Tag Archives: Joshua Coval

Economic “Experiments”

After my last post, some friends stopped by my office with a few questions: “If, as you say, we are conducting a big experiment in spending, will the experiment produce evidence that finally answers the question of whether or not fiscal stimulus works? Why can’t we just compare the economy’s performance during periods of stimulus with its performance during normal times?  Why mess with military spending as Barro and Redlick do, when what we want to know is whether stimulus spending works, not military spending?” (This latter question gets at Harry Moroz’s point too).   

Here is my attempt at an answer:

Let’s start by imagining the ideal conditions to test for the effect of a stimulus. Suppose the distribution of stimulus money were determined not by the political process, but by a scientist. This scientist would probably randomly assign units of observation two groups: a “treatment” and a “control” group. He would use a coin or some other random process to select some regions to receive money and some regions to receive none. Ideally, he would do this over the course of several years, distributing money both during boom and bust periods to see if the economy responded differently. Then, he would compare various measure of well-being (growth rates, unemployment rates, etc.) in times and places that received stimulus (the treatment group) with comparable measures in times and places that did not receive stimulus (the control group). 

Unfortunately for the scientist (fortunately for the citizen), stimulus money isn’t doled out this way. Instead, politicians make some attempt to target the expenditure of stimulus money to hit times and places that are in need (as my colleague, Veronique de Rugy has shown, they aren’t always very good at hitting their target). But this means that it becomes very difficult for the economist to assess, empirically, the impact of fiscal stimulus.

Why? Because economies in times and places that are in need tend not to grow at the same pace as more normal economies. As standard economic theory teaches us, market-based economies have natural recuperative properties. For example, if aggregate demand suddenly falls, causing a contraction, a chain of events is set in motion that helps sow the seeds of recovery. Spending will fall, lowering prices and increasing savings. The lower prices cushion some of the blow, allowing consumers’ dollars to go farther than before and allowing them to spend more than they otherwise would. As saving increases, interest rates fall and business investment picks up. As these processes work their way through the system, the economy begins to heal. Economists famously argue about how effective this process is, but few would deny that there is some truth to this story.

But knowing that this process happens to at least some degree, we can’t simply compare economic growth in times and places that receive stimulus with that of times and places that don’t. Otherwise, instead of picking up the effect of stimulus, we may just end up measuring the natural recuperative abilities of the market economy. Nor, more generally, can we compare economic growth in times and places where governments spend a great deal of money with economic growth in times and places where governments spend little. This is because there is strong reason to believe that causation runs the other way too: when the economy is humming, state and federal coffers are flush with cash and tend to spend more and when times are lean, states have no choice but to cut back spending.

The problem is analogous to that of understanding the impact of police patrols on crime. We would like to measure crime rates in times and places where patrols are sent with crime rates in times and places where patrols are not sent. But, like politicians distributing stimulus funds, police captains don’t randomly pick the areas where they send their patrols. Instead, they try to target patrols to the places and times where they are needed. Thus, a naïve look at the data shows that places with more police patrols tend to have more crime! This clearly doesn’t make sense, but it is what the data show.    

Which gets us to the question: why study military spending when we are interested in stimulus spending? The answer is that it helps solve the statistical problems I mention above. I won’t get into the technical details of two-stage least squares regression techniques (I’d prefer you finish reading the post), but here is the basic gist of the strategy: start by finding some phenomenon that is correlated with the treatment (the treatment here being cops or government spending) but uncorrelated with the outcome of interest (in this case, crime rates or economic growth). If you can find such a phenomenon, you can use it to study the pure, unbiased effect of the treatment on the outcome.

In the case of police and crime ­­­­­­­­­Steven Levitt came up with an ingenious phenomenon to help unravel the real relationship. He accurately surmised that elections might induce elected officials to increase the number of patrols on the street. And since elections are not directly related to the underlying crime rate, this allowed him to obtain an unbiased estimate of the effect of patrols on crime. As you probably guessed, this unbiased estimate showed that, indeed, more police patrols actually lead to less crime.

So what about stimulus? As I mentioned in my previous post, Robert Barro and Charles Redlick use military spending to assess the impact of stimulus spending on economic growth. Military spending is positively related to overall government spending. But it turns out that it isn’t related (positively or negatively) with economic downturns. Thus, it makes an ideal phenomenon to assess the impact of stimulus. As I mentioned, Barro and Redlick found that stimulus spending isn’t stimulative.

Similarly, Lauren Cohen, Joshua Coval, and Christopher Malloy, make clever use of another phenomenon to assess the impact of government spending on economic activity. They rely on the fact that government spends more in Congressional districts whose members are chairs of powerful committees than in districts whose members are just rank and file. Like Barro and Redlick, they find that government spending isn’t stimulative.   

I suspect that right now some clever economist is working on a study of the current stimulus that relies on a technique similar to these. I sincerely hope that it will bring us closer to a consensus on the effect of stimulus. If Barro and the others are correct, we can’t afford to keep throwing good money after bad.

Why This Isn’t A Time to Worry that Government Is Spending Too Little

Last week, Ezra Klein wrote that state budget shortfalls constituted a massive “anti-stimulus” which might overwhelm the Federal Stimulus (implying the need for further federal spending). I responded with a post arguing that, while Klein’s story is plausible, the numbers just don’t add up. The massive increase in federal spending in the last few years has more-than made up for any decreases in state spending.

This, in turn, prompted an interesting response from Harry Moroz over at Huffington Post. Mr. Moroz writes:

Obama’s efforts to counteract the economic downturn…accounted for only 34 percent ($205 billion) of increased spending in 2009. The rest of the increases have little to do with stimulating the economy….A comparison of federal spending and aggregate state spending is irrelevant. Comparing federal stimulus spending and state spending cuts is only appropriate and useful because both are responses to the economic downturn.

In other words, Mr. Moroz would prefer that we not look at overall spending increases because most of these increases were not intended to be stimulative. (I trust that Mr. Moroz will correct me if I am mischaracterizing his assertion.)

I agree with Mr. Moroz’s point that most of the spending increases were not stimulative (that’s kinda the problem). But the much-ballyhooed Keynesian model—on which proponents of increased government spending hang their intellectual hats—makes no allowance for intentions. Instead, they assert that all government spending, no matter what it is spent on, is stimulative. Here is Lord Keynes on the subject:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again…there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

For his part, President Obama made a similar claim in February of 2009:

Then you get the argument ‘well, this is not a stimulus bill, this is a spending bill.’ What do you think a stimulus is? That’s the whole point. No, seriously. That’s the point.

And though Mr. Moroz would not like to count President Bush’s $700 billion TARP bill either, the fact remains that that president, too, thought he was stimulating the economy.

The real question is: Intentions aside, does government spending actually stimulate the economy? Over the long run (when Lord Keynes said we were all dead) the answer is almost certainly “no.”

Using international data, a number of peer-reviewed studies have examined the relationship between government size, somehow measured, and economic growth. Here is a sample: Barro (1991 and 1989); Folster and Henrekson (2001); Romero-Ávila and Strauch (2008); Afonso and Furceri (2008); Chobanov and Mladenova (2009); Roy (2009); and Bergh and Karlsson (2010). Each of these studies finds a strong, statistically significant, negative relationship between the size of government and economic growth.

What about the short run? Here again the evidence seems weak at best. Consider new research by Harvard’s Robert Barro and Charles Redlick. They find that for every dollar the government spends on the military (read: takes out of the private economy), the economy gains just 40 to 70 cents. Spending a dollar to obtain 40 to 70 cents does not a good deal make. Or consider another study by Harvard’s Laruen Cohen, Joshua Coval and Christopher Malloy. They rely on the fact that the federal government tends to spend more money in districts whose congressional members are chairs of powerful committees than in districts whose members are just rank-and-file. They find that firms actually cut capital expenditures by 15 percent following the ascendency of a congressman to the chairmanship. Moreover, firms seem to scale back employment and experience declines in sales.

It seems to me that by just about any measure, we are currently conducting a large-scale experiment in massive government spending. Moreover, I believe the results of previous experiments predict that this one will lead to slower growth and less economic opportunity. This is not the time to worry that perhaps we have spent too little.

I may be missing a nuance in Mr. Moroz’s argument. I hope he will disabuse me of my errors with a reply.