Fiscal Multipliers in War and in Peace

It truly is breathtaking how certain some people are of what they know to be true about the way a macroeconomy operates. The Krugmans and DeLongs of this world really make it sound like everything we really need to know has been settled long ago. Yes, the science is "settled" (where have we heard this before?).

I recently came across this piece by Brad DeLong: A Guide for the Perplexed. Consider the following quote:

But when fiscal boost was tried on a large enough scale, it certainly did the job. And it is reasonable to infer (with all the caveats provided by the CBO) that what is true in the very large will be true in the merely large as well. Eugene Fama says that it is theoretically impossible for fiscal stimulus to boost output: World War II proves him wrong. Robert Barro says that the multiplier is zero: World War II proves him wrong. Benn Steil says that Jacques Rueff in 1947 conclusively proved that fiscal policy could not boost employment: World War II proves him wrong.

Implication: a WWII style fiscal stimulus will "do the job" in a peacetime recession. WWII "proves" it. Egad...how does he know this? Why do I not feel as confident that this is the case? Am I truly that dense? (an invite to some rather rude comments, I'm sure!)

In any case, I decided to gather my thoughts on the subject and post them here for public review and criticism. The piece is a bit too long for a blog posting; so if you're interested, please click here. Looking forward to any comments.

Fiscal Multiplier Mockery

Just came across this IMF Staff Position Note by Olivier Blanchard (and coauthors) entitled Fiscal Policy for the Crisis.

The best part of this paper is contained in Appendix II: Fiscal Multipliers-A Review of the Literature, and Appendix III: Five Case Studies of Fiscal Policy During Financial Crisis.

The conclusion I arrive at in reading these appendices is that during a financial crisis: [1] fixing the financial sector is of primary importance; and [2] fiscal policies may be marginally beneficial at best, and seriously detrimental at worst.

In the body of the paper, the authors draw several lessons from history.

[1] Successful resolution of the financial crisis is a precondition for achieving sustained growth.

Here, they give the example of Japan during the 1990s. Evidently, "fiscal actions following the bursting asset bubble failed to achieve sustained recovery because financial problems were allowed to fester."

In short, fiscal stimulus failed in Japan. But we don't really want to believe that fiscal stimulus doesn't work. It didn't work here because things were not set up to allow it to work. I wonder how one might modify an IS-LM model to formalize this notion?

But there are more examples. "Delaying interventions, as was also done in the US during the Hoover administration and during the S&L crisis, typically leads to a worsening of macroeconomic conditions, resulting in higher fiscal costs later on."

So I guess that if we wait too long, the fiscal multiplier now is severely negative. Not sure what to make of this (like, where does this show up in the IS-LM model?). And in any case, they have their history wrong: Hoover did in fact react quickly to the crisis (although many of his measures were frequently blocked by the Democrats-Roosevelt, in particular-and then later adopted wholesale by the Democrats). And even though "interventions" were evidently delayed during the S&L crisis, I seem to recall a fairly protacted spell of growth in the 1980s. Unimportant details, I suppose.

Ah yes, but there was the "prompt and sizeable support to the financial sector by the Korean authorities that limited the duration of the macroeconomic consequences thus limiting the need for other fiscal action."

Huh? The Korean government fixed the financial sector, thereby eliminating the need for future fiscal stimulus? So fiscal stimulus is not needed, if the financial sector is repaired. This is supposed to be taken as evidence that fiscal stimulus is needed?

[2] The solution to the financial crisis always precedes the solution to the macroeconomic crisis.

Sure.

[3] A fiscal stimulus is highly useful (almost necessary) when the financial crisis spills over to the corporate and household sectors.

Not sure where this came from; they cite no examples (and indeed, the examples above seem to suggest otherwise).

[4] The fiscal response can have a larger effect on aggregate demand if its composition takes into account the specific features of the crisis.

In this regard, they note that the tax/transfer policies implemented early in the Nordic crisis did little to stimulate output. Sure, the Ricardian equivalence theorem at work. As for "evidence" as to how a different composition of expenditure might work, they make the following compelling statement: "In theory, public spending on goods and services has larger multiplier effects..."

I see. That would be the same theory (IS-LM) that has absolutely nothing to say about financial crisis?

And so, on the basis of this, the authors' conclusions are:

The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another “Great Depression” requires a commitment to do more, if needed;collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt
explosion and adverse reactions of financial markets.

And so there you have it. The fiscal multiplier is greater than one. Unless, that is, the stimulus in question is any one of: not-in-time, small, short, undiversified, non-contingent, non-collective, and unsustainable.

Believing in Fiscal Stimulus 2

In part 1, I asked the question: Why do some people believe that fiscal stimulus "works" in the sense that it leads to a desirable increase in aggregate output and employment?

I have yet to see what I would consider to be a persuasive argument in favor of this belief.

Bruce Wilder (see his response to my earlier post) suggests that most economists do not believe that this is true universally; but that it is true only under "special" circumstances like a large negative "aggregate demand" shock. According to Bruce:

The case for fiscal stimulus rests on the belief that macroeconomic circumstances are such that the economy is not near, and is not headed in the near-term toward, a full-employment equilibrium, and that the price matrix is seriously out-of-whack.

I think that his view reflects accurately how many economists feel about why a massive fiscal stimulus is currently needed. The question I have for non-believers is the following: Do you find Bruce's argument persuasive?

Personally, I do not. He makes no attempt to justify his belief that the price-system is seriously out-of-whack. And even if it is out-of-whack, he makes no attempt to explain to us why this is the product of market malfunctioning, rather than government regulation. Moreover, he does not tell us what "the full-employment" level of employment is in the U.S. Nor does he identify other episodes in economic history where the policy has worked under similar "special" circumstances. No...instead we are asked simply to believe. Indeed, the non-believers are asked to explain why they do not believe!

I have stated earlier that I believe that fiscal stimulus can "work" as a redistributive mechanism. The only semi-clear evidence I see where fiscal policy has "worked" to stimulate aggregate output and employment is in the U.S. during WW2. But this policy was also associated with a significant decline in private consumption. In short, people were willing to make sacrifices to support the war effort. A similar policy today would not likely be viewed as welfare-enhancing by a population not currently facing a large threat to national security.

Where else can we find examples of economies subject to Bruce's special "deflationary" shock? How about Japan? Why did Bruce not mention the "success" that Japan has had in overcoming its troubles with fiscal stimulus. Let me explain to you why. Because the evidence clearly does not support the hypothesis; see my earlier post here. (Actually, if memory serves, perhaps Bruce mentioned that the Japanese case simply shows that fiscal stimulus is "not enough." But even so, this is hardly a persuasive argument to make in favor of fiscal stimulus).

But then, there are a lot of really smart people out there that believe that it works. Take Brad DeLong for example in his debate with Michele Boldrin; see my post here. DeLong, being the economic historian that he is, even goes so far to give us examples that purport to show why fiscal stimulus will work. What are his three examples? Here they are:

[1] The 2003-2005 housing boom, facilitated by loose monetary policy;[2] The 1996-1998 internet boom;[3] The post 1982 boom following the easing of monetary policy, the Reagan tax-cuts, and increase in military expenditure.

Now are you persuaded?

Perhaps we should believe on the basis of what some econometricians report to be fiscal multipliers above one? No one will be persuaded; this "evidence" is simply not compelling. (Among other things, we know that based on the manner in which fiscal purchases are accounted for in NIPA, the "true" contributions to GDP are by definition overstated).

Where is the evidence? Somebody please tell me. I need something more than a thinly-veiled belief that the private sector is screwed up and that therefore "something" must be done by the government to correct this screw-up.

Let me repeat what I have said in earlier posts: if a case is to be made for fiscal stimulus, it should likely be framed in terms of its desired effects as a redistributive mechanism. Here, I think the evidence is much clearer and can be made much more persuasive. One may question why it is socially desirable to keep construction workers or auto workers employed when there is clearly too much product on the market, but at least it is clear how such a policy benefits these unfortunate workers.

I suspect that this argument is not made for two reasons. The first is political; i.e., it is much more politically palatable to sell a fiscal stimulus package on the grounds that "everyone" will be made better off. The second has to do with the way most conventional macroeconomic models are structured; in particular, they are usually one-sector models so that economists trained in these models have not often thought about how, in practice, fiscal policy is usually directed to specific sectors. Who knows...this is largely conjecture on my part.

Believing in Fiscal Stimulus

My earlier post appears not to be having its desired effect. What I am really curious to know is why people believe that fiscal stimulus "works" in the conventional sense; i.e., leads to a desirable increase in aggregate output and employment.

Personally, I do not believe this; that is, I remain unconvinced by the arguments people typically employ to support this belief. This does not mean that I believe that the contrary is true; it simply means that I remain agnostic.

But most people appear not to be agnostic on the matter; they appear to believe very strongly that fiscal stimulus works. Of course, there are some that believe very strongly that the opposite is true. I am not sure what accounts for their belief either, but I choose to ignore them. The burden of the proof surely rests with those that believe. If you want me to make a big earthly investment in relation to your belief in Jesus Christ, then it is up to you to convince me (it is not up to me to disprove the existence of God).

When I was an undergrad, I believed that fiscal stimulus worked. Why did I believe this? Because this was what I was told; and at that young age, I had no reason not to believe what my professor told me. Moreover, he could show me the "logic" of the argument by way of a simple theory (at that time, the IS-LM model). He could even point to WW2 as empirical evidence in support of the theory. This theory was further corroborated in my mind by the fact that policymakers, newspaper columnists, and many other economists said exactly the same thing. The "truth" of this matter was (and still remains) conventional wisdom.

I also used to believe that Lemming populations were prone to commit mass suicide by jumping off cliffs. Why did I believe this? Because this is what I was told; in particular, this is what Walt Disney told me in his Academy Award winning 1958 documentary White Wilderness. You can see the footage here. How's this for empirical evidence?


Naturally, almost everyone who has ever heard of the phenomenon actually believes it. The image of lemmings running off a cliff has become a popular metaphor for following a crowd in an unthinking manner; see figure above.

It was only many years later that I discovered that this "fact" was a myth. Even worse, the "Norwegian" lemmings shot by Disney were imported from Hudson Bay to Calgary, where they did not jump off the cliff but were, in fact, launched off the cliff using a turntable.

I suppose that the point I am trying to make is that we are all to some extent "slaves of received wisdom." This is unavoidable. But it is not unavoidable that we should let this defect prevent us from questioning the conventional wisdom handed down to us by our predecessors (and repeated in rote-like fashion by true believers). I am wondering to what extent the widespread belief in fiscal stimulus is similar in any way to what many believe to be true of lemming populations?

As I mentioned in my earlier piece, many (certainly not all) people appear to believe in fiscal stimulus because they can see how it "works" at the microeconomic level. For example, here in my home province of British Columbia, we can measure quite directly the impact on gross employment stemming from the government's decision to build several state-of-the-art "fast ferries." The shipworkers benefited; as did a number of related trades. And the incomes earned by these people in this endeavor were no doubt spent in a manner that "stimulated" other economic activity.

But while the impact on gross employment is easy to measure, the impact on net employment is not. This particular fiscal stimulus program cost provincial taxpayers close to $500 million. This is 500 smackeroos that was no longer in the hands of the people who earned it. This loss of private sector purchasing power must have surely depressed the demand for all sorts of goods and services; and by implication, depressed the demand for labor in many sectors of the economy. Moreover, some of that income that would have been saved to ultimately finance other capital expenditures, now found its way to finance a fleet of fast ferries. In short, the aggregate impact of this policy--if measured correctly--is not likely to have been very large. (Unfortunately in this case, it did turn out to be large, but in the opposite direction; see fast ferry fiasco).

It would be more persuasive, in my view, if proponents of fiscal stimulus promoted their belief on the basis of its redistributive effects; not its aggregate effects. There may very well be a good reason to advocate fiscal stimulus with the view of supporting various sectors in dire need of help. But this is a very different argument than asserting that (almost) everyone will somehow benefit. This latter argument may even be true; but like I said, I have yet to be presented with convincing evidence.

Does Fiscal Spending "Work"?

I just returned from a visit to the Bank of Canada and had the opportunity to speak to a few high-level officials at the Bank along with several leading academics concerning a variety of issues relating to the current financial crisis.

In some of my conversations, I brought up the subject of fiscal spending; in particular, the desirability of many of the so-called "fiscal stimulus" packages that are currently being proposed. I am not sure why I was surprised, but almost everyone I spoke to thought that there was clear merit in the idea of "fiscal stimulus;" especially in the form of infrastructure investment.

Once their view was made known, I asked the question "why?" What evidence can be brought to bear in support of their view? What was it that convinced them of their belief on this matter?

Judging by the delay in the responses I received, I got the impression that many were not used to being asked such a question. They had to pause, after the initial shock I suppose, of having to collect their thoughts on the matter. The responses I received were not entirely convincing.

The responses could be divided into one of three categories:

[1] There is econometric evidence which suggests that the government spending multiplier is greater than one;
[2] The big jump in U.S. fiscal spending during WW2 and corresponding increase in GDP constitutes clear evidence of the efficacy of fiscal stimulus; and
[3] These are unusual times; the market is screwed up and *something* of this sort must be tried.

Personally, I am skeptical of having one's belief on the matter so firmly rooted on the basis of [1]. But perhaps one of you might persuade me otherwise.

The second world war is one data point that most people like to point to for confirming evidence. But is it wise to base one's beliefs on this one data point? The war experience was rather unusual. True, there was a massive buildup in military hardware (and hence, measured GDP), much of which was destined for destruction. But there was also a sharp drop in personal consumption expenditures (e.g., foodstuffs and material were rationed to the population). And while employment surged, much of this was by taking women out of the home sector and into the production of war materials. I can see why a population might want to make such sacrifices during a period of war; but would they be willing to do so today? And if so, would such a diversion of resources make society better off in any meaningful sense? I am not sure.

I found [3] the least convincing. My own view is that if we do not have convincing evidence that a particular policy will "work," then how do we know that doing "something" might not leave things even worse off than doing "nothing" at all? Since doing "something" involves the mass appropriation of resources from private citizens, would it not be better to err on the side of doing "nothing?" (Evidently not).

Of course, there may be better answers to the questions I asked, but these were the answers I received. My surprise, I suppose, was not in the answers themselves; but rather, how firmly people seemed to believe in the value of fiscal stimulus on the basis of their reported answers. Is this some sort of new religion? Perhaps they might have provided more convincing answers if they had a little more time to think about it, but I am not sure.

My own view is that people believe that fiscal stimulus works because there is no question that it does work at the microeconomic level. That is, when the government commissions a large number of workers to build something, one can actually see it being built, and one can actually see workers being employed in the act of construction.

But of course, what appears to work at the microeconomic level does not necessarily mean that it "works" at the macroeconomic level. It is harder to "see" the general equilibrium effects. It is harder to estimate net employment creation (rather than gross). What would these workers have been doing absent the government project? Would they have sat at home "idle;" or would they have been employed in some other sector (or perhaps engaged in retraining?). And how does the tax bill levied on the population at large affect their desired spending? If government spending is so successful in one area, then why not have the government coordinate all production activities in the economy? What is the optimal level of government spending? How does one calculate it? These are much harder questions to answer; and so, I suppose it is easier if they are not asked.

I leave you with a couple of articles on Japan's fiscal experience:
Bloated Bureaucracy Exposed (Japan Times)
Japan's Big-Works Stimulus is a Lesson (NY Times)

For the time-being, I remain agnostic on the subject (although, I confess that the evidence from Japan leans me more in one direction than the other). If someone can provide me with clear evidence one way or the other, I'd really appreciate it!

Multiplier Mischief

The current debate over the size of the "government spending mulitiplier" is a perfect measure of the sway that conventional economic theorizing continues to grip the minds of people who should know better.

At the center of the theorizing is the income-expenditure identity: Y = C + I + G. This identity is not a theory; it is something that is true by definition. The theory comes in by way of behavioral assumptions that are imposed on C and I. All that is left is to determine how an exogenous change in G manifests itself as a change in Y. The government spending multiplier is dY/dG. Now all economic historians have left to do is to try to estimate the size of dY/dG. They frequently "discover" that dY/dG > 1. That is, it appears that for every dollar the government spends, the national income appears to increase by more than a dollar. Conclusion: Obama's stimulus package is a good idea.

There you have it. The only puzzle remaining is why it takes 4 full years of training to receive a PhD in macroeconomic theory; and why it should take a further 6 years to become a tenured professional by publishing papers examining what we all know to be the self-evident truth embedded in this "really useful ad hoc model."

Unfortunately, I am apparently one of few who have trouble absorbing this simple theory. But perhaps there is still some hope for me. I just need a few questions answered.

[1] What does this theory predict concerning the optimal level of Y? Is more Y always to be preferred to less? When Y was expanding rapidly above trend during WW2, were people really made materially better off? Were people made happier by their long hours employed in military manufacture and European adventures? Did people really enjoy the rationing of foodstuffs and gasoline associated with the increase in G? Was the general destruction of capital (both physical and human) during WW2 really associated with increasing wealth levels?

[2] Do *measured* increases in Y associated with increases in G correspond in any meaningful way to *true* increases in Y? Do we not know that when the government pays for something, the "value" of this purchase is measured by cost (instead of market-value) by the National Income and Product accountants? Is this not a serious problem in assessing the "true" value of an increase in G? Are measured government spending multipliers simply a figment of this questionable accounting exercise?

[3] What are we to make of multiplier estimates that are above unity? Is this a linear approximation? Does it represent the value of the marginal dollar spent? (If it does not, then is the implication that the entire economy should simply be nationalized?).

[3] Do the "microeconomic" details concerning the added G not matter at all? Does it matter, for example, that almost $100 million in "stimulus" money is being directed to the Milwaukee Public School system to construct new schools (a district that has been closing schools as a result of declining attendance; see here)? Are people still willing to argue that "digging up holes and filling them in" is a wise use of economic resources?

[4] What does this simple theory identify as the "cause" of recession? An exogenous decline in private sector "sentiment?" What does this mean? Is this purely pyschological? Can we not expect private sector agents to make estimates of the future based on the best information available? Does the government have better information? If so, why does it not make it available? Can declining consumer and business sector "confidence" not be reasonably interpreted as a symptom, rather than a cause, of any economic downturn? How can we know, one way or the other? What evidence can be brought to bear on the idea that recessions are "inefficient?" Is the arrival of a harsh winter that freezes construction to a halt also inefficient? Should the government promote construction activity during a freezing winter?

[5] What is the government spending multiplier in Japan since 2000?

[6] Should we follow Christina Romer's advice and take employment as a metric of economic welfare? Has she not studied economic theory? (Actually, I know the answer to this last question--it is no). I recall reading an article from the TASS news agency, published in 1957 that "the unemployment rate in the Soviet Union, as in previous years, was equal to zero." Should we seek "full employment" along the old Soviet model? Is this how we are to measure success?

I have many more questions, but these will do for now. Of course, some of these questions are rhetorical in nature. But many are not; I genuinely do not know the answers to them. Evidently, the likes of Romer, DeLong and Krugman do know the answers to them. But perhaps this is because none of these esteemed academics are macro theorists. They likely view my ignorance on these matters as evidence supporting their proposition that too much macroeconomic theory distorts the mind. Thank goodness we have these clear-thinking folk around to set me straight!

DeLong vs Boldrin on Fiscal Stimulus

The following links are from Greg Mankiw's blog. The first is a statement by Brad DeLong, explaining why the large fiscal stimulus package can be expected to work; see here.

Any good scientist will try to support his or her views by pointing to the evidence. What is the evidence that large fiscal stimulus packages have worked in the past? DeLong gives us three examples:

[1] The 2003-2005 housing boom, facilitated by loose monetary policy;
[2] The 1996-1998 internet boom;
[3] The post 1982 boom following the easing of monetary policy, the Reagan tax-cuts, and increase in military expenditure.

He goes on to write:

These are just three examples of a general principle: each major business-cycle expansion we have seen has been driven by a leading wave of spending—by some group that became enthusiastic about their prospects and decided to greatly increase its spending. And that pulled employment and production up.

I view this as evidence that DeLong should have his degree in economics revoked.

This is the best he can do? The first two examples have nothing to do with fiscal policy. The suggestion that the 1980s boom would not have occurred absent the Reagan tax cuts and increased military spending is dubious at best. Moreover, he neglects to point to the several cases we know of demonstrating the converse (with Japan being the most notable recent example).

His thesis appears to be that a significant increase in "confidence" is followed by an increase in spending and an increase in production. This much is no doubt true. Whether this "starry eyed" optimism begins in the private sector or the public sector is, in his view, irrelevant. This is almost surely not true. Confidence in the private sector is ultimately based on information that signals the expected productivity of capital investment (these expectations can turn out to be wrong ex post, of course). In short, private sector confidence is a by-product of changing fundamentals; that is, confidence is symptomatic and not causal. Confidence cannot be manufactured out of wishful thinking; which is the approach that fiscal policy appears to based on.

For more sober appraisal, I refer you to Michele Boldrin's take on this; see here.

A New Look at the New Deal

In my previous post, I made note of Paul Krugman's statement that "Everyone's looking back to the 1930s for policy guidance-and that's a good thing."

I think what he likely meant by this is that it is a good thing that everyone appears to acknowledge the self-evident fact of how FDR's New Deal policies lifted an unwilling American private sector out of what would otherwise have been a state of permanent stagnation; and how current policy should be designed with the knowledge of this experience firmly engrained in our minds.

It is certainly true that many people are looking back to the 1930s for current-day parallels. But obviously, not everyone shares Krugman's religion on this matter. Consider, for example, this recent piece by Professor Hal Cole (University of Pennsylvania) and Lee Ohanian (UCLA) in the Wall Street Journal:

How Government Prolonged the Depression

Pop quiz: Which U.S. president made a speech in which he acknowledged that the American economy had become a "concealed cartel system like Europe"? Hint: the speech was made in 1938.

A Stimulating Lesson from Japan?

Here we go again. Economic growth is slowing. Stock markets have plunged. Banks are failing. Perennial doomsayers are basking in a glow of perverted pleasure. A plethora of pundits are earnestly explaining the dire need for "stimulative" government spending measures to reverse the course of what will otherwise be a prolonged depression. In short, par for the course.

Well, perhaps not quite par. This time around, many governments appear to be taking seriously the notion that a massive government "electric shock therapy" is needed. Things certainly do seem gloomy out there. Is there any merit in the view that a massive government fiscal action can rescue the day? Apparently, there must be. Why would all these learned people be advocating a policy prescription that is not solidly backed by economic theory and the historical evidence?

To learn more about this view and what underlies it, I decided to visit the arch-liberal Professor Krugman. He begins a recent article by stating that

Everyone’s looking back to the 1930s for policy guidance—and that’s a good thing. But we don’t have to go back that far to see how fiscal policy works in a liquidity trap; Japan was there only a little while ago.

Japan? Well, this sounds promising. What does he have in mind exactly? Evidently, it is the evidence provided in Adam Posen's new book, Chapter 2, entitled Fiscal Policy Works When it is Tried.

Posen argues that, contrary to common perception, Japanese fiscal policy during the 1990s was not really expansionary. On pg. 49 he highlights an exception to this case; a brief period in September 1995. He interprets the corresponding increase in GDP in late 1995 and early 1996 as being attributable to the September stimulus package. This is his evidence that fiscal policy works when it is tried.

Well, maybe he's right. Or maybe not. Quite frankly, I doubt that anyone really knows. In any case, I thought it would be interesting to see how this hypothesis might square up with another look at the data. For this purpose, I chose to consult the Penn World Tables; an international data set frequently used to make international comparisons.

In what follows, I compare Japan to the US. Annual data is available for the time period 1950-2004. I take a look first at levels of real per capita income (GDP) across these two countries. The data look a lot like what one would expect. Relatively stable growth in the U.S., interrupted by the occasional recession. The post-war Japanese growth "miracle," interupted briefly in the 1970s, the late 1980s boom followed by the "lost decade" of economic stagnation.

Next, let's take a look at the available measure of government spending (government purchases; which excludes that sizable chunk of government spending in the form of entitlements). The data reveal a general upward trend, as one would expect in growing economies. Significant bumps in US government spending occur during the Korean war, the peak of the Vietnam war, and in the late 1980s. The growth in government spending in Japan appears more stable and rapid. Note that the 1995 stimulus bill (and subsequent contraction) highlighted by Posen shows up as a relatively minor blip on this chart. Moreover, the pattern appears to have been sharply reversed in the late 1990s and into the 2000s.

A better measure of the "size" of government is to compare it to the "size" of an economy; say, as measured by its GDP. The next figure plots the ratio of government purchases to GDP. By this measure, the relative size of the U.S. government has been in secular decline since the Korean war. There is an even sharper secular decline in the relative size of the Japanese government in the early part of the sample. This latter trend appears to have ended by 1970; and has shown signs of accelerating upward since 1990. On the basis of this data, I think that one might be forgiven for adopting the "mistaken" impression that Japanese fiscal policy has been largely expansionary since 1990.

The last figure I present considers the relative magnitudes of GDP across Japan and the U.S.; as well as the relative magnitudes of the government spending (purchases) share (GPS) across these two economies.

The blue line plots relative income (real per capita GDP). That is, in 1950, real per capita income in Japan was roughly 20% of that of the U.S. By 1970, it was roughly 70%; and by 1991, it was roughly 85%. By any measure, this constitutes a remarkable economic achievement. And this must especially be the case when one considers the devastated state of the Japanese economy at the end of WW2.

The question I want to ask here relates to the behavior of the relative size of government spending over this episode; this is plotted by the red line in the figure. The downward plunge in the early part of the sample reveals that Japanese government spending (as a fraction of GDP) declined rapidly relative to its U.S. counterpart. The upward rise during the latter part of the sample reveals that Japanese government spending (as a fraction of GDP) increased rapidly relative to its U.S. counterpart. The most interesting thing to note is that the blue and red lines are virtual mirror images of each other.

Of course, there are several ways in which the patterns displayed in this data might be explained or interpreted. I am especially eager to learn how this evidence might be construed as supporting the notion that fiscal policy "works" and how this lesson from Japan might be fruitfully employed to cure the current economic crisis.