More on Laffer’s math

I guess that most of my readers have noticed that I have been somewhat upset by Arthur Laffer’s attempt to demonstrate that fiscal stimulus doesn’t work. While I am certainly very skeptical about how fruitful fiscal stimulus will be I was not impressed with Laffer’s “evidence” that fiscal stiumulus does not work. I did, however, not plan to write more on this – as I certainly do not want to promote fiscal easing anywhere and find this fiscal issue somewhat boring and irrelevant for understanding the present crisis – but then I got an interesting email from Jim Allbery.

Jim is not an economist, but a software developer with a degree in math. Jim had been equally upset by the bad math in Laffer’s Wall Street Journal piece as I had been and Jim actually has taken a closer look at Laffer’s math. Jim sent me a note on his considerations about Laffer’s math. I think Jim’s note is rather interesting and Jim has kindly allowed me to publish it. So here is Jim’s comment on Bad Math in the WSJ

Finally, just to get my position clear. I believe there is a rather significant need for fiscal consolidation in both the US and the euro zone. There is therefore no room for fiscal easing in the US or in most euro zone countries. However, the fiscal position is being made worse by overly tight monetary policy, which seriously depresses growth in both the US and the euro zone. I therefore agree with Laffer that fiscal stimulus is not the way forward in the present situation. However, I am no Calvinist and I do not believe that our present problems are due to bad fiscal policies, but rather due to overly tight monetary policy.

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Related posts:

Arthur Laffer you’re embarrassing yourself
More on Laffer and Estonia – just to get the facts right
“Meantime people wrangle about fiscal remedies”
There is no such thing as fiscal policy

David Glasner’s posts on Laffer’s math:
Arthur Laffer, Anti-Enlightenment Economist
A Laffer Postscript

More on Laffer and Estonia – just to get the facts right

Arthur Laffer’s recent piece in the Wall Street Journal on fiscal stimulus has generated quite a stir in the blogosphere – with mostly Keynesians and Market Monetarists coming out and pointing to the blatant mistakes in Laffer’s piece. I on my part I was particularly appalled by the fact that Laffer said Estonia, Finland, Slovakia and Ireland had particularly Keynesian policies in 2008.  In my previous post I went through why I think Laffer’s “analysis” is completely wrong, however, I did not go into details why Laffer got the numbers wrong. I do not plan to go through all Laffer’s mistakes, but instead I will zoom in on Estonian fiscal policy since 2006 to do some justice to the fiscal consolidation implemented by the Estonian government in 2009-10.

In his WSJ article Laffer claims that the Estonian government has pursued fiscal stimulus in response to the crisis. Nothing of course could be further from the truth. One major problem with Laffer’s numbers is that he is using public spending as share of GDP to analyze the magnitude of change in fiscal policy. However, for a given level of public spending in euro (the currency today in Estonia) a drop in nominal GDP will naturally lead to an increase in public spending as share of GDP. This is obviously not fiscal stimulus. Instead it makes more sense to look at the level of public spending adjusted for inflation and this is exactly what I have done in the graph below. I also plot Estonian GDP growth in the graph. The data is yearly data and the source is IMF.

Lets start out by looking at pre-crisis public spending. In the years just ahead of the escalation of the crisis after the collapse of Lehman Brother in the autumn of 2008 public spending grew quite strongly – and hence fiscal policy was strongly expansionary. I at the time I was a vocal critique of the Estonian’s government fiscal policies.

There is certainly reason to be critical of the conduct of fiscal policy in Estonia in the boom-years 2005-8, but it does not in anyway explain what happened in 2008. Laffer looks at changes in fiscal policy from 2007 to 2009. The problem with this obviously that he is not looking at the right period. He is looking at the period while the Estonian economy was still growing strongly. Hence, while the Estonian economy already started slowing in 2007 it was not before the autumn of 2008 that the crisis really hit. Therefore, the first full crisis year was 2009 and it was in 2009 we got the first crisis budget.

So what happened in 2009? Inflation adjusted public spending dropped! This is what makes Estonia unique. The Estonian government did NOT implement Keynesian policies rather it did the opposite. It cut spending. This is clear from the graph (the blue line). It is also clear from the graph that the Estonian government introduced further austerity measures and cut public spending further in 2010. This is of course what Laffer calls “fiscal stimulus”. All other economists in the world would call it fiscal consolidation or fiscal tightening and it is surely not something that Keynesians like Paul Krugman would recommend. On the other hand I think the Estonian government deserves credit for its brave fiscal consolidation. The Estonian government estimates that the size of fiscal consolidation from 2008 to 2010 amounts to around 17% (!) of GDP. I think this estimate is more or less right – hardly Krugmanian policies.

And maybe it is here Laffer should have started his analysis. The Estonian government did the opposite of what Keynesians would have recommend and what happened? Growth picked up! I would not claim that that had much to do with the fiscal consolidation, but at least it is hard to argue based on the data that the fiscal consolidation had a massively negative impact on GDP growth. Laffer would have known that had he actually taken care to have proper look at the data rather than just fitting the data to his story.

Laffer of course could also have told the story about the years 2011 and 2012, where the Estonian government in fact did introduce (moderate) fiscal stimulus. And what was the result? Well, growth slowed! The result Laffer was looking for! Again he missed that story. I would of course not claim that fiscal policy caused GDP growth to slow in 20011-12, but at least it is an indication that fiscal stimulus will not necessary give a boost to growth.

I hope we now got the facts about Estonian fiscal policy right.

PS David Glasner has an excellent follow-up on Laffer’s data as well.

PPS If you really want to know what have driven Estonian growth – then you should have a look at the ECB. Both the boom and the bust was caused by the ECB. It is that simple – fiscal policy did not play the role claimed by Laffer or Krugman. It is all monetary and I might do post at that at a later stage.

PPPS Time also has an article on the “Laffer controversy”

Arthur Laffer you’re embarrassing yourself

During George W. Bush’s years as president I most say that I lost a lot of respect for Paul Krugman. It was very clear that he was suffering from what Charles Krauthammer called the “Bush Derangement Syndrome” (BDS). BDS undoubtedly made Krugman write crackpot articles about all kind of subjects. Krugman for example on numerous occasions has argued in favour of protectionism – something the pre-Bush Krugman would never have done.

Unfortunately, this President Derangement Syndrome (PDS) has infected a number of US right-wing economists who used to be clever economists, but today seem to have forgotten everything about economics – mostly as a result of an apparent hatred of President Obama. I am no fan of President Obama, but I do not let that change my view of economics.

I have earlier highlighted that I think that Allan Meltzer who is one of my great monetarist heroes seems to have forgotten everything about monetary theory that he once preached exactly because of PDS. Unfortunately he is not the only right-wing US economist to suffer from PDS. The latest example is supply-side hero Arthur Laffer who frankly is embarrassing himself in a recent Wall Street Journal article.

The stated purpose of Laffer’s article is to show that “in country after country, increased government spending acted more like a depressant than a stimulant.”

Anybody who reads my blog would know that I am certainly no fan of “fiscal stimulus” and that I believe that fiscal policy can not “overrule” monetary policy. Hence, I believe in the so-called Sumner Critique. Furthermore, I strongly believe that there is good empirical evidence that a larger government is a drag on the economy and that more government spending in general will tend to reduce productivity growth in the longer run. Hence, I strongly agree with Laffer in terms of the overall view that fiscal stimulus is unlikely to be helpful in getting us out of this crisis and in the long run a larger public sector is likely to hamper growth.

However, even though I agree on Laffer’s skeptical view of fiscal stimulus I nonetheless find his “analysis” to be shockingly bad.

In his analysis Laffer compares the change in real GDP growth from 2006-2007 to 2008-2009 with the change in government spending in the same period in different OECD countries. (By the way look Laffer’s numbers look very odd – David Glasner discusses that in his post on Laffer here.) Here is Laffer’s somewhat surprising conclusion:

“The four nations—Estonia, Ireland, the Slovak Republic and Finland—with the biggest stimulus programs had the steepest declines in growth.”

Are you joking Art?? Estonia? Biggest stimulus program? You can’t seriously think so. I think Prime Minister Ansip of Estonia would be rather upset that you say that his government apparently has conducted some kind of Keynesian fiscal stimulus. I know for a fact that Mr. Ansip has no respect for Keynesian fiscal stimulus. In fact his government has rightly been praised for its conservative fiscal stance.

Mr. Ansip’s government has since the crisis hit in 2008 (in fact it already started in 2007 in Estonia) passed significant austerity measures such as cutting public sector wages and pensions. Mr. Ansip’s government has shown an enormous commitment to reducing the budget deficit and reining in the public debt. In fact by saying what you are saying Mr. Laffer you are making a mockery of the truly remarkable fiscal consolidation in Estonia.

I don’t know where Mr. Laffer has been recently – didn’t he notice that THE KEYNESIAN Paul Krugman has been highly critical of Estonia’s fiscal consolidation and that has upset Estonian policy makers a great deal (and rightly so). Mr. Laffer would of course have known this if he had read the WALL STREET JOURNAL!!!

Estonia by far has the lowest debt-to-GDP ratio in the OECD area so how Mr. Laffer can claim that Estonia is an example of an evil Keynesian experiment is somewhat of a puzzle to me. The limit for public debt in the EU is 60% of GDP. Estonia’s public debt is 6% (!) of GDP. And Estonia is running a public finance SURPLUS!

But ok, lets say that Mr. Laffer made one mistakes in his assessment. The three other countries have to be irresponsible countries. No! They are certainly not. In fact Finland and Slovakia are both in the group of the most fiscally conservative countries in the EU and the markets agree. Just look at Finnish and Slovakian bond yields. In fact few market participants would question the creditworthiness of Finland. After all Finland has a BETTER credit rating than Germany! Finnish government bond yields is basically at the same level as German bond yields.

So how about Ireland? It is true that the country has seen a sharp rise in public debt since 2008. However, that can hardly been seen as a result of “fiscal stimulus”. The rise in public debt is mostly due to banking rescues in 2008 and 2009, which of course can be questioned whether that has been a good idea, but you can hardly say that Ireland has conducted keyensian style fiscal stimulus. Furthermore, after the sharp rise in public debt consecutive Irish governments have put a lot of effort into fiscal consolidation and Ireland has rightly been praised for its effort to curb public debt. As a result Ireland is generally perceived more positively by the markets and credit rating agencies than the other so-called PIIGS countries.

So we can easily conclude that Arthur Laffer got it completely wrong. So why is that? Well, maybe he never heard about cyclically adjusted government spending. It should be no surprise to anybody who just spent one hour reading an intermediate textbook on public finances that government spending tend to increase in cyclical downturns and tax revenues drop when the economy slumps.

Estonia in 2007-2010 went through a Great Depression sized collapse in economic activity and hence it is no surprise that that led to an increase in public spending as outlays to unemployment benefits and other social benefits rose sharply. To its credit the Estonian government reacted to this worsening of public finances by putting through significant austerity measures. Mr. Laffer, however, in his eagerness to badmouth President Obama’s fiscal policies forgets this and knowingly or unknowingly trashes the heroic fiscal performance of Mr. Ansip’s Estonian government. I think an excuse would be in order.

I am sorry to say it, but Mr. Laffer’s article is yet another example of right-wing US economists that for the sake of partisan politics completely trash all economic logic. That is too bad, because Mr. Laffer could instead have told the story of the great example of Estonia, a country that is gradually coming out of this crisis WITHOUT fiscal stimulus. He could also have told the story about Greece’s and Spain’s fiscal stimulus packages of 2009 that did a lot to increase these countries’ public debt levels. He could also have told the story about how fiscally conservative policies have ensured that Finland is the country in Europe with the best credit rating.

I strongly believe that less public spending is positive for long-term growth (and that is a supply-side argument Mr. Laffer!) and I doubt that fiscal stimulus (without monetary stimulus) will do much to increase growth in the short-run, but I have far better arguments than Mr. Laffer.

I think it is about time that my fellow free market economist friends in the US start to behave as economists rather than playing party politics. That would strengthen the case for free markets and less government intervention. By playing party politics economists like Allan Meltzer and Arthur Laffer are not doing the cause much service.

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PS I use the term “right-wing” economist above to mean an economist who generally is in favour of free markets and generally opposes government intervention in the economy. In that sense I am obviously a right-wing economist myself.

PPS I also suspect John Cochrane and Casey Mulligan of suffering from PDS.

Update: Brad DeLong also has a comment on Laffer’s WSJ piece. I am getting tired of agreeing with him and Krugman in their criticism of (certain!) “right-wing” economists.
Update 2: Karl Smith joins the debate.
Update 3: And here is Matt O’Brien on the same topic – with a golden quote: “He really is the anti-Keynes. When the facts change, Laffer changes the facts back, so he won’t have to change his mind.”

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