Wednesday, December 5, 2012

Are Fiscal and Monetary Policy Both Ineffective?

Tyler Cowen asks us to ponder the following sentences:
This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010.  Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures.
Those sentences are from prominent Market Monetarist and NGDP Targeting proponent David Beckworth. His conclusion based on the above graph and a similar one depicting the declining budget deficit is that:
Both figures seriously undermine the argument for coutercyclical fiscal policy and suggest a very a low fiscal multiplier.  They also indicate that the Fed has been doing a remarkable job keeping NGDP growth stable around 4.5%. Monetary policy, in other words, appears to be dominating fiscal policy in terms of stabilizing aggregate demand growth.
Trying to find support for Beckworth’s claim, I thought a brief look at how changes in the money supply over the past couple years compare with NGDP might do the trick. Here’s what I found:
The above chart shows that NGDP has been largely unaffected by both severe tightening and expansion of monetary policy since 2010. Looking at M2 versus NGDP growth displays a similar story:
Both charts suggest that changes in the money supply have little impact on NGDP growth. Given that percent changes in either money supply measure are far greater than those of recent fiscal policy, one might conclude that monetary policy has a smaller multiplier than fiscal policy.

Based on the above charts, which conclusion should we accept? Or are both fiscal and monetary policy ineffective? The reality is that all of these charts tell us very little about the causation between either fiscal or monetary policy and NGDP. Noah Smith says it best:

Beckworth's conclusion is not necessarily valid, and illustrates the danger in drawing conclusions about structural variables from looking at correlations between macroeconomic aggregates. Here's why the conclusion might not be valid:
Suppose that Keynesian demand management policy works perfectly: in other words, fiscal stimulus perfectly smooths fluctuations in aggregate demand. In that case, you will observe substantial swings in fiscal policy, but no swings whatsoever in aggregate demand. When external shocks push AD up, fiscal tightening will push it back down; when external shocks push AD down, fiscal policy will push it back up.

To conclude: The graphs Beckworth shows are perfectly consistent with a large fiscal multiplier. In fact, they are perfectly consistent with the hypothesis that monetary policy is essentially ineffective, that the Fed is basically powerless, and that fiscal policy is capable of doing a perfect job of smoothing NGDP growth all on its own.
Smith’s conclusion similarly applies to the charts depicting Monetarist demand management policy. The point is that these graphs can be subjectively interpreted to support fiscal policy, monetary policy, or neither. These charts may appease proponents of the respective camps, but far more and better empirical data will be necessary to actually change any minds.  


Update: A reader asks for a chart depicting M1 versus NGDP during this period. Always trying to oblige my readers' requests:
If monetary policy affects NGDP, this chart doesn’t reflect it.

12 comments:

  1. When asked to guess between whether X has zero effect on Y, or X has been so perfectly executed as to appear to have zero effect on Y, I am pretty certain the better answer is always "X has zero effect."
    In this case, the sheer hidebound momentum of fiscal policy would seem to negate any possibility of perfect adjustment. There is a long start up cycle to government spending as well as a long feed back cycle as to movements in the economy, meaning fine adjustment is functionally impossible.

    Probably the safest claim is to say that both fiscal and monetary policy have small effects on NGDP, but those effects can be drowned out by other small effects in some cases and not in others, making them part of of the background noise surrounding larger movements in underlying fundamentals. But if I had to chose between "Zero effect" and "So perfect you can't even detect it!" I would pick the former, every time.

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  2. I also recall one claim that monetary policy was acting in such a way as to nullify fiscal policy, but I don't recall the details well... it was in some Econtalk or another.

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  3. The top diagram seems to imply that the fiscal contraction slowed the recovery.

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    1. I believe the top diagram from Beckworth was intended to show that fiscal policy has little effect on NGDP growth. However, one could interpret fiscal policy as slowing the recovery and interpret monetary policy, not shown, as boosting it. My main point was to show that these types of charts demonstrate little regarding monetary or fiscal policy, which is not to say neither has any actual impact.

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  4. While the rate of growth in Federal expenditures was rising or constant, the rate of growth in NGDP increased. Right after the rate of growth in Federal expenditures began to decrease, the rate of growth in NGDP stalled and remained at a constant level. A cursory examination of these data strongly suggests that fiscal policy was effective. But it, of course, leaves out some very important additional factors, including the rate of growth in state and local expenditures and the rate of growth in autonomous taxes.

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    1. I agree with your underlying view but am not sure this data provides a "strong" suggestion of anything. There is good reason to believe that fiscal policy CAN help the recovery, but I don't see it in these charts.

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  5. It would be intersting to see a chart using M1. M1 is the closest counterpart of the means of payment definition of money. There are good reasons to believe that the NM1M2 aggregate is reverse caused and therefore should not be expected to affect NGDP. Therefore any effect of money should show up by M1 affecting NGDP.

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    1. Sorry for the delay, but I've fulfilled your request above. While certainly open to interpretation, the chart of M1 versus NGDP seemingly fails to offer any more support for monetary policy than the previous ones.

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  6. Since there is a lot of uncertainty about the effects of both monetary and fiscal policy on NGDP, expansionary economic policy calls for diversification. So it should not be monetary versus fiscal policy. It should be mnnetary AND fical policy.

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    1. Your approach appears to imply that the benefits of monetary and fiscal policy outweigh the potential costs with certainty. I'm not sure that debate is so clear cut and might argue that balance sheet expansion by the Fed is doing more to harm the economy then help, at this point.

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  7. If you're targeting inflation, you would expect changes in the money stock and fairly flat ngdp, wouldn't you?

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    1. If you're targeting inflation, I might expect larger variations in NGDP but relatively stable inflation with changes in the money stock. This has actually occurred throughout the crisis as core-PCE (the Fed's preferred measure of inflation) never dropped below 1% or above 2% y-o-y since late 2008 (http://research.stlouisfed.org/fred2/graph/?id=WM1NS).

      To be clear, I think the Fed has significantly more ability to restrain inflation through altering interest rates than it has to create inflation through any means. I think inflation targeting allowed the Fed to retain credibility, which will be lost if NGDP targeting is pursued.

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