On Fiscal Policy

In recent weeks, there seems to have been a resurgence in the discussion of the relative effectiveness of counter-cyclical fiscal policy. This discussion is clouded by the fact that there are some whose political ideology seems to get in the way of reasonable discussion of evidence (and who believe that only those who disagree with them are biased!). In this post I would like to make the following points: (1) there is no such thing as “the” fiscal multiplier, (2) empirical and theoretical estimates are highly sensitive to assumptions about monetary policy — assumptions that seem to be violated by the behavior of central banks, and (3) New Keynesian models are flawed models for estimating a fiscal multiplier (especially in the context of log-linearized equations).

The most fundamental point surrounding the discussion of the fiscal multiplier is that there is, in fact, no such thing as “the” fiscal multiplier. Put differently, the fiscal multiplier is not a structural parameter that can be identified through careful theoretical or empirical work. To the extent that it is possible for a fiscal multiplier to exist, such a multiplier is likely to be dependent on a number of other factors such as the monetary regime and the composition of spending, to name two.

This point is important as it pertains to interpretations of empirical work designed to measure the magnitude of response of a change in fiscal policy. For example, in order to empirically estimate the magnitude of the effect of fiscal policy on output, one needs to find some sort of exogenous change in government purchases to avoid problems of endogeneity in estimation. To avoid the problem of endogeneity, many researchers have used military purchases since military build-ups in the face of war can be considered exogenous (i.e. the government isn’t building tanks to increase GDP, but to fight a war). These types of studies provide estimates of a multiplier effect of military purchases on real output. However, it is important to note that these estimates do not necessarily provide an estimate of a fiscal multiplier that corresponds with all forms of government spending. The composition of spending matters.

This point is particularly important when we consider the differences between the these estimates and the likely effects of the American Recovery and Reinvestment Act (ARRA), or as it is commonly referred as “the stimulus package.” The ARRA is not made up of a significant chunk of military spending. In fact, a significant portion of the ARRA consists of transfer payments. Even in the Keynesian income-expenditure model that is unfortunately still taught to undergraduates to understand macroeconomics, transfer payments have no effect on GDP. Thus, the multiplier effect of these provisions is zero. It follows that it would be incorrect to take an estimate of a fiscal multiplier from studies that use military spending as an explanatory variable and apply that multiplier to the total amount of spending. In addition, there is no obvious reason to apply this multiplier to the non-transfer payment fraction of the ARRA as it is not obvious that the marginal impact on real output from building a road, a bridge, or a school or buying a new fleet of government vehicles is equal to the marginal impact of military spending.

Even if we ignore the issue of the composition of spending on estimates of the multiplier, it is necessary to consider the effects of fiscal policy in light of monetary policy. If monetary policy responds actively to changes in economic conditions, then a purportedly effective fiscal policy will cause monetary policy to be more contractionary that it would have been otherwise. Put differently, monetary policy will offset, either in whole or in part, the effects of fiscal policy.

Recent theoretical and empirical work seems to appreciate this point, but argues that at the zero lower bound on nominal interest rates, monetary policy is ineffective and therefore fiscal policy can be effective. But how valid is this assumption? Central bankers certainly don’t believe that monetary policy is ineffective at the zero lower bound. If so, there would be no debate about quantitative easing because none would have taken place. In addition, this assumption requires that monetary policy work solely through the nominal interest rate (or the expected time path of the nominal interest rate). However, if this is the case, then monetary policy is always relatively ineffective because interest rates do not have strong marginal effects on variables like investment. Empirical work on monetary policy over the last 20 years seems to refute that ineffectiveness proposition. In fact, Ben Bernanke’s work on the credit channel is motivated by the very fact that the federal funds rate seems insufficient to understand transmission of monetary policy. Once we dispense with this notion of the ineffectiveness of monetary policy at the zero lower bound, we realize that empirical studies that estimate a fiscal multiplier by holding monetary policy constant are really estimating a strict upper bound.

These empirical estimates, however, have been informed by the predominant framework for monetary policy and business cycle analysis, the New Keynesian model. In the NK model, monetary policy works solely through changes in the interest rate. As a result, at the zero lower bound, fiscal policy can be effective — quite effective in some cases. Nonetheless, there are reasons to doubt these estimates of the fiscal multiplier. First, if monetary policy works through alternative transmission mechanisms, then the assumption that we can hold monetary policy constant is flawed. Second, even if we believe that the zero lower bound is a legitimate constraint on policy there is reason to believe that the estimated marginal effect of fiscal policy in the NK model is flawed.

The most compelling reason to doubt the multipliers that come from NK models, even imposing the constraint of the zero lower bound, is that these estimates are driven by the particular way in which these models are solved. For example, Gauti Eggertsson (and others) have pointed out that in the NK model at the zero lower bound, there is something called the paradox of toil. Intuitively, the paradox of toil refers to the characteristic in which the labor supply actually declines following a decrease in taxes. A paradox indeed! (Upon hearing this a commenter who shall remain nameless at a recent conference at the St. Louis Fed found it interesting that presumably it would be possible to increase government spending and fund the increase through higher taxes on labor income all while generating a multiplier effect.) This characteristic is part of a broader conceptualization of the world at the zero lower bound. In short, things look profoundly different than when the interest rate is positive.

But is the world really that different at the zero lower bound? The answer turns out to be no. As Tony Braun and his co-authors have shown, the funny business that goes on at the zero lower bound (i.e. the conclusions that run counter to the conventional wisdom in the discipline) is a figment of the way in which NK models are solved. In particular, the standard way to solve models in the literature is to take a set of non-linear equations that summarize equilibrium and log-linearize around the steady state. One can then generate theoretical impulse response functions from the log-linearized solution to the model. The impact multiplier from the change in government spending in the NK model is therefore a theoretical estimate of the fiscal multiplier. However, it turns out that when the models are solved through non-linear methods the counter-intuitive results disappear and the theoretical estimates of the multiplier are substantially lower — again, even imposing the zero lower bound as a constraint.

The general takeaway from all of this is that there is reason to be skeptical about the discussions and the purported precision of estimates of the fiscal multiplier — whether theoretical or empirical. (And that is to say nothing about the political constraints that go into devising the composition and allocation of spending!) However, what I have written does NOT necessarily imply that there is no role for fiscal policy during a recession. If some form of infrastructure investment by the government passes the cost-benefit test, I think that it is certainly reasonable to move such projects closer to the present because even in the absence of a multiplier effect these projects provide something of value to society. If there is an additional effect on output, then all the better.

Quote of the Day

“Unusual state’? Is that what we call it when our favorite models don’t deliver what we had hoped? I would call that our usual state.”

– Robert Lucas

Re-Focusing the Federal Reserve

The Shadow Open Market Committee is scheduled to meet next week in New York City. In anticipation of the meeting, I would like to draw attention to SOMC member Peter Ireland’s position paper on Federal Reserve policy that he recently posted on his website. The paper is excellent and I would like to quote a few passages at length.

Ireland’s paper begins by assessing the current policy “predicament” of the zero lower bound:

With their federal funds rate target up against its lower bound of zero, Federal Reserve officials have been led — some would say forced — to experiment with a variety of new approaches to policymaking. Chairman Bernanke (2012) mentioned several of these novel strategies in his comments at Jackson Hole this past August; the minutes from the September meeting of the Federal Open Market Committee (2012) mention them again. They go by the names “maturity extension,” “forward guidance,” and “large-scale asset purchases.”

To be honest, the whole situation seems really, really complicated. But does it have to be? Or might the apparent limitations of more conventional policy measures reflect, not so much the constraints imposed by the zero lower bound on nominal interest rates, but instead the inadequacies of common intellectual framework that places far too much emphasis on the behavior of interest rates to begin with? Might it be more helpful, in these circumstance, to refocus on other variables that have always played key roles, but have been neglected in popular discussions for far to long?

Ireland’s paper does a great job of answering these questions. For example, changes in Federal Reserve policy are often communicated through changes in the federal funds rate in normal times. However, as Ireland points out, the fact that changes in the federal funds rate communicate policy changes does not mean that the federal funds rate is the only tool of monetary policy or the only variable capable of communicating the stance of policy. In fact, interest rates might provide incorrect interpretations about the stance of monetary policy. Ireland explains:

Under ordinary circumstances, like those that prevailed in the halcyon days pre-2008, the Federal Reserve eased monetary policy by lowering its target for the federal funds rate and tightened monetary policy by raising its target for the federal funds rate. That is why most economists and financial market participants, even now, associate Federal Reserve policy most closely with changes in interest rates.

But it is important to recall that even during normal times, the Fed does not control market rates of interest like the federal funds rate by fiat. Instead, Federal Reserve officials must act to bring about their desired outcomes, in which the actual federal funds rate moves in line with changes in their target. These monetary policy actions take the form of open market purchases and sales of US Treasury securities that change the dollar volume of reserves supplied to the banking system. That is, first and foremost, what a modern central bank does, as the one and only agent in the economy with the authority to change the supply of bank reserves.

And so it is the dollar quantity of reserves supplied that the Fed really controls.

[...]

Thus, during normal times, interest rates and money offer two ways of looking at exactly the same thing. One can view a monetary policy easing as either a decline in short-term interest rates or as an expansionary open market operation that increases reserves and the money supply. And one can view a monetary policy tightening as either an increase in short-term interest rates or as a contractionary open market operation that decreases, or at least slows down the growth rates of, reserves and the money supply.

Under more extreme circumstance, however, these tight links between interest rates and money may break down. An economy experiencing chronically high inflation, for instance, will very likely have high nominal interest as well, as these become necessary to compensate investors for the loss in purchasing power they would otherwise experience while holding nominally-denominated bonds. But those high interest rates certainly don’t signal that monetary policy is too tight! To the contrary, rapid growth in bank reserves and the broader monetary aggregates will correctly reveal that the inflation itself is being driven by an inappropriately expansionary monetary policy. At the opposite extreme, Milton Friedman and Anna Schwartz (1963) observe that when deflationary expectations take hold, as they did in the United States during the Great Depression, nominal interest rates can be very low. But these low interest rates do not mean that monetary policy is too loose. Instead, declining growth rates or even levels of reserves and, especially, the broader monetary aggregates will correctly indicate that monetary policy is much too tight.

Those who keep these considerations in mind will then feel puzzled that new terms like “quantitative easing” are even needed to describe some of the Federal Reserve’s policy actions over the recent period when the funds rate has been stuck at zero. For those observers will be quick to remind us that in both normal and extreme times, all monetary policy easings are quantitative,” in that they are associated with — and, in fact, originate in — expansionary open market operations that increase reserves and the money supply.

One reason that focus on the interest rate has become paramount is because of the logic of the New Keynesian model. According to the standard NK model, the interest rate is the sole mechanism available for monetary policymakers. When the nominal interest comes up against the zero lower bound, this model suggests that the main tool of monetary policy is in communicating the future time path of the nominal interest rate. Ireland, drawing on some of his own recent work, argues that this story is incomplete:

Furthermore, while Federal Reserve statements providing forward guidance have mentioned only short-term interest rates, they can be read as having implications for open market operations and the supply of reserves in the future as well. In particular, although these details are typically relegated to the background in most New Keynesian analyses, my own recent work (Ireland 2012) extends the basic model to account for the activities of a private banking system that demands reserves, accepts deposits, and makes loans. This extended model highlights that even under New Keynesian assumptions, movements in the federal funds rate are associated with — some might even say caused by — open market operations that add or drain reserves from the banking system, give rise to subsequent movements in the broader monetary aggregates, and lead ultimately to changes in the price level and all other nominal variables. Viewed from this broader perspective, forward guidance regarding the future path of the funds rate also signals the Fed’s intentions for future open market operations and the future path for the money supply. Unlike
maturity extension, therefore, forward guidance appears as a coherent part of a genuine monetary policy strategy.

But while the logic behind forward guidance certainly seems strong, one might still worry that, when it comes to a policy initiative that relies exclusively on promises for the future, the devil is in the details. Even as it argues, most forcefully and persuasively, in support of stronger and sharper forward guidance, for instance, Michael Woodford’s (2012) own paper from the Jackson Hole symposium must concede that central banks around the world have had mixed success in using their words alone to influence expectations of future monetary policy actions. Reflecting on this, one might wonder, as well, if the New Keynesian view that the short-term interest rate is all that matters is excessively narrow. To cite just one alternative: a long traditional of monetarist thought, summarized by Allan Meltzer (1995), asserts that the channels through which monetary policy actions impact on the economy are far too varied and complex to summarize using a single variable like the short-term interest rate. Efforts to encapsulate these monetarist ideas into a modern macroeconomic model that might compete more directly with the New Keynesian framework has thus far yielded mixed results — here again, therefore, we have an important topic for future research! Yet, consistent with the monetarist view, Eric Leeper and Jennifer Roush (2003) and my own paper with Michael Belongia (Ireland and Belongia 2012c) show that even in the most recent data, strong statistical information about the stance of monetary policy appears in the monetary aggregates that is not in contained in interest rates alone. But, above all, one might ask: why try so hard to finesse things, by making ever more audacious promises about future open market operations, when it remains perfectly feasible, even with short-term interest rates stuck at zero, to conduct those same open market operations today, for all to see as well as to believe?

In addition to the passages quoted above, the paper also addresses large-scale asset purchases, maturity extension through operation twist, and how the Federal Reserve can re-focus itself on nominal variables. I realize that I have quoted this paper at length, but I would encourage blog readers to read the paper in its entirety.

We Are Not Entitled to Our Own Facts

Contrarianism is running rampant. Go to a local bookstore and you will note countless “what you know just ain’t so”-type arguments. I am beginning to wonder if this type of trend downplays serious analysis and leaves us open to any argument regardless of whether it is blatantly incorrect. A case in point is a recent op-ed in the New York Times entitled, “Why Chavez Was Re-Elected.”

The op-ed purports that Chavez was re-elected because his policies have been successful. According to the op-ed:

Since the Chávez government got control over the national oil industry, poverty has been cut by half, and extreme poverty by 70 percent. College enrollment has more than doubled, millions of people have access to health care for the first time and the number of people eligible for public pensions has quadrupled.

According to survey evidence by the World Bank, poverty has fallen in Venezuela. However, it is important to put this in context. The earliest data that we have available on poverty from the World Bank is from 2002 and according to the survey the poverty rate was around 60%. It has come down appreciably since. However, this statistic and the corresponding claims in the op-ed ignore what is driving these measured changes and the long-run implications thereof.

Throughout Chavez’s tenure, he has seized thousands of businesses and imposed controls on foreign exchange as well as strict price controls. Any improvement in economic statistics in this type of regime is meaningless. The reason is because Venezuela is experiencing extractive growth. We know from economic theory and historical experience that extractive growth cannot last. (We need only look to the last 15 or so years of research by Daron Acemoglu and James Robinson to understand this conclusion.) The improvement in the statistics that the author highlights are merely the result of the fact that Chavez has seized control of the oil companies and uses revenues to finance social programs. Extractive growth, however, deters foreign direct investment and it reduces the incentives to innovate and re-invest in existing businesses. More broadly, higher risks of expropriation lead to lower income per capita. Meanwhile, according to Bloomberg, price controls have created shortages in “everything from electricity to sugar and beef.”

The author, however, seems to believe that Chavez and others like him have discussed some alternative to “neoliberalism” to foster growth. This view is misplaced. Where so-called neo-liberalism has tried and purportedly failed is in countries that have insufficiently inclusive societal institutions. Yet the author seems to accept correlation as causation in these cases.

If this is where the op-ed ended, I would conclude that the author’s assertions were misguided, but would be content to agree to disagree. However, the author’s claims only become more dubious as the op-ed proceeds. For example, he argues:

Not surprisingly, the leftist leaders have seen Venezuela as part of a team that has brought more democracy, national sovereignty and economic and social progress to the region. Yes, democracy: even the much-maligned Venezuela is recognized by many scholars to be more democratic than it was in the pre-Chávez era.

I’m not sure what I am to make of such a dubious statement. Chavez controls the voter rolls. There have been no external audits of the election. In addition, according to this piece in the Wall Street Journal, there are 10,000 voters who are registered between the ages of 111 and 129. Perhaps Chavez has also improved longevity!

Markets and migration also tell a different story. Since 2000, approximately 120,000 Venezuelans have migrated to the United States. To put that in perspective, that represents a 125% increase in the number of Venezuelans in the United States. In addition, Chavez’s victory was met with a sharp decline in the price of Venezuelan bonds, which had previously rallied on the prospect of his defeat.

Curiously, there was also no mention of lawlessness, violence, and kidnappings under the current regime. One Venezuelan criminologist says that there have been over 155,000 murders in Venezuela during Chavez’s tenure. Gangs rule the streets of Caracas and many crimes go unsolved. This is evident in news reports, but I also know this from talking to Venezuelans who have left.

The op-ed seemingly seems impervious to facts as well:

After recovering from a recession that began in 2009, the Venezuelan economy has been growing for two-and-a-half years now and inflation has fallen sharply while growth has accelerated.

According to the World Bank, inflation has been very high. Over the last three years, consumer price have risen by 27.1%, 28.2%, and 26.1%, respectively. When measured by the GDP deflator, inflation has been even worse. Over the last five years, annual inflation by this metric has been 15.4%, 30.1%, 7.8%, 45.9%, 28.1%, respectively. And this is in the context of a regime of strict price controls and therefore there might be reason to believe that these number understate the actual inflation rate. To put this in perspective, Bloomberg reports that out of all of the countries that they track, only Iran and Belarus have higher rates of inflation than Venezuela.

Venezuela is not prospering and Chavez has not discovered an alternative path toward economic growth and prosperity. The Chavez regime is an extractive regime. There are no incentives for long-run growth, inflation is high, lawlessness is rampant, and there are serious reasons to doubt the validity of the election process. This is the reality. And all of this is contrary to the recent New York Times op-ed.

Observational Equivalence, Again

Suppose that prior to the recession, I told you that I had a theory of the business cycle. My theory suggested that shocks to net worth were a significant explanation of the business cycle. Following a shock to net worth, consumption, investment, and hours worked would decline. Suppose that I also told you that increases in the monetary base by the Federal Reserve would keep inflation close to the implicit objective, but have little effect on consumption, investment, and real GDP. Given the events of the last four years, this theory seems to fit pretty well with what we have actually observed. What might surprise you, however, is that the framework I am describing is a real business cycle model with financial market frictions. This view seems largely consistent with James Bullard’s interpretation of events.

Suppose instead that I told you that I had the following theory of the business cycle. My theory suggested that liquidity shocks were a significant explanation of the business cycle. Following a shock to liquidity, and without appropriate Federal Reserve policy, nominal and real GDP would decline and unemployment would rise. In addition, suppose that I told you that if the Federal Reserve increased the monetary base without an explicit target or goal that such an expansion would have little effect on real economic activity. Given the events of the last four years, this theory seems to fit pretty well with what we have actually observed. This view is largely consistent with Scott Sumner’s interpretation of events.

I have used these two examples to illustrate a couple of points. First, neither Bullard nor Sumner (or anybody else associated with similar views) are crazy. They have logically consistent ideas that are consistent with casual observation. Second, confirmation bias is dangerous. It is very tempting to have a theory, look at the world, observe events consistent with your theory, and conclude that your theory is correct. But that is just confirmation bias. What is necessary is to provide evidence to support your theory in light of other theories that have observationally equivalent observations. This is substantially harder to do — even for those who realize it is necessary. Third, and perhaps most importantly, the ability to distinguish between these and other competing theories is incredibly important given the vastly different monetary policy implications.

Twitter

An increasing number of readers have been demanding encouraging me to set up a Twitter account. I’m not sure if this means that they want to hear more from me (thinking I will tweet more than I post) or they want me to be more concise (limit my characters). In any event, you can now follow me on Twitter @RebelEconProf.

On Administrative Costs in Health Insurance

In a recent post, Garett Jones asks, “Will ACA’s cost-cutters outcut private insurers?” The post was inspired by a new paper in the New England Journal of Medicine presents an argument in favor of the ACA. I would like to offer some corresponding comments.

One thing that the paper emphasizes is the role of administrative costs. One argument often made in favor of a single payer system is that there are lower administrative costs with one insurer. This is thought to be true of both the insurers and the providers who would only have to negotiate payment rates with one insurer rather than many. Typically, single payer advocates use this to argue that more administrative costs imply that there is a waste of resources. Nonetheless, there are important reasons to question these claims.

First, the game is rigged. Estimates of administrative costs for government-provided insurance never include any estimate of the deadweight loss from taxation that would result from switching individuals on private insurance plans to a public plan.

Second, and substantially more important, is that this argument treats the problem as static rather than dynamic. Insurance companies have an incentive to reduce these costs. If these firms innovate in eliminating some of these costs, these innovations will also leak over into other areas of the economy. To the extent to which insurance companies are marginalized, such innovations will be less likely, which can potentially reduce the benefits of positive externalities that result from innovation.

Third, there seems to be either a misunderstanding or a lack of curiosity with respect to the issue of administrative costs on the insurer side. For example, if the government exhibits economies of scale and the private sector doesn’t then the government can provide the service more efficiently. However, the observation of lower administrative costs on the part of the government does NOT imply greater efficiency. Suppose that administrative costs are predominantly variable costs (the more claims, the higher the cost). It is possible that each individual firm’s variable cost curve lies below the government’s variable cost curve, but that the sum of the variable costs of all private firms is above that of the government. Since we are generally looking at aggregate costs of the private sector versus the public sector, this is consistent with the observation that administrative costs in the private sector are above the public sector, but does not imply any gain in efficiency by switching to the government.

Finally, on the provider sign, the claim is that providers are wasting resources by negotiating with multiple insurers. But, this argument begs the question. Why don’t providers simply negotiate rates multilaterally with insurers? Why do they choose to negotiate individually with insurers with different characteristics like size? To the extent that we believe that health care providers are profit-seeking, why wouldn’t they explore other arrangements? The observation that providers voluntarily choose to negotiate different rates with different insurers suggests not that these negotiations are a waste of resources, but rather that they are beneficial. Thus, in this instance, “waste of resources” seems to imply “not using resources the way we want them to.”