More on Fiscal Policy
In my post on fiscal policy and why it tends not to be so great at working to counter-act a recession there was extensive discussion on why. Although I laid out the case for crowding out as one of the reasons this was met with considerable skepticism. In a rather nicely timed post we have Greg Mankiw summarizing several studies on this very topic.
The Keynesian model has some clear, practical insights about how to think about fiscal policy during economic downturns. But are those insights true?
One approach to answering this question is to examine the data using the techniques of time-series econometrics without imposing much a priori theory. For monetary policy, there is a large literature that does this; for fiscal policy, the literature is smaller but growing. The results from this exercise, however, do not always confirm the predictions from textbook Keynesian models.
For example, here is the conclusion of Andrew Mountford and Harald Uhlig (a prominent econometrician now at the University of Chicago) in an empirical study called “What are the Effects of Fiscal Policy Shocks?“:
Our main results are that
- a surprise deficit-financed tax cut is the best fiscal policy to stimulate the economy
- a deficit[-financed government] spending shock weakly stimulates the economy.
- government spending shocks crowd out both residential and non-residential investment without causing interest rates to rise.
These finding are not consistent with standard Keynesian theory, according to which government spending multipliers are larger than tax multipliers and crowding out occurs through increases in interest rates.
An earlier, related paper by Olivier Blanchard and Roberto Perotti called “An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output” reported similar anomalous results:
we find that both increases in taxes and increases in government spending have a strong negative effect on private investment spending. This effect is consistent with a neoclassical model with distortionary taxes, but more difficult to reconcile with Keynesian theory: while agnostic about the sign, Keynesian theory predicts opposite effects of tax and spending increases on private investment. This does not appear to be the case.
Blanchard, incidentally, is now the chief economist at the IMF.
Mankiw is a bit circumspect in that he isn’t sure how to convinced he is by the results. However, he does offer a word of caution in purusing Keynesian policies since the above indicates that they could have effects that are not desired.