Stopping a Depression: Appendix

Consider this post an appendix for a forthcoming piece in Bloomberg. I share here additional graphs and notes about how the economy would have done in the absence of the increase in federal expenditure from January 2007 through January 2010. As I normally do, I will post the Excel version of my calculations under the "Data" tab.

Graph 1: Year-over-year growth in real GDP. Blue line is actual, red line is counterfactual in which federal spending is set to have no net impact on real GDP from 2007 to 2013, assuming fiscal multiplier of 1.



Graph 2: Level of real GDP, same actual and counterfactual.



Graph 3: Implied employment impact of the increase in federal spending, assuming fiscal multiplier of 1 and Okun's law parameter of 0.42. (That is, a 1 percent change in real GDP corresponds to a 0.42 percent change in the unemployment rate.)



Graph 4: Implied unemployment rate in the absence of that spending, same assumptions to construct counterfactual.



Notes:

- I estimate the employment effects based on year-over-year change in GDP. This seemed to me far more consistent with the empirical behavior of the labor market than quarter-over-quarter change. It does not bias the results, anyway.

- The 0.42 estimate came straight from the data of year-over-year change in GDP and quarterly change in the unemployment rate, using a dataset from 1948 to 2013. It's still an open question for macroeconomic research whether this parameter has changed since 1948. Ball et al. find that it hasn't. Gordon finds that it has risen. In any case, this is a reasonable estimate.

- These are only estimates for the impact of increased federal expenditure. Tax receipts also fell significantly, both as a result of automatic stabilizers and discretionary fiscal policy. That means that these are all well below the true assessment of the aggregate impact of fiscal policy.

- My sense, from doing this number-crunching, is that fiscal and monetary policy actually did stop what would have been a second Great Depression. As in, an unemployment rate in the high teens, a drop of real GDP in the range of 15-20 percent from peak. The drop in private demand was that severe. Even when one makes reasonably conservative estimates, as I have throughout these calculations, it's hard to avoid the conclusion that fiscal stabilization, complemented by monetary accommodation, saved the United States from something truly and utterly disastrous.

Which Fiscal Policy Works?

In Bloomberg, I talk with Ricardo Reis about a new paper he has written with Alisdair McKay. Reis and McKay find that relieving borrowing constraints and underinsurance are the two most important qualities of fiscal stimulus -- and that somewhat revises the dominant view of aggregate stabilization:

In a new working paper, Ricardo Reis of Columbia University and Alisdair McKay of Boston University say no. They find that stabilizing aggregate disposable income plays a “negligible role” in stabilizing the economy as a whole. Transfer payments can indeed stabilize output, they find, but mainly through a different channel -- not by changing disposable income in the aggregate, but by changing its distribution. Fiscal policy, in other words, is all about inequality.

“It’s the redistribution that has a lot of kick,” Reis said in an interview. “The usual argument for transfers is basically Keynesian. We find that has very low impact in our model.”

Reis and McKay reach this conclusion by building a complex macroeconomic model calibrated to U.S. data, but the intuition isn't all that complicated. Transfer payments yield the highest amount of stabilization per dollar when focused on people who can't effectively insure themselves against macroeconomic volatility -- namely, people with little savings to draw on and limited opportunities to borrow.

“When you look at the different programs, we find that food stamps and similar programs are really the ones that work, because they are being targeted to individuals who are up against their borrowing constraints and aren't going to work less because they are already unemployed," Reis told me. "They have very high marginal propensities to consume and are very underinsured, so it can very stimulative."

I'm looking to do more pieces on interesting economics papers -- the previous one was on the Tideman-Plassman proposal for emission bond futures -- and would definitely welcome suggestions. (Send me an email or leave a comment.)

Where Next for Monetary Policy?

This blog began with a strong focus on monetary policy. That was in part because I believed -- and still do -- in its possibilities. The other part was that I just find monetary policy to be one of the most interesting parts of the field. So I'm happy that I could write what might be my first long post about monetary policy in a good while for Bloomberg. Excerpts below, continue reading here.

What else is the Fed watching? What news and what sorts of numbers will convince its members that they can withdraw stimulus -- or that they need to extend or even boost their injections?

Payroll employment. The Fed has tied policy to the unemployment rate, now at 7.5 percent, but officials understand its limitations. (The rate falls when workers are so discouraged they stop looking for work, for instance -- hardly a sign of progress.) They could be looking for three to six months of growth in payroll employment of 200,000 or more each month. That could be the “substantial improvement in the labor market” they have in mind.

Inflation. The Fed’s preferred measure of inflation, the annual change in the PCE price index, stood at 1.0 percent in March. The Fed keeps an eye on other price indexes, too, and they all suggest that near-term inflation could run below target. The "core" PCE price index, which excludes volatile food and energy prices, rose by 1.1 percent. The consumer price index, and its corresponding “core” variant, are both slightly below 2 percent. Another measure of “core” inflation known as "trimmed-mean inflation" -- obscure to the public but closely monitored inside the Fed -- stands at 1.4 percent and is poised to keep falling.

More than is recognized, the decision to exit may ride on inflation. James Bullard, the president of the Federal Reserve Bank of St. Louis, said recently that the Fed should hold fast to its “price stability” goal, and that inflation has lately fallen too far below target. If inflation drops below 1 percent -- a psychologically significant threshold -- there’d be strong internal pressures to increase bond purchases.

Misunderstanding Medicaid

I haven't written a personal blog post in a while. I am hoping I will get some time to do that this summer. I do have some things I think might be worth writing up. In the mean time, here are two unrelated comments on things people are getting wrong.

(1) A major health study is out from a randomized controlled trial in Oregon, which expanded Medicaid. Its results are feeding a new line of conservative criticism that the expansion creates no health benefits. (See, for example, this piece by Michael F. Cannon of Cato.)

Whatever one thinks of the Medicaid expansion, such a statement makes an egregious, basic error in interpreting statistical data. Let me quickly explain why. The questions presented in the Oregon Health Study are hypothesis testing problems. Basically, we might ask such a question as "Is the Medicaid expansion associated with, say, a decrease in the probability of a diagnosis of diabetes?"

But here's how studies test this question, more exactly. They create two separate hypotheses, a null hypothesis and an alternative hypothesis. The null, in our case, is "No, the Medicaid expansion is not associated with a significantly decrease in the probability." The alternative is that "Yes, it is associated."

What the Oregon study did was that it did not reject the null in favor of the alternative in several relevant instances. It's not that the study proved the null. It's not that it rejected the alternative. Sorry, that's just not how statistics work. It said that we do not have sufficient confidence in the improvement in health (which was there in the data) to say that it is statistically significant. This an important subtlety. Those who are saying otherwise don't know how to interpret statistical evidence properly, let alone interpret this study.

(2) Matt Yglesias has a new column out for Slate in which he tries to throw cold water on the idea of "disruptive innovation." I think Yglesias' basic argument -- that disruption has been overweighted as a way to better goods and services, and that we should look to other methods like incremental gains in quality -- might be wrong and refutable with some data I just happen to have read recently.

From a new NBER working paper by Daron Acemoglu et al.: "[T]he existing literature attributes as much as 70% or 80% of productivity growth in the United States to reallocation -- exit of less efficient and entry of more efficient firms."

I think this is pretty much the narrowest definition of disruption you can have. And it's a shockingly high share of all productivity gains. It's not clear to me that we spend enough time talking and writing and legislating about ways that we can encourage more corporate disruption.

Boston and Immigration Policy

In Bloomberg, me on immigration reform:

Experts on immigration policy have no idea what these seven congressmen are talking about. "Both arguments, really, are specious," said Edward Alden, a senior fellow at the Council on Foreign Relations, who has written a book on immigration policy and terrorism.

"I don't think there's anything that could have been done through the immigration system that would have had any impact on this attack," Alden said. "And, conversely, I don't think there's anything in the immigration reform bill that would have any impact, either. It appears to be completely irrelevant, given the intelligence we have now on the Tsarnaev brothers."

After Austerity

An excerpt of a post in Bloomberg:

What comes next, however, isn’t clear. Don't expect a clean break. Some austerity is already locked in: Gradual fiscal tightening will occur as recovery dampens "automatic stabilizers" such as unemployment insurance and food stamps. Aside from that, fiscal policy could move in any of several directions.

Longer-term issues might come to the fore. How can we best restructure social-insurance programs like Medicare, Medicaid and Social Security? How can we best reduce spending on defense programs? How can we best raise new tax revenue? Washington will probably do some modest long-term tightening, especially where partisan fervor is less intense -- on corporate tax reform, for instance. But don't expect much more.

Here's another possibility: Attention might turn back to monetary policy. That would make sense, because the evidence suggests that central banks have mattered much more than treasuries in influencing the depth of the recession and the pace of recovery. If aggregate demand is the problem -- and in the U.S., Europe and Japan, there's every sign of it -- then one solution is to adopt a monetary-policy rule that returns nominal income to its pre-recession growth path. That's something Congress could tell the Federal Reserve to do -- revising the mandate it laid down in 1978. Japan is already talking monetary policy. Europe will be forced to soon.

Maybe political debate will focus on other subjects altogether. The rise of new issues -- such as gun control, immigration, and gay marriage -- may crowd out a fiscal battle fought to stalemate. At least in the U.S., this might even be a good thing. Putting the budget on autopilot for a while -- and dealing with questions that were sidelined during years of fiscal monomania -- might be the best result.