Russ Roberts did a recent post complaining about the way Paul Krugman uses data to support his arguments. Roberts pointed out that when things turn out as he expected, Krugman cites the events as proof of his (Keynesian) worldview. When they don't, he suggests that "other things" interfered, and that the model is still correct. Now Krugman has a new post that doesn't specifically mention Robert's post, but responds to this general criticism.
First let's think a bit more about fiscal policy and "other things." Suppose the authorities reduce federal spending on output. That's a contractionary fiscal policy. And suppose that GDP rises rather than falls. That seems inconsistent with the Keynesian model. Could this outcome have been due to other factors? Yes, it certainly would have been. By definition, either state and local spending rose, or investment spending rose, or consumption rose, or the trade balance improved. So yes, there definitely would have been "other factors." The question is how we think about the cause of these other factors.
Perhaps the most confusing of the other factors is state and local spending. Many economists wrongly assume that state and local (S&L) spending are a part of fiscal policy, because we attach the letter "G" to their output. But in the Keynesian model they are really no different from private investment. During recessions both private companies and state and local government are less likely to build things like new roads. These decisions are made by 1000s of entities, and should be viewed as endogenous in any model of federal spending as a tool of fiscal policy. For instance, if fiscal stimulus causes 100,000 new houses to be built in suburban Phoenix, then local governments in that area will endogenously add roads, sewer lines, schools, etc. Or as the economy improves revenues will rise, and states constrained by balanced budget rules will spend more.
In calendar 2013, fiscal policy in the US became dramatically more contractionary. This isn't even debatable. The budget deficit plunged by an astounding $500 billion in a single year. Now suppose your prediction of a slowdown doesn't turn out to be true. How would you try to minimize the amount of austerity that occurred in 2013? One technique would be to use fiscal years, as the big tax increases occurred on January 1st, not at the beginning of the fiscal year. Thus the fall in the budget deficit for fiscal 2013 was somewhat less than $500 billion, although still extremely large. (I have no evidence Krugman did this; his IMF data has no link.)
Another technique is to focus on government consumption, which is only one component of fiscal policy. This will make the changes look much smaller. For instance, in 2013 most of the austerity consisted of tax increases and cuts in transfer payments, not reductions in government consumption. And another technique would be to muddy the waters by citing figures for the change in both federal and S&L deficits.
In Krugman's posts he has two graphs of government consumption, which show that as federal consumption fell, state and local consumption rose. Interesting data, but it's not clear what it tells us about fiscal policy. Then he makes a different claim:
What we should have realized, but I didn't - at least not fully - was that the sequester just wasn't that big relative to the economy. The CBO put the first-year impact on the deficit at $68 billion, or 0.4 percent of GDP, in the first year with much smaller additional impacts thereafter - not trivial, but not huge either.
The sequester included government consumption and transfers, but not the big increase in government taxes. Recall that back in early 2013 Keynesian economists were extremely concerned about the dramatic shift toward austerity. And it wasn't just Krugman, there was a letter signed by 350 Keynesians warning that the austerity could lead to a recession. I think these guys were exactly right about one thing; there really was a lot of austerity occurring in 2013. (Yes, we didn't get 100% of the feared "fiscal cliff", but the $500 reduction in the deficit was only slightly less than that worst case, according to the estimates I've seen.) The estimates I saw suggested that the total austerity package would have been expected to reduce GDP by 1.5% to 2%. Can someone confirm that?
While I don't agree with Krugman's revisionist view that there really wasn't much austerity, I'd like to accept it as a working assumption for the rest of this post. And I'd like to analyze its implications.
1. First of all, it's worth pointing out that the same sort of mistake seems to have been made in Britain, for unrelated reasons. (S&L is less important over there.) At roughly the same time as the US misjudgment, many Keynesian economists were warning that austerity in Britain was a disastrous policy that would slow the recovery. But then Britain suddenly started doing much better, especially in the employment area. (Recall that British productivity was weak, but the Keynesian model says more AD will create jobs, it does not include a magic wand to make those new jobs more productive.) Once the strength of the labor market became apparent, many Keynesian economists decided that the austerity was actually much less than they had been assuming. Including during the period when they were loudly complaining about austerity.
So let's say there was nothing disingenuous about all these flip-flops. I've made similar mistakes at various times in my life. Even so, doesn't this call into question the effectiveness of fiscal policy? It's already a pretty blunt instrument; requiring politicians of different stripes to come together in a timely fashion to set the appropriate cyclically adjusted budget balance. If we are now to believe that even in real time it's extremely hard for the world's leading Keynesian economists to tell whether policy is contractionary or not, then how likely is it that this tool will be used effectively?
2. And if we have not one but two major misdiagnosis of the stance of fiscal policy in key economies, in just the past few years, how many others have occurred that we don't know about? How many posts by Krugman can you find that say "I claimed fiscal austerity in country X would lead to recession, and recession did occur as I predicted? But new data shows that there really wasn't any fiscal austerity. I now think the recession was due to other stuff." Can someone point me to these posts? Indeed how likely is it that Paul Krugman would have done the post I am commenting on, if the US and Britain had fallen into a euro-style double-dip recession in 2013? "Oops, no austerity, my mistake." In other words, using a legal analogy, is Krugman more like an impartial judge, or an attorney that advocates for his client, and only feels a need to present evidence that supports his case?
Now before commenters start claiming that everyone does this, let me admit that this is normal behavior in the blogosphere (with a few exceptions such as Tyler Cowen.) So then are we just left with a "he said she said"? Just a series of anecdotes that are open to interpretation? I'd make a couple observations here:
1. We do have some systematic evidence. The early cross-sectional regressions supported the Keynesian model. Later work by Mark Sadowski and others found this result only applied to countries that lacked an independent monetary policy. (And I'd add that there are some tricky causality issues for even those countries.) As of this moment, I know of no systematic evidence for the effectiveness of monetary fiscal policy under the current inflation-targeting regime used by most countries. BTW, I've acknowledged that fiscal stimulus is effective under other regimes, and have cited the boost to GDP provided by war spending in the 1940s. That spending did not boost welfare (consumption fell) but it undeniably reduced the unemployment rate. And certain types of fiscal stimulus can be effective even under inflation targeting; such as employer-side payroll tax cuts and VAT cuts.
2. In a sense this entire debate is an artifact of a flawed stabilization policy regime, with unclear lines of authority. As I just indicated, fiscal policy would be effective (i.e. effect GDP) in certain types of clearly defined monetary regimes. And Paul Krugman has agreed that fiscal policy would not be effective if interest rates were above zero. Indeed he has advocated a 4% inflation target precisely because that would eliminate the need for fiscal stimulus. If the precise role of the Fed at the zero bound were made explicit, then this debate would go away.
There are very few debates in economics that could be resolved by Congress, but this is one of them. In this post I explain how.