Working Papers

Single-Issue Forecasting Tragics

Don Harding has a great piece on economic forecasting in today’s Australian:

In the future there will continue to be financial crises and recessions, all of which economists, bankers, finance gurus, bureaucrats, politicians and the public will fail to predict.

To be sure there will be some who claim predictive success… Most will be single-issue tragics who predict the next calamity in the same way that I, an Essendon tragic, successfully predicted their win over St Kilda in round 20 by predicting that Essendon would win every match. The only information in such predictions is about the tragics who make them.

Harding also notes the appalling state of the debate over fiscal stimulus in Australia:

Public policy standards are so low in Australia that my expectation is that we won’t get well-researched, evidence-based answers to these questions from either the bureaucrats or the politicians.  Instead we will get spin, vitriol and blame shifting.

Here’s a suggestion for the FOI desk at The Australian: request all the materials that form the basis for the Treasury’s estimates of the impact of fiscal stimulus on economic growth and employment.

posted on 01 October 2009 by skirchner in Economics, Financial Markets, Fiscal Policy

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‘You Will Not Ask Me Any Questions’

Academics speaking truth to Doug Cameron at the Senate Economics References Committee:

Senator CAMERON—Who would want an academic running the economy? I said that this morning and the more I hear from academic economists the more I believe that it would be a fatal mistake.

Prof. Makin—Ben Bernanke is an ex-academic economist and he seems to be getting a lot of credit for what he has done.

* * *

Senator CAMERON—Do you believe the government has made any positive economic decisions since it has come to power?

Prof. Davidson—Yes. The government delivered on the tax cuts that were promised by the Howard government.

Senator CAMERON—Is there anything else?

Prof. Davidson—The government scrapped the Fuelwatch scheme.

Senator CAMERON—Is there anything else?

Prof. Davidson—The government scrapped the GroceryWatch scheme.

* * *

Senator CAMERON—Are you seriously putting to this inquiry that the federal government should play no role in investing in the nation’s road infrastructure?

Prof. Davidson—I am putting it to you that if you wanted to build roads that you would give the money to the states and allow the state governments to make decisions as to what roads they wish to build.

Senator CAMERON—That is an interesting point of view!

Prof. Davidson—We have a constitution that actually has states that make decisions about these things. You do represent the states, don’t you?

Senator CAMERON—I am here to ask the questions, not you.

Prof. Davidson—Actually, I am a taxpayer. I will ask questions too.

Senator CAMERON—You will not ask me any questions.

posted on 25 September 2009 by skirchner in Economics, Fiscal Policy, Politics

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The Tax Cut that Could Have Been

How much of a tax cut could you get for $97 billion in federal fiscal stimulus spending?  Alex Robson does the sums.  Of course, from a Ricardian standpoint, a temporary and unfunded tax cut should be no more effective in stimulating activity than a temporary and unfunded increase in government spending.  However, it does have the advantage that whatever spending does occur out of the tax cut is on things people actually want, rather than projects the government thinks we need, while the private sector also gets to allocate any increase in saving. 

posted on 18 September 2009 by skirchner in Economics, Fiscal Policy

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Minsky Remembered

Eric Falkenstein recalls Hyman Minsky:

I was Minsky’s TA while a senior at Washington University in St.Louis in 1987, and took a couple of his advanced classes, which regardless of the official name, were all just classes in Minskyism. He was a maverick, but perhaps a bit too much, being a little too dismissive of others, as he hated the traditional Samuelson/Solow Keynesians as much as the Friedmanite Monetarists. He always thought a market collapse was just around the corner…

Most articles celebrating Minsky have a strong subtext, kind of like Krugman’s wistful remembrance of his undergraduate macro based on the General Theory, that if we only go back to the days when Nixon famously said ‘we are all Keynesians now’, we would have more faith in government top-down solutions. That was when Federal spending was 30% of GDP. Now it’s 40%. Economists did not abandon Keynesianism because they are capitalist dupes, rather, it was inconsistent, generated poor models of economic growth, and it neglected the micro economic factors that make all the difference between a North Korea and South Korea: free markets, property rights, decentralized incentives. A Keynesian thought he could steer the economy via two controls, the budget deficit and the Fed Funds rate, and indeed in the short run these are very powerful tools, but in the longer run, rather unimportant.

It is reassuring that the critics of mainstream macro have nothing better than Minsky to turn to, but still no less excusable.

posted on 16 September 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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The Political Psychology of Activist Fiscal Policy

David Hirshleifer ponders the loaded character of the language behind activist fiscal policy:

Regardless of who’s right on the economics, clearly the ‘stimulus’ language captures the pro side perfectly, and the con side not at all. Indeed, the term immunizes the mind to opposing evidence…

So, here’s a political psychology question. Why did opponents gullibly swallow the stimulus terminology, and thereby defeat?

The antidote to the loaded language of activist fiscal policy is to draw attention to the government’s inter-temporal budget constraint.  Few people would regard the announcement of a $42 billion future tax increase as ‘stimulatory’, but that is exactly what the federal government’s unfunded fiscal stimulus package amounts to in the absence of an explicit commitment to future cuts in government spending.

(HT: Don Boudreaux)

posted on 08 September 2009 by skirchner in Economics, Fiscal Policy

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The Welfare Costs of Federal Infrastructure Spending

Henry Ergas and Alex Robson highlight the welfare costs of federal infrastructure spending:

Australian Government spending on infrastructure projects has increased rapidly in recent years, and especially so over the course of 2009. In this paper, we examine the processes for project evaluation, in the light of the Government’s commitment, in the 2008-09 Budget, to “(infrastructure) decision making based on rigorous cost-benefit analysis to ensure the highest economic and social benefits to the nation over the long term .. (and to) transparency at all stages of the decision making process.” We find that contrary to this commitment, significant projects have been approved either with no cost-benefit analysis or with cost-benefit analysis that is clearly of poor quality. Moreover, despite the commitment to transparency, very little information has been disclosed as to how most projects were evaluated.

To better assess the quality of project evaluation, we examine the largest single project the Commonwealth Government has committed to – the construction of a new National Broadband Network – and find that in present value terms, its costs exceed its benefits by somewhere between $14 billion and $20 billion dollars, depending on the discount rate used. We also find that it is inefficient to proceed with the project if its costs exceed $17 billion, even if the alternative is a world in which the representative consumer cannot obtain service in excess of 20 Mbps and even if demand for high speed service is rising relatively quickly. This amount of $17 billion is well below current estimates of the costs the NBN will involve, especially if (as the Government has pledged) the NBN is to serve non-metropolitan areas.

posted on 02 September 2009 by skirchner in Economics, Fiscal Policy

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Resolving Equity and Bond Market Divergence

Richard Cookson suggests two scenarios for the resolution of the current episode of equity and bond market divergence:

The benign argument for bond yields (and equities) revolves around supply.  Many pundits and investors have been in a lather about the vast quantities of debt that governments have to issue. But if an unexpected mountain of supply raises the risk premium that investors demand for holding longer dated paper, the opposite is also true: supply that becomes less Everest-like than feared would reduce it.

So the benign explanation for why bond yields have been falling even as equity markets have been rallying is that worries about the surge in government bond issuance are lessening as signs of recovery mount.

That in turn should lead to a fall in government issuance and thus long-term yields, especially since inflationary pressures (apart perhaps from the UK) are so muted and yield curves so steep by historical standards.

And if that’s right, lower government bond yields would increase the appeal of riskier assets, equities included.

Effectively, the ex ante equity-risk premium would be driven higher because the long-term risk-free rate, but not the growth rate, would be lower.

Sadly, there’s also an altogether more malign explanation. Much as was the case in Japan in the 1990s, it could be that low government bond yields are telling you that this recovery is unsustainable once the monetary and fiscal medicine wears off.

It could be saying that, thanks to the required private sector deleveraging, especially in the US and UK, the long-term potential growth rate of the developed world is much lower than it was. That would lead to a sharply lower ex ante equity risk premium and thus  potentially dreadful returns from equities.

Unfortunately, another lesson from Japan in the 1990s is that the world’s lowest bond yields can co-exist with the world’s worst fiscal policy outcomes.  This makes the first of Cookson’s scenarios less plausible.  We are more likely to end up with whatever is behind door number two.

posted on 01 September 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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More Survey Evidence for Ricardian Equivalence

Andrew Leigh uses survey evidence to estimate the amount by which the 2009 fiscal stimulus payments boosted spending in Australia.  The cross-sectional variation in the spending rate finds evidence in favour of Ricardian equivalence:

The third variable tabulates the spending rate against respondents’ degree of worry about government debt. This is a loose test of Ricardian equivalence – the theory that consumers will only spend a payment if it is accompanied by a reduction in government expenditure. Respondents who are more worried about government debt (and therefore perhaps more concerned that government payments now will lead to tax increases in the future) are significantly less likely to spend the rebate. For example, only 25 percent of respondents who are very worried about government debt spent the rebate, as compared with 46 percent of respondents who are not at all worried bout government debt. This difference remains significant even in a multivariate regression.

The survey results find that just under 60% of respondents save the payments/paid off debt, while 40.5% claim to have spent it. Leigh suggests this points to a marginal propensity to consume out of the stimulus of 0.41 to 0.42.  However, he also notes an obvious limitation of the Australian survey data:

the US questions asked respondents whether the rebate would lead them to increase spending, while the Australian question asked respondents whether they would spend the money. In theory, Australian respondents who did not think that the money would increase their overall spending might nonetheless have told the interviewer that they would spend it, if they thought that the question related to cash flow rather than net expenditure.

Because stimulus payments are fungible with other income, the survey question does not directly address the issue of whether recipients increased their overall spending.  This problem also afflicts the Westpac-Melbourne Institute survey noted by Leigh.  The ANU survey results may therefore overstate what is already a low MPC.

Meanwhile, Peter Garrett discovers the marginal propensity to import.

posted on 27 August 2009 by skirchner in Economics, Fiscal Policy

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Anchoring Fiscal Expectations

Eric Leeper argues that expectations for fiscal policy are as important as those for monetary policy.  Leeper points to ‘an egregious example of non-transparent fiscal policy’:

the recent $787 billion American fiscal stimulus plan. Leading up to the introduction and passage of the American Recovery and Reinvestment Act, the entire economic rationale for thestimulus package consisted of the job creation prediction in a document by Romer and Bernstein (2009).  The document claims it “suggests a methodology for ensuring the package contains enough stimulus. . . [to] create sufficient jobs to meet the Presidentelect’s goals [p. 2].” An appendix reports multipliers for a permanent increase in government spending and decrease in taxes of 1 percent of GDP. Four years after the initial stimulus, government purchases raise GDP by 1.55 percent, while tax cuts raise GDP by 0.98 percent. Sources for these numbers are reported as the Federal Reserve’s FRB/US model and “a leading private forecast firm.”

To assess how this rationale for stimulus measures up in terms of transparency, I raise some questions that are not addressed in the Romer-Bernstein document, but are important for anchoring fiscal expectations:

• What are the economic models underlying the multiplier numbers and are those numbers reproducible?
• Why consider permanent changes in fiscal variables when the Act makes transitory changes?
• What are the consequences of the stimulus for government debt?
• What are the repercussions of significantly higher government debt?
• Will the debt run-up be sustained or retired?
• How will policies adjust in the future to either sustain or retire the debt?
• What “methodology” does this document suggest for gauging the necessary size of fiscal stimulus?

Some might accuse me of finding a straw man to ridicule. But this is an important example because of its potential impact on the world economy.

The same questions could be asked in the Australian context.

Robert Carling and I make a similar case for rules-based fiscal policy here.

posted on 25 August 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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Stimulus Skeptics

I’m quoted in a story in The Australian today on the effectiveness of fiscal stimulus.  As I noted in this post, if we are to accept the proposition that fiscal stimulus has been effective in supporting demand, then this implies that monetary policy has had less work to do and that interest rates have been higher than they otherwise would have been.  To be clear, that is not my view, but it is where the logic of the pro-stimulus camp must lead.  In that case, all fiscal stimulus has done is trade-off monetary for fiscal easing.

Kevin Hassett has noted the same inconsistencies in the discussion of fiscal policy in the US:

Democrats opposed the Bush tax cuts from the beginning not because lower marginal tax rates are bad, but rather, because they believed they would lift deficits and interest rates.

The interest-rate effect is so large, goes this line of reasoning propounded by disciples of the “Rubin school,” that the net effect of tax cuts would be harmful.

But now we hear that we can adopt the Obama health-care plan, increase an already massive deficit, and it will be no problem. But if raising taxes can reduce deficits and spur the economy, then cutting spending should do that too. So why are we increasing spending yet again? Democrats have no answer…

The fact is, deficits are a problem precisely because politicians can get away with running them with near impunity. If interest rates did soar in the face of deficits, it would provide a constraint on the growth of big government.

Sadly, there will be no such constraint.

posted on 19 August 2009 by skirchner in Economics, Financial Markets, Fiscal Policy

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Demand is Not Supply

Asked about the effectiveness of discretionary fiscal stimulus measures, RBA Governor Stevens told the House Economics Committee on Friday that:

we believe that the fiscal measures have supported demand and, therefore, at least to some extent, output.

The distinction was probably lost on members of the Committee, but is nonetheless an important one.  Demand can be met out of imports and inventories, without boosting domestic production.  This is why indicators like retail sales are entirely inappropriate as a measure of the effectiveness of fiscal policy.

Some remarkably good questioning from Liberal MHR Scott Morrison also flushed out some more of the Governor’s position on using monetary policy to target asset prices:

One view, the Alan Greenspan view, is you cannot know it is a bubble until it has burst, so you should not do anything much, and then you should clean up the mess once it has burst… I personally would not want to commit to saying, ‘We’re definitely never going to pay attention to asset prices and totally ignore them.’  That has been shown to be a mistake, basically. But nor do I think it is our brief to aggressively chase down asset things that pop up here and there that we might personally find hard to accept or agree with, at the expense of other things that we have as our objectives. So I think that, into the future, it is going to be a matter of judicious, careful use of our instrument in trying to meet all these worthy goals—keeping in mind as well that there is a whole separate debate about other tools that might be applied to booms and busts and asset prices. That is a whole separate section of this debate—what tools could be used by the supervisory authority to rein in the lending.

In fact, no one has ever suggested that asset prices should be completely ignored.  Greenspan explicitly rejected this proposition in his 1996 ‘irrational exuberance’ speech.  The issue is whether asset prices should have a weighting in the central bank’s reaction function that is independent of the inflation forecast.

Stevens can at least be thankful he does not have to appear before the US Congress:

Far from deference, Mr. Bernanke’s recent testimonies have been treated with all the delicacy usually reserved for a mob boss.

posted on 17 August 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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Where Your Taxes Go

Read and weap.

posted on 30 July 2009 by skirchner in Economics, Fiscal Policy

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A Carling-Kirchner Ticket?

Robert Carling and I have an op-ed in today’s Australian on our proposals to reform Australia’s federal fiscal responsibility legislation.

Henry Thornton’ responds:

Pardon my cynicism, but I see Australia as a long way from establishing another “self-binding” system, one that enforces long-term economic rationality on the government of the day.

Carling and Kirchner might consider offering themselves for election at the next federal election, and see how enthusiastically this plan is embraced by the voters.

Thornton underestimates voters.  There is a reason Kevin Rudd claimed to be a fiscal and economic conservative when running for office.  The federal opposition now campaigns on debt and deficits because it thinks it will play well with voters. 

Our proposal offers a framework through which politicians could make a credible commitment to fiscal responsibility, so that voters would no longer need to rely on politicians promises in relation to fiscal policy. 

The idea of linking politicians pay to fiscal performance is also likely to be popular, not least because politicians have long argued that private sector pay should be tied to performance.  As Mark Latham demonstrated in relation to parliamentary superannuation, if a major party were to run with our proposal, it would be very hard for the other side of politics to argue against it.

posted on 15 July 2009 by skirchner in Economics, Fiscal Policy

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Monetary versus Fiscal Stimulus

Tony Makin, on the relative effectiveness of monetary and fiscal stimulus:

dramatically easier monetary policy has probably done more for the Australian economy than fiscal policy. A less modest, or perhaps more independent, Reserve Bank would take more credit for this.

Tony makes an important point.  The RBA’s very low public profile relative to the very noisy fiscal stimulus efforts of politicians is skewing perceptions of the relative importance of these two arms of macro policy.

It was not that long ago that many economic commentators were talking of a direct trade-off between fiscal and monetary policy.  Tax cuts and smaller budget surpluses, we were told, would lead to higher inflation and interest rates.  This argument never had much merit, not least because the actual (as opposed to the forecast) fiscal impulse was simply too small to matter very much for the economy.  The former government put in place some of the tightest fiscal policy settings since the early 1970s. 

By contrast, the current government has put in place an unprecedented fiscal easing of 4.4% of GDP in a single financial year.  The RBA’s statements on monetary policy suggest that it believes that fiscal stimulus is supporting economic activity (in sharp contrast to previous years, in which fiscal policy was rarely even mentioned).  This would argue against reductions in interest rates at the margin, even if it is based on an exaggerated view of the effectiveness of fiscal policy.  The proponents of discretionary fiscal policy can’t have it both ways.  If activist fiscal policy is thought to be effective, there is less work for monetary policy to do in supporting activity and official interest rates will be higher than in the absence of a discretionary fiscal easing.

posted on 14 July 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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New CIS Policy Monograph: Fiscal Rules for Limited Government

Robert Carling and I have released a new CIS Policy Monograph, Fiscal Rules for Limited Government: Reforming Australia’s Fiscal Responsibility Legislation.  The paper makes the case for a rules-based framework for fiscal policy to replace the Charter of Budget Honesty, as well as the establishment of a new Fiscal Commission to increase the independence, transparency and accountability of the federal budget process.

There is a write-up in the SMHJulie Novak makes a similar case in The Canberra Times.

posted on 09 July 2009 by skirchner in Economics, Fiscal Policy

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