Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 4 March 2015

Fiscal policy, correlations and causation

I have a sense that Paul Krugman wrote this post out of exasperation with those who cherry pick data to draw incorrect conclusions about the importance of fiscal policy. I know the feeling. Here is my version of what Paul did, using OECD data. We take growth in government consumption (G) [x axis] and GDP [y axis] for a whole bunch of countries for each year from 2010 to 2013, and plot the two variables against each other.


Paul’s point in that post was not that this positive correlation proves fiscal policy matters, but that there is a lot of variation, and so it will always be possible to find a case where G fell and GDP rose, or vice versa, but the general pattern is that the two variables are positively correlated.

I think that is as far as this should go. As Paul also said, you can quite legitimately argue that the relationship is not causal. Here is a very good argument about why it will not be. Imagine an ideal world where growth was always steady, and everything generally went according to plan, but some countries grew faster than others. If every country planned to keep the ratio of G to GDP constant, in the fast growing countries you would be likely to see high growth in both GDP and G, while in the others you would expect slower growth in both variables. What you would observe is lots of points close to a 45 degree line. This would tell you nothing about how a shock to G would influence Y. If you tried to read the 45 degree line as telling you about a G multiplier you would get implausibly large numbers.

This is not an academic point. Look at the three points involving 8% or more growth. They are for Estonia and Turkey. Growth in G in those cases happened to be quite low but positive, but no one would seriously suggest that this meant there was a huge multiplier in those countries. But these observations drag any trend line to be closer to 45 degree line. Indeed any trend line fitted to this data would come close to having that slope.

The other extreme numbers on the negative side are mainly Greece. Now there this reverse causation argument is less convincing: we know that negative growth in Greece did not cause the Greeks to reduce government spending. However the correlation there can still not be taken as causal because of another elementary econometric problem: omitted variables. Austerity did not just involve cuts in government consumption, but many other fiscal variables that will also have had a large impact on GDP.

All this is of course why people do proper econometrics on this question. Unfortunately the fact that there has been so much econometric work looking at multipliers itself creates a similar problem. Because difficulties involving omitted variables, simultaneity and other issues are difficult to solve, and because of different data sets, not all econometric work is going to come up with identical answers, and it will be possible to cherry pick among those as well.

One way of dealing with this problem is for new studies to start by replicated their predecessors where they can, as Jordà and Taylor do for example. (This is part of what David Hendry calls encompassing.) An alternative is to look at meta studies, like this recent example from Sebastian Gechert. To quote from his abstract: “We find that public spending multipliers are close to one and about 0.3 to 0.4 units larger than tax and transfer multipliers. Public investment multipliers are found to be even larger than those of spending in general by approximately 0.5 units.” Fortunately that is consistent with what theory might suggest. A subsequent meta analysis by Gechert and Rannenberg shows that multipliers are "systematically higher if the economy suffers a downturn", a result which is also key in Jordà and Taylor.   

Despite the number of econometric studies already done, I'm sure there is plenty still to do. Sharp disagreements still exist that remain unresolved, although I suspect a lot will be sorted out when the monetary regime in place is adequately controlled for. Of course we have very few recent observations of the ‘Zero Lower Bound/QE’ regime. Leaving QE to one side, what basic New Keynesian models tell us is that multipliers observed under fixed exchange rates probably act as a lower bound for ZLB multipliers, which is why what has happened in the Eurozone periphery is of some relevance to the UK, US, Japan and Eurozone as a whole. We already know enough from both theory and evidence elsewhere to suggest that at the ZLB multipliers could be large, but just how large remains unclear. However I doubt our knowledge will be improved by drawing more scatter plots. 

19 comments:

  1. Do you mean 45 degrees rather than %?

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    1. Of course - I've corrected the post. Thanks.

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  2. Why is it G v GDP rather than deficit v GDP? For example, would an increase in G paid for by a tax increase be stimulative or would stable G and a cut in taxes paid by the bottom 20% be stimulative?

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  3. Ahh... the my kid gets a fixed percent of my earnings as his allowance, so if I give my kid a bigger allowance daddy's earnings go up argument.

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    1. It's certainly possible to make the reverse causality argument and argue that rising government spending is a consequence rather a cause of growth. No how matter how you look at it though, the allowance metaphor is a bad one (like the "nations credit card").

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    2. I agree with both of your sentences. Bad metaphor, but nonetheless correct on causation. My way might make one think Estonia just has a lower tax rate.

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    3. No, not correct, merely arguable. The arguments in favour of growth as a consequence of government spending in this sample are a good deal stronger.

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  4. Simon
    Why not use total growth in spending, public and private, to see what effect it has on GDP?
    To growth in government consumption also should be added growth in credit and growth in savings. This provides total spending that affects GDP. Only then you could see where growth came from the most. Also knowing that government spending can trigger increased credit growth and you can get total multiplyer. Saving is the leakage where spending is succumbed, also credit repayment.

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    1. Surely total combined growth in public/private spending and GDP are near enough the same thing?

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    2. Government final consumption spending is a component of GDP, Add a billion to government spending and you add a billion to GDP on day one. The total GDP increase as that billion gets spent again and again, depends on the "rate of leakage" it suffers at every stop it makes; how often it stops and for how long. The leakage being, how much it got taxed; saved or spent on imports at each stop.

      UK government final consumption is circa 19% of total domestic final consumption which is GDP plus the Trade Balance (Acorn)

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    3. Andreas
      So, i am sure you do get the point. Why there is so much economist's mumbo jumbo when it is demolish austerian argument with saying that government spending is part of GDP. Why so much calculations to prove a point sideways and around the main formula/ model.
      Just say, look government spending is part of GDP.

      Same problem with inflationistas. MV=YP. If M grows why take that only P will grow when there is two more options. When M grows any and all others will grow, why only one?

      This complicated concoction by economists to explain a simple mathematical model is mind boggling.

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    4. Ah; the old MV = YP, they don't invent them like that any more. If M grows P will grow; but, only if you assume that the velocity of circulation of money is constant and, that the economy is always at its maximum output; which they never are.

      BTW. Accountants will tell you that the best government fiscal spending multiplier occurs when there is a reduction in sales taxes like VAT. It works best when the VAT is added at the till, not hidden in the sticker price as it is in the UK. (Mandated deliberately by the UK government so the Retailer gets the blame when the tax is put up). It's even better when you say VAT reduced for a limited period.

      The second best multiplier is when the government does a fiscal injection (spends) directly into the private sector to buy something the private sector is not / can not, already produce on its own. That is, goods and services that are not substitutes for existing private sector output. Like a motorway; an airport; big stuff.

      " ... metaphor is a bad one like the "nations credit card". You couldn't be more wrong AP. That is exactly what a fiat currency government has. http://www.3spoken.co.uk/2011/01/how-governments-super-platinum-credit.html

      All the best Acorn

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    5. Jure Jordan, at one level it is just a mathematical relationship we could write as:

      Y = C + G (output = private consumption + government consumption)

      The thing is though, this is just a model we can't simply assume that real world output (Y) is entirely determined using it. If it was the case then why not up government consumption to as much as we like (As people have patronisingly pointed out to me in the past in comments here)? A counter argument might be that Y is fixed (or determined outside the model), if which case there Y would be an upper limit and a rise in government consumption beyond the limit would need to be offset by a fall in private consumption (crowding out).

      SWL's regression is a primitive one but it does seem to support the idea that the basic model above is holding true at this time. There is still the reverse causation argument, but that argument runs into trouble explaining the fall in Greek GDP.

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  5. "You couldn't be more wrong AP"
    Anon, I could have came up with a better metaphor. See, I have learned that when it suits an economist, or government, taxes can be considered transfer payments and G and C offset because it becomes C vs C. (so convenient!!). I also learned that saying C and G offset, on the front end, is a violation of says law even though it is really an obvious accounting identity. But then, and this is my favorite, when it comes to paying back future borrowing, the same person ignores says law and tells you it's an accounting identity of G offsetting C. (Yes Wren, John Cochrane and I both obviously need a book on macro...maybe we can go to class together and I can order in a deep dish pizza a la Jeff Spicoli)
    This all makes sense as long as you make certain that accounting is not a requirement for a degree in Econ.
    Now as for gov't revenue/spending driving GDP and not the other way around...ROFLMAO!!! The more taxes I pay the more income I make... my 7 year old knows better. Talk about people so caught up in ideological nonsense that they would draw that conclusion..WOW!! WOW!! and WOW!!!

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    1. Ah; the old Say's Law, they don't invent them like that any more. Reminds me of that film where the guy said "build it and they will come". He could have said “supply creates its own demand” if he had been a classical brand economist. Didn't work then even in a barter economy. Doesn't work now in a fiat currency economy.

      Cochrane still believes Gold Standard economics applies to sovereign floating fiat currency economies. http://bilbo.economicoutlook.net/blog/?p=18765

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    2. So does Mankiw, really:

      "Dynamic scoring requires the solution of a general equilibrium model. To solve a dynamic GE model, you need to specify how the government is going to satisfy its present-value budget constraint. You might be tempted to ask the model what happens if the government cuts taxes and never does anything else. But you won't get very far. The model will tell you that the government has to do something else eventually, and it won't tell you what will happen if the government tries to do something impossible."

      If the author of THE textbook in macro says that,I think we can pretty much say that Keynesian economics is dead in modern macro-economics. What a strange thing to be talking about in the current environment. Also, the "The model tells you" speaks volumes. What does history tell you, that is what you should be worried about.

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  6. David Beckworth shows you get very different correlations for the Eurozone countries than the other countries.

    http://macromarketmusings.blogspot.ca/2015/02/the-eurozone-counterfactual.html

    That makes a lot of sense, because Greece cannot do monetary offset. But the lessons from Greece could not be applied to countries that have their own central banks.

    Estimates of fiscal multipliers from (say) US states have exactly the same problem. Plus they have an additional problem, because even a pure supply-sider would say that if you increase G or cut T in one region, labour and other resources would migrate to that region.

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    1. Nick - it was seeing David's post that gave me the motivation to write this one. Yes, having the ability for monetary offset is important (indeed, it is a key part of the anti-austerity argument), but you will not demonstrate it with scatter plots - there are plenty of econometric studies that do this much better.

      As I also say in this post, NK theory suggests the multipliers from Greece (well, fixed exchange rate economies) can be applied to ZLB economies, but multipliers in ZLB economies are likely to be higher. We do not have enough data to test that yet, but when we do it will be from econometric studies, not scatter plots.

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    2. Greece still has its own central bank, all Eurozone countries do, the fifty US States don't. They are still "lenders of last resort". They do the settlement process and supply the necessary liquidity (cash) for their respective commercial banks. The nineteen national central banks will be doing QE in a joint exercise with the ECB.

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