06 Feb 2010

The Empirical Evidence for Fiscal Stimulus…Anyone? Bueller?

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In this post Paul Krugman explains that a popular critique of the benefits of fiscal expansion is a non sequitur, since the authors improperly look at deficit spending in periods where there is no liquidity trap (and hence we shouldn’t be surprised if deficit spending doesn’t spur growth). A fair test of Keynesianism would only look at big deficit spending during periods where central banks had pushed interest rates down to the zero bound:

First, the whole stimulus debate is supposed to be about what happens when interest rates are up against the zero bound….Yet the Alesina-Ardagna analysis doesn’t make that distinction; Japan in the 90s, which was up against the zero bound, is treated the same as a batch of countries in the 70s and 80s, when interest rates were quite high.

Second, they use a statistical method to identify fiscal expansions — trying to identify large changes in the structural balance. But how well does that technique work? When I want to think about Japan, I go to the work of Adam Posen, who tells me that Japan’s only really serious stimulus plan came in 1995. So I turn to the appendix table in Alesina/Ardagna, and find that 1995 isn’t there — whereas 2005 and 2007, which I’ve never heard of as stimulus years, are.

So to put it bluntly, I’m not much persuaded by a paper that doesn’t even identify the one clear example we have in the postwar period of large Keynesian stimulus in a zero-rate environment.

Are there any papers that, in my view, do this right? Yes: Almunia et al, which uses data from the 30s — a zero-rate era — and uses defense spending as an instrument to identify spending changes. And their results look pretty Keynesian.

Everyone got that? Krugman admits that the only two examples in world history to test the effectiveness of Keynesian policies are:

(1) The world in the 1930s, and

(2) Japan in 1995.

These are the two examples to prove how good Keynesian policies are at fixing economies and stimulating growth.

By the way, don’t say World War II you silly fool–Krugman has explicitly argued that that isn’t a test of Keynesian fiscal remedies.

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