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An Alternative View Of Fiscal Stimulus

I don’t know about you but I have a bad feeling about the way we are all rushing around enacting new programs and blithely assuming that giving politicians somewhere in the neighborhood of a trillion dollars or so to spend on stimulus. We need a few people to say wait a minute! Let’s step back and think this through.

So I was more than a bit pleased to find this from Greg Mankiw, a Harvard economics professor. Mankiw points out that there might be some worth in considering tax cuts rather than blindly following a Keynesian, throw money at the problem, solution.

So what are these multipliers? In their new blog, Bob Hall and Susan Woodward look at spending increases from World War II and the Korean War and conclude that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. Similarly, the results in Valerie Ramey’s research suggest a government spending multiplier of about 1.4. (Valerie does not present her results in multiplier form, but she emails me this translation: “The right column of figure 5A of my paper shows that for a log change of government spending of 1, log GDP rises by 0.28, implying an elasticity of 0.28. To back out the implied multiplier, we can use the fact that government spending averages around 20% of GDP. This implies a multiplier of 1.4.”)

By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars. The puzzle is that, taken together, these findings are inconsistent with the conventional Keynesian model. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers.

How can these empirical results be reconciled? One hypothesis is that that compared with spending increases, tax cuts produce a bigger boost in investment demand. This might work through changing relative prices in a direction favorable to capital investment–a mechanism absent in the textbook Keynesian model.

Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes (as suggested by Bils and Klenow). This tax cut would reduce the cost of labor and, if labor and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit.

This hypothesized channel seems broadly consistent with the empirical findings of Blanchard and Perotti, Mountford and Uhlig, Alesina and Ardagna, and Alesina, Ardagna, Perotti, and Schiantarelli. The results of all these authors suggest you need to go beyond the standard Keynesian model to understand the short-run effects of fiscal policy.

I have to first apologize to Professor Mankiw for excerpting so much of his post. I don’t hold with the standard blog practice of adding little thought to someone else’s content. In this case, the post was short and the arguments mercifully terse. He makes a great point, however. We are embarking on a very expensive journey with little thought or debate as to what we truly will accomplish. The prospect of massive fiscal stimulus is like honey to bees for politicians. There is much more in their calculations than the mere righting of an upside down economy. For that reason and that reason alone, we need to listen to the dissenting voices.

There is a lot to be done but let’s not do it rashly and let us be very wary of those who try to push too hard in any particular direction.

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