Christina Romer's Case for Fiscal Stimulus

In a new press release Christina Romer, Chair of the Council of Economic Advisors in the US, defends the Obama admistration's nearly $800 billion fiscal stimulus. She discusses her views on the effects of fiscal policy and then discusses the rational behind the timing and choice of spending programs in the Recovery Act.

In setting out her position she makes clear her disagreement with Barro over the size of the multiplier. In particular she argues that Barro's approach suffers from omitted variable bias as he advocates using periods of war to look at spending and output. Her own research, with her husband David Romer, isolates periods in which tax changes are uncorrelated with output and attempts to guage their effect. She reports that her findings indiciate "a tax cut of 1% of GDP raises GDP by between 2 and 3% over the next three years".

She acknowledges that conducting similar resarch for government spending is all the more difficult due to the liklihood of omitted variable bias but believes that this will bias the estimates of the multipliers downwards. The estimates of the effects of the recovery package conducted by Romer and Bernstein suggest that, using conventional multiplier estimates, "a tax cut has a multiplier of roughly 1.0 after about a year and a half, and spending has a multiplier of about 1.6".

Her rebuttal to accusations that fiscal policy is less effective in the precence of malfunctioning financial markets is the following:

I think it is possible that fiscal policy will have even more oomph in this situation. When households and businesses are liquidity-constrained by reduced lending, any money put in their pockets is more likely to be spent.

This assumes that households are currently illiquid (or even insolvent) and therefore have to spend any extra money given to them. What about those housholds who are not below this threshold? If they've experienced negative wealth effects from a fall in asset prices or are concerned about their future income (i.e. job), are they not more likely to save? This will only be worsened by credit market imperfections which prevent households from smoothing by borrowing and force them to save, even when it is not optimal to do so.