Robert's Stochastic thoughts: My Usual Comment on Simon Wren-Lewis

Wednesday, June 03, 2015

My Usual Comment on Simon Wren-Lewis

Simon Wren-Lewis very frankly discusses his faith in multipliers.

Why am I confident that multipliers that result from temporary decreases in government spending in current conditions will be somewhere around one rather than somewhere around zero? It is not because of empirical studies that try to directly estimate multiplier sizes.
Do not get me wrong. Such studies are very important, as are meta studies that try and pull together and synthesise the large number of individual studies. However I tend to use them to either confirm or question my priors. My priors come from thinking about models, or perhaps more accurately mechanisms, that have a solid empirical foundation. Let me explain.

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Here my starting point is to note that because the increase in government spending is temporary, any impact on pre-tax income or taxes will be relatively small relative to a consumer’s lifetime income. As a result, aggregate consumption is likely to change either way by an amount that is a lot less than the cost of the school. For similar reasons firms think long term when planning investment, so they are not going to invest that much because of a temporary increase in government spending and GDP.

the cost of the school is the increase in G

My comment.

This is my usual comment. I think it might be well worth ignoring.

I get the impression that you consider the range of debate (the Overton window) to be from RBC to New Keynesian (with a bit of open-ness to aggregate modelling). The reason is that you consider only two possible beliefs about multipliers "will be somewhere around one rather than somewhere around zero"

You don't consider the possibility that the government spending multiplier (for an economy at the ZLB) might be well above 1, as it would be in a paleo Keynesian IS-LM model.

"any impact on pre-tax income or taxes will be relatively small relative to a consumer’s lifetime income. "

"My priors come from thinking about models, or perhaps more accurately mechanisms, that have a solid empirical foundation. "

Also perhaps less accurately. You have a strong prior that consumption mainly depends on lifetime not current income. Importantly, you are discussing macro and multipliers so you have a strong prior that aggregate consumption mainly depends on permanent not current income.

Yet you discuss strong empirical support. I ask whether there is any empirical support for your view. There is an over long timesome literature on testing the PIH, but there is not a similarly large literature on testing the hypothesis that only current and lagged income matters.

At the very least, there should be evidence of Ricardian effects -- that if one considers consumption and disposable personal income, then high budget deficits should correspond to surprisingly low consumption. I know of no evidence of this (of course I am considering market economies without legal rationing so not WWII).

Surprisingly high consumption should be followed by unusually rapid income growth. It is not for the USA.

What is the empirical basis for your beliefs that there is something to the PIH, and that the economy can be understood by assuming that consumption of the non-liquidity constrained roughly fits the PIH ?

I think consumption can be fit almost exactly using disposable personal income and the ratio of non-human wealth to disposable personal income. That non-human wealth includes a lot of common stock -- whose price is not correlated with future dividend growth (as noted by Robert Shiller).

Investment is highly correlated with GDP growth. It may be that firms should think of the medium term when choosing investment. I note that a large part of the cyclical variation of NIPA investment is variation of net inventory investment. I do not see why firms should think of the medium long term when choosing inventory levels. Another very important component of investment is residential investment -- that is the type which responds noticeably to real interest rates.

I think your priors come from thinking about models.

update: Stolen from Paul Krugman's comment thread trusted commenter Woof wrote

Woof! is a trusted commenter NY 13 hours ago

Two fiscal multipliers are commonly used (focusing on expenditure):

1. Impact multiplier=(∆Y(t))/(∆G(t))

2, Multiplier at horizon i=(∆Y(t+i))/(∆G(t))

So it would be useful to know to which PK is referring. It appears that he is talking about the impact multiplier.

Secondly, it matter if monetary policy is "normal" or if the CB implements a ZLB policy.

Based on a survey of 41 studies, Mineshima and others (2014) show that first-year "normal" multipliers amount on average to 0.75 for government spending in advanced economies.

But there is general agreement that at ZLB (zero interest policy) the fiscal multiplier can be higher.

Christiano and others in 2011, for the US, have a multiplier of 1.1 , but for ZLB implemented they estimate that initially the multiplier can be as high as 3.7

Eggertson 2010 has 0.5 , with 2.3 for ZLB. Erceg and Linde (2010) have a multiplier of 1, but at ZLB an initial multiplier of 4.

Finally, it has to be kept in mind that ZLB multipliers fall with time, and that the Fed's has operated at ZLB for several years , As always, the devil is in the details.

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Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections By Nicoletta Batini, Luc Eyraud, Lorenzo Forni, Anke Weber, International Monetary Fund, Oct 2, 2014,

11 comments:

Thornton Hall said...: 1. In creating the set of economics professors, we very carefully weed out anyone without the skills needed to be good at what economists mid-label as "mathematical modeling".
2. It is human nature to believe that one's skills are useful and helpful
3. "Mathematical modeling" is incapable of advancing our understanding of human behavior, even when considered at the level of "the economy".
4. Therefore, no economist is willing or able to see the obvious gap between "economics" and reality.; 8:55 PM
Anonymous said...: I guess I'm left with the logic that was as I remembered how the multiplier effect worked. Money spent on public works then creates (when no crowding out occurs) wages and sales to vendors-- who then to the extent this is slack in the economy spend money on other purchases, and so forth. Now you would expect to look at the specific dynamics of that spending-- e.g-- can that industry expand past current activity or are we bidding on finite resource, then there is taxes and savings as leakage and of course the exports -imports parts. I would expect that each multiplier is different for each situation-- as in the overall economy and the microeconomics of where the multiplier plays out.

My gut feel is that tax cuts don't multiply much but that the dams etc built during the Great Depression had pretty big multipliers.; 10:07 PM
Robert said...: Thornton. I uh am uh technically as sort of economics professor. I'd say a lot of economists perceive a gap between economic theory and reality. Some turn to empirical work with structural parameters identified by common sense (and I think they are actually learning useful things about the real world but the approach doesn't work very well for macroeconomics). Others just live with useless and unhelpful skills.

Anonymous, your gut feel corresponds to the current assessment by economists. I fear that mainly means it corresponds to our gut feel. Even different tax cuts are expected to have very different effects. It is generally assumed that cutting taxes paid by billionaires doesn't affect their consumption which is limited by their time not their budgets. On the other hand, really poor people are likely to spend at least a large part of the money from a tax cut (or tax credit increase).

But it's all very controversial.; 10:40 PM
Unknown said...: Shouldn't we pay some attention to whether the increase (say) in government spending
displaces future government spending?

Case 1: Spending 100,000,000 pounds on a yacht to celebrate some royal jubilee. If you
decide not to, the jubilee will come and go, and there is no expectation that you will
buy the yacht later.

Case 2: Spending 100,000,000 pounds on fixing bridges that will need to
be fixed at some point, because otherwise they'll fall down.

Obviously this question has a theoretical and an empirical component, so I will
direct it also to Simon. Possibly the empirical answer is pretty simple: when
deciding what to spend now, no one considers future taxes to pay for the Queen's
yacht, or future taxes they won't have to pay because the bridges are already fixed.
But actually, is there empirical research along these lines? The theoretical
question is more vexing because in principle expected future taxes will diminish
current consumption (at least so say the fresh water folks) in one case but not
the other, but this never seems to enter the discussion, not just here, but in
almost all the discussion of fiscal policy at the ZLB that I have seen.; 1:29 AM
Robert said...: NashNumber I entirely agree with you. So does Wren-Lewis (it is one of his favorite arguments).

I'm googling trying to find him saying it. This is close
http://mainlymacro.blogspot.it/2012/04/framing-fiscal-stimulus-arguments.html

The cost of fixing bridges isn't the £100,000,000 which will have to be spent sooner or later but interest plus depreciation times 100,000,000 . First there is real interest paid on the £100,000,000 worth of bonds. This is currently almost exactly zero in the US and UK, as nominal interest rates are close to inflation rates. It is definitely negative in Germany. There it is an additional benefit of fixing bridges now not later. There is also depreciation. If we fix it now, then later we won't have a brand new repaired bridge. Another example-- roads have to be resurfaced about once every 20 years. If we resurface a road 18 years after it was last resurfaced (to stimulate) we have to resurface in 2 years earlier again and again every 20 years. Real interest rates are usually positive, so this is a cost. But it is a tiny fraction of the total 100,000,000.

In theory this should affect the multiplier. Already the cost of a temporary for the jubilee spending increase should cause a small permanent reduction in consumption (say 5% of the cost year after year) so a small reduction in the multiplier. With bridge fixing, in theory the reduction of consumption should be on the order of 5% of (the real interest rate plus the depreciation rate) times the 100,000,000 or something like £250,000 per year nationwide. All of this is according to the theory for which I have total utter contempt.

So you are absolutely completely 100% right -- the case for spending now on projects which will have to be financed at some point is overwhelmingly strong. A total no brainer. And no politician in Europe dares make it.

Importantly, the multiplier should be zero "at some point" in the future when the economy is not at the zero lower bound (not in the liquidity trap) as monetary policy can be made looser to make up for the 100,000,000 less of bridge fixing demand.

Finally, even if one is totally paranoid about public debt, deficits and the public sector borrowing requirement, the multiplier should be smaller but still positive if the bridge fixing is financed not with debt but with higher taxes right now. The reason is that not all of the tax increase becomes reduced consumption demand. According to the permanent income theory which Wren-Lewis likes and which I don't like consumption decreases by about 5% of the tax increase -- in the data analysis I do like more on the order of 50% but in both cases less than one for one, so tax financed public spending has a multiplier of 0.5 to 0.95 as big as deficit financed publis spending. It is possible to have fiscal stimulus without deficit spending. For some reason, almost nobody every discusses this (Wren-Lewis does and so do I).

I don't know of any empirical work specifically on the effect of fixing things which must be fixed at some point.; 2:22 AM
Unknown said...: Thanks a lot...

While we're at it, here's another argument that no politician in Europe dares to make. Properly considered, the government's total indebtedness is the sum of outstanding bonds and future bridge maintenance obligations (and of course a whole bunch of other stuff we'll ignore). When it issues bonds to pay for bridge maintenance, it isn't increasing total indebtedness, but rather converting debt from one type to another. If the people betting on bonds are smart (as I have read is the case) this maneuver won't have any first order effect on their estimate of the probability of eventual default, or the risk premium. So, "even if one is totally paranoid about public debt," arguing for infrastructure austerity on that basis is, in effect, asserting that these markets are stupid.; 4:05 AM
Thornton Hall said...: As an empirical matter, the owners of a mid-sized software consulting firm in Virginia learn about tax breaks when the accountants explain their tax returns. So they couldn't possibly change their behavior w/o at least s one year time lag.; 1:33 PM
Robert said...: NashNumbers I agree entirely except for the guess that people betting on bonds are smart. I know a smart person who bets on bonds -- she is now immensely rich. This means that the market is stupid (one can't become immensely rich outsmarting an efficient market).

A dramatic example similar to the stupidity of dealing with debt by delaying necessary maintenance is dealing with deficits by privatizing. Here the problem is that the state is printing too many pieces of paper called bonds and selling them to the public and the solution is to print pieces of paper called shares and sell them to the public. Privitization revenues are counted like tax revenues and not like the proceeds of selling bonds (the deficit). This is actually extreme since investors demand much higher return on stock than on bonds (John Quiggin made this point repeatedly long ago and is always well worth a google).

@Thornton heh indeed. And owners of software consulting firms are relatively on the ball (and have accountants). Regular tax payers didn't calculate that the ARRA stimulus tax cuts would have to be offset by higher taxes later. They didn't even consider that the tax cuts were temporary. The vast majority never learned that their taxes had been cut. In one poll 12% accurately answered the question of whether Obama and congressional democrats had cut the income taxes paid by the vast majority of US families (at the time the correct answer was yes). In another 8% did. So we have people in the real world who don't know there had been a tax cut, even though the taxes of the vast majority of them had been cut, and models in which people can and do accurately forecast future changes in taxes.; 4:07 PM
Anonymous said...: While we are at it, there is an interesting side perspective on how spending multipliers and external effects work together. So, repairing a bridge may or may not have much of an external economy--repairing and upgrading the bridge may. For example-- one of the bridges around here was upgraded some years ago to be high enough so the drawbridge was eliminated. Haven't thought it through but while I would default to treating these effects independently--the external economy and the multiplier-- I do wonder if there in some cases an interaction occurs and is there a repeatable theoretical logic to that interaction?

BTW on the response to my earlier post-- I agree -especially on the tax question--but sometimes tax cuts are done in a complicated budget environment that gives but also takes away for those high MPC categories.; 6:11 PM
Soccer Dad said...: why so much theory and so little empirical data ?; 12:08 AM
Unknown said...: Agree with all. BTW John Q. is across the hall from me here at UQ (in real life I am Andy McLennan) and I do follow his blog. Unfortunately the Queensland government and others around Australia bring up the issue rather frequently, so I have read all too much about it.; 12:53 AM