Zombie Keynesians!

Greg Mankiw discusses the Obama administration economic policies at length, treating them as standard Keynesian prescriptions. I thought Keynesian economics had been refuted decisively by the 1970s, since the Keynesian policies of Nixon, Ford, and Carter led to stagflation. But Keynesianism is not dead; it has risen, zombie-like, as if out of a 1970-s horror movie. A decade of stagflation following the “increase spending” model; thirty years of prosperity following the “tax cuts” model; and the administration goes with spending.

Finally, economists are catching up:

Textbook Keynesian economics tells us that government-purchases multipliers are larger than tax-cut multipliers. And, as we have seen, the Obama administration’s economic team consulted these standard models in deciding that spending would be significantly more effective than tax cuts.

But a great deal of recent economic evidence calls that conclusion into question. In an ironic twist, one key piece comes from Christina Romer, who is now chair of Obama’s Council of Economic Advisers. About six months before she took the job, Romer teamed up with her husband and fellow Berkeley economist David Romer to write a paper (“The Macroeconomic Effects of Tax Changes”) that sought to measure the influence of tax policy on GDP. Crucial to the Romers’ method was their effort to identify changes in tax policy made during times of relative economic stability, and driven by a desire to influence economic behavior or activity (to encourage growth, say, or reduce a deficit), rather than those changes made in response to a recession or crisis. By studying such “exogenous” tax-policy changes, the Romers could be more confident that they were in fact measuring the effects of taxes and not those of extraneous conditions.

The Romers’ conclusion, which is at odds with most traditional Keynesian analysis, was that the tax multiplier was 3 ā€” in other words, that every dollar spent on tax cuts would boost GDP by $3. This would mean that the tax multiplier is roughly three times larger than Obama’s advisors assumed it was during their policy simulations.

…But several studies on government-spending multipliers have been conducted using techniques similar to those used by the Romers. And none has found government-spending multipliers to be so large as to justify assumptions about the inherent superiority of government spending over tax cuts.

Some excellent work on this topic has come from Valerie Ramey of the University of California, San Diego. Ramey finds a government-spending multiplier of about 1.4 ā€” a figure close to what the Obama administration assumed, but much smaller than the tax multiplier identified by the Romers. Similarly, in recent research, Andrew Mountford (of the University of London) and Harald Uhlig (of the University of Chicago) have used sophisticated statistical techniques that try to capture the complicated relationships among economic variables over time; they conclude that a “deficit-financed tax cut is the best fiscal policy to stimulate the economy.” In particular, they report that tax cuts are about four times as potent as increases in government spending.

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