Monday, September 9, 2013

Economics is not Science - ECB Working Paper Edition

There is a ongoing discussion if economics should be considered science. I personally think that not being able to test any policy in a controlled environment without external influences keeps it from being and possibly ever becoming science. This brings me to a recent ECB working paper by Nickel and Tudyka titeld "Fiscal Stimulus in Times of High Debt"(pdf).
They argue that an increase of 1 percent in government consumption at a high debt to GDP ratio might cause a complete collapse in private investment, GDP, and significantly improves the trade balance a few years later; aka massive austerity.  Sorry, I am not buying that at all. Here is why:

There is also a shorter VoxEU blog post (look at the graphs provided -> massive austerity a few years after a smallish 1 percent government consumption impulse at high debt to GDP ratios) of said paper available. They conclude:

Consequently, the effectiveness of fiscal stimuli to boost economic activity or resolve external imbalances may fade with increasing debt-ratios. In fact they may even be counterproductive. From a policy perspective, these results therefore lend additional support to increased prudence at high public-debt ratios.
Of course, it should come as no surprise that ECB economists conclude that there was no other choice but to use austerity. What did surprise me was the overall approach. They uses 17 European countries from 1970-2010, including Germany. They do not mention any precautions taken to prevent having all their results affected by the reunification of Germany. Also many of countries included joined the euro during the time frame which completely changes the situation due to no monetary policy being available anymore.

There is also no mention of precautions taken that the "measurements" stay unaffected by externalities. The shock through the oil crisis of 1973 was for example answered in Italy by giving out vouchers for gasoline. Yes, this was aimed at stimulating tourism, but the external price shock caused fiscal stimulus, which of course could not mitigate the real oil price more than doubling. The next hit on GDP was caused by another oil price shock in 1979. It is mind boggling that the 1970ies were included into the data, because clearly external forces caused the falling GDP. Any stimulus enacted in 1974 could by the end of the decade in the model look like it had caused a massive drop in GDP, which is not what happened.

Even worse is that the Great Recession is included. Any action taken during the in the years 1995-2005 therefore looks like it had a massive negative impact even though it is in no way responsible for what happened from 2008 onwards. For example, the dot-com bubble bursting caused the consumption expenditure to increase in many countries in 2002 (e.g Greece 17.4 % to 18.3 % of GDP France 22.8 % to 23.5 %). Six years later, the great recession hits, which might again make any effort at the beginning of the decade look like it caused the crisis if no precautions by the model designers.

This seems to be exactly what happened. Now, personally I would have been quite worried about the functionality of my model if I input a 1 percent increase; and it returns a massively negative shock of around 6 percent of GDP around a decade later in some cases. A smallish increase in spending leads to massive austerity and private investment collapse a decade later, really? But, hey perhaps Ireland's reaction to the oil price shock in 1973 might actually be responsible for regime change in Iran at the end of the decade; and Greece's futile effort after the dot-com bubble burst could have caused all actors on the US housing market to go ape-shit. At least that seems to be what the study is suggesting.The results would be completely different if the the years 2008 onwards would not have been included.

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