Macro-Economists Have No Good Multiplier Estimates

This discussion between Mark Thoma and Scott Sumner touches on two key issues: first, this is a balance sheet recession; and second, macro-economists do not have good multiplier estimates for fiscal policy in a depressed economy.

Regarding the difference between the current downturn and garden variety business cycle recessions, Thoma explains that insolvency is the distinguishing characteristic. While policymakers have mostly focused on the banks, household balance sheets are in bad shape as well, as the following chart of household debt-to-GDP shows.

Since households are still more or less swamped in debt, they will likely use any tax cuts to save or pay down debts. While this won't prop up aggregate demand, it should speed up recovery. Indeed, since consumer spending makes up such a large part of the American economy - some 70% at the peak of the bubble - there will not be a sustained recovery until households regain their financial footing. And as tax cuts will help households pay off what they owe quicker, there is a compelling argument for including them in any stimulus. Nonetheless, to prevent aggregate demand from completing collapsing into a deflationary spiral, Thoma argues for the necessity of fiscal stimulus.

And here's where things get interesting. Sumner and Thoma agree that macro-economists have no good estimates for fiscal multipliers. As Sumner explains, under normal economic conditions, if fiscal policy created an inflationary pressure, the Fed would raise rates in order to meet its inflation targets. In other words, monetary policy would counteract fiscal policy to prevent the economy from heating up too much. Consequently, we don't have good estimates of what the multipliers of fiscal policy would be, holding all else equal. Of course, today we are in a situation where the Fed is desperately trying to create inflation, so we do not have to worry about fiscal and monetary policies working at cross purposes. But when economists argue about the different multipliers of different types of tax cuts or spending, they are largely flying blind, relying on theory rather than empirical tests. In other words, economics is much, much less a science than its adherents usually like to pretend.