Economists Do It With Models

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When Economics And Politics Collide, Crowding Out Edition…

March 2nd, 2010 · 5 Comments
Macroeconomics · Policy

In addition to teaching economics, I often find myself having to make a pitch for why it’s important to understand economics in the first place. One of the reasons I usually give is something along the lines of “so you don’t have to take on faith what politicians have to say about policy choices.” I mean, how many times have politicians tried to say that they were going to save consumers from the evil oil companies by imposing taxes on the oil companies rather than on consumers?* People who paid attention in their economics classes know better.

* In case you don’t remember, the burden of a tax ends up getting shared by consumers (in the form of higher prices inclusive of the tax) and producers (in the form of lower prices net of the tax) regardless of who the tax is placed on from a logistical perspective. In practice, there may not be perfect equivalence, but it’s not really possible to have taxes affect one side and not the other.

Nowadays, I feel like I have to take that argument one step further and say that people need to understand economics so that they are aware of economists’ lack of consensus, at least in macroeconomics, and calibrate what they read and hear appropriately. (If you are not familiar with the ideological divides in macroeconomics, Paul Krugman does a decent job of getting people up to speed. And yes, I get that Krugman is not the most objective writer ever, but his description in this case seems to be reasonably fair.) At the heart of the current debate is whether government spending can actually stimulate the economy out of the recession that it’s currently in. (To the best of my knowledge, it is merely a coincidence that the sides of this debate roughly line up with the ideologies of the major political parties in the United States.) More specifically, some economists believe that government spending does result in more jobs overall, and others believe that government spending is wasteful in that it crowds out jobs that would otherwise be offered by the private sector, thus creating few, if any, new jobs overall and artificially diverting resources from their best uses. (The way that this crowding out could happen is via interest rates, and it’s a tad more complicated that I would like to get into here.)

For example, consider the cartoon posted a few days ago on (the appropriately named) Cafe Hayek:

(For the record, I do love the comments on that post that suggest how the cartoon could be made more accurate. For example, one commenter suggests that Obama’s blanket should be smaller than the part that is missing from the other dude’s sweater.) Economist Dave Prychitko even calls this “One of the best economics cartoons I’ve seen in years.” So where’s the problem?

The problem lies in the fact that the economists on the other side of this ideological divide don’t seem to be finding evidence of this crowding out phenomenon. At least Brad DeLong and Menzie Chinn don’t:

Crowding out has a strong hold on many people’s imagination. Some equate crowding out in the financial market with crowding out in the real side of the economy. Let me make a couple observations on why this simplistic equation need not hold. First, the empirical magnitude of investment crowding out depends critically on the interest sensitivity of investment expenditures. Second, if investment depends upon the change in GDP, as in a simple accelerator model (see a discussion of competing investment models here), then government spending that induces an increase in GDP can result in higher investment, despite an increase in interest rates.

(Prof. Chinn’s original article can be found here. It’s a bit more technical than I would like for this sort of forum, but it has some nice graphs.) So far I would give the advantage to DeLong/Chinn, for using actual data if nothing else. But wait, there’s more…

Steve Landsburg summarizes Robert Barro’s analysis of the stimulus effects in the Wall Street Journal in a handy table:

Hm. So the negative impact on private spending indicates crowding out…but the fact that the negative impact is less than the government spending implies that there isn’t total crowding out…but in the long run it’s a different story, since over time the negative impact on private spending is larger than the positive amount of government spending. Landsburg is very clear about what he supports about this analysis and what gives him pause, so his is a particularly good article to read.

So this leaves me at advantage…confusion? I think Barro’s analysis is very solid, but it’s still based on a lot of assumptions that may or may not be accurate. (When you assume, you make an ass out of u and…ok, I will stop now.) It’s also a little convenient that all of these analyses line up with their authors’ previously held ideologies. Nevertheless, I think I’ve made my point that issues such as these are not open and shut cases and thus shouldn’t be treated as such. I remember one year on the first day of teaching undergraduate macroeconomics, Greg Mankiw pointed out to his students that he found macroeconomics to be more interesting than microeconomics because there were more unanswered questions to be had. Well, he’s at least right about the latter part.

Tags: Macroeconomics · Policy

5 responses so far ↓

  • 1 Brian // Mar 2, 2010 at 4:50 pm

    Once real income is rising and unemployment declines (a lagging indicator, i know) we can start to talk about crowding out in the macroeconomy.

    All these groups in the private sector who are so angry about the government need to take a short run view rather than the long run. In the long run, yes a government owned FoP may be a bit too much for the free market junkies to take.
    But, a stat I heard, stop me if you’ve heard this one before, is that banks have only dealt with resolving only 1% of the subprime loans. In dealing with the rest of the loans, in either reducing principal borrowed or interest rates, the banks ( and the rest of us) may be in for more of a rough ride.

    I realize this is hardly academic and nowhere near how I want to sound as a future economist. But, I’m not sure we are where we want to be as a country/macroeconomy just yet.

  • 2 Kirk // Mar 2, 2010 at 8:51 pm

    It is easy to come up with a negative projection for GDP for any given year if you assume an increase in taxes, which even Keynes would certify as a negative multiplier to GDP. The devil in these projections is not surprisingly in their details as the government will admittedly raise taxes, the question remains in what proportion to GDP will those taxes be increased before one could even estimate the net change to GDP over that period. That said the crowding out effect of investment has always bothered me with respect to the capital being created was not in government hands, and could very possibly be in use after the government subsidies have waned. Is that still useful capital equipment to not be considered positive to GDP even though the direct revenue from fiscal policy is no longer the principal source of revenue?

  • 3 PeterM // Mar 2, 2010 at 9:07 pm

    This is a nice summary, but more importantly, you pointed out that economic analysis often follows general political ideologies. (Though not always — DeLong the other day largely agreed with Prof. Tabarrok at Marginal Revolution about the bad effects that could come about from a dual labor market composed of government insiders and outsiders.)

    It is sad, though, to read academics spooning the same old hash from certain “foundations” (which are funded by politically inclined groups.) I’m trying to be polite, but I think you know who the usual suspects are.

  • 4 ArL // Mar 3, 2010 at 6:39 am

    Just to clear up mortgage information since it always seems to be a hot topic.

    Somewhere between 20-30% of subprime mortgages have been modified to date. Somewhere around 40% of remaining subprime mortgages are still current, and a better than average number of these have never missed a payment.

    The real problem for the housing market is the mounting foreclosure pipeline from unemployed Prime borrowers, stated income Alt-A borrowers (Liar Loans), and NINJA borrowers (No Income No Job). If the government can continue to force servicers to smooth this inventory overhang, through HAMP, and subsidized modifications, back into the market it’s possible to have a slow recovery in housing.

    Additionally the current measure of regional housing prices, Cash-Schiller, is at present predominantly expressing the price of distressed sales, which are in general far below the level a voluntary seller can transact. Unfortunately this price metric tend to feed all the models built by banks and money managers.

    Because of the reckless accounting standards adopted by FASB in 2003, and 2007, these models are wrecking havoc as they can only make extrapolations on data that is questionable at best.

  • 5 Stephan // Mar 3, 2010 at 11:44 am

    In general this blog entry is very balanced, but I strongly disagree in regard to Robert Barro. First of all in every recession (minor or major) he’s essential saying the same thing although there’s no empirical evidence for it.

    In August 1981 after the US Congress gave out large tax cuts he predicted consumption would not rise. Why? Of course because of crowding out People would save more to “pay for the future tax burden”. The actual data shows that personal saving rate fell between 1982-84.

    Now he’s back again with his “predictions”. These Barro “predictions” rest on the assumption of Ricardian Equivalence, which is his obsession because it’s his major “finding”. Plus because this time because it’s a SUPER major recession he dreams up some extreme numbers.

    Just in the Feb. 2010 Report from CBO the assumptions for Ricardian Equivalence were ridiculed:

    “Although some analysts favor the rigor of that approach
    to modeling behavior, other analysts view the assumptions
    underlying households’ and businesses’ decisionmaking
    in those models to be unrealistic and leading to
    unrealistic predictions. In particular, this type of model
    generally assumes that people are fully rational and
    forward-looking, basing their current decisions on a full
    lifetime plan. The extreme version of the forward-looking
    assumption implies that people expect to eventually pay
    for any increased government spending or reduced revenues
    in the form of future tax increases and that they
    incorporate those expected payments—even if far in the
    future beyond their lifetime—into their current spending
    plans. Thus, they are assumed to reduce their consumption
    when government spending rises, because their lifetime
    income and that of their heirs has fallen by the
    amount of the eventual taxes. For the same reason, cash
    transfer payments and tax refunds have little or no effect
    on current consumption in such models. People in the
    models generally also have full access to credit markets, so
    they can borrow to maintain their consumption when
    faced with a temporary loss of income. This class of models
    does not typically incorporate involuntary unemployment:
    People can work as many hours as they choose at
    the wage rate determined by the market. Finally, in these
    models, monetary policy usually follows a fixed rule by
    which increased output or inflation implies higher real
    (inflation-adjusted) interest rates.”

    The numbers he dreams up for his “analysis” are: a spending multiplicator of 0.4 for the first year and 0.6 over two years. And a tax multiplier of 1.1 He constructs a doomsday scenario he seems to wish for. Plus given the absurd idea of crowding out is true, the question remains why there’s now crowding out in line 3 of his table?

    Barro is an ideologue, who refuses to recognise what is happening in the real world.

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