Tuesday, October 04, 2011

Baxter & King 1993: Why government spending isn't just moving money around


This is the first in a series of posts called "Papers You Should Know". I believe one of the essential roles of econ blogs should be to bring research into the public consciousness. There's a ton of really interesting papers out there that get mooted in academic circles, or taught in grad classes, but whose insights never really make it into the wider discussion. That's a shame. It means that most intelligent, educated non-economists encounter a hundred worthless American Enterprise Institute hackonomics propaganda pieces for every one serious piece of scholarly research. Which, I find, often leaves people with the vague notion that academic economists spend 90% of their time glorifying the frictionless perfection of the free market, and the other 10% collecting "consulting" fees for big banks.

It isn't so. There is absolutely tons of research out there that looks at questions of how markets break down, and how complex "frictions" make interesting stuff happen. Today I'm going to look at one such paper: Marianne Baxter and Robert G. King's "Fiscal Policy in General Equilibrium" (American Economic Review, 1993).

First, for some background. One of the biggest questions for macroeconomists right now is whether government spending can boost the economy. You often hear conservative-minded economists saying that no, government spending is just "moving money around" without creating any wealth. For example, here is John Cochrane, of the University of Chicago, from 2009:

[M]oney [spent by the government] has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending.

Where this idea really comes from is an academic paper - in fact, one of the most famous econ papers ever written. In "Are Government Bonds Net Wealth?" (Journal of Political Economy, 1974), Robert Barro (currently of Harvard) showed that under certain conditions, the timing of government spending doesn't matter for the economy. This idea, which is called "Ricardian Equivalence", is exactly what John Cochrane was talking about. In this model, government can only move economic activity around, not create it.

When I read this famous paper, I immediately found it fishy. One of the model's (unstated) assumptions is that government spending consists entirely of transfer payments - i.e., taking money from one person and handing it to another. In other words, Barro assumes that government is fundamentally different from, say, a corporation; while a corporation can invest money today to create new wealth tomorrow, government can only shuffle money around. There is no "government capital" that we can invest in today that will create new wealth down the road.

To me, this felt a bit like assuming the conclusion. If you just assume government doesn't produce anything new, of course it's going to be hard to get government spending to boost the economy! If you think that public goods can boost the economy, then everything changes. I pointed this out in a blog post back in March, and even considered writing a paper about it. Then I found out that someone had already written that paper. And those someones were Marianne Baxter and Robert G. King, in 1993.

Only scooped by 18 years. Not bad, eh?

What Baxter and King (here's the link again) do is to take your most basic neoclassical business cycle model - the RBC model - and simply add government capital. What is government capital? Well, it's any kind of capital that the private sector can't or won't build (or can't or won't build enough of). In other words, government capital is a nonrival production input, or "public good." For the math on how those work, see here. Basically, these are things like roads, electrical grids, airports, and other infrastructure. Schools and research centers and courts and police could also count.

So Baxter & King put public goods into the production function. Instead of only including private capital and labor, GDP now depends on government capital as well. Here's the equation, for those of you who like equations:


Everything else is just pure RBC - no frictions, no sticky prices, no sticky wages, no financial sector, no nuthin'. Exactly the way Ed Prescott would like it, except for that little KG thing there on the end.

And of course, what happens? "Ricardian equivalence" goes straight out the window! If the government can invest in useful projects just like a firm, then the timing of government spending matters a lot, just like the timing of private investment. Baxter & King find that, in their model, government spending has a huge "multiplier", even with none of the Keynesian stuff like sticky wages.

But this is hardly surprising. Like I said, Barro starts with the assumption that government spending is 100% transfers. It's almost painfully obvious that if you allow for government to actually build useful things, you're going to get a very different result. In fact, while giving full props to Baxter & King, I'm a little surprised it took until 1993 for people to do this.

So, do the data support Baxter-King? Well, the short answer is that I need to look into this a lot more. But here is an interesting paper by Michigan's own Rudi Bachmann, along with Eric Sims of Notre Dame, that shows that when the government invests more money, especially during downturns, it raises business confidence. The last line from the abstract basically says it all:
In particular, spending shocks during downturns predict future productivity improvements through a persistent increase in government investment relative to consumption, which is in turn reflected in higher measured confidence.
Which is exactly what you'd expect from Baxter-King.

Now let's return to the present debate over government spending. Most of that debate revolves around things like liquidity traps, sticky wages, business confidence, and so on. But if we live in a Baxter-King world (or a Bachmann-Sims world), the case for more spending is actually a lot simpler. We desperately need to repair our country's infrastructure. Only government will do that. Interest rates are historically low, meaning that now is the perfect time to borrow money to rebuild the roads. Doing so would raise employment today, but because roads are necessary for tomorrow's businesses to thrive, it would also raise GDP in the future. It's not just a slam dunk, it's a free lunch!

There is, of course, a caveat here. Government capital has its limits. As Japan proved when it concreted over its rivers and built bridges to nowhere in the 1990s, you can reach a point where more infrastructure is just inefficient (something that Baxter & King, notably, do not allow for in their model). But I would argue that, given the dilapidated, crumbling nature of America's roads and bridges, we are not anywhere near that point. 

So to sum up: Baxter & King (1993) show that it's very easy to get government spending to matter in a big way. All you have to do is assume that public goods exist. Every time you hear someone say that "the money [for stimulus] has to come from somewhere!", just tell them that the money will come from the future wealth that private businesses will create once they can ship goods to each other over our shiny, new, government-built roads. Or just say "Baxter & King, 1993".

28 comments:

  1. ivansml4:08 PM

    I haven't read Baxter & King paper closely, but even if they find large output multiplier, that doesn't automatically mean that increase in government expenditures improves welfare, right? E.g. some figures in the paper show increase in output, but decrease in consumption.

    Also, their model is deterministic, so it can tell us things about steady-states or one-time transitions, but not so much about cyclical effects of fiscal policy, which is what people usually have in mind when discussing stimulus. Maybe building a stochastic version of their model and computing optimal fiscal policy would be a step towards that direction, but my guess is that you won't get strong results in favor of active fiscal policy from this kind of models.

    PS: Cochrane actually cites BK93 paper in the linked piece as an example that fiscal stimulus may be undesirable even with positive multiplier ("Some “equilibrium” analyses do say fiscal stimulus can increase output – but by making us feel poorer, work harder at lower wages, and consume less.")

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  2. "Which, I find, often leaves people with the vague notion that academic economists spend 90% of their time glorifying the frictionless perfection of the free market, and the other 10% collecting "consulting" fees for big banks.

    It isn't so."

    Now we know you're Greg Mankiw writing under a pseudonym, trying to distract us from the reality of your life.

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  3. Anonymous8:13 AM

    Noah,

    I don't have any substantive comments to make. I just wanted to say, as someone who probably is double your age, and a non-economist, that your posts are very helpful to me, and i look forward to readimg more of the 'papers you should know' series.

    Thanks

    Nicola

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  4. dilbert dogbert11:01 AM

    [M]oney [Saved] has to come from somewhere. If everyone [saves] a dollar , that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased [savings] must correspond to one less dollar of private spending. Jobs created by [saving] are offset by jobs lost from the decline in private spending.

    Gee that was fun.

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  5. dilbert dogbert11:05 AM

    Oh Crap! I wanted also to comment on the Golden Gate Bridge. It, and the San Francisco Bay Bridge were built during the bottom of the Great Depression by governments. For the GGB it was the city of SF and for the Bay it was California and some national. We have a great book, High Steel, that shows the photos documenting the building of those bridges. Great photography.

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  6. @dilbert dogbert:

    I really love it when people get my little picture references. You win 10 Commenter Points. :D

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  7. Anonymous4:15 PM

    Nice. But I don't think Barro was talking about timing of government spending, he was talking about timing of taxes. Subtle difference.

    Valerie Ramey has a paper on the multiplier effect

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  8. Anonymous4:54 PM

    For a more recent version with more realistic fiscal rules that take the financing dynamics into account, you might want to look at Leeper/Walker/Yang (2010): Governmentinvestmentandfiscalstimulus (http://mypage.iu.edu/%7Eeleeper/Papers/LWYGovInvest.pdf)
    Unfortunately, depending on the timing and the financing instrument, the Baxter/King result may be overturned.

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  9. Anonymous7:53 AM

    Noah,

    While you've been away, the Detroit River International Crossing battle has heated up. It is a very interesting real time example of private sector can'ts and won'ts (mostly won'ts) that spurred the government to act to deal with a real problem of capacity, efficiency and aged infrastructure. I would love to hear your take.

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  10. Noah:

    Is the general feeling amongst academic economists that the criticisms of them are misplaced, and that free market economics is just the ugly tip of the iceberg?

    I'm quite critical of mainstream economics but I understand that there is good work in there. My problem is that I feel the crisis has revealed a lot of its shortcomings (in particular I dislike equilibrium models for a complex system such as the economy), and wonder whether we need a proper 'sweep away everything' revolution rather than simply adding epicycles to existing models.

    But at the saem time, I feel arrogant in asserting that centuries of theory - which I have a fair amount of knowledge of, but not complete - are false.

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  11. @Cahal:

    It's pretty split. The "freshwater" people just disregard their critics, while everyone else, probably rightly blames the freshwater people for the widespread criticism of the macro profession.

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  12. Anonymous2:34 PM

    That's a little unfair Noah. Here Cahal is talking about getting rid of equilibrium models altogether, and you respond with a jab at "freshwater" economists (whoever they are now days). Why don't you explain to him that the paper you've presented fits nicely in the mainstream approach to modeling (specify technology, preferences and equilibrium concept.. then do comparative statics/impulse response).

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  13. I like your blog, but I think that here you missed a point of Barro's paper (I'm still reading it).

    Assumption that government doesn't produce anything new is not supposed to be realistic. Obviously it could be engaged in productive activity. But Keynes argued that even government spending which doesn't create any public goods – like pyramid building or digging holes in the ground – can boost the economy. For exploring whether and on what conditions is it true, it is quite useful to have a model in which government doesn't produce anything and merely prints bonds and transfers money.

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  14. We've long since established that markets are more effective than planners at efficiently allocating private goods. Some of the few countries that still have planned economies are...Cuba, Libya, North Korea, Saudi Arabia, Belarus, and Myanmar.

    Once people are forced to pay taxes then public goods are essentially no different than private goods.

    So...markets are more effective than planners at efficiently allocating private goods...and public goods are not essentially different than private goods...yet we still have planners allocating public goods. Why is that?

    Why don't we just allow taxpayers to directly allocate their individual taxes among the various government organizations at anytime throughout the year?

    Sure, the government has to spend money somewhere...but without forcing taxpayers to consider the opportunity costs of their tax allocation decisions...then the government has no clue where the money is most needed.

    "Nevertheless, the classic solution to the problem of underprovision of public goods has been government funding - through compulsory taxation - and government production of the good or service in question. Although this may substantially alleviate the problem of numerous free-riders that refuse to pay for the benefits they receive, it should be noted that the policy process does not provide any very plausible method for determining what the optimal or best level of provision of a public good actually is. When it is impossible to observe what individuals are willing to give up in order to get the public good, how can policymakers access how urgently they really want more or less of it, given the other possible uses of their money? There is a whole economic literature dealing with the willingness-to-pay methods and contingent valuation techniques to try and divine such preference in the absence of a market price doing so, but even the most optimistic proponets of such devices tend to concede that public goods will still most likley be underprovided or overprovided under government stewardship." - Patricia Kennett, Governance, globalization and public policy

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  15. Anonymous12:32 PM

    Public goods are not provided by corporations, by definition. Anyone who thinks otherwise is da stupid.

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  16. Xerographica, the logic in your post starts bad, and gets worse.

    Anonymous, corporations can and do produce public goods. However, it's well established that they'll underproduce. And, of course, they'll produce public bads, and dump them on people.

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  17. Barry, care to point out the flaws in my logic?

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  18. "We've long since established that markets are more effective than planners at efficiently allocating private goods. Some of the few countries that still have planned economies are...Cuba, Libya, North Korea, Saudi Arabia, Belarus, and Myanmar."

    Strawman.

    Xerographica: "Why don't we just allow taxpayers to directly allocate their individual taxes among the various government organizations at anytime throughout the year?"

    Because some things would be underfunded, and others overfunded. It's not really a fallacy, just a stupid argument.

    "and public goods are not essentially different than private goods"

    Lie.

    "..yet we still have planners allocating public goods. Why is that?"

    Because private parties will underproduce public goods. See any econ textbook discussing this.


    "Once people are forced to pay taxes then public goods are essentially no different than private goods."

    This doesn't follow. Please see the definitions of private and public goods.

    "...Once people are forced to pay taxes then public goods are essentially no different than private goods."

    Assertion without proof.

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  19. Getting benefits of government action out of a chicken model is not surprising. I think you missed the point of Barro.

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  20. It sort-of impresses me how relentlessly ideological the Minnesota economics education is. The whole idea of "chicken model" is a perfect example. It's a kind of indoctrination that would make Mao jealous.

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  21. Well I didn't get my PhD at Minnesota but whatever floats your boat.

    The point is that any model with a built-in role for government is obviously going to find a role for government. Whether such a friction exists is left hanging. Baxter and King is a very good paper but doesn't do a good job addressing whether their production technology is reasonable. It's more of a 'if this is the technology, here's what happens' sort of paper. Which is all well and good but you surely can understand why people are hesitant to apply the conclusions.

    The chicken model flippery is just pointing this out. There is an important question of when and how the government can intervene in markets or perform actions that private agents can't. I don't just like assuming they can and voila we're done.

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  22. Let me riff off of Barry's points about Xerographica's logic. Even if we assume that the market allocates resources better than a planner, which is clearly not always the case, since there are those pesky things called externalities and those other pesky things called public goods, what Xerographica is, in essence, proposing is uncoordinated planning of public expenditure. Barry does a good job of explaining why that's wrong.

    "[Y]et we still have planners allocating public goods. Why is that?" It is easy to allocate funds by the free market when we have buyers and sellers pursuing their own interest and thereby pursuing a common interest (partial fallacy which I'm choosing to disregard for a second). The government has to step in when the market fails to allocate appropriately. Four words: "externalities and public goods."

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  23. Barry and Julian, please step away from any preconceived notions and ready-made arguments that you might have because chances are way too good that you've never discussed political-economics with a pragmatarian before.

    Both of your responses seem to be based on the impression that I don't understand the concept of public goods. Not sure where you got that impression from.

    I didn't say anything about getting rid of or lowering taxes...and the quote I included mentioned the free-rider problem.

    The issue I have with planners is that they have no way of knowing how much of one public good a taxpayer would be willing to forgo in order to increase the supply of another public good.

    This is the "opportunity cost" concept that neither of you addressed in your response.

    The resource allocations of non-profit organizations reflects the billions of opportunity cost decisions that millions of donors are forced to make. I'm sure there are plenty of causes that both of you support but because of limited disposable income you have to prioritize which non-profits you donate to.

    If you donate to PETA it means that you forgo the opportunity to donate to the World Wildlife Fund.

    The Golden Gate Bridge is awesome and I've driven over it more than a few times...but would taxpayers have chosen it over all the other possible public goods if they had been given the choice?

    Perhaps more taxpayers would have allocated their taxes to Medi-Cal because they felt that the positive externalities of a healthy populace were more important.

    Or maybe more taxpayers would have allocated their taxes to public education and/or after-school programs for underprivileged youth.

    It's rather absurd to say that the Golden Gate Bridge was the best use of public funds when the public was not given a choice which government organizations received their individual taxes.

    As a pragmatarian I could care less whether an organization is public or private...what I care about is that taxpayers are given the freedom to decide which organizations offer the best results for their hard-earned money.

    Allowing for a division of labor between taxpayers will reveal the ideal division of labor between the private and public sector.

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  24. Anonymous4:17 PM

    @Xerograhica: Ever heard of a concept called "Democracy" for aggregating preferences?

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  25. Anonymous, from Wikipedia..."opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently." Can you cite any sources that even vaguely mention or refer to "aggregating preferences" leading to efficient use of limited resources?

    The only reason that congress allocates taxes is because it was a considerable improvement over having a king solely allocating taxes.

    It was a fundamentally liberal step for control of taxes to pass from a king to congress and it will be a giant liberal leap when control of taxes passes from congress to taxpayers themselves. Man, how epic would it be if this were to happen in our lifetimes? It would be hard to think of any single event during the past 100 years that could be considered more progressive.

    Instead of having to endure hyperpartisan obstructionism your taxes would go directly to the government organizations that needed them the most. Let congress debate the public healthcare issue all they want...but if you supported public healthcare then your taxes would freely flow to either Medicare or Medicaid or both. The amount of money that public healthcare received would determine the percentage of the population that qualified for coverage.

    Private healthcare is so ridiculously expensive that it's kind of hard to imagine that we wouldn't have universal coverage in a pragmatarian system.

    With pragmatarianism...the scope of government would narrow or broaden based on the allocation opportunity cost decisions of taxpayers.

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  26. "There is, of course, a caveat here. Government capital has its limits. As Japan proved when it concreted over its rivers and built bridges to nowhere in the 1990s, you can reach a point where more infrastructure is just inefficient"

    I here there is a lot of that going on in China too.

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  27. Really? I've never heard a non-Minnesota Ph.D. refer to chicken models before. It's sad that the idea is spreading.

    It's a purely ideological point because it requires you to assume that markets work perfectly unless you can identify the "friction" that prevents them from working. So there's never any onus to explain why markets work in a particular instance -- rather markets work effortlessly by default.

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