Old Theory of Keynesian Stimulus Comes Up against Hard New Facts

This article appeared in Investor’s Business Daily on September 15, 2010.
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Dana Milbank, a new Washington Post columnist, thinks Republican politicians “managed to turn the Keynesian notion of economic ‘stimulus’ into such a dirty word that President Obama and his aides are afraid to let it escape their lips.”

He blames “think tanks such as the Cato Institute” for not agreeing that Keynesian theory is so “unassailable” and “universally embraced” that daring to question the elixir of deficit spending “has a flat earth feel to it.”

Milbank forgets that Keynesian Democrats, including the recently departed OMB director Peter Orszag, constantly hectored Republicans about the evils of budget deficits while Reagan or Bush was in office.

UC Berkeley economist Brad DeLong wrote a 2004 paper for the Center for American Progress assailing Bush’s budget deficit. “A bigger deficit means less investment in America,” he wrote; “And less investment in America means slower economic growth.” DeLong quoted Bush adviser Greg Mankiw who likewise argued that, “government budget deficits reduce the economy’s growth rate.”

Milbank now claims Mankiw supports the exact opposite idea — namely, that budget deficits “stimulate” the economy’s growth rate. Unfortunately, any theory that explains everything must also explain nothing.

The Republican alternative to more fiscal stimulus says Milbank, is for government to “do nothing, and let the human misery continue.” Any doubts about the efficacy of fiscal stimulus, he argues, were discredited by the remarkable discovery that recessions still happen: “Economists offering alternatives to Keynes devised mathematical models showing how markets would behave efficiently. But those ideas collapsed along with everything else in 2008.”

This is ignorant nonsense. Efficiency never meant markets can’t be surprised and crash. Besides, academic criticism of fiscal stimulus is mainly based on fact, not theory.

Apologists for the 2009 spending spree point to an August paper by Ben Page of the Congressional Budget Office, “Estimated Impact of the American Recovery and Reinvestment Act.” The only part of that paper worth reading is the Appendix: “Evidence on the Economic Effects of Fiscal Stimulus.”

Page confesses that, “In analyzing ARRA’s economic effects, CBO drew heavily on versions of the commercial forecasting models of two economic consulting firms. … Because they emphasize the influence of aggregate demand on output in the short run, the macroeconometric forecasting models tend to predict greater economic effects from demand‐​enhancing policies such as ARRA than some other types of models do.”

Even short‐​run predictions from such models are notoriously lousy, so CBO simulations of what might have happened under different scenarios tell us more about the models’ assumptions than about reality.

The CBO paper goes on to explain that “another type of research uses historical data to directly project how government policies will affect the economy on the basis of how economic variables such as output and consumption have behaved in the past relative to government spending and revenues …

“Many estimates of this sort suggest that crowding‐​out effects dominate in the case of government purchases so that the impact on output tends to be less than one-for-Ã�­one and tends to diminish over time. … Estimated multipliers for tax cuts are generally higher than those for spending, and they tend to grow over time.”

Footnote 5, where a sample of such non‐​Keynesian evidence is buried, reads as follows:

See Christina D. Romer and David H. Romer, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, vol. 100, no. 3 (June 2010), pp. 763—801; Robert J. Barro and Charles J. Redlick, “Macroeconomic Effects from Government Purchases and Taxes,” Working Paper 15369 (Cambridge, Mass.: National Bureau of Economic Research, September 2009); Andrew Mountford and Harald Uhlig, “What Are the Effects of Fiscal Policy Shocks?” Working Paper 14551 (Cambridge, Mass.: National Bureau of Economic Research, December 2008); Roberto Perotti, “In Search of the Transmission Mechanism of Fiscal Policy,” Working Paper 13143 (Cambridge, Mass.: National Bureau of Economic Research, June 2007); Olivier Blanchard and Roberto Perotti, “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output,” Quarterly Journal of Economics, vol. 117, no. 4 (November 2002), pp. 1329—1368; and Valerie Ramey and Matthew Shapiro, “Costly Capital Reallocation and the Effects of Government Spending,” Carnegie—Rochester Conference Series on Public Policy, vol. 48, no. 1 (June 1998), pp. 145—194.

The first name on that list is Christina Romer, the outgoing head of President Obama’s Council of Economic Advisers. Another is Olivier Blanchard, director of the research department of the International Monetary Fund. The CBO’s Ben Page is not quite in the same league.

In a paper co‐​authored with Cato Institute scholar Jagadeesh Gokhale, however, Page wrote, “If the government does not pay for what it purchases with current taxes, it must raise them later — either to retire the ensuing debt or to pay interest forever.” That explains why sending borrowed bucks to Peter at the expense of taxpayer Paul is no stimulus.

The CBO’s footnoted paper by Romer and her husband estimates that a legislated “tax increase of one percent of GDP lowers real GDP by roughly three percent.” Moreover, “the output effects are highly persistent,” with a “strong response of investment.” The Romers acknowledge that “when marginal tax rates actually change,” it “could have large supply‐​side effects … on incentives and productivity.”

The second paper, by Harvard’s Robert Barro and his former student, also finds no evidence that federal spending has a “multiplier” effect on GDP. Barro and Redlick estimate that “a one‐​percentage‐​point cut in the average marginal tax rate raises the following year’s GDP growth rate by around 0.6% per year.

The third paper, by Andrew Mountford of the University of London and Harald Uhling of the University of Chicago, found that “investment falls in response to both tax increases and spending increases and that the multipliers associated with a change in taxes (are) much higher than those associated with a change in spending. … The responses of investment, consumption and real wages to a government spending shock are difficult to reconcile with the standard Keynesian approach.”

The other papers in the CBO footnote likewise find little or no “stimulus” from added borrowing and spending. Reducing the highest, most damaging marginal tax rates is far more effective.

As the Romers observed, “The most significant tax cuts to stimulate long‐​run growth are well known: the 1948 tax cut passed over Truman’s veto; the 1964 Kennedy‐​Johnson tax cut; the 1981 Reagan tax cut; and the 2001 and 2003 Bush tax cuts.”

Republicans should get some credit for the last two of those growth‐​oriented reductions in top marginal tax rates (the 1986 tax reform was more bipartisan). Yet Milbank suspects, “Republicans don’t realize that some of their tax‐​cut proposals are as ‘Keynesian’ as Obama’s program.”

That depends. Any tax policy like the frivolous 10% tax bracket added in 2001 is indeed a Keynesian policy and it always fails. Republicans suggesting that multiple surtaxes on high incomes would be harmless if postponed for a year or two are also using foolhardy Keynesian arguments.

The research by Romer, Barro and others is about raising revenues in ways that do the least damage to economic incentives, not about deliberately planning to minimize short‐​term tax collections.

Keynes explained that, “taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.”