Wednesday, January 14, 2009

On Multipliers

One point that I've yet to see stressed much in the econoblogosphere is that the magic of fiscal stimulus depends on the economy being significantly below potential output, for all but the most extreme Keynesians. I am not at all convinced that this holds. Not that I have the time to delve into the calculations of potential GDP, but I'd suspect they rely on estimates of the value of financial services (and perhaps also auto production, to pull out another industry) that don't reflect how these goods and services will be valued going forward.

Two stories can be told. One, the contraction is predominately caused by the obsolescence of large amounts of physical and human capital due to changes in the economy - e.g. new information comes to light about the risk of certain financial products, resulting in a change of preferences which renders said capital useless, reducing potential GDP and causing a recession. Two, aggregate demand drops for an exogenous (think random), such as we don't like oranges today as much as we did yesterday, which happily leaves potential GDP chugging along, as good as ever.

Okay, I'm playing favourites, yes, but I'd still like to see a good rebuttal of why American potential GDP isn't down.

EDIT: The first story is the States, but the second story could well be Canada - the exogenous shock in the USA reducing aggregate demand here at home. Fiscal stimulus could induce Canadians to buy up those lost exports, for example, and increase GDP.

EDIT: I concede there could be positive second-order effects from fiscal stimulus, e.g. self-discovery or TFP improvements from infrastructure investment, but there are also negative ones, e.g. anticipation of higher future taxes, governmental deadweight loss and distorting incentives (think ethanol), etc.

1 comment:

Nick Rowe said...

I think you are right to question the accuracy or meaningfulness of measures of actual and potential GDP. But the real story is unemployment. Is unemployment above the natural rate?

You could argue that relative shocks to labour demand have increased the natural rate (workers are heterogeneous). Whether the actual has or will increase relative to the natural rate is another question. Disinflation suggests it has increased more.