What is it about German economics?

I recently had the privilege to speak in Berlin at the 10th anniversary celebration of the Macroeconomic Policy Institute (IMK). (The talk I gave, on the Knowledge Transmission Mechanism, is here if anyone really wants to watch it.) I had known about the IMK for some time through reading incisive posts by Andrew Watt on the Social Europe website, but more recently I had been citing important papers by other IMK economists looking at the costs of austerity. You could describe the IMK group within Germany in various ways (see below), but one would be an island of Keynesian thinking in a sea that was rather hostile to Keynesian ideas.

As my talk, and this subsequent post, focused on how Keynesian ideas are pretty mainstream elsewhere, this raises an obvious puzzle: why does macroeconomics in Germany seem to be an outlier? Given the damage done by austerity in the Eurozone, and the central role that the views of German policy makers have played in that, this is a question I have asked for many years. The textbooks used to teach macroeconomics in Germany seem to be as Keynesian as elsewhere, yet Peter Bofinger is the only Keynesian on their Council of Economic Experts, and he confirmed to me how much this minority status is typical. [1]

There are two explanations that are popular outside Germany that I now think on their own are inadequate. The first is that Germany is preoccupied by inflation as a result of the hyperinflation of the Weimar republic, and that this spills over into their attitude to government debt. (The recession of the 1930s helped create a more serious disaster, and here is a provocative account of why the memory of hyperinflation dominates.) A second idea is that Germans are culturally debt averse, and people normally note that the German for debt is also their word for guilt. The trouble with both stories is that they imply that German government debt should be much lower than in other countries, but it is not. (In 2000, the German government’s net financial liabilities as a percentage of GDP were at the same level as France, and slightly above the UK and US.)

A mistake here may be to focus too much on macroeconomics. Germany has recently introduced a minimum wage: much later than in the UK or US. I think it would be fair to say that German economists generally advised against this. In the UK and US the opinion of economists on the minimum wage issue is much more balanced, largely because there is a great deal of academic evidence that at a moderate level the minimum wage does not reduce employment significantly. So here German economics also appears to be an outlier.

Many people have heard of ordoliberalism. It would be easy to equate ordoliberalism with neoliberalism, and argue that German attitudes simply reflect the ideological dominance of neo/ordoliberal ideas. However, as I once tried to argue, because ordoliberalism recognises actual departures from an ideal of perfect markets and the need for state action in dealing with those departures (e.g. monopoly), it is potentially much more amenable to New Keynesian ideas than neoliberalism. Yet in practice ordoliberalism does not appear to allow such flexibility. It is as if in some respects economic thinking in Germany has not moved on since the 1970s: Keynesian ideas are still viewed as anti-market rather than correcting market failure, and views on the minimum wage have not taken on board market distortions like monopsony. But that observation simply prompts the question of why in these respects German economics has remained isolated from mainstream academic ideas. [2]

One of the distinctive characteristics of the German economy appears to be very far from neoliberalism, and that is co-determination: the importance of workers organisations in management, and more generally the recognition that unions play an important role in the economy. Yet I wonder whether this may have had an unintended consequence: the polarisation and politicisation of economic policy advice. The IMK is part of the Hans-Böckler-Foundation, which is linked to the German Confederation of Trade Unions. The IMK was set up in part to provide a counterweight to existing think tanks with strong links to companies and employers. If conflict over wages is institutionalised at the national level, perhaps the influence of ideology on economic policy - in so far as it influences that conflict (see footnote [1]) - is bound to be greater. 

As you can see, I remain some way from answering the question posed in the title of this post, but I think I’m a bit further forward than I was.  

[1] The ‘Hamburger Appell’ of 2005, signed by over 250 German economists, is clearly anti-Keynesian. The intellectual rationale given there is unclear, but one theme is that a more effective way of increasing employment is to increase international competitiveness by holding down domestic costs. Now if you are part of a fixed exchange rate regime or a monetary union, and you have - for institutional reasons - an ability to influence domestic wage costs that other countries that belong to the regime do not have, then it may make perfect Keynesian sense to use that instrument. This is exactly what happened (deliberately or not) from 2000 to 2007, which of course is a major reason why Germany is currently not suffering the recession being experienced by the Eurozone as a whole. (Of course, unlike a fiscal stimulus, it is a beggar my neighbour policy, because demand increases at the expense of other countries in the regime: for the regime as a whole a flexible exchange rate will offset the impact of lower costs on competitiveness.)

[2] On this isolation see Tony Yates here. At the end of this post Tony also references an interesting discussion regarding ordoliberalism and other issues in comments on a post of my own: see here.   

Austerity as a Knowledge Transmission Mechanism failure

In this post I talked about the Knowledge Transmission Mechanism: the process by which academic ideas do or do not get translated into economic policy. I pointed to the importance of what I called ‘policy intermediaries’ in this process: civil servants, think tanks, policy entrepreneurs, the media, and occasionally financial sector economists and central banks. Here I want to ask whether thinking about these intermediaries could help explain the continuing popularity amongst policy makers of austerity during a liquidity trap, even though there is an academic consensus behind the idea that austerity now would harm output.

In this post I looked at various reasons for thinking there was such a consensus, and one of them was that the framework generally used to analyse business cycles was the (New) Keynesian model. In this Keynesian framework cuts in government spending when interest rates are stuck at their lower bound clearly reduce output, with multipliers around one or more.

Where are these models used in anger? Among academics studying business cycles of course, but also within central banks. As far as I know, pretty well all the core models used by central banks to do forecasting and policy analysis are (New) Keynesian. (This includes the ECB.) An important point about the delegation of stabilisation policy to independent central banks is that expertise on business cycles has tended to shift from civil servants working in finance ministries to economists working in central banks.

Suppose you are a policy maker, who is genuinely concerned about what impact cuts in government spending might have in the period after the Great Recession. Where would you, or your civil servants, go to find expertise on this issue? Given the above, one obvious source, and perhaps the main source, would be independent central banks. One big advantage that independent central banks have over academics as a source for the received wisdom on this issue is that they are a single point of reference. No need to ask the many economists working in the central bank - just ask the central bank governor, who you would expect to distil the wisdom of their own economists.

Following this logic, you might expect to find central banks shouting the loudest about the dangers of austerity. After all, they get the rap for deflation, so anything that makes their job more difficult and uncertain when interest rates have hit their lower bound they should perceive as especially unwelcome. In front of committees of congress/select committees and the like, they should be banging on about how they cannot be expected to do their job if politicians continue to make life difficult by deflating demand. If they did this, some politicians (particularly on the centre left) would have had ammunition with which to counter homilies about Swabian housewives and maxed out credit cards. 

Of course this does not happen. The extent to which it does not happen varies among the major banks. In the US Bernanke did very occasionally (and somewhat discretely) say things along these lines, but he seemed reluctant to do so in any way that might prove influential. In the UK Mervyn King is believed to have actively pushed for greater austerity, and the Bank of England has never to my knowledge suggested that austerity might compromise its control of inflation. The ECB, of course, always argues for austerity. It is one of the great paradoxes of our time how the ECB can continue to encourage governments to take fiscal or other actions that their own models tell them will reduce output and inflation at a time when the ECB is failing so miserably to control both.

So what is going on here? I think there are two classes of explanation, related to the distinction between the roles of interests and ideas in political economy (see Campbell here, for example). The first class talks about why the interests of the elite might favour austerity, and how these interests could be easily mediated through senior central bankers. It could also explore the interests of finance, and their close connections to central banks.

The second class might focus on ideas involving perceived threats to central bank independence. In the US, this might be nothing more than a desired quid pro quo whereby central bankers avoided mentioning fiscal policy so that politicians steer clear of comments on monetary policy. More seriously, amongst other central bankers it may represent a primal (and in the current context quite unjustified) fear of fiscal dominance: being forced to monetise debt and as a result losing both independence and control of inflation. In this context I often quote Mervyn King, who said “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

These ideas are in conflict with the message on fiscal policy coming from the central bank’s own models. In the UK and US, this contradiction is partly resolved by an excessive optimism about unconventional monetary policy. But it can also be resolved through overoptimistic forecasts, given that inflation targeting is in reality targeting future inflation. Although both these mechanisms come with a limited shelf life, they only need to operate for as long as austerity and the liquidity trap last.

The story I like to use about the Great Recession is that it exposed an Achilles’ heel with the consensus assignment that helped give us the Great Moderation. Yes, it was best to leave monetary policy to independent central banks, but the Achilles’ heel is that this would not work if interest rates hit their lower bound. In that situation fiscal policy had to come in as a backup for monetary policy. But if the analysis above is right the creation of independent central banks may have helped make that backup process much more difficult to achieve. By concentrating macroeconomic received wisdom in institutions that were predisposed to worry far too much about budget deficits, a huge spanner was thrown into the (socially efficient) working of the knowledge transmission mechanism.

  

The latest IMF paper on debt

This paper by IMF economists Jonathan Ostry, Atish Ghosh and Raphael Espinoza has attracted some media attention. (Flip Chart Rick has a good summary.) I want to talk about it because it does something that is quite rare - it talks about optimal debt policy in the longer run, rather than focusing on the shorter term issues associated with austerity. It also uses theory that I have used in a number of my own papers.

The headline result, that many will find startling, is that countries with what the IMF call ‘fiscal space’ have no need to reduce government debt at all, and should not therefore undertake fiscal consolidation to reduce debt - not today, or tomorrow. By fiscal space they effectively mean that the market is perfectly happy buying the debt, and are not suffering - and are unlikely to suffer - any kind of significant default premium that raises the interest on their debt. The paper suggests that most countries, including the UK, now have this fiscal space (see their page 4).

Many will find this message surprising, particularly coming from the IMF, because we are always hearing about why higher government debt is such a bad thing, and in particular how it imposes such a burden on future generations. However the result the paper is using is perfectly standard in the literature. To put it very simply, high debt does impose a burden, because the taxes required to pay the interest on that debt are ‘distortionary’ - for example income taxes prevent people from working as much as they should. But cutting debt also imposes a burden - taxes have to be raised to get debt down. Analogies between households and governments are misleading: while we as individuals do not live forever and therefore need to pay back debt eventually, the state can act as if it will go on forever. We therefore face a trade-off: is it worth paying higher taxes now in order to reduce government debt so we can pay lower taxes in the future? (Conceptually we can make the same point when talking about government spending cuts.)

The answer to that question depends on two key variables: the real rate of interest and the discount rate: the rate at which we discount utility in the future compared to utility today. In the standard model used by many/most macroeconomists, and used in this paper, these two variables are equal in the long run. If this is the case, it turns out that raising taxes today to cut debt and taxes tomorrow is a net cost, and it is better to leave debt where it is. That is where the headline message of the paper comes from. (Footnote for economists – [1].)

So suppose an economy suffers a positive government debt ‘shock’ - caused by a financial crisis, for example. The optimal policy is to leave debt higher, if the markets are happy to buy the debt (i.e, there is no additional default premium). The costs of getting debt back down again exceed the benefits. What that means for the UK, for example, is that we should not be going for a zero deficit, but should be happy with a deficit of a little over 3% of GDP that leaves the debt to GDP ratio constant.

Do I agree with this argument? The answer is no and yes.

No, because I think there are good reasons to believe that the real rate of interest on debt is normally a bit higher than the discount rate relevant to social welfare, although I admit this assumption is being put to the test right now (see the secular stagnation debate). If the long run real interest rate does exceed the discount rate, it becomes optimal to aim to reduce debt over time. (Footnote for economists - [2].)

Yes, because even in what I believe to be the more realistic case, debt is reduced very slowly. As some colleagues and I show in this paper, we could be talking about debt reduction over the period of a century or more. So, in terms of the current policy debate, the standard model used in this paper may be a useful starting point. (Footnote for economists - [3].)

The paper has plenty of interesting stuff in it. One point that I particularly liked addresses an argument that is often made to defend a rapid reduction in government debt in the UK: we must make room for the next crisis. On pages 12 and 13 the paper goes through a little cost benefit calculation to show why this argument is probably wrong. The paper does not argue that debt should never be reduced in countries with fiscal space. If opportunities arise to reduce debt without incurring significant distortionary costs, they should be taken. The obvious UK example where that was done in the past was the windfall from the sale of 3G spectrum licenses, which Gordon Brown used to reduce debt. The obvious example where that was not done were revenues from North Sea oil, which should have led to paying off public debt and/or building up a sovereign wealth fund as Norway has done. (Please note irony in terms of recent UK politics.)

In terms of the current policy debate, the message to politicians is clear and I suspect pretty robust. The shock of the financial crisis and Great Recession led to a large increase in debt levels in nearly all OECD countries. We should be in no hurry to try and return debt (relative to GDP) to pre-shock levels. That means that we can certainly afford to wait until interest rates have begun to rise, so that monetary policy can offset the impact of any subsequent fiscal consolidation. The case for reducing debt right now has no basis in standard macroeconomic theory.      

[1] This is sometimes called the steady state random walk debt result.

[2] In this case the optimal long run level of debt becomes negative. So what is called the ‘random walk steady state debt’ result from the paper is a knife edge result: even an epsilon increase in the long run real interest rate leads to a radically different optimal long run debt level. To see why we get this apparent knife edge, see the next footnote.

[3] The general result is that debt should be reduced, but slowly. The closer the discount rate gets to the real rate of interest, the slower the adjustment should be. When they are equal, adjustment should be infinitely slow - that is where the ‘steady state random walk debt’ result comes from. 

The academic consensus on the impact of austerity

In discussing the forthcoming UK budget, Robert Peston writes:

“And before I am savaged (as I always am) by the Krugman crew of Keynesian economists for even allowing George Osborne's argument an airing, I am not saying that the net negative impact on our national income and living standards of cutting the deficit faster is less than their alternative route of slower so-called fiscal consolidation.

I am simply pointing out that there is a debate here (though Krugman, Wren-Lewis and Portes are utterly persuaded they've won this match - and take the somewhat patronising view that voters who think differently are ignorant sheep led astray by a malign or blinkered media).”

I do not want to disappoint, and as I was about to write something on the macroeconomic consensus on austerity anyway, let me oblige - not in savaging (I leave that to my American colleague in arms!), but in justifying why I think there is such a consensus in the places that count. By consensus I do not mean that everyone agrees - of course not - but that a very large majority do, which probably counts as consensus in economics.

Unfortunately we do not have a great deal of information on what academic economists as a whole think about austerity, but we do have two important survey results which are pretty conclusive. In the US, there is the IFM Forum, which regularly asks a group of distinguished economists - including many macroeconomists - their views on key policy issues. The last poll I have seen suggests that 82% of that panel thought the 2009 Obama stimulus had reduced unemployment, while only 2% disagreed. In the UK, the CFM survey asked a similar question to a smaller group of academic economists, most of whom are macroeconomists. Only 15% agreed that the austerity policies of the coalition government have had a positive effect on aggregate economic activity, while 66% disagreed. That consensus is not universal - it would not apply in Germany for example - but I doubt if anyone would disagree when I say that US economists call the shots as far as academic macroeconomics is concerned. 

This is why economists the world over continue to teach Keynesian macro to undergraduates, and normally not as one ‘school of thought’ but rather as an initial approximation of how the economy actually works. As Amartya Sen so forcefully reminds us, the experience of the last hundred years has earned Keynesian theory this central role.

However we have another, more indirect, source of evidence. If you asked whether there was a standard model for analysing the business cycle among economists in academia and in policy making institutions, the answer would have to be the New Keynesian model. I want to include economists in central banks in particular because they have to put theories of the business cycle into practice on a regular basis. The key macromodels that central banks use to forecast and to analyse policy are Keynesian, and many are New Keynesian. Having worked a great deal with New Keynesian models myself, I also know what they imply about temporary changes in government spending in a liquidity trap (see this paper by Mike Woodford, for example). It may be possible to adapt these models to give you expansionary austerity, but no such adaptations command general or even partial support.

The models used by pretty well all central banks would therefore imply that temporary cuts in government spending were contractionary, absent any monetary policy offset. The governors of the central banks of the UK and US say this publicly. European central bank governors do not tend to say this, and instead continue to advocate austerity despite deflation. The reason why they might do this despite what their models tell them will be the subject of a later post, but I suspect it has little to do with conventional macroeconomics (but see also the point about German academic views above, and Sen’s article). If temporary cuts in government spending are contractionary in a liquidity trap, it follows that it is much better to delay this form of austerity.

I could add repeated arguments from economists at the IMF (e.g. here and most recently here), and now also the OECD (FT here, or ungated here). Of course there are some academic economists who continue to argue that the impact of austerity is expansionary or at least minor - I suspect there always will be, as long as this remains an intense political debate. They would be joined by many City economists, but they are neither unbiased nor the source of any particular expertise on this issue.

This is why, among economists with expertise, there is a clear majority view that fiscal austerity is significantly contractionary in a liquidity trap. That does not automatically mean that the 2010 policy switch was wrong, or that it had a big impact on the UK in 2010-2012: there are additional issues here which I have discussed many times. How damaging to the macroeconomy any additional austerity from Osborne will be also depends on whether we are or will be in a liquidity trap. But the fact that we might well be means that additional austerity now is a big mistake, and on this I believe the great majority of academic macroeconomists and those macroeconomists working in policy making institutions would agree.

As far as the media is concerned, I cannot believe that Robert Peston would disagree that a large section are ‘malign’, given how political this issue is. When I have talked to journalists who have some freedom to report the facts rather than what their editors want them to report, the argument I most often hear is that because this issue is political, they have to report it as a ‘debate’ come what may. I have never had the pleasure of talking to Robert Peston (he is welcome to email at any time), and I would be very interested in how he would respond to the evidence I have laid out. As for the public, the word sheep is his not mine. Would he really argue that the public are independently well informed on these matters, or unaffected by the media’s presentation of this and similar issues? Which is why I will continue to - as he might say - bang on about this, even though my audience is tiny in comparison to most journalists.

Multipliers and evidence

I should be more careful with titles. The title of this post may have misled some (including Paul Krugman) to characterise what I was saying as favouring a priori beliefs over evidence. What I was in fact talking about was different kinds of evidence.

One kind of evidence on multipliers comes from directly relating output to some fiscal variable like government spending. In much the same way we could base monetary policy on attempts to relate output or inflation directly to changes in interest rates. This is sometimes called ‘reduced form’ estimation. As I said in my post, these studies are valuable, and if they repeatedly show something different from other evidence that would be worrying. However in my experience I have found them less reliable than evidence based on looking at the structure of the economy. I discuss a personal example here, but two more recent examples where reduced form evidence has not proved robust concern the impact of debt on growth and evidence supporting expansionary austerity.

As I wrote in the recent post: “My priors come from thinking about models, or perhaps more accurately mechanisms, that have a solid empirical foundation.” Again perhaps I was remiss in not emphasising that last clause, but it is critical. Robert Waldmann did interpret what I wrote correctly, but has a more worrying (for me) charge - that my view of what specific structural empirical evidence says is tempered by modern microfounded modelling.

A good example concerns how consumers might react to a temporary increase in income. I wrote that my prior is that consumers will largely discount temporary income changes. But what exactly do I mean by ‘largely’ here? Is a marginal propensity to consume out of temporary income of, say, 0.3 large or not? As I have noted elsewhere, there is good empirical evidence to support a number of that kind, and it is possible to explain this in terms of consumers optimising in the face of uncertainty. 

But the plain vanilla intertemporal consumption model implies a marginal propensity to consume out of temporary income close to (or identical to) zero. So when I wrote “largely discount”, did I in fact temper my knowledge of the empirical evidence because of this basic (and in macro ubiquitous) theory? Or was I attempting to use a form of words which was ambiguous enough not to upset those who did have a strong attachment to the plain vanilla model, which would have been just as bad.

It would be ironic if I had been. On a number of occasions I have argued that it was unfortunate that the microfoundations revolution has completely killed (in the academic literature, if not in all central banks) the alternative of analysing aggregate models where relationships are partly justified by empirical evidence. One of my reasons for believing this to be unfortunate is that it tends to put too much weight on simple theory relative to evidence. When I wrote ‘largely discount’ was I providing an example of just this kind of thing?

If it was, it may only have been a temporary lapse. Paul thinks a multiplier of around 1.5 is reasonable (I assume at the Zero Lower Bound when there will be little or no monetary policy offset), and when I wrote this I also assumed a multiplier of 1.5. However I think the point that Robert was making is a very important one: in macro we seem generally happier falling back on what standard theory says than on what the majority of empirical evidence suggests.     

The Knowledge Transmission Mechanism and Macroeconomic Crises

Sometimes when people talk about the influence of macroeconomic ideas on policy they seem to have a very simple framework in mind. Policy makers need to understand how the economy works, so they go to academics to find out what the current received wisdom is. In this framework, when things go wrong - in the extreme if there is a macroeconomic crisis - we need to ask why the received wisdom was wrong. In short, to understand macroeconomic crises you need to understand the bad or inadequate theory that generated it.

The archetypal example of this would the Great Depression of the 1930s. Policymakers had a classical view of macro, that had no room for recessions caused by demand deficiency. But similar stories are told about later crises. One story for the inflation of the 1970s is that the received wisdom was that there was a permanent inflation/unemployment tradeoff, and policymakers were attempting to use that to get unemployment a bit lower. However because in reality the Phillips curve was vertical, we got steadily increasing inflation. It is a neat story, but as a description of what was happening at that time it is at best far too simplistic, and probably just wrong.

A simple story about the financial crisis is that policymakers were too dependent on macro models that ignored finance, models which therefore implicitly assumed a financial crisis could not happen. As a result, macroeconomists failed to predict the crisis. This story can be often found in heterodox accounts, but some eminent policymakers have said similar things. The bit about macro models neglecting finance is true, but as an account of why the financial crisis happened it is also probably wrong, as I argue here.

Where the simple idea that crises reflect bad theory comes completely unstuck is for Eurozone crisis of 2010. Here the crisis owed a good deal to policymakers ignoring the received wisdom. This happened on two occasions. The first time was in the fiscal architecture of the Eurozone, where the problem of competitiveness imbalances caused by asymmetric shocks was wished away, and therefore the potential that national countercyclical fiscal policy could have to moderate these imbalances was ignored. I would never claim that had macroeconomic received wisdom been incorporated into Eurozone fiscal rules from the start the 2010 crisis would not have happened, but it certainly would have been more manageable.

The second time that the macroeconomic received wisdom was ignored by policymakers was in the reaction to the 2010 crisis: the subsequent austerity which was the major factor behind the second Eurozone recession. So in both cases policymakers did not act on the prevailing macro theories, but ignored them, and in doing so helped create a crisis.

One way of explaining how this could happen is that policymakers were well aware of the macroeconomic received wisdom, but chose to ignore it. In some cases that may be what happened. However another possibility is that the what I call the knowledge transmission mechanism between academics and policymakers broke down. To explore that possibility you need to think seriously about what could be called ‘policy intermediaries’. Here is a simple diagram.

I want to cast the net of potential policy intermediaries pretty wide. Obvious candidates are the civil service and policy think tanks, or the policy entrepreneurs that Paul Krugman has talked about. However to get a full picture of what went on in 2010, I think you need to also think about economists in the financial sector, the media and especially central banks. Of course central banks are policy makers when it comes to monetary policy, but on fiscal policy issues they can  advise governments. As I hope to argue in a later post, their role in misdirecting policymakers after 2010 may have been very important in at least some countries. 

Faith in multipliers

Economists could skip to the penultimate paragraph

The multiplier is the size of any decrease in output that results from a fiscal contraction (lower government spending or higher taxes), both measured in the same units. 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.

Some of the terminology makes more sense if we talk about an increase in government spending (for example, a new school being built), so from now on I’ll consider that. A multiplier around one means that for every school built GDP increases by the cost of that school (a multiplier of exactly one) plus or minus some private sector expenditure (hence around one). If private sector expenditure falls we talk about it being crowded out, but if private sector spending increases we can talk about that expenditure being encouraged or crowded in by the additional public spending. The first point to note is that by thinking in this way I’m focusing on aggregate demand rather than aggregate supply, which I think is appropriate in the situation we have recently been in. If, in contrast, everyone was already working as much as they could, it might be more natural to start from a multiplier of zero, because the school will have been built with labour that otherwise will have built something else. A multiplier of zero is called complete crowding out.

Will we get crowding in or crowding out? 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. There is a lot more we could say here, but I want to keep it simple.

We next need to think about whether this reasoning could be upset by some change in a price that results from the extra school being built. The two key prices here are the real exchange rate and the real interest rate. My basic model of exchange rates is that they are grounded in some medium term view concerning competitiveness, plus beliefs about what might happen to short term interest rates. If the spending is temporary medium term competitiveness is largely unaffected, so what happens to real interest rates is critical. If they rise as a result of the additional employment required to build the new school, then this might lead to a real exchange rate appreciation. This will reduce the demand for domestically produced goods, and higher real interest rates will also discourage private spending directly. So what happens to interest rates is critical.

This is the second point at which actual circumstances are important. Nominal interest rates have been stuck at their Zero Lower Bound, which suggests that they would be quite likely to remain there despite any increase in employment generated by our additional school. If the additional GDP adds a bit to inflation, real interest rates might actually fall, leading to crowding in. (The point is reinforced if we reverse the sign and think about fiscal austerity - central banks will be unable to cut rates to offset austerity’s impact.)

That is where my priors come from: thinking about the structure of the economy, and situation we are in and the nature of the experiment involved. The problem for empirical studies that directly relate changes to output to changes in government spending is that they face huge difficulties in relating the data to particular circumstances and the kind of experiment involved. For example, is any increase in government spending observed in the data expected to be temporary (with relatively minor consequences for tax) or permanent (with implications for tax that could lead to complete crowding out as a result of lower consumption)? Some studies try and take account of this by focusing on shocks to spending, but that is not quite the same thing. (A new school will tend to raise GDP whether it is expected or not.) Even if the change in government spending is expected to be temporary, if any additional borrowing is paid for by cutting future spending rather than increasing taxes this will in theory make some difference.

Up until recently studies have not really controlled for monetary policy, which as we saw was crucial. This recent study from the IMF is an exception, although if you read it you will see just how difficult trying to control for monetary policy actually is. They find that monetary policy does have a large influence, which fortunately agrees with the analysis above. What some earlier studies have shown (I’ve often referenced a study by Jorda and Taylor, but here is another, and a meta analysis is here) is that multipliers tend to be larger when economies are depressed. What has not been clear is whether this is picking up a monetary policy effect (if economies are depressed, monetary policy is unlikely to try and offset the impact of any fiscal expansion), or whether it is picking up something else (for example, multipliers could be larger in a recession because more consumers are credit constrained). This IMF study, which is just based on US data and which does allow for monetary policy, finds no additional depressed economy effect. It will be interesting to see if that result proves robust to alternative treatments of monetary policy and data for other countries.