Fiscal Policy: What's the Null Hypothesis?

My entry at the Romer Roundtable:

Don't "Nullify" Fiscal Policy

When deciding between two alternatives such as whether the government should intervene in the economy with a fiscal stimulus or not, the choice of the null and alternative hypotheses influences the type of errors we are likely to make.

A standard example to illustrate this is the problem of deciding guilt and innocence. If we make guilt the null hypothesis, and only reject the null when there is overwhelming evidence to the contrary, then we are going to find people guilty unless there is enough evidence presented to convince jurors the person did not act as charged. The biggest risk here is that innocent people will be sent to jail since innocence must be established through overwhelming evidence, but guilt is presumed. It's possible that a guilty person will be found innocent, but the more evidence that we require to find someone innocent—e.g. a strict standard like beyond a reasonable doubt—the smaller the chance that the guilty will be set free.

If we make innocence the null hypothesis, then things are reversed. In this case we will only send someone to jail if the evidence overwhelmingly points to guilt, so the biggest risk under this null is that guilty people will be found innocent. Again, it's possible that an innocent person will be found guilty, but the system requires a high burden of proof so as to minimise the possibility of this happening.

In the US, we think sending innocent people to jail is a bigger mistake than setting guilty people free, so we make innocence the null hypothesis in court cases rather than guilt, and we require a high level of "proof" before rejecting the null. (When money rather than freedom is at stake as in civil cases, the standard for conviction is often lower. This causes more innocent people to have to pay fines, but fewer guilty people escape them).

What does this have to do with deficit spending and recessions? Our tendency is to assume that the economy is doing fine and doesn't need help from fiscal authorities unless there is clear evidence the economy is crashing. Only then does the government intervene with deficit spending.

Thus, our null hypothesis is that the economy does not need any help, and we require a fairly high burden of proof to overcome that presumption. Because of this, the error we are most likely to make is to do nothing when action is called for, and that includes ending help too soon, particularly given the information lags we face in assessing the state of the economy. It's possible that we could get fooled by the data into acting when it isn't necessary, but since we require clear signals that the economy is in trouble before we act, and because data are slow to arrive, acting when it isn’t needed is less likely than doing nothing when, in fact, active intervention is called for.

Unlike in court cases, however, where a null of innocence allows us to minimise the costly error of jailing the innocent, the null that the economy is "innocent", i.e. that intervention from authorities is not required, leads us to minimise the wrong outcome.

Which is the bigger error, to deficit spend when it's not needed, or to fail to do so when it is? I think the bigger risk is doing nothing when it's needed, particularly when the economy has the type of difficulties we are seeing now. The risk of doing nothing is a severe depression, while the risk of overreacting is inflation or, perhaps, slightly slower growth for a period of time in the future. I don't see those risks as balanced at all, allowing a depression is—to me—the more severe error, the equivalent of sending the innocent to jail.

We saw the problem with having the wrong null hypothesis when the economy was slipping into the recession. The stimulus package should have been in place long before it was actually implemented in order to be maximally effective, but policymakers were reluctant to act until there could be no doubt that action was called for.

And we are seeing this again now. We may very well need another stimulus package, and we ought to be doing the work to get it ready, but there just isn’t enough evidence to convince policymakers that's the case. They will have to see clear evidence of continuing troubles and also believe there's no chance that recovery is just around the corner before they will act, and that’s a high standard to meet. And worse, as we’ve seen recently, as soon as the evidence that we are still in a recession becomes a bit foggy—at the first sign of green shoots—many people will be ready to end the intervention even though that may not be the right course of action.

I can understand the tendency to resist intervention at the first inkling of troubles. So on the front side of a recession, I can understand a null hypothesis that no action is needed, but it ought to be one that can be overturned with a fairly low burden of proof. We shouldn't have a "beyond a reasonable doubt" standard, it's not criminal to mistakenly intervene, it should be more like the "clear and convincing" standard sometimes used in civil procedures, or, even better, the weaker "preponderance of the evidence" standard used in civil cases.

But once we are in a recession, as now, I cannot understand why the null does not change to being one where the economy is presumed to need help until there is—beyond any reasonable doubt—evidence that the economy is on the path to recovery. Look at the 1937 experience on the graph in Mrs Romer's article again and see how costly it is to pull back too soon, then compare that to what the cost would have been to continue the policies for a year, or several years, even though they weren't needed. It seems pretty clear to me that the cost of pulling back too soon was the much bigger worry. We are facing the same choice now, or will soon. Do we pull back at the very first signs of green shoots, as we seem to want to do, or do we wait until we are much, much more certain that things have, in fact, improved to the point where recovery is all but certain before withdrawing stimulus measures?

As Brad DeLong notes, if it is the long-run budget you are worried about, ending the stimulus package, say, six months or a year earlier makes little difference to the long-term budget outlook. That being the case, and given the dangers of not doing enough and the dangers of ending the help too soon, why are we in such a hurry to end the stimulus package, and we are we so reluctant to consider doing more?

Other entries from:

• The Lessons of 1937 - Christina Romer (Lead Essay)

• Allan Meltzer: Think, plan, and tell us the plan
• Brad DeLong: Worse than we planned for
• Harold James: Develop an exit strategy
• Tyler Cowen: An unprecedented experiment
• Michael Bordo: Avoid monetary tightening
• Barry Eichengreen: Inflation signs are misleading
• Ray Stone: An imperfect parallel

Update: See also

• Brad DeLong on Allan Meltzer

Comments

[theblindtib...:]

With due respect to the author, my memory serves me differently.

He writes: "We saw the problem with having the wrong null hypothesis when the economy was slipping into the recession. The stimulus package should have been in place long before it was actually implemented in order to be maximally effective, but policymakers were reluctant to act until there could be no doubt that action was called for."

Are we living on the same planet?

I rememeber the DJIA soaring to 14,000 and then a violent and precipitious crash followed by an almost immediate and frantic response to pass an enormous stimulus bill through Congress that everyone admitted was ill-thought out. It was an absolute panic reaction with even the Oracle of Omaha declaring the economy was having a heart attack and the paddles must be plied without a moment's hesitation or further deliberation. So, while elegant and well written, I reject this thesis entirely, as it is rewriting history to fit its convictions. We can always fashion myth to serves any means.

Jun 19 07:48 PM

[Jasper M:]

I second Blindy's comment, on all points.

Jun 19 10:17 PM

[nym:]

Yes, Professor, were you one of those soft-landing advocates during the first half of this decade?

Jun 19 11:22 PM

[nonedare:]

Nonsense! Keynes is nonsense and has no place in a free country. Austrian economics is a more logical way to approach the topic in America unless you are one of the Insiders who have a stake in the lies and theft behind deliberate inflation, deficit spending, and politicians who sell their votes for "pork."

Jun 20 08:58 AM

[nonedare:]

Excellent review of the "null hypothesis.

Jun 20 08:59 AM

[tweaks:]

So, what would have been the data that caused us to reject or accept the null hypothesis however described? Your appetite for alpha and beta risk should drive your decisions, and until you show us those weights (1%?, 5%?, 10%?) the above is just a philosophical - even worse, a political - argument.

And how about my ("consumer risk") appetite? Frankly, most of us don't see the need to prop up reckless financiers and politician's with our children's futures. Put a beta of .3 or .4 in your calculations and see where you end up.

With respect, using statistical language doesn't help your case if one has a modicum of understanding of statistics.

Jun 20 10:32 AM

[Jeff Nielson:]

This is not a "null hypothesis" scenario, in any way. It is a "no-win" scenario.

Too much reckless spending by the U.S. to try to borrow-and-spend its way out of insolvency destroys the U.S. dollar and causes hyperinflation.

Too little spending, and the U.S. economy suffers a debt-implosion very similar to the Soviet Union.

The U.S. government is engaging in wishful thinking in hoping there is a "middle ground" which doesn't lead to either of those scenarios. Instead, it is likely to get BOTH.

See "Rising U.S. interest rates signal hyperinflationary depression" www.bullionbullscanada...

Jun 20 11:16 AM

[The Arthurian:]

Once I figured out that by "null" you mean "default" your article made perfect sense to me. Except for one thing. You write: "Which is the bigger error, to deficit spend when it's not needed, or to fail to do so when it is? I think the bigger risk is doing nothing when it's needed..."

Yes we need to do something, and yes the economy needs stimulus. But <i>more deficit spending</i> is dogma. Set it aside and rethink it through, as the great and wonderful Keynes would do.

Blindy, the trouble with your analysis is that stock market peaks are not the best indicators of peaks in economic growth. As Milton Friedman points out [<u>Free to Choose</u>, Chapter 3, under "The Onset of Depression"] "Business activity reached its peak in August 1929, two months before the stock market crashed." Could be wrong, but I think it was more than two months, this time.

p.s. Look for the "Stimulus Watch" gadget for your iGoogle page.

Jun 20 12:18 PM

[whidbey:]

Interesting mistake. His argument is not relevant to his application. Mr Thoma assumes that when the true outcome is not known it is best to be biased against making an error in the direction of making things worse (if you can know that at the outset). But in a very flexible economic situation the consequences of outcomes will shift almost daily or monthly. This is hardly comparable to requiring guilt beyond a reasonable doubt where we can assume there is just one correct answer and it will not change over time. It is a misapplication of a statistical proposition. I am just a little shocked professor.

Jun 20 01:51 PM

[jorloskawitz:]

The further misapplication is assuming that these decisions are not cumulative. In our judicial system, once a person is convicted, he or she is largely put away for the term of sentencing. In an economy, these decisions present themselves relatively frequently. That might sound like a good thing, since it means any action can be "reversed", but a reasonable implication of the author's thesis is that more often than not action will be taken to "do something"--something inflationary and deficit increasing. That might seem better than the alternative in a one-off depression or recovery scenario, but it ignores the bigger forest which is a constantly expanding money supply and an exponentially accumulating deficit. If that's not a risk worth avoiding, I'm not sure what is.

Jun 21 01:10 PM

[Michael_Cohen:]

I'd say government spending is worse than lack of it. More government is more inefficiency. A society where the government is a greater percentage of GDP is going to have a lower standard of living than a more free market economy....basically compare us to Western Europe/Japan (or at least how we used to be).

Jun 21 05:51 PM

[walleke:]

You've got it exactly backwards Mr. Thoma. We have been stimulating the economy for decades. Picture a cow walking down the road. Impatient for the cow to move faster we give it a "stimulus" with an electric prod. At first the cow hustles. But after the fiftieth prod the old cow is ready to drop dead.

What's the difference between a liberal and a conservative? A liberal thinks you can balance the budget by increasing spending, and a conservative thinks you can balance the budget by decreasing taxes.

Jun 21 10:01 PM