A History of Japanese Audit Firms, 1965–2010

Integrating Personal Expertise: A History of Japanese Audit Firms, 1965–2010

by

Masaru KARUBE (Institute of Innovation Research, Hitotsubashi University, Japan)

Hironori FUKUKAWA (Graduate School of Commerce and Management, Hitotsubashi University, Japan)

ABSTRACT

To examine empirically the knowledge integration process of professional expertise that individuals have in a professional firm, this paper examines the emergence and growth of four large audit firms (ShinNihon, Azusa, Tohmatsu, and ChuoAoyama) in Japan over a period from the mid-1960s to 2010. Known as the Big Four, these firms—the product of a series of mergers between more than 70 audit firms—handled the vast majority of audit services for listed companies during this period. After the dissolution of ChuoAoyama in 2006, the remaining three audit firms have dominated the market.

A longitudinal case study documents how these professional service firms were successful in providing nationwide services through mergers with domestic competitors and the provision of global services in alliance with large international firms, even though they did not sufficiently realize the systematic attainment of individual expertise. The historical account of this process suggests that the two driving forces underpinning the merger growth of the Big Four were strategic intent in (1) systematizing individual expertise and (2) establishing nationwide and global service networks in response to the increase in size and growing diversity and complexity of their client base. Finally, this paper discusses the knowledge tension between localized individual expertise and organizational knowledge in a global context.

URL: http://econpapers.repec.org/paper/hitiirwps/13-07.htm

Review by Masayoshi Noguchi

This paper is an interesting piece of work that intertwines management and accounting history with a focus on post-war developments in Japan. The paper was distributed by NEP-HIS on 2013-04-06.

The main issue is ‘how knowledge workers collaborate and create new knowledge through collaboration’ in general, and ‘how professional knowledge workers collaborate between themselves and how collaboration is organized’ (p. 2) in particular. Then the authors state the research question in this study as follows:

‘Our basic research question concerns why large audit firms through a series of mergers have replaced audit services, as initially provided by a single or limited number of individual accountants’ (p. 2).

The fieldwork in Karube and Fukukawa’s paper moves forward by exploring the official history of accounting firms while, at the same time, looking for stated motivations of mergers during the post-war period. As a result, they state the following views as motivation for mergers amongst accounting firms:

‘(1) to overcome the intrinsic contradiction between economic dependency and the independence of audit opinion,

(2) to enhance their systematized audit capabilities to meet the growing and diverse need for audit services by client firms, and

(3) to acquire new client firms by establishing a reputation for audit services’ (p. 2).

Point (3) above is the most interesting, particularly given the stated aim of Karube and Fukukawa. Point (3) seems to be an important driver that helps to explain the mergers between major large-scale firms, according to the authors; who also state that:

‘…such explicit differences did not exist between major firms in terms of the substance of competence. Rather, it seems that no explicit difference in terms of the substance of competence promoted further competition for scale expansion. In other words, scale itself came to serve as a symbol of competence in the competition process between audit firms, especially large major firms. Scale expansion through merger then emerged as a reflection of the intense competition for the social proof of competence’ (p. 27).

According to Karube and Fukukawa, audit firms expanded through the acquisition of the audit services for the Nippon Telegraph and Telephone Public Corporation, Japan National Railways and the Japan Tobacco & Salt Public Corporation. In this regard, greater detail as to the process and selection of these acquisitions would provide interesting case material and warrant further examination in order to deepen the business history of Japanese corporation. In this regard Karube and Fukukawa state that:

‘…these firms were all large, the expectation was that the designated auditor or auditors would have sufficient human resources to provide audit services for such large firms. Moreover, many audit corporations shared the understanding that audit service was in essence difficult to differentiate, so that the size of the audit firm mattered for gaining these sorts of clients’ (pp.17-18).

A key concept in this study is ‘the social proof of competence’, where acquiring reputation, social status and symbolic outputs is more important than actual results/outputs. Therefore, for Karube and Fukukawa during the post-war period Japanese professional auditors:

‘…are more concerned about gaining social proofs of competence than the substance of competence. To do this, they pursue strategies that win reputation from clients, acquire good clients regarded as having high status, and produce symbolic outputs that are visibly appealing to clients. Reputation also derives from each client’s own experience of audit services, or is inferred from the provider’s past experiences, including their courses of action and results. Thus, past courses of action and experience for providers matter in gaining reputation from clients’.

In spite of this profound understanding, the authors develop the following proposition:

‘…in contrast to consulting services, as audit services derive more from the formal audit procedures decided by government, it is more difficult to differentiate services. Thus, the most symbolic output is the scale of services, as exemplified by the number of clients, the number of good clients, revenues from audit services, and the geographic coverage in providing services’ (pp. 6-7).

To be sure, the author will also consent to the other elements, such as recognition from influential others, such as government, being important, though size is one of the important elements for acquiring reputation.

Finally Karube and Fukukawa find no evidence that expansion through mergers contributed to an improvement in organizational competence nor that it improved the quality of audit services (and reduce accounting fraud. Specifically the authors state that:

‘…in the light of the substantial integration of organizational competence, there should be efforts to remove such weak integration as soon as possible after the merger. In the case of Asahi-kaikeisha Audit Corporation, it took nearly 10 years to dissolve the personalized audit system and to systematize the job and client rotations of junior professionals among audit offices within the firm. … As a result, Japanese audit firms succeeded in gaining social proofs of competence by way of scale expansion through mergers rather than realizing the substance of competence, in that they still faced difficulties with the internal integration of the merged firms’ (pp. 25-26).

‘The fact that this mobility [of accountants caused by the demise of Misuzu Audit Corporation] was observed six years later when Chuo and Aoyama merged in 2000 implies not only the existence of insufficient integration but also the presence of strong relationships between clients and accountants in their operations, suggesting the possibility of insufficient systematization of the substance of organizational competence’ (p. 28).

If the social proof of competence and substance of competence are completely different and scale expansion pursues the former objective, this result of the merger of the audit firms is quite natural. Probably, the relationship of both would not be so simple. The merger between the audit firms should have offered an important opportunity to enhance organizational competence, such as wider risk diversification, enhanced economic independence, strengthened bargaining power, improvement through scale merit, nationwide services, etc. Rather it largely depends on the management after the merger whether this opportunity can be exploited or not. In this sense, the authors’ following indication is appropriate:

‘[w]hile merger can be the “easiest” way for a firm to grow, the process of post-merger integration remains a critical and ongoing issue for management’ (p.29).

The State of Business and Economic History in Africa

Does Africa need Business History?

Editor’s note:
In her first contribution to our blog, Stephanie Decker (Aston), the new member of the nep-his blog editorial team, departs from the usual norm of commenting on specific working papers to discuss a forthcoming panel on African business history in the next Association of Business Historians meeting. This departure responds to NEP’s commitment to building and supporting academic communities.

Review by Stephanie Decker

On the fringes of the The XVIth World Economic History Congress in Stellenbosch (South Africa),  my South African colleague Grietjie Verhoef, the vice president of the International Economic History Association, and I had several interesting discussions regarding the state of business and economic history of our host country and continent. And while the economic history of Africa has gone from strength to strength, which is to no small extent due the activities of groups such as the African Economic History Network, the same cannot be said for the business history of Africa. Perhaps ten years ago this would have not been an issue, as business history was still better integrated in the wider field of economic history. But since then, the conference circuit, the publications, and the institutional location of business and economic historians have diverged, and with it common methodologies and research problems seem to have disappeared.

Satellite image of Africa, showing the ecological break that defines the sub-Saharan area (Photo credit: Wikipedia)

As the economic development of the African continent has gone from protracted crisis to what some refer to as an “African Renaissance”, the role of business in Africa, and its institutional legacies, is certainly a subject worthy of further inquiry, and of wider relevance. It is certainly an ideal research setting to observe the role that business can play in supporting or obstructing the economic and social development of poor societies. And around the world there are scholars working on these issues from a variety of angles.

My colleague Grietjie and I decided to write a call in order to find out who is interested in these problems, and whether, if we brought them together, we could find common research agendas that may improve our knowledge of these issues. We were delighted to get responses from scholars around the globe, and on a wide variety of topics.

English: Johannesburg from the top of the Carlton Centre. Deutsch: Innenstadt Johannesburgs (Blick vom Carlton Center) (Photo credit: Wikipedia)

Kofi Asante, as well as Sherryllynne Haggerty, both take a classic African Studies approach byinvestigating the role of African agency in the encounter with the colonial administration and the slave merchants, respectively. But the encounter with foreign powers went beyond colonialism and slavery, as shown by Kingsly Ollong, and Suzanne McCoskey. Kingsly Ollong is interested in how French multinationals manage their investments in Africa through the framework of corporate social responsibility (CSR), even though this may range from lip service to actual commitment to creating social value. Suzanne McCoskey addresses the difficult encounter of African-American freed slaves with Liberian society – similarly to present-day debates about CSR, good intentions did not always translate into social improvements. Finally, Tetsuhiko Takai reflects on the state of the archives of colonial chambers of commerce in some countries of Francophone Africa. Here he specifically highlights the importance for scholars of African business history to cross borders to collect material both on the African continent and beyond.

This is a good reminder of how challenging it is in practice to write African business history, and why so little of it comes from the African continent itself. With perhaps the exception of South Africa, it is difficult for students of African business to write an archivally based history of business without traveling internationally. We are now looking forward to our meeting with these scholars at the Association of Business Historians Annual Conference (http://www.abh-net.org/conferences.html)  at the  University of Central Lancashire, 28th & 29th of June 2013, and hope that this will only be the first step in our initiative to create a global network of scholars interested in the history of business in Africa.

Patents, Super Patents and Innovation at Regional Level

Related Variety, Unrelated Variety and Technological Breakthroughs: An analysis of U.S. state-level patenting

By Carolina Castaldi  (c.castaldi@tue.nl), School of Innovation Sciences, Eindhoven University of Technology

Koen Frenken, (k.frenken@tue.nl) School of Innovation Sciences, Eindhoven University of Technology

Bart Los, (b.los@rug.nl), Groningen Growth and Development Centre

URL: http://econpapers.repec.org/paper/eguwpaper/1302.htm

Abstract

We investigate how variety affects the innovation output of a region. Borrowing arguments from theories of recombinant innovation, we expect that related variety will enhance innovation as related technologies are more easily recombined into a new technology. However, we also expect that unrelated variety enhances technological breakthroughs, since radical innovation often stems from connecting previously unrelated technologies opening up whole new functionalities and applications. Using patent data for US states in the period 1977-1999 and associated citation data, we find evidence for both hypotheses. Our study thus sheds a new and critical light on the related-variety hypothesis in economic geography.

Review by Anna Missiaia

This paper by Carolina Castaldi, Koen Frenken and Bart Los was distributed by NEP-HIS on 30-03-2013. The paper is not, strictly speaking, an economic or business history paper. However, it provides some very interesting insights on how technological innovation and technological breakthroughs happen. This is a large and expanding field in economic history and on-going research on the economics of innovation, I believe, can be of interest to many of our readers.

Professor Butts and the Self-Operating Napkin: The “Self-Operating Napkin” is activated when the soup spoon (A) is raised to mouth, pulling string (B) and thereby jerking ladle (C) which throws cracker (D) past parrot (E). Parrot jumps after cracker and perch (F) tilts, upsetting seeds (G) into pail (H). Extra weight in pail pulls cord (I), which opens and lights automatic cigar lighter (J), setting off skyrocket (K) which causes sickle (L) to cut string (M) and allow pendulum with attached napkin to swing back and forth, thereby wiping chin. (Rube Goldberg, 1918).

The paper is concerned with the study of how innovation in a region is affected by the connections within its sectors in terms of shared technological competences. The term “variety” conveys this concept. The authors differentiate in two types of variety: related and unrelated variety. The former describes the connection among sectors that are complementary in terms on competences and can easily exchange technological knowledge. Unrelated variety, on the other hand, steams from sectors that do not appear to have complementary technology.

These two different types of variety are useful to distinguish for their effects on innovation. Related variety supports productivity and employment growth at regional level. However, unrelated variety is the one that causes technological breakthroughs, as it brings a completely new type of technology into a sector. In a subsequent stage, unrelated variety becomes related, being absorbed by the new sector.

The paper keeps these two types of variety separate and tests for their effects. The authors use patent data for US states in the period 1977-1999. The methodology implies regressing the number of patents as a proxy for innovation, on measures of related variety, unrelated variety, research and development investment, time trend and state fixed effects.  Variety is measured by looking at the dispersion of the classification of patents within and between technological classes of the patents. The paper also proposes two different regressions, one using the total number of patents as dependent variable and one using the share of superstar patents, which represent patents that lead to breakthrough technologies. Superstar patents are distinguished from “regular” patents according to the distribution of their citations: superstar patents have a fat tail, meaning that they are cited more in later stages of their development compared to regular patents.

A nice contribution of this paper is to measure super patents through their statistical distribution of their citations instead of relying on superimposed criteria such as being on the top 1% or 5% of the citations. The idea here is to distinguish between general innovation (regular patents) and breakthrough innovation (superstar patents). Theory predicts that regular patents will be positively affected by related variety, producing general innovation, while superstar patents will be positively correlated with unrelated variety, producing breakthrough innovation. The empirical analysis nicely confirms the theory.

Technological progress is said to resemble a flight of stairs

The possible shortcomings of the paper are related to the role of geography in the analysis. The sample is at US state level and the underlying implication is that variety in the state affects the number of patents registered in it. There could be, under this assumptions, some issues of spatial dependence. The authors touch upon this point in two parts of the paper: in the methodology section they explain that superstar patents tend to cluster in fewer states that general patents and this pattern requires a different approach for the two types of patents. It would be useful if this issue could be elaborated further by the authors in a future version of the paper.

As for the possible spatial dependence effect among explanatory variables, the authors try to control for the fact that R&D in one state could affect the patent output of neighboring states as well. They construct an adjacency matrix to capture the effect of the R&D effort of neighboring states.

The conclusion is that the analysis is robust to spatial dependence. In spite of this robustness check for spatial dependence, some concerns remain. Restricting the R&D effect only to neighboring states could be a limit, as the effect could not only go through physical proximity, but also through other types of connections: for example, the same firm could have different branches in different non-adjacent states, leading to an influence not captured by the adjacency matrix.

In short, this paper provides a very interesting insight on how two types of innovations can arise as measured by patent citations at regional level. The results are consistent with the theory and could be useful to future research in historical perspective. A further improvement of the paper could be to conduct more robustness check on the geographical aspects of these results, especially expanding them to non-adjacent states.

Images of the future technology – The Jetsons, 1962

The Origins of the Modern Concept of Money

French economists and the purchasing power of money

by Alain Béraud (alain.beraud@u-cergy.fr), THéorie Economique, Modélisation et Applications (THEMA), Université de Cergy-Pontoise (France)

Abstract

When French economists read The Purchasing Power of Money, they were primarily interested in the equation of exchange and the reformulation that Fisher proposed regarding the quantity theory of money. This reading led them to ponder the meaning that should be given to this theory and to study its empirical significance. Some of them, namely Rueff and Divisia, went further still and considered Fisher’s work as a starting point for their own analyses, which were related in particular to the monetary index, the integration of money into general equilibrium theory and the analysis of monetary phenomena in an open economy.

Keywords: quantity theory of money; price index; theory of purchasing power parity; marginal utility of money; integration of money into general equilibrium.

URL http://econpapers.repec.org/paper/emaworpap/2013-10.htm

Review by Bernardo Bátiz-Lazo

This paper was circulated by NEP-HIS on 2013-03-30. Alain Béraud, its author, offers a detailed account of how many French economist criticised Irving Fisher’s (1867–1947) quantity theory of money while others supported it. In particular, he explores the extent to which Firsher’s ideas appear within the work of two great French economists, namely François Divisia (1889-1964) and Jacques Rueff (1896-1978).

Alain Béraud – Professeur de Sciences Économiques
(Université de Cergy-Pontoise)

Fisher’s formulation of the equation of exchange (where the total price of commodities sold equals the total value of the money that was given in exchange) is now part and parcel of every undergraduate programme in economics. It is integral and fundamental to the current understanding of macroeconomic management. Given this plus the rise of digital payments, mobile-phone wallets and crypto-currencies like Bitcoin, it is important to remember and indeed timely, to have an in depth discussion about how our conception of money – then measured as notes and coins – came to be and how it was shaped by dissenting views. In this regard says Béraud:

From the time of its publication through to the 1930s, The Purchasing Power of Money was the reference work for French economists who interpreted it as the modern, rigorous version of quantity theory. But this theory was hardly popular. It is therefore not surprising that many French economists, while recognising its merits, fiercely criticised it. It was only in the 1920s that Rueff and Divisia, both graduates of the École Polytechnique where they had been students of Clément Colson, used this book to develop their own analyses of monetary phenomena. Here, I have defended the idea that their contributions were certainly original but were nonetheless based on ideas that Fisher had supported.

Front of French frank coin (1996), commemorating the life of Jacques Rueff

As noted above, through his narrative Béraud compares and contrasts how the work of Fisher was incorporated into the ideas of French economists. He also offers a rich discussion of the reasons why there was dissent and why many took exception and actively criticised Fisher’s work.

The picture that emerges from Béraud’s work allows us to see how economist of the early 20th century on both sides of the Atlantic are engaging in a type of debate that now dominates the discipline, namely highly quantitative and empirically based. Something that, I thought, only took place after World War II – and thus, happy to be set straight. Moreover, this sort of debate was something that, according to Walter Friedman’s brief biography of Fisher, characterised Fisher’s early contributions to our understanding of macroeconomic phenomena. However, we are not provided by Béraud with enough detail to ascertain if a debate with such characteristics was widespread in France or whether it is Béraud’s reconfiguration of the debate between monetary factors and prices, that which leads us to emphasise its quantitative, formal, empirical aspects.

It was also interesting to know that the contemporary discussion of Fisher’s ideas was hampered by lack of available data. For instance, Béraud notes that at this point in time: “data on bank deposits [was unavialble]. Only some establishments published monthly statements.” Here, in my view, some more context as to how and when such measures came to be mainstream and a brief reference to the overall construction of macroeconomic statistics in France would have given a bit more sense of perspective to the discussion.

In the same vein, I would have liked, as a manner of introduction, some context as to why, how relevant and how widespread the debate of Fisher’s ideas was in France during the interwar period. It seems French economists are very concerned with determining exchange rates and the future of the Gold Standard at the end of the First World War. But this is only mentioned in passing. For the international reader it would have also been helpful to have an introduction as to the broad configuration of French economists groups or lines of work at this point in time.

But for all my comments and on balance, this paper makes an interesting read.

François Divisia (1889-1964) – a founding member of the “Econometric Society”

Knowing the Who: Identifying the effect of entrepreneurs on firms

Do entrepreneurs matter?

Sascha O. Becker (s.o.becker@warwick.ac.uk), CAGE University of Warwick

Hans K. Hvide (hans.hvide@econ.uib.no), University of Bergen, CEPR and University of Aberdeen

Abstract

Within the broad literature on firm performance, economists have given little attention to entrepreneurs. We use deaths of more than 500 entrepreneurs as a source of exogenous variation, and ask whether this variation can explain shifts in firm performance. Using longitudinal data, we …find large and sustained effects of entrepreneurs at all levels of the performance distribution. Entrepreneurs strongly affect firm growth patterns of both very young firms and for firms that have begun to mature. We do not find significant differences between small and larger firms, family and non-family firms, nor between firms located in urban and rural areas, but we do find stronger effects for founders with high human capital. Overall, the results suggest that an often overlooked factor –individual entrepreneurs plays a large role in affecting firm performance.

URL: http://d.repec.org/n?u=RePEc:wrk:warwec:1002&r=his

Review by Beatriz Rodriguez-Satizabal

Promoting entrepreneurship has been fashionable since the 1980s and there are no signs of it going away. Messages about the importance of becoming your own boss, giving something back to the society, and be an active agent of the economy are there to be seen everywhere on a daily basis. Governments around the world are constantly discussing new ways to increase the number of entrepreneurs and we also see on a regular basis articles within broadsheet newspapers and the popular media trying to identify and challenge those who see themselves grow by creating firms and markets.

In this paper, distributed by NEP-HIS on 2013-01-28, Hvide and Becker question the outcomes of investments to promote entrepreneurship during the last 20 years: Do the entrepreneurs really deliver technological change? Is it sustainable for an emerging country to allow a growing number of entrepreneurs? Is the longevity of the firm related to the characteristics of the founder? Should entrepreneurs be employees in their firms?

The idea of the entrepreneur as an important agent is not entirely new. But studying the role of the entrepreneur within the firm and its effect over its performance has been neglected. In this regard evidence documented in this paper is a step towards a better understanding of the effect of the entrepreneur over the performance of the firm.

Based on the assumption that the death of an entrepreneur has an immediate effect on the firm due to the changes in corporate governance that it implies, Becker and Hvide constructed a database of Norwegian firms consisting of incorporated, limited liability companies for the period 1999 to 2007. The authors identified a total of 500 firms where the founding entrepreneurs died, providing an opportunity to quantify whether entrepreneurs have a causal effect on firm performance or not.

As a result of a thorough statistical analysis, the authors find that the effects are large and strong. The entrepreneur shapes the firm and affects its growth patterns. Entrepreneurs matter because of the loss of human capital (but, interestingly, the effect could be also negative as higher performance takes place after death of the founder). Surprisingly, Becker and Hvide do not find any difference between small and large firms, family and non-family owned, nor between firms located in rural or urban areas. This last result is certainly, in my view, an open call to bring the individual characteristics of the entrepreneur to the study of the firm, which is a unit that needs the human capital factor to success.

This paper is a valuable contribution to those studying entrepreneurship because it positions the role of the individual deep into the nature of firm performance rather than having it as a separate unit. It calls our attention over the widely spread assumption that entrepreneurs also innovate within the organization (Schumpeter) and have effects in and out of it (Baumol). If entrepreneurs matter, then knowing the who, why and how must be part of the discussion on public policy to promote entrepreneurship. Moreover, when in emergent countries the close relationship between the successful entrepreneurs and the government still persists.

“If they couldn’t guarantee the property rights of the land they gave away, how could they possibly sell it?”: Land Privatization and Property Rights in the Nineteenth Century Neo-Europes

The Political Economy of Land Privatization in Argentina and Australia, 1810-1850: A Puzzle

Alan Dye (adye@barnard.edu), Barnard College, Columbia University

Sumner La Croix (lacroix@hawaii.edu), University of Hawai’i-Mānoa

URL: http://d.repec.org/n?u=RePEc:hai:wpaper:201207&r=his

Abstract: This paper compares public land privatization in New South Wales and the Province of Buenos Aires,in the early nineteenth century. Both claimed frontier lands as public lands for raising revenue. New South Wales failed to enforce its claim. Property rights originated as de facto squatters’ claims, which government subsequently accommodated and enforced as de jure property rights. In Buenos Aires, by contrast, original transfers of public lands were specified de jure by government. The paper develops a model that explains these differences as a consequence of violence and the relative cost of enforcement of government claims to public land.

Review by Manuel Bautista Gonzalez

The U.S. economy has racked up an enviable record of two centuries of sustained economic growth —an achievement, it has often been asserted, that was predicated on the establishment of institutions guaranteeing the security of property rights. My aim in this article has been to qualify this assertion by reminding scholars that economic development also requires that societies be able flexibly to reallocate property rights in response to new technological and other developments. If such reallocations could always occur smoothly—either through market transactions or a consensus effort on the part of society to capture the resulting gains in efficiency—there would be nothing mysterious about this qualification. As I have shown, however, reallocations in the United States have often been involuntary, and losers have not always received adequate (or any) compensation. Owners whose property has been taken from them have routinely charged that property rights are in fact not secure, but aside from some relatively brief episodes when broader protest movements have taken up their cause, these kinds of complaints have never become general. Hence the mystery. Despite the many involuntary reallocations of property that have occurred repeatedly since the formation of the republic, Americans still strongly believe that their property rights are secure and they act in their economic lives accordingly. – Lamoreaux (2011), emphasis added.

This paper was first distributed by NEP-HIS on 2012-05-15. The paper reviewed in this post was a more recent version from January 4, 2013, made available by the authors.

Alan Dye

Sumner La Croix

Dye and La Croix’s paper is an illuminating exploration of the history of land property rights in the province of Buenos Aires (Argentina) and the colony of New South Wales (Australia) in the first half of the nineteenth century. Whereas Australian squatters acquired de facto claims over lands outside the official settlement areas defined by colonial authorities and some of them managed to transform their claims into de jure property rights, porteño landholders often relied on the will of the authorities of the nascent republic to enforce de jure property rights, with mixed results. Why did authorities honor or not existing claims over land when governments stood to lose revenues from their sale or lease?

In their answer, the authors refute the presentist bias of popular institutionalist and factor-endowment accounts: contrary to the belief, developed countries have not always had a better record of securing and enforcing property rights over land than developing countries. Why?

Fiscal Policy during high unemployment periods: still a bad idea?

Are Government Spending Multipliers Greater During Periods of Slack? Evidence from 20th Century Historical Data

Michael T. Owyang, Valerie A. Ramey, Sarah Zubairy

Abstract

A key question that has arisen during recent debates is whether government spending multipliers are larger during times when resources are idle. This paper seeks to shed light on this question by analyzing new quarterly historical data covering multiple large wars and depressions in the U.S. and Canada. Using an extension of Ramey’s (2011) military news series and Jordà’s (2005) method for estimating impulse responses, we find no evidence that multipliers are greater during periods of high unemployment in the U.S. In every case, the estimated multipliers are below unity. We do find some evidence of higher multipliers during periods of slack in Canada, with some multipliers above unity.

URL: http://econpapers.repec.org/paper/fipfedlwp/2013-004.htm

Review by Sebastian Fleitas

For a very long time the size of the expenditure multipliers has been one of the most vivid economic debates. For instance as recently as 2009, when the Obama administration proposed a fiscal stimulus package, there was a heated discussion regarding the relative size of the expenditure and tax multipliers. The reason fuelling this narrative is perhaps clear: ascertaining the potential impact of a particular proposed measure is key when designing the fiscal policy.

The paper by Owyang, Ramey and Zubairy, which was distributed by NEP-HIS on 2013-02-08 tries to answer this question: Are government spending multipliers greater during periods of slack for the US and Canada when we look at the historical data? The argument behind it is to consider that the expenditure multipliers will be greater in times of crisis, that is, during periods without full employment of labor and capital in the economy. This argument follows the idea that to wake up animal instincts, you need to have something in the forest when guys go out to hunt.

Image in Barro’s comment on expenditure multipliers debate in 2009 in Hoover Institution Stanford University’s blog (http://www.hoover.org/publications/hoover-digest/article/5401)

The answer that the authors offer is counterintuitive, which makes the paper very interesting. They find that the expenditure multipliers were higher in periods with high unemployment in Canada but they were the same for both periods in the US. To arrive to this conclusion the authors first construct high frequency (quarterly) historical data for the US and Canada. The procedure they follow to build the database is documented in an online available annex of the paper (here). After this process they have data on GPD, GDP deflator, government spending and the unemployment rate for the period 1890q1 to 2010q4 for the US and from 1921q1 to 2011q4 for Canada. The other key variable is the “news” variable, which reflects the changes in expected present value of government spending in response to military events as in Ramey (2011), which in turns directs to Ramey (2009).

Regarding the econometric approach, the authors use Jorda’s (2005) local projection technique to calculate impulse responses. The idea in Jorda (2005) is that, in contrast to VAR approaches which  linearly approximate the data generating process to produce optimal one period forecasts, when we are looking at impulse response analysis we should care about the estimation of longer horizons. In this context, it is a better approach to estimate the impulse responses consistently by a sequence of projections of the endogenous variables shifted forward in time onto their lags using ordinary least squares (OLS) with standard errors addressing heterogeneity and serial correlation. The authors estimate a set of OLS regressions of different number of leads of the log of per capita government expenditure and GDP, over their lags and the variable news for periods with high and low unemployment and a quadratic trend. The coefficient for the variable “news” is the impulse response at that certain number of lags.

Finally, the paper made me think of three comments. First of all, the paper shows a very interesting and creative way to proceed when the data needed for the study is actually not available for that historical period. Besides combining sources of information, the authors constructed quarterly series of the variables. Since the paper was prepared for the American Economic Review Paper and Proceedings, it is a very short paper and the procedure to construct the variables is explained not in the paper but in the Annex. Given the lack of data, assumptions about the data generating process must be made. However, and besides the obvious limitation of space, the reader could miss an explanation about the assumptions that are made in the methods used and, also, what implications these assumptions have for the results, in particular about what is the source of variation that allows the identification of the coefficients. Maybe a section in the paper or in the appendix discussing these issues can shed light about what are the potential problems of different assumptions.

The last two comments are related to what is exactly the interpretation of the results. The first one directly follows from the last sentence of the paper. The authors state that they do not adjust for the fact that taxes often rise at the same time as government spending, which turns these multipliers not equal to pure deficit financed multipliers. However, it seems plausible that the effect of the multiplier on the GPD depends on whether this increase in the government was financed by taxes or by debt. If that is the case, and if the episodes when the former and the latter happen are mixed in a non-random way between the periods of high and low unemployment, then it is possible that the value of the coefficients can reflect not only the effect of the exogenous shock but also the effect of different ways to finance it.

A joke?

The last comment relates to the consistent estimation of the parameters of the model. In the paper the “news” about military expenditure is taken as the only source of exogenous shock in this economy during the period of two years, four years and the time of the peak of each response. This “news” variable reflects exogenous innovations to the expenditure from a military source. However, it would be relevant for the paper to discuss the existence of other (non-military) sources of exogenous shocks to the expenditure. The relevance of this issue is because, given that the estimation of the parameters of interest is done by OLS, the consistency of the estimates requires zero covariance between the ¨news” and the error term of the equation, and this assumption can be violated if there exist this kind of non-military shocks and they are correlated to military “news”.

Overall I think this is a very interesting paper because of the results they find and also because of the construction of historical data. I found the results very puzzling and therefore a big motivation to continue trying to understand the relationship between GDP and public expenditure.