Another day at the fiscal dentist... without anaesthesia

What's the effect of fiscal policy during a downturn? Somewhat to the embarrassment of the profession, economists only agree that multipliers are somewhere between zero and infinity. In a bid to make at least someone happy, the new Spanish government has decided to find out just how contractionary fiscal consolidation in the middle of a crisis can be -- tax just went up, from one day to the next, by as much as 7 percentage points at the top (and the tax rises kick in pretty quickly). Then there are more spending cuts, amounting to several billion in expenditure per year. What is the likely result going to be? Here is my guess -- Spain is going to repeat some of the Greek experience. Growth - already negative as of late 2011 - will slump. The huge tax hike will hardly produce any extra revenue (and forget about the idea this is just temporary, for two years. If you have to make a mistake, make it for a long time). As in Greece, the absolute deficit will hardly fall at all as economic activity collapses even more quickly than forecast. Remember that Greek ABSOLUTE deficits in euros hardly declined in recent years, despite very large rate hikes. There may be some good economic logic behind it, too. Gautti Eggertsson of the Fed in NY and co-authors have a new paper on public debt dynamics and tax and spending multipliers. They offer a strong argument for why - in the presence of a zero bound on interest rates - raising taxes in a slump may cause particularly large contractions. In their calibration exercise, multipliers are particularly big when tax hikes and expenditure cuts are not accompanied by interest rate reductions. This continues earlier work that Gautti has done with Paul Krugman on debt and deleveraging in a crisis... I wish I could say they were wrong, but I fear they may be spot-on.

Spain keeps shrinking

Spain is much in the headlines these days. Markets worry about the PIGS (Portugal, Ireland, Greece, and Spain) not being able to meet their obligations. Paul Krugman has been pointing out that the cases are very different -- that Greece lied and cheated its way into EMU is well-known, as is the fact that its fiscal policies have been utterly irresponsible for as long as anyone can remember. Spain, on the other hand, had a surplus not that long ago, and its overall debt is still less than Germany's. The problem is not fiscal recklessness, but a massive real appreciation following EMU that left the economy largely uncompetitive on world markets. Institutions - labor market institutions in particular - are not up to dealing with this kind of problem, and the time-honored solution of the good old peseta days (devaluation) is no longer on the table. Now, news from the last quarter of 2009 shows that in contrast to almost all other OECD countries, Spain is still shrinking. I was particularly amused to see the folks over at Marketwatch reporting that

"Analysts at Capital Economics said Thursday's GDP data backs up the theory that a return to solid and unsustainable growth in Spain is unlikely anytime soon."

As typos go, this one is just wonderful. I am sure they meant sustainable, but... there is so much that was utterly unsustainable about the boom in the last 10 years that one doesn't even know where to start. Building houses that nobody wants to live in, at prices no-one is willing to pay, is my #1 on the list. It also sums up nicely the problem -- the old growth model post-1999 won't work, and there is not much of an alternative in sight. The government keeps saying R+D will pull Spain out of the crisis, but that is like Greece saying that a closer look at its national accounts show a massive surplus.
This relates to another of this week' highlights: Tim Kehoe was giving here on Tuesday, giving a talk at the Barcelona GSE about lessons from the Great Depressions of the 20th century for the Spanish financial crisis. He compared Chile to Mexico, and (not entirely surprisingly) blamed divergent fortunes on the ill tidings brought by wrong-footed government intervention in the latter. A case that is not in the book that he edited with Prescott, which I think could have provided a more appropriate analogy, is interwar Britain. Britain re-entered the gold standard in 1925 at an overvalued exchange rate, hoping that the currency regime would provide "discipline" for the last 10 percent of factor cost adjustment vis-a-vis the US. Instead, it got sub-par growth while everyone else enjoyed the roaring twenties... By Kehoe's reckoning, Spain's unit labor costs are now about 135% of their 2000 level, while Germany's are at 110%. While unions were powerful in interwar Britain, I am sure they are more powerful in Spain today. There is none of the grim determination to regain competitiveness that I saw in Germany over the last 20 years, after the reunification boom and debt orgy produced a sharp decline in competitiveness. My sense is that a lost decade or two for Spain are beginning to look more likely by the day. And who knows? When Tim Kehoe presents the Catalan edition of his book in a few years (he actually speaks Catalan), there may be a chapter in it on the Spanish depression of 2008-2018.

more crisis round-tabling...

If nothing else, the financial crisis seems to have created a lot of demand for people to sit around round or square tables, and to debate in front of their peers. I am on this afternoon at the Barcelona Trobada, the local version of the all-UC meetings in California. The session chair, Jordi Gali, gave us some homework to make sure we all come prepared:

1. In your opinion, what has been the impact of the crisis on:

(i) how the outside world perceives economists and economic research?

(ii) how you perceive the value of economic research?

2. Do you think the economics profession deserves part of the blame for

the great financial crisis as some (even famous colleagues) would claim?

So I did some background reading, from revisiting the "famous" Krugman piece to the now infamous "Crisis? What crisis?" papers by Chari, Christiano, and Kehoe. The latter's abstract is worth reproducing:

Facts and Myths about the Financial Crisis of 2008
Patrick J. Kehoe - Monetary Advisor
V. V. Chari - Consultant
Lawrence J. Christiano - Consultant

The United States is indisputably undergoing a financial crisis and is perhaps headed for a deep recession. Here we examine three claims about the way the financial crisis is affecting the economy as a whole and argue that all three claims are myths. We also present three underappreciated facts about how the financial system intermediates funds between households and corporate businesses. Conventional analyses of the financial crisis focus on interest rate spreads. We argue that such analyses may lead to mistaken inferences about the real costs of borrowing and argue that, during financial crises, variations in the levels of nominal interest rates might lead to better inferences about variations in the real costs of borrowing. Moreover, we argue that even if current increase in spreads indicate increases in the riskiness of the underlying projects, by itself, this increase does not necessarily indicate the need for massive government intervention. We call for policymakers to articulate the precise nature of the market failure they see, to present hard evidence that differentiates their view of the data from other views which would not require such intervention, and to share with the public the logic and evidence that burnishes the case that the particular intervention they are advocating will fix this market failure.

Some economists, when faced with diatribes like Krugman's, sound a bit like General Buck Turgidson. When scolded by the President about the fact that despite the "human reliability program", an air force general ordered his wing of nuclear-armed B-52's to attack the Soviet Union, Turgidson says:

Well, I don't think it's quite fair to condemn the whole program because of a single slip-up, sir!

Having said that, I think I will talk a bit about unreasonable expectations -- why the public thinks its a good way to measure the value of economics in terms of predictive power, and why that makes little sense.

Noisy business cycles

If you read the Krugman piece in the NYTimes, and think that macro has becoming a field of warring tribes with nothing to say to each other... you may be more right than I would like, but it doesn't mean that there is no way to heal the breach. At the CREi seminar this Monday, Marios Angeletos gave a talk on Noisy Business Cycles (forthcoming in the NBER macro annual). The paper marries many elements of real business cycles (RBC) models with noise about the state of the aggregate economy. Because agents do not know how the economy is doing overall, even very small technology shocks can translate into large aggregate fluctuations. The result is an economy that has a strong RBC flavor, but behaves in a Neo-Keynesian way -- noise is going to look like demand shocks. I normally don't as much out of theory papers as I would like, but this one was so clearly presented that I wished we had had another 30 minutes to see some of the applications and extensions...