02 Apr 2014

Data Confirm: Earthquakes Not Good for Boosting Output

Economics 23 Comments

Tyler Cowen links to a paper by Johannes Wieland. The following excerpt from the paper should give you some insight into the state of formal economics:

Standard sticky-price models predict that temporary, negative supply shocks are expansionary at the zero lower bound (ZLB) because they raise inflation expectations and lower expected real interest rates, which stimulates consumption. This paper tests that prediction with oil supply shocks, an earthquake, and inflation risk premia, demonstrating that negative supply shocks are contractionary at the ZLB despite also lowering expected real interest rates. These findings are rationalized in a model with financial frictions, where negative supply shocks reduce asset prices and net worth, translating into larger borrowing spreads so that consumption contracts. In this data-consistent model fiscal stimulus at the ZLB is substantially less effective than in standard sticky-price models.

Let me translate: The author is saying something like, “Some economists since 2008 have been touting the efficacy of government deficit spending when interest rates are near 0%. The standard models used to rationalize these policy recommendations work through a particular channel. This mechanism has the counterintuitive property that in this type of scenario, a sudden disruption in oil deliveries, or even an earthquake, could actually lead to higher economic output. However, I have tested this empirically, and find that even when interest rates are low, earthquakes reduce economic activity. This leads me to
question whether government deficit-spending is actually a really good idea when interest rates are near zero.”

In case the reader doubts my summary, go read John Cochrane’s discussion of the paper back in 2013 (I guess when he read a working version of it).

23 Responses to “Data Confirm: Earthquakes Not Good for Boosting Output”

  1. Transformer says:

    Where does the bit about “government deficit spending” come from ?

    The bit you quote makes it sound as if negative supply shocks are supposed to be expansionary (due to raising inflation expectations and reducing real interest rates) totally independently of governments.

    • Andrew_FL says:

      “In this data-consistent model fiscal stimulus at the ZLB is substantially less effective than in standard sticky-price models.”

      “Fiscal stimulus” = government deficit spending.

  2. Edward says:

    Theres a big difference between raising OUTPUT, wealth, and living standards and raising EMPLOYMENT. Thats where the Keynesians went into cloud cuckoo land it think. I fully agree that negative supply shocks are not good for output, but even the broken window fallacy is not a fallacy at all when you measure the jobs created from repairing the disaster WITHOUT opportunity cost. When you confuse the two, you can assert all sorts of ridiculous things. Like government spending “can’t create jobs” which is ludicrous nonsense when taken literally, when the real question that should be asked is can government raise wealth and raise living standards? (Answer: To a minarchist like me, with a few exceptions, mostly no)

    • Transformer says:

      A Keynsian could say just say “Only a an idiot would expect a supply shock to boost a depressed economy, what we really need is real stimulus such as that provided by govt deficits”.

      I think I’m missing the point of this post.

      • Bob Murphy says:

        Transformer wrote:

        A Keynsian could say just say “Only a an idiot would expect a supply shock to boost a depressed economy,…

        Transformer you should click the link. Here’s a quote Cochrane pulled from the paper (as of 2013, don’t know if it’s still like this in the paper):

        Does destroying productive capacity raise output when the zero lower bound (ZLB) binds? [ZLB: When interest rates are zero, the Fed can’t lower them any more in response to shocks -JC] While this question may seem absurd, in fact it is a common prediction of many macroeconomic models: In these models, temporary negative supply shocks raise inflation expectations and lower expected real interest rates at the ZLB, which stimulates consumption and output. While some prominent economists have subscribed to this view and its policy implications (e.g., Eggertsson and Woodford [2003], Eggertsson and Krugman [2011], Eggertsson [2012]), there is wide disagreement over such a radical and unintuitive proposition.

        But yes, many would agree that only an idiot would offer such views.

        To be clear, Transformer, Krugman et al. aren’t proposing that the government somehow cause earthquakes. (For that matter, Krugman isn’t endorsing the faking of an alien invasion.) But the logic for why they think even wasteful government deficit spending will “help the economy,” should also apply during supply shocks.

        Transformer, Krugman has explicitly said that in a liquidity trap, environmental regulations that make companies throw out existing equipment etc. and replace it with new, compliant stuff will boost employment and output (whereas in a normal economy it wouldn’t, it would just reduce harmful climate change).

        • guest says:

          The difference between “output” and “wealth” escapes them.

          Output is only wealth when it satisfies individuals’ preferences.

        • Transformer says:

          To interpret the post a bit uncharitably: You seem to be picking up on a rather zany theory proposed by some New Keynesians and then trying to imply (without every actually saying it) that this theory is being used by some real Keynsians to suggest that the govt should create artificial supply shocks.

          Cochrane says

          “In these models, temporary negative supply shocks raise inflation expectations and lower expected real interest rates at the ZLB, which stimulates consumption and output”

          While this theory sounds vaguely plausible at one level I’m not really surprised that empirical testing shows it to be untrue once you take the full picture into account

          You acknowledge now that Keynsians (including Krugman) aren’t really using this theory to suggest the govt should create supply shocks , so I think that’s why I’m not getting the point of the post.

          Keynesian theory clearly believes it is possible to use stimulus to increase the flows without first reducing the stock. When Krugman talks about stimulus from rules that cause still-functioning capital to be thrown-out he probably believes that (even leaving aside the stimulus effects) the environmental benefits outweigh the costs so this is not the same thing at all as engineering a negative supply shock.

          The example you give

          • Bob Murphy says:

            Transformer wrote:

            You seem to be picking up on a rather zany theory proposed by some New Keynesians and then trying to imply (without every actually saying it) that this theory is being used by some real Keynsians to suggest that the govt should create artificial supply shocks.

            I’m not putting words in anybody’s mouth. Krugman and DeLong have explicitly said that government spending on useless things will boost employment and output. That’s the point of Keynes’ idea of burying bottles of money, and Krugman’s fake alien invasion.

            Krugman has explicitly endorsed creating a “supply shock” via environmental regulations. Now it’s not an “artificial” supply shock in the sense that it’s not arbitrary; it will (he thinks) reduce climate change. But in a normal economy, the regulations would indeed reduce the output of other goods and services. Yet not so when we’re in a depressed economy near the ZLB, where the Fed can’t simply cut interest rates and restore full employment.

            I’m not putting words in his mouth, that’s explicitly what Krugman has argued. Go look up the cited papers and see if JW is lying about their position.

            • Bob Murphy says:

              Maybe this is what’s tripping you up: No Keynesian is saying, “The best policy right now would be to hamper supply.” Rather, the point is that the mechanism through which their *actual* recommendation works, would also mean that a natural supply disruption should boost GDP. And even here, it’s not that this link is provided by the critics; the Keynesians themselves have agreed, and have used such thought experiments to motivate discussion of their actual policy recommendations.

              So Krugman e.g. isn’t recommending that the Pentagon literally fake an alien invasion in order to get the public to agree to (useless) military expenditures. Rather, he is saying that that would be better than the status quo. Once you “realize” this, then you can see why spending money on building bridges or schools or unemployment benefits would be even better still.

              • Transformer says:

                The logic of the JC post is:

                1. Some New Keysnians clearly say things that indicate they believe that negative supply shocks can be a goods thing: He quotes Krugman saying “And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment “.

                2. He then quotes the report that uses empirical evidence to show that real “natural” negative supply shocks don’t actually boost output.

                He then concludes that a ” central night-is-day New-Keynesian proposition” is wrong.

                My problem with this is as follows:

                The key New Keynsian proposition here is not “supply shock are good” but rather “raising expectations of future inflation and lower future interest rate are good”. Looking at empirical evidence of real supply shocks doesn’t say much about the real NK proposition. Lots of other things are going on in real disasters to make that kind of “empirical study” a bit dubious.

                I think Keysians (including Keynes himself) do say things along the lines of “Stumulus is so powerful that it will work even if the stimulus is provided via a artificially created supply shock”. But clearly this is different from actually recommending the creation of supply-shocks. The report at best disproves the “even if” bit not the central Keynsian claim about stimulus from inflation expectations.

    • Major_Freedom says:

      “but even the broken window fallacy is not a fallacy at all when you measure the jobs created from repairing the disaster WITHOUT opportunity cost. ”

      Yes, when you deny the existence of costs, any activity can be believed as a net gain.

      • Matt M (Dude Where's My Freedom) says:

        Assuming that costs don’t exist is just about a vital prerequisite for a career in any “public service” sort of job (academia, politics, etc.)

        • Tel says:

          Other people’s money — no cost to the decision maker.

    • Silas Barta says:

      Yes, this is why I prefer to frame stimulus (government or seismic) as “lowering the cost of thought” or “making the optimal use of resources *more obvious*”. Long explanation.

      That is, when you have an earthquake or wealthy spender making something obviously profitable (rebuilding, or selling what the government’s buying), then it’s easier to justify committing resources to that. The economic stars align.

      But it’s not because “stimulus” as some magic “enriching” power; it’s because it makes the cost of coming up with a viable business plan a lot lower.

      • Major_Freedom says:

        And we can step back even more and generalize further: what we are seeing is but a special case of the law of diminishing returns. Abstractly, each additional unit of satisfaction requires a greater input of factors: land, labor, capital … and thought (sometimes called “entrepreneurial ability”). Generally, the further up you pick the fruit, the harder it is to pick the next branch up, in terms of any factor of production, including and especially thought. Conversely, if you suddenly face a sharp drop in satisfaction by being deprived of more fundamental necessities, it becomes easier to decide what to do: replace those necessities!

        That is a very compelling theory. Well done!

        I would only add that maybe you should emphasize that the factor of thought is what it is only in the immediate moment. What I can do right here and now based on my thoughts is limited to the thoughts I have right here and now.

        I am able to learn over time, and become more informed of how I could improve myself. As that happens, the marginal cost of thought goes down, and as a result I can do more and more with my thoughts.

        Take away some of my goods that don’t require a lot of thought to replace, and it’s easier for me to produce at that time. Take away my goods that take a lot of thought to replace, and it would be harder for me to produce.

        • Silas Barta says:

          Good points! There could be some important implications for economic theories of learning. I’ll have to think about it. (And thereby lower my cost of thought d-; )

          • Major_Freedom says:

            I hope you do. I suspect you might be able to find a rigorous, logically consistent way of showing that Keynesianism makes us all dumber than what we otherwise would be, because instead of finding ways to colonize the moon, and learning about that, we’re stuck on Earth repairing windows all goddamn day in the name of employment.

            • guest says:

              Ship the broken windows to the moon and repair them there = Brilliant!

              So many employed resources!
              😀

              My mind is a raging torrent, flooded with rivulets of thought cascading into a waterfall of creative alternatives.

        • Tel says:

          People tend to get herded toward the existing government during times of crisis, so the earthquake actually increases the cost of genuinely independent thought, but reduces the cost of thought for just going with the crowd.

          Note how “America’s Mayor” ™ stood around looking important back in 2001, not actually doing anything useful but instead sending cleanup crews into piles of asbestos dust without breathing filters. The public lapped it up because here was decisive leadership. Politicians wait a lifetime for opportunities like that.

          What the disaster does is provide the leader a stage from which to give the appearance of being a key decision maker.

    • Matt Tanous says:

      Jobs for the sake of jobs is the great economic fallacy of the modern age. Doesn’t matter what you make, as long as you’re making something.

      It’s right up there with the glorification of manufacturing, the demonization of automation, and the idea that unions and legal mandates – and not capital accumulation – are behind the growth in living standards in the 20th century.

  3. Edward says:

    “That’s where the Keynesians went into cloud cuckoo land I think”

  4. Dyspeptic says:

    Does the concept of Negative Supply Shocks as economic stimulus apply to academia too? If so, maybe we could increase output and employment by firing every Keynesian economics professor in the country and replacing each one with ten carnival barkers, psychics, palm readers, or cold fusion researchers.

    For that matter, why single out economics professors? We could expand this stimulus program to include Climate Change researchers, Gender & Race Studies Professors and anyone who has ever smeared Walter Block in a public forum. The possibilities for universal prosperity are endless.

  5. Tel says:

    Overall if you look at Japan, they have had what should have been a dream run for Keynesian economics:
    * They had the earthquake, tsunami, and reactor leak so plenty of broken windows.
    * They had the money printing, with prices going up, trying to discourage people from thrift.
    * They recently had a round of wage rises, supposedly providing stimulus.
    * They also have had a tax hike so government can continue to expand.

    Japan should be growing GDP like nothing else right now.

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