Sunday, September 6, 2009

State Finances and Mankiw's Unit Root Hypothesis

Glenn Reynolds mentions an article in the WSJ by Indiana governor Mitch Daniels The Coming Reset in State Government:
During the last decade, states increased their spending by an average of 6% per year, gusting to 8% during 2007-08. Much of the government institutions built up in those years will now have to be dismantled.

...unlike the aftermath of past recessions, odds are that revenues will take a long time to catch back up to their previous trend lines—if they ever do. Tax payments have fallen so far that it would require a rousing economic rally to restore them. This at a time when the Obama administration's policies on taxes, spending and more seem designed to produce the opposite result. From 1930 to 2008, our national average annual real GDP growth rate was 3.49%. After crunching the numbers, my team has estimated that it would take GDP growth of at least twice the historical average to return state tax revenues to their previous long-term trend line by 2012.
That reminded me of Greg Mankiw's Unit Root Hypothesis. Here are a couple of key quotes from that:
...according to the [President's Council of Economic Advisors], because we are now experiencing below-average growth, we should raise our growth forecast in the future to put the economy back on trend in the long run. In the language of time-series econometrics, the CEA is premising its forecast on the economy being trend stationary.
Mankiw's research [PDF] suggests that the trend stationary premise is incorrect:
The data suggest that an unexpected change in real GNP of 1 percent should change one's forecast by over 1 percent over a long horizon.
In mid-August the professor added this:
What Olivier is saying is that the shocks to the level of GDP from banking crises are typically permanent...

By the way, the administration's midsession review, with its updated forecast, should be coming out soon. Will Team Obama continue to forecast a rebound to the previous trend path, as they did earlier in the year, or will they change their view and take to heart the kind of evidence Olivier describes above? Either way, it will be noteworthy.

No comments: