Thursday, April 02, 2009

Crowding, Ricardian, and forecast accuracy 

...we find substantially smaller government spending multipliers than those used by Romer and Bernstein. For example, the multiplier associated with a permanent increase in government spending by the end of 2010 lies between 0.5 and 0.6. In other words, government spending does not induce additional private spending but instead quickly crowds out private consumption and investment.

We also provide an assessment of the impact of the American Recovery and Re-investment Act. This legislation implies measures amounting to $787 billion and spread over 2009 to 2013 but peaking in 2010. Our estimate of the total impact is closer to 1/6 of the effect estimated by Romer and Bernstein. By 2010 we project output to be about 0.65% higher. Using the same rule-of-thumb as Romer and Bernstein, this increase in GDP would translate to about 600,000 additional jobs rather than three to four million.

Why is our assessment of government spending multipliers so different? Well, first of all Romer and Bernstein constrain the Fed to keep interests rates constant at zero forever.

Such an interest rate peg would lead to explosive behaviour and instability in New Keynesian models. Instead we allow the Fed to raise rates eventually, starting in 2011, or more realistically, in 2010. Committing to 1 or 2 years of zero interest rates still implies much additional monetary stimulus. Furthermore, people out there worry about the future. Thus, the models we use take into account that forward-looking households and firms will modify their expectations and change their behaviour in response to the new fiscal policy measures.

Finally, at least some people out there realise that higher government spending and debt today ultimately require raising more taxes in the future. Such households will consume less today....

In light of these findings, European policy makers are well-advised to question the usefulness of further stimulus packages. They ought to carefully monitor the impact of decisions already taken on the burden imposed on future taxpayers. The available funds and remaining borrowing capacity should be utilised where it is still most needed � to prevent a collapse of the financial system and finance the necessary re-capitalisations and toxic asset removals. If governments exhaust their fiscal space in measures that have little aggregate effect, they will instead stimulate scepticism of their capability to back up the financial system.
Volker Wieland on Tuesday, commenting on estimates of the effects of fiscal stimulus. He argues for quantitative easing in the EU. The model uses the New Keynesian methods now popular in policy analysis (for one small example, see this paper on their use in Armenia.) While CBO does not project the Fed funds rate, it does foresee a 4% T-bill rate average for 2012-2015 (as do OMB and the Blue Chip consensus.) I do believe that looking at T-bill futures will help us see which story is right. As for now, it's August 2010 before the market expects Fed funds to get above 1%.