely to get at military spending that people expect to persist (I can't think of anyone that has been as explicit about the need for making this distinction as Ramey). If you think about the Romers' work on tax policy, these too are policies that people expect to persist (although I don't think they consider the distinction I make here quite so explicitly). So it's not hopeless, but it's a lot harder. Policy that changes easily (the spending side of fiscal policy or monetary policy) is going to be particularly hard to find exogenous dynamic variation, even though you may find creative ways to pick out exogenous static variation.

Maybe the way to go is to look for natural experiments, but of course natural experiments bring special circumstances. The Depression provides some good ones: FDR and gold for monetary policy and WWII for fiscal policy.


  1. ~Maybe the way to go is to look for natural experiments, but of course natural experiments bring special circumstances. The Depression provides some good ones: FDR and gold for monetary policy and WWII for fiscal policy.~

    So, if these are indeed considered natural experiments by economists I'm curious as to the nature of the sub-populations (the treatment and the control group) involved in either of those examples.

  2. The first rule of empirical macro: The macro economy is not identified.
    The second rule of empirical macro: See above.

    Every time I see these guys presenting in seminars or read one of their papers, I say a silent prayer of thanks that I'm not in that game. Many of them are incredibly bright, but they're up against daunting odds. No matter how convincing one side thinks their argument is -- and some theoretical positions are undoubtedly more convincing than others IMO -- the other will always be able to marshal some evidence against it, or cast enough doubt on the exogeneity requirements.

    Short of some courageous/insane policy makers actually going in for random experiments, the best we can hope for is to periodically flood the World of Warcraft with gold and see what happens.

  3. Controlled experiments are at best, hard to come by in the field of economics.

    But with regard to empirical testing of multiplier effects...have there been any studies on the fiscal multiplier done using the methods of non-parametric statistics?

  4. Maybe the way to go is to look for natural experiments, but of course natural experiments bring special circumstances. The Depression provides some good ones: FDR and gold for monetary policy...

    Oh great. So let's see if the economy from 1933 onward was good... Nope it was absolutely horrible, the worst 7 years in US history (I think?).

    Ah, but I'm supposed to compare to the counterfactual in which we didn't go off gold in 1933, right Daniel? :)

    1. Well you have a panel of countries that discontinuously went off the gold standard. The discontinuity is key for the identification (and it's something you don't usually have in fiscal policy or monetary policy).

      Or am I missing something?

    2. One of the main problems is that there are some fundamental disagreements over exactly what a gold standard is. Anyway, the world remains on a kind of gold standard if you take Washington Agreement seriously (plus all the major world states have significant reserves of gold which exist to defend their currencies). So gold remains a major player in how monetary policy works.

    3. OK, one thing "gold standard" definitely doesn't mean is just that "gold remains a major player in how monetary policy works".

    4. Yes, I assumed that would be your contention, now explain why that is the case. Surely the Daniel Kuehn the Great and Powerful can do that.

  5. Actually the "worst 7 years" might be more like 1931-1938 or such. But, you get my point I hope. In terms of seeing what we actually can observe, FDR going off gold coincided with an awful economy. It's only because of one's priors that s/he thinks it's a great example of the power of inflation to fix things.

    1. By "natural experiment" I don't mean that you can just look at a time series and see it - I mean something that you can identify the model from. Something notable and exogenous that's more of a one-off event. That, it seems to me, is as good a definition of "natural experiment" as any.

      I'm not sure if the Konczal claim really cuts it because we're all just muddling along. There are differences across countries. Some of those differences are exogenous and more "cultural". So you can squint and look at the data and say "eh - Europe's doing pretty crappy". But don't try to pull out a multiplier estimate much less differentiate monetary and fiscal policy.

      What Konczal was looking at is vagueish, probably reassuring, but not really well identified vagueish vote of confidence for expansionary policy generally (oh - did I forget to mention vagueish?). And hell, I'll take that if that's all we've got. 1933 provides a somewhat better identification of the model.

    2. Anyway - more importantly we have an even harder time getting exogenous variation in policy changes of expectations. We might have a better time getting exogenous variation in static changes in policy.

      One could probably give a pretty convincing argument that going off the gold standard changed expectations and was exogenous by virtue of the abruptness (so sort of in a RDD/DID sense - we don't think that anything would have been really different if they had done it in 1932 or 1934).

  6. http://economics.mit.edu/files/2973

  7. Btw, Daniel I came across this old quote again recently, which you may also have seen previously:

    My recollection is that Bob Lucas and Ed Prescott were initially very enthusiastic about rational expectations econometrics. After all, it simply involved imposing on ourselves the same high standards we had criticized the Keynesians for failing to live up to. But after about five years of doing likelihood ratio tests on rational expectations models, I recall Bob Lucas and Ed Prescott both telling me that those tests were rejecting too many good models.
    - Thomas Sargent in an interview with Lee Evans and Seppo Honkapohja (Source)

    The context is rather different (he is talking about the rise of model calibration as one response to the Lucas Critique), but still a fun quote.


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