Thursday, August 19, 2010

Fiscal Stimulus

An interesting piece by Jim Manzi in the New Republic argues that uncertainty about the impact of fiscal stimulus is inevitable because of the difficulties of doing counterfactual exercises. Of course to do a credible counterfactual you have to specify a model and you need agreement about which is the correct model. This is complicated especially with a topic like fiscal stimulus.

But I wonder if there is also another problem. What if the relationship between fiscal stimulus and growth is non-linear? Is it implausible that a credible fiscal retrenchment might lead to an investment boom? There is considerable evidence that fiscal consolidation can be expansionary, according to Albert Alesina. It may also be the case that conventional Keynesian remedies can work, especially in countries that do not have too much government debt already.

But if both fiscal stimulus and fiscal consolidation are expansionary it may be hard to isolate the effect in standard econometric exercises. It may also explain why each side in the debate can point to evidence that supports their view.

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