Sunday, October 6, 2013

Dupor and Li on the Missing Inflation in the New-Keynesian Stimulus

Bill Dupor and Rong Li have a very nice new paper on fiscal stimulus: "The 2009 Recovery Act and the Expected Inflation Channel of Government Spending" available here.

New-Keynesian models are really utterly different from Old-Keynesian stories. In the old-Keynesian account, more government spending raises income directly (Y=C+I+G); income Y then raises consumption, so you get a second round of income increases.

New-Keynesian models act entirely through the real interest rate.  Higher government spending means more inflation. More inflation reduces real interest rates when the nominal rate is stuck at zero, or when the Fed chooses not to respond with higher nominal rates. A higher real interest rate depresses consumption and output today relative to the future, when they are expected to return to trend. Making the economy deliberately more inefficient also raises inflation, lowers the real rate and stimulates output today. (Bill and Rong's introduction gives a better explanation, recommended.)

So, the key proposition of new-Keynesian multipliers is that they work by increasing expected inflation. Bill and Rong look at that mechanism: did the ARRA stimulus in 2009 increase inflation or expected inflation?  Their answer: No.

This is a quantitative question. How much do the large-multiplier models say the ARRA should have increased inflation? Their answer: 4.6%. Where is it?

We know, of course, that inflation (especially core inflation) basically did nothing during the period of the ARRA, and Bill and Rong have some nice graphs. Defenders might say, aha, but except for the stimulus, we would have had a catastrophic deflation spiral. Critics might reply, that's what George Washington's doctors said while they were bleeding him. As always, teasing out cause and effect is hard.

Bill and Rong have a range of interesting facts that address this question. Here are two that I thought particularly clever. First, they look at the survey of professional forecasters, and examined how the forecasters changed inflation forecasts along with their changes in government spending forecasts, i.e. when they figured out a big stimulus is coming. I plotted the data from Bill and Rong's Table 2

Dupor and Li Table 2
As you can see, in 2008Q4 and 2009Q1, many forecasters updated their views on government spending, a few by a lot.  However, there is next to no correlation between learning of a big stimulus and increases in expected inflation, especially among the forecasters who strongly update their stimulus forecasts.

Bill and Rong's interpretation is that the stimulus failed to increase expected inflation. The main defense I can think of is to say that this evidence tells us about professional forecaster's model, not about true inflation expectations. Professional forecasters are a bunch of old-Keynesians, not properly enlightened new-Keynesians; they don't realize that stimulus works through inflation, they're still thinking about a pre-Friedman consumption function. That's probably true. But if so, it's hard to think that everyone else in the economy does understand the new truth, and changed their inflation forecasts dramatically when they learned of the stimulus.

Another nice piece of evidence: The US had much bigger government spending stimulus than the UK. The behavior of expected inflation revealed in the real vs. nominal treasury spread was almost exactly the same. (Yes, Bill and Rong delve into the TIPS pricing in the crisis.)

Source: Dupor and Li

Finally, a key point missing in most of the stimulus debate. These models predict big multipliers not just at the zero bound, but anytime that interest rates don't respond to inflation. We don't have to just rely on theory, there is some experience. New-Keynesians since at least Clarida Gali and Gertler's famous regressions have said that the Fed was not increasing interest rates fast enough in the 1970s, and the 1930s and interest-rate peg of the late 40s and early 50s are another testing ground. Using standard measures of exogenous spending increases, Bill and Rong find no impact of government spending on inflation in any of these periods.

New Keynesian stimulus analysis has been particularly slippery, on the difference between the models and the words, and on advocating the policy answers without checking or believing the mechanisms. The models are Ricardian: the same stimulus happens whether paid for by taxes or borrowing. The opeds scream that the government must borrow. The models say totally useless spending stimulates. The opeds are full of infrastructure, and roads and bridges. (At least, the "sprawl"  complaint is temporarily quiet.) The models say that spending works by creating inflation, not through a consumption function. Inflation being totally flat, and the counterfactual argument weak, you don't hear much about that in the opeds.  The models say we should be in a huge deflation with strong expected output growth. The facts are protracted stagnation. (More in my last stimulus post.) The models are models, worthy of careful examination and empirical testing. All I ask is that their proponents take them seriously, and not as holy water for a completely different old-Keynesian agenda.