The View from the White House

My friend in the White House emails me his analysis of a possible second stimulus package:

We are frequently asked whether there should be a "second stimulus" bill. Unfortunately, what is being considered on Capitol Hill is a very different animal from what we did earlier this year.

10-second macroeconomic review

GDP = Consumption + Investment + Government spending + Exports - Imports = C + I + G + X - M

In January the President proposed, and in February Congress enacted, a bill that was short-term macroeconomic stimulus. We wanted that stimulus policy to be big, fast-acting, an efficient use of taxpayer dollars, and an effective stimulus to broad-based economic growth. We let taxpayers keep more of their wages, assuming that they would spend some of those refunds, thereby increasing consumption (C). We also temporarily cut taxes on business investment in an attempt to increase (I). The idea is that these two actions would quickly increase GDP. Millions of American workers and families and thousands of firms can react quickly to a change in their financial status.

This strategy appears to be working. We've got evidence from multiple sources suggesting that people are spending some of their stimulus checks, and that this is helping to support increased consumption. It's harder to tell how much firms are taking advantage of the investment incentives, because it's hard to measure that in real time.

In yesterday's Wall Street Journal, Professor Martin Feldstein writes that the stimulus was a "flop". Specifically, he argues that the recent GDP data show that the boost to consumer spending from the rebates was small relative to the overall size of the rebates. He estimates that $12 billion was spent out of a total of $78 billion in rebates paid out by the end of June. The core of his argument is that we didn't get a lot of bang for the buck - only a small bump to GDP for a large loss of revenue for the government.

We disagree with this analysis. First, we think the stimulus bang is bigger than $12 B. Prof. Feldstein assumes that the growth in consumer outlays would have been flat had there been no stimulus. He then observes that consumer outlays actually grew by $12 billion more from Q1 to Q2 than they did in the prior quarter, and attributes that to the stimulus. Many observers think that, without the stimulus, consumer outlays would have grown more slowly in Q2 than in Q1. If this is the case (and we believe it is), then the effect of the stimulus is bigger than $12 billion.

In addition, we have felt only part of the bang so far. The stimulus enacted in February will have ongoing impacts in the upcoming months. Almost all the cash to consumers is out the door, but the resulting boost in consumer spending has not yet reached its full effect. We anticipate that the past stimulus law is continuing to increase GDP in the 3rd quarter, with a diminishing amount in the 4th quarter of this year. Monetary policy works with an even "longer lag" - the evidence suggests that when the Fed cuts interest rates, it takes about a year for half of the economic effect to take hold. So there's more bang left in the remainder of this year from past actions on both the fiscal and monetary sides.

Also allowing people to keep more of their money for one year is better than not doing so at all, so the loss of government revenue is actually a good thing if that money stays in the hands of the taxpayers who earned it, even if we can only get Congress to agree to do that for one year. We agree with Marty that the stimulus would be more effective if we had been able to enact a permanent tax cut, rather than a temporary one. Legislative realities forced it to be temporary.

On the second stimulus question, the following interchange from May 19th is instructive. Our deputy press secretary Scott Stanzel talked with a White House reporter at the "daily gaggle":

Q Scott, is the administration looking any more closely at a second economic stimulus package? The Commerce Secretary was on Late Edition over the weekend, and didn't directly and definitively shoot that idea down.

MR. STANZEL: Well, what's in the second stimulus package that you're talking about?

Q Well, just -- I'm saying that many in Congress say we need a second economic stimulus package.

MR. STANZEL: Right, but what's in that? That's the thing. The idea of the second stimulus has become sort of this catch-all phrase for adding a lot of additional government spending, or doing things that Democratic leaders in Congress may have wanted to do previously, but are now -- would want to sort of put under the umbrella of a stimulus package.

Before last Thursday, there was no second stimulus proposal. Now there's a proposal from the Chairman of the Senate Appropriations Committee, Senator Byrd (D-WV), but we have seen no indications that House or Senate Democratic leaders have signaled support for that proposal.

For more than two months we were asked to comment on something that did not exist. What does exist is pent-up demand in Congress to spend more money, and then to label that spending as a "second stimulus." We anticipate that demand will only increase as we get closer to an election.

Congressional advocates for increased government spending this Fall have been arguing, in effect, that we should expand (G) in the equation above, and that doing so will increase economic growth.

But trying to stimulate short-term economic growth through increased government spending has a few problems:

1. It's slow. - Construction projects take years to plan and build. History shows that only about 27¢ of each dollar is spent in the first year.

2. It's often funneled through States. - Infrastructure spending and increased federal funds for programs like Medicaid result in transfers from the Federal government to State governments. This transfer doesn't actually increase GDP, it just shifts money from one level of government to another. It's more like putting in motion 50 potential stimulus packages, each of uncertain efficacy and speed. Some States might try to spend the funds quickly. Others might shift money around and use the Federal dollars to pay down debt, or wait until their State legislature convenes next year to allocate the funds. There's also a danger that providing States with aid during challenging economic times will encourage states to spend irresponsibly during boom years, counting on Federal bailouts when times are tough.

You can make other arguments for spending more taxpayer funds on roads and bridges, but it's a highly inefficient tool to stimulate immediate economic growth. Many of the advocates for a so-called "second stimulus" know that spending taxpayer funds on roads and bridges is popular with voting constituents.

There's an important philosophical difference between the first stimulus (which was overwhelmingly bipartisan) and current Congressional attempts to increase government spending. The first stimulus proposed by the President looked at the economy as a whole, and tried to design a package that would help spur growth across the entire economy. Ideas being bandied about for a so-called "second stimulus" tend instead to take a constituency-based approach: they try to identify who is hurting, or who is politically powerful, and funnel government funding to them. Advocates then claim that these funds will stimulate broad-based economic growth.

We think that the first stimulus was both more fair and more effective by providing taxpayer rebates to more than 100 million Americans and broad-based business investment incentives to thousands of firms. And we think that there's more economic bang still left from those recently implemented policies.

In summary:

* We think the stimulus is working and increased Q2 consumption and GDP.

* The effects of the first stimulus are not yet complete. Most of the cash is out the door, but we think there will be increased consumption effects this quarter, and a diminishing amount in Q4.

* For many, "second stimulus" is code for "allow Congress to increase politically popular government spending shortly before Election Day, and call it macroeconomic stimulus."

* Increased government spending is slow and ineffective macroeconomic stimulus.

CBO on Fiscal Stimulus: A Strange Menu

The CBO gives its analysis of various forms of fiscal stimulus.

Some of the proposals on the table strike me as particularly odd. For example: a temporary increase in food stamp benefits.

In standard macroeconomic theory, the business cycle is symmetric. That is, stimulating an economy that is suffering from insufficient aggregate demand should be the opposite of cooling off an overheated economy to reduce inflationary pressures. Would anyone seriously propose a temporary cut in food stamp benefits in an overheated economy? I don't think so. Food stamps seem the wrong tool to address the business cycle.

By contrast, the first line of defense against short-run economic fluctuations--monetary policy--is applied symmetrically. You cut money growth and raise interest rates in an overheated economy, and you increase money growth and lower interest rates in a lackluster one.

Update: Jason Furman emails me:

Greg,

As always, thanks for using your blog as a means to educate your readers through discussion and debate. I was surprised to see you single out food stamps as an example of what is wrong with fiscal stimulus. At a minimum the same logic would apply to every other fiscal stimulus option. You are correct that policymakers do not cut food stamps in order to restrain an overheated economy. Then again, policymakers do not generally raise taxes during booms either—if anything it is the opposite and the transitory revenue boost associated with an overheated economy is often employed as an argument for more tax cuts.

The Congressional Budget Office menu is responsive to the question policymakers from both parties are asking today: if we want to increase aggregate demand in the short run, what is the best way to do it. And a temporary increase in food stamps is, appropriately, high up on this list. Food Stamp administrators could simply press a button and everyone’s electronic debit cards would have, say, an additional 20 percent more money starting almost immediately and ending whenever policymakers want. Plus as Marty Feldstein explained: “Food stamps strikes me as a pure cash transfer to people with a high propensity to spend and people who would not benefit from a tax cut.” Tax rebates are administratively more difficult and have somewhat lower bang-for-the-buck, but have the big benefit of being scalable to the size policymakers desire – which is why Doug Elmendorf and I recently included them in our list of more effective stimulus options.

You might be convinced that food stamps are no worse than any of the other options and, from a purely technocratic point of view, even somewhat better. But what about the case for fiscal stimulus in general? An economist king would use both fiscal and monetary policy to stabilize aggregate demand. In particular, because monetary policy takes about a year to significantly impact the economy, the economist king would well-designed fiscal policies like tax rebates and food stamps to affect aggregate demand over three to six month horizons.

I have not written down the model, but I suspect that even if the economist king was constrained to use asymmetric fiscal policy (i.e., fiscal expansions timed to downturns but no fiscal contractions timed to booms) it would still be better to use a combination of fiscal and monetary policy to stabilize the economy than to eschew fiscal policy altogether.

Of course, reality falls a considerable amount short of even the asymmetric economist king. Just how far short is a difficult judgment and entails weighing the benefits of fiscal stimulus done right against the costs of fiscal stimulus done wrong. But given that policymakers have now chosen to undertake fiscal stimulus, one important task for economists is to help them sort through their options so that the end result is at least a little bit closer to what an economist king would do.

Jason

Greg again: Marty Feldstein may well be right that those on food stamps have a higher-than-average marginal propensity to consume. Nonetheless, I wonder if we really want to target such cyclical measures on the poorest members of society. That is, for any mean level of food stamps, wouldn't the poor be better off with a constant stream of benefits than with a benefit that fluctuates over the business cycle? Using food stamps as a cyclical tool seems to risk destabilizing some families' food consumption in an attempt to stabilize the overall business cycle.

If we are going to use fiscal policy to smooth out the business cycle on a regular basis, then we should think harder about improving the economy's automatic stabilizers. For example, imagine we enacted an investment tax credit, the size of which was a function of the unemployment rate. Firms would have an incentive to time their investment projects toward those periods when the economy was weakest and most needed a shot in the arm.

I can more easily imagine, when the economy starts to overheat, telling corporations that their investment credit has shrunk or disappeared than telling poor families that their food budget has been cut.

Backus on Spending Stimulus

In response to a previous post, NYU econ prof David Backus sends me his views of a spending stimulus:

Greg,

I was surprised to see you mentioned as the only stimulus skeptic the Obama team could find. If you'd like company, let me add my name to the list.

I'd label myself, if not a skeptic, then at least ambivalent. It's not that I'm convinced stimulus is a bad idea, but that economics isn't a precise science: we don't know for sure that a stimulus package will cure what ails us. Here are some reasons for doubt, and I'm sure you and your readers have others:

• Hard to do. It's not easy to spend large amounts of new money quickly. Harder still to do it in a way that creates good value for society and doesn't bring out the worst in our politicians. (I can hear Jon Stewart on the Daily Show: "Where's Ted Stevens when we need him?")
• Bad timing. Right now, most forecasts call for continued shrinkage in the first half of 2009, modest growth in the second half, when the stimulus starts to come online, and faster growth in 2010, when spending hits high gear. This is, of course, the classic argument against countercyclical fiscal policy: it's hard to get the timing right.
• Small multiplier. Let us say that for every dollar of extra government spending, GDP goes up m dollars, where "m" is the multiplier. Undergraduate textbooks, including your favorite, sometimes suggest m is large. The evidence is fuzzy, to be sure, but to me it suggests a multiplier around one, maybe smaller. Even stimulus cheerleader Paul Krugman only claims 1.1. If that's the case, the impact of government spending (say 700b over two years) is barely enough to reverse the decline in GDP we expect to see over the next two quarters.
• Long-term budget issues. I don't spend much time in Washington, but I thought the mainstream view among government economists was that our retirement and health-care programs were likely to bust the budget over the next 2-3 decades. Recent directors of the CBO under both Republican and Democratic Congresses have made this point, and I hope I wasn't the only one listening. The US is not Argentina, but it still seems a little incongruous to advocate massive increases in spending when the long-term problem is paying for spending already on the
  books.
• It's the financial system, stupid. Japan in the 1990s is a Rorshach test for macroeconomists, so I can't claim everyone sees this as I do. But my take (borrowed from Anil Kashyap) is that Japan demonstrated that the real issue in financial crises is the financial system. If we don't fix it, no amount of fiscal stimulus will make much difference. That's one of the reasons I'm optimistic about the US right now: unlike Japan, we faced our problems, ugly as they were, and have acted decisively to correct them.

What would I do? I'd prefer to remain in my comfortable office at NYU, but if forced to make a recommendation, I guess I'd say the following: Go ahead, spend a few hundred billion over the next two years; it may help, especially if the economy performs worse than we expect. But spend it on things that have clear social value. At the same time, try to make some progress on the long-term spending issues built into our current retirement and health-care systems. That won't be nearly as popular as spending money now, but it's an opportunity to show some real leadership. And make sure you keep your eyes on the financial system: if the banks don't recover, none of us will. Good luck!

Best,
Dave

Thanks, Dave, for sharing your views.

The CEA's Impossible Job

The ARRA, the fiscal stimulus act passed last year, gave the Council of Economic Advisers an impossible job: measuring how many jobs the act created.  Here is the CEA's latest attempt.  As far as I can tell, there are two kinds of evidence here.

First, there are model simulations.  That is, the CEA took a conventional Keynesian-style macroeconomic model and used those set of equations to estimate the effect the stimulus should have had.  Essentially, the model offers an estimate of the policy's effect, conditional on the model being a correct description of the world.  But notice that this exercise is not really a measurement based on what actually occurred.  Rather, the exercise is premised on the belief that the model is true, so no matter how bad the economy got, the inference is that it would have been even worse without the stimulus.  Why?  Because that is what the model says.  The validity of the model itself is never questioned.

(Moreover, the fact that other organizations simulating similar models come to similar conclusions is no evidence about the validity of the model's simulations.  It only tells you the CEA staff did not commit egregious programming errors when running their computer simulations.)

Second, the CEA offers some statistical evidence that things got better after the stimulus passed.  Some of this evidence comes early in the document in the form of simple graphs.  Some comes later by examining deviations from forecasts based on a two-variable vector autoregression.  But the nature of the evidence is basically the same: Post hoc ergo propter hoc.

Of course, there were a lot of other things going on in the economy at this time.  Monetary policy, for example, has gone to extraordinary measures to get the economy going.  TARP was also an unusual intervention that seems to have done its job of returning the economy to some degree of financial normalcy (even if leaving the bad taste of increased moral hazard).  Giving credit for the economic improvement to the fiscal stimulus is a large leap.

In the end, I do not find this CEA document very persuasive.  At the same time, I feel the CEA's pain.  The stimulus act instructed them to do the (nearly) impossible.  Perhaps someday someone will conduct a study that credibly measures the macroeconomic effects of this particular fiscal stimulus.  But it won't be easy.  And it won't look much like the study released today.

Ray Fair on the Stimulus

Yale economist Ray Fair, who maintains a well-known macro model, emails me some simulation results:

This link has my latest baseline forecast, which assumes no stimulus bill, and then a (crude) stimulus experiment.

The stimulus has a big effect in 2010, but by 2012 the economy is roughly back to baseline (except for variables like the federal government debt). In the baseline case the federal debt rises from $5.78 trillion at the end of 2008 to $8.74 trillion at the end of 2012. In the stimulus case the debt at the end of 2012 is $9.34 trillion, about $600 billion more than in the baseline case. This does not take account of possible increases in the federal debt from the bailout activity.

So there is short run gain from the stimulus bill, mostly in 2010, but the potential long run costs do not seem trivial. If the stimulus bill is passed and the bailout continues, it may be that large tax increases will be needed starting in late 2011 or 2012.

Thanks, Ray.

Infrastructure Spending as Stimulus

From Nobel laureate Gary Becker:

Some of this infrastructure spending may be very worthwhile-I return to this issue a bit later- but however merited, it is difficult to believe that they would provide much of a stimulus to the economy. Expansion of the health sector, for example, will add jobs to this sector, but it will do this mainly by drawing people into the health care sector who are presently employed in jobs outside this sector. This is because unemployment rates among health care workers are quite low, and most of the unemployed who had worked in construction, finance, or manufacturing are unlikely to qualify as health care workers without considerable additional training. This same conclusion applies to spending on expanding broadband, to make the energy used greener, to encourage new technologies and more research, and to improve teaching.

An analysis by Forbes publications of where most jobs will be created singles out engineering, accounting, nursing, and information technology, along with construction managers, computer-aided drafting specialists, and project managers. Unemployment rates among most of these specialists are not high. The rebuilding of "crumbling roads, bridges, and schools" highlighted by in various speeches by President Obama is likely to make greater use of unemployed workers in the construction sector. However, such spending will be a small fraction of the total stimulus package, and it is not easy for workers who helped build residential housing to shift to building highways.

A second crucial issue relates not to the amount of new output and employment created by the stimulus, but to the efficiency of the government spending. Efficiency is not likely to be high partly because of the fundamental conflict between the goal of stimulating employment and output in order to reduce the severity of the recession, and the goal of concentrating infrastructure spending on projects that add a lot of value to the economy. Stimulating the economy when employment is falling requires rapid spending of this huge stimulus package, but it is impossible for either the private or public sectors to spend effectively a large amount in a short time period since good spending takes a lot of planning time.

Putting new infrastructure spending in depressed areas like Detroit might have a big stimulating effect since infrastructure building projects in these areas can utilize some of the considerable unemployed resources there. However, many of these areas are also declining because they have been producing goods and services that are not in great demand, and will not be in demand in the future. Therefore, the overall value added by improving their roads and other infrastructure is likely to be a lot less than if the new infrastructure were located in growing areas that might have relatively little unemployment, but do have great demand for more roads, schools, and other types of long-term infrastructure.

Accountability?

Click on the graphic to enlarge. Source. Click here to see an updated graph.

When the Obama stimulus plan was proposed, the president's economic team put out a report in January 2009 that purported to show what would happen with and without the fiscal stimulus. The chart above is from page four that report, together with the actual results over the past couple months. As you can see, the actual outcome is significantly worse than the projection with the stimulus plan and is, in fact, roughly on track with what was projected without the stimulus.

What does this mean? One interpretation is that the fiscal stimulus has failed to achieve what Team Obama thought it would. Another interpretation is that the baseline was worse than they believed at the time. I am confident the report authors would adopt the second interpretation. If so, that fact is consistent with what I said in a previous post: In light of the shifting baseline, it is impossible to hold the administration accountable for whether its policies are achieving their intended effects.

To be clear, this lack of accountability is not a feature on this specific administration but is, instead, a reflection of the inherent uncertainties associated with macroeconomics. The administration, however, has not been particularly forthright in admitting to this lack of accountability. Indeed, the act of releasing quarterly reports on how many jobs have been "created or saved" gives the illusion of accountability without the reality.

Fiscal Stimulus Update

Alex Brill, formerly an economist at the Ways and Means Committee, emails me:

Have you noticed how the stimulus bill is shifting? Only in Washington can there be two definitions of what $150 billion means. The House and the White House wanted $150 billion stimulus in 2008 but the Finance Committee appears to define the $150 billion price tag as the 10-year cost, not the one year cost. Subtle but important difference. As a result they have increased the 2008-2009 cost to $196 billion and the ten year cost is now the "magic" $150 billion. The policy changes? More rebate checks and tax relief for firms with NOLs in 2006 and 2007 (presumably home builders and financial services companies being notable winners).

Here and here are the numbers.

Update: Jason Furman emails me a comment:

I think your correspondent gets the "only in Washington" definition backwards. The important fact to understand is that both the House and Senate stimulus plans contain bonus depreciation. That allows companies to take larger depreciation allowances in the first year in exchange for lower depreciation allowances in future years. The one-year cost of the House version is $44 billion but much of that money is recouped so that the net present value is $13.6 billion. Only in Washington (and in this case the House bill that your correspondent seems to implicitly support) would this be described as $44 billion. Any business would use a concept much closer to the NPV.

You get closer to the NPV by using 11 year nominal totals, which taking the entire bills are $117 billion for the House and $156 billion for the Senate. This does not say which is substantively better, but it is the better way to pose the question.

Also, like your correspondent I am skeptical about allowing firms to essentially get tax credits against net operating losses, it does nothing to increase the rate of return to new investment and I do not expect the improved cash flow to have much stimulative effect. But I would have thought you would have agreed with former Bush administration Assistant Secretary for Tax Policy Pamela Olson who argued, "In a perfect world, economists (of all stripes) wouldn't just permit carrybacks and carryforwards, they'd refund losses to taxpayers... So, I would say that it's a good idea, but it will cost revenue, which will have to be balanced against the benefit."

Finally, most policymakers do not realize that the "true-up" that allows taxpayers to claim the best of 2007 and 2008 adds extra complications, has no stimulative effect, and creates the marginal rate problems you identified in your earlier post. Maybe you should see if you could convince folks to drop this provision so that the rebate will be entirely a lump sum transfer, rather than mostly a lump sum transfer.

Also, The Onion gives us the latest stimulus proposal.

Four Goals of Tax Policy

I thought it might be useful to put the debate over fiscal stimulus in a broader perspective.

When designing a tax system and evaluating tax proposals, policy analysts have at least four goals in mind:

1. Efficiency: The tax system should distort incentives as little as possible (and, in the case of externalities and Pigovian taxes, correct incentives when necessary).
2. Intergenerational equity: The tax system should raise enough revenue so current generations do not unduly burden future generations.
3. Egalitarianism: The tax system should try to achieve a more equal distribution of after-tax incomes.
4. Stabilization: The tax system should help maintain the economy at full employment.

The current debate over fiscal stimulus involves trading off these goals. The stimulus package being discussed is mainly aimed at achieving goal 4, but it does so at the cost of sacrificing goals 1 and 2 to some degree. Efficiency is sacrificed because the phase out raises effective marginal tax rates and because the higher future taxes that result from the extra government debt will likely be distortionary. Of course, the phase out is there in order to achieve goal 3: This is the classic tradeoff between efficiency and equality.

Differences of opinion arise when policy analysts weight these goals differently. Advocates of fiscal stimulus put a large weight on goal 4. Critics of fiscal stimulus come in two varieties. One type of critic discounts goal 4 entirely because they are skeptical of Keynesian theories that underlie this goal. A second type of critic admits that goal 4 is legitimate in principle but believes that in the current environment macroeconomic stabilization is best left to monetary policy so fiscal policy can focus on goals 1 and 2. I am in this latter category.

A Federalist Fiscal Stimulus

Many economists are calling for another fiscal stimulus package. For example, Martin Feldstein, who once wrote an article called "The Retreat from Keynesian Economics," recently pulled a full Keynesian in an article in the Washington Post:

The only way to prevent a deepening recession will be a temporary program of increased government spending.

Marty thinks the tax rebates earlier this year did not do much to stimulate consumer spending. I think Marty is too quick in reaching this conclusion: Other scholars who have seriously analyzed the data disagree.

If there is going to be another fiscal stimulus, there will likely be a division between those who want tax rebates to households and those who want to help states pay for extra infrastructure spending. I have a compromise, based on the grand U.S. tradition of federalism: Let each state decide.

Congress could pass a fiscal stimulus of a certain amount per person but offer two ways to have it paid out. Each state governor could be allowed to determine whether to take the money as state aid or have it paid directly to his or her state's citizens. Those governors who think they have valuable infrastructure projects ready to go would take the money. Those who do not would let their citizens take the extra cash. When designing a fiscal stimulus, there is no compelling reason for one size fits all. Let each governor make a choice and answer to his or her state voters.

Krugman on Stimulus Skeptics

Paul Krugman is unhappy with the economics profession:

What’s been disturbing, however, is the parade of first-rate economists making totally non-serious arguments against fiscal expansion. You’ve got John Taylor arguing for permanent tax cuts as a response to temporary shocks, apparently oblivious to the logical problems. You’ve got John Cochrane going all Andrew-Mellon-liquidationist on us. You’ve got Eugene Fama reinventing the long-discredited Treasury View. You’ve got Gary Becker apparently unaware that monetary policy has hit the zero lower bound. And you’ve got Greg Mankiw — well, I don’t know what Greg actually believes, he just seems to be approvingly linking to anyone opposed to stimulus, regardless of the quality of their argument.

If Paul really wants to know what I believe, he can read what I have written on the subject.

Let me make one thing clear: When I link to another economist here on this blog, it is typically because I think his or her arguments are worth hearing and thinking about, not necessarily because I agree with all of them. I don't have the time (and, in some cases, expertise) to offer a refereeing service for every article I mention. So when I say, "Here is an article by Professor X," I mean "Here is an article by Professor X," not "Here is an article by Professor X, and I approve of everything he says."

In recent weeks, I have linked to Christy Romer making the case for the Obama fiscal stimulus as well as many economists on the opposite side the debate. It is true that I have linked more to those opposed. That is partly a reflection of my opinion on the issue. It is also partly to provide a counterpoint to the view disingenuously promoted by some members of the incoming administration that almost all major economists are lined up behind their stimulus plans. As Paul's list of prominent stimulus skeptics documents well, that is simply not the case.

Stimulus Spending Skeptics

An AP story reports:

Obama advisers, including Christina Romer and Lawrence Summers, have been contacting economists from across the political spectrum in search of advice as they assemble a spending plan that would meet Obama's goal of preserving or creating 2.5 million jobs over two years....Only one outside economist contacted by Obama aides, Harvard's Greg Mankiw, who served on President Bush's Council of Economic Advisers, voiced skepticism about the need for an economic stimulus, transition officials said.

Skepticism, rather than unequivocal opposition, is the right word. When contacted, I said the same things I have been saying on this blog: that monetary policy is not out of ammunition, and that tax cuts are potentially more potent than spending increases. I could have added that a spending-based stimulus to address the current short-term crisis might lead to a long-term increase in the size of government, but I doubted that concern would sway Team Obama. In general, I think economists need a large dose of humility when evaluating alternative proposals to deal with the current downturn, as there is still a lot we do not understand.

I am sure I am not the only person in the economics profession skeptical of spending increases to stimulate the economy. See, for example, GMU economist Tyler Cowen. If the new administration wanted to find more skeptics of stimulus spending among professional economists, I could have come up with some possible candidates for them, but the Obama economists probably already know who those likely skeptics would be.

By the way, House Republican leader John Boehner is compiling "a list of credentialed American economists who would like to add their voices to the list of stimulus spending skeptics." Click here to learn more.

Lindsey on Stimulus

Larry Lindsey's plan to stimulute the economy, including his membership application to the Pigou Club:

Permanent tax cuts offer a much better option. The incoming chairman of the Council of Economic Advisers, Christina Romer, has estimated that the macroeconomic benefits of tax cuts can be two to three times larger than common estimates of the benefits related to spending increases. The relative advantage of tax cuts over spending is even clearer when the recession is centered on the household balance sheet. Some relatively minor changes, like making the current 15 percent tax rate on dividends and capital gains permanent, would not only help household cash flow, but also put a floor under equity prices much as their introduction did in 2003. This would help protect against further wealth destruction and balance sheet deterioration.

But the centerpiece of any tax cut should be employment taxes: in particular, a permanent halving of the current 12.4 percent Social Security payroll tax on the first $106,800 of wages, split evenly between workers and employers. The direct revenue effect of that would be a bit under $400 billion per year, roughly in line with the present quantitative needs of the economy. It also meets our three tests of effective stimulus.

First, the funds would flow directly to households through higher take-home pay and indirectly through a reduction in the cost of employment. Economic studies conclude that the benefits of a reduction in the employer portion of the payroll tax are ultimately received by employees. But the immediate effect would be an improvement in the cash flow of credit-starved businesses (as well as being a marginal incentive to keep
employment up).

Second, the funds would be extremely timely, with the benefits hitting the economy with the first paycheck after the plan was implemented.

Third, by lowering the taxation of labor, the plan would help produce a higher-employment recovery than would otherwise be the case. Since the tax cut should be permanent to have maximum effect, the biggest challenge would be how to make up for the lost revenue once the macroeconomic need for fiscal stimulus had passed. In the short run, effective fiscal stimulus requires that government revenue drop, thereby enriching the private sector, and with the Treasury making the Social Security trust fund whole by way of intergovernmental bookkeeping. Longer term, however, spending cuts or a new source of revenue would be needed.

Given the agenda of the incoming administration, the best source of such funds would be a greenhouse emissions tax. It would be a much more efficient way of achieving the desired environmental objectives of the administration than any of the regulatory or "cap and trade" ideas now being considered. Such programs have failed in Europe since they are so easily gamed. Unlike regulations or cap and trade, moreover, an emissions tax can be phased in and calibrated as macroeconomic conditions permitted, specifically as the unemployment rate declined.

Sounds good to me.

Update: More Pigou Club endorsements here and here.

Measuring Jobs Created or Saved

The stimulus bill Congress passed a few months ago apparently requires the Council of Economic Advisers to report quarterly on the employment effects of the act. That job is, essentially, impossible. Because we have only one economy, there is no way to know for sure what would have happened without the stimulus bill. It is like asking a doctor, "How much sicker would this particular patient have been if you had not given him treatment up to now?" You can get, as an answer, the doctor's subjective professional judgment, but you cannot expect objective measurement.

Click here to read the CEA document describing how they will respond. Click here to read a press briefing on the matter with a senior administration official (who might that be?). The best question and the official's answer follows:

Q: A lot of this report is based off estimates about what the multipliers of GDP from government spending and from tax cuts, what those multipliers are. When you do the reevaluations, are you going to be retesting whether or not those assumptions about the multipliers were reasonable? Will that be part of the --

SENIOR ADMINISTRATION OFFICIAL: That would certainly be one of the things that we'll be looking at. The other thing we'll definitely be checking are the spend-out assumptions, because certainly our estimates have been based on what we -- how we thought the program was going to spend out. That's something we'll need to check.

The other thing that's going to be so nice about getting the direct reporting, right, so we can try to say, here's what we thought we were going to get, and when we get the numbers back, how do they compare? It will inherently be at -- you know, it'll be a two-way test. There are issues involved in how good the numbers we get back are going to be, and it will also be a test of what we were assuming about multipliers. And so, absolutely.

One of the things that I try to emphasize in the reports -- because we haven't yet even had to face a report to Congress -- is, we're going to do it lots of ways but I think -- to make sure that we've covered all our bases, we're going to try estimating it one way, we'll look at the direct numbers, we'll try some different multipliers, we'll be looking at other studies, we'll be doing some microeconomic analysis to see if, you know, a county had a whole lot of government spending; does it show up in the county employment data?

We're just planning to very much go on all fronts to get as complete a picture of what this Act is doing as we possibly can.

Here is the question I would have asked: "Going forward, what macroeconomic data would you have to observe before you concluded that the stimulus bill has been a failure? Or will you conclude, no matter how bad things get, that the economy would have been in even worse shape without the stimulus? And if the latter is the case, aren't these quarterly reports just a bit surreal?"

Fiscal Stimulus and Fed Policy

If some journalist out there talks to a member of the Federal Open Market Committee, here is the question I would ask:

If the economy now gets the fiscal stimulus being proposed (about 1 percent of GDP), does that mean that the Federal Reserve will cut interest rates less than it otherwise would?

My follow-up questions:

If the answer to the first question is No, then ask, Why the heck not? Monetary and fiscal policy are two tools available to increase the aggregate demand for goods and services. The goal here is to prop up demand sufficiently to maintain full employment without causing inflation. If the U.S. government is using fiscal policy more, it should use monetary policy less.

If the answer to the first question is Yes, then ask, How much higher will interest rates be kept as a result of the fiscal stimulus? And is it really better to have a fiscal stimulus and higher interest rates than a smaller deficit and lower interest rates?

Triangles vs Gaps

A smart reader (who, because of his current job, prefers anonymity) offers this input about the recent debate over fiscal stimulus:

I've enjoyed your stirring the pot on the great stimulus discussion in recent weeks. One thing I haven't seen much discussion of is the idea that there are intertemporal tradeoffs involved. Suppose, for purposes of discussion, that stimulus does actually work, but that taxpayers do ultimately have to pay for it. In that case, there is a tradeoff between increasing economic welfare in the short-run and reducing economic welfare in the long-run (because of the distortions of raising taxes). Are there any well-established macro models that provide some guidance on how that balancing should be done? Many analysts seem to believe that the stimulus should be sized to close as much of the output gap as possible. But it isn't obvious to me that's true if, in a perfect world, we are balancing the short-term gains against long run costs.

The reader is right that this consideration has not gotten much attention of late. Why? I suspect the answer is that those who are most confident in Keynesian policy prescriptions are most skeptical about the distortionary effects of taxation. To put it perhaps a bit too bluntly, the Keynesian mutliplier is about income effects, while neoclassical tax distortions are about substitution effects. For those of us eclectic enough to see the world including a variety of effects, both Keynesian and neoclassical, policy decisions are far harder than they are for those eager to focus on one effect while setting the other close to zero. You can guess which effect those on the far left and those on the far right choose to focus on.

Jim Tobin once addressed this issue, saying, "It takes a heap of Harberger triangles to fill an Okun's gap."* That is a great slogan for the Keynesian team. But I agree with the reader that it would be better to go beyond quips and try to quantify the issue with real data and real models. (PhD students: Take note of a possible dissertation topic.) In light of the looming tax increases that may well occur over the next few decades to finance promised entitlement programs for the elderly, Harburger triangles loom larger now than they did in Tobin's day.
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* For economists under the age of 40, who may be less familiar with these archaic terms: A Harberger triangle is the area in a supply and demand diagram that measures the deadweight loss of taxation. An Okun's gap is the loss in output and employment when the economy falls below potential because of insufficient aggregate demand.

Are fiscal multipliers now big or small?

Small, says Richard Clarida:

Because of the financial crisis and the severe damage caused to the system of credit intermediation through banks and securitization, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Many of you will remember from Econ 101 the idea of the Keynesian multiplier, which is that the impact of traditional macro policies is “multiplied” by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It is important to remember why and how policy multipliers actually work. Policy multipliers are greater than 1 to the extent the direct impact of a policy on GDP is multiplied as households and companies increase their spending due to the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand generated by the initial round of stimulus. Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001 the economy was in recession, but households took advantage of zero rate financing promotions – as well as ready access to home equity withdrawals from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts, as well as income earned from government spending on goods and services, will not be leveraged by the financial system to nearly the same extent, resulting in (much) smaller multipliers.

Big, says Christy Romer:

Critics have complained the Obama administration has been all doom and gloom about the economy, but in an apparent shift in rhetoric since the President's address to Congress last week, one of his top advisers today predicted the stimulus package will prove even more beneficial than expected in helping the nation out of its recession and ushering in a period of "very rapid growth".

“A common argument is that fiscal stimulus will have less effect because financial markets are operating poorly and lending is not flowing. I want to offer a different view,” said Christina Romer, chair of the Council of Economic Advisers. "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.”

In a speech this morning at an economics conference in northern Virginia, just outside Washington DC, Romer, noting that "the deeper the recession, the more rapid the rebound," forecasted that when the country recovers from its current crisis, it will enjoy a period of “very rapid growth”.

“When the economy turns around and confidence returns, the resulting pent-up demands spur rapid growth," she said. "What this means for the current situation is that fiscal policy may have a very large effect at some point. Given how far the economy has fallen, it is clear that sooner or later, we are going to have a period of very rapid growth as things return to normal.”

In a previous post, I suggested that, in light of the substantial uncertainty we now face, the marginal propensity to consume is likely larger than normal. As a result, multipliers would be larger than normal as well, as Christy Romer suggests. But I will be the first to admit that all of these arguments--Clarida's, Romer's, and mine--are essentially theoretical. I don't know of much empirical work on state-dependent fiscal multipliers to establish convincingly which side of this debate is correct.

Another Stimulus Spending Skeptic

A letter from a reader:

I read your blog on a daily basis and I've noted your skepticism about the monstrous bailout package being considered by the incoming Obama administration. In reading all of the econblogs I can find, I'm struck by the lack of practical knowledge both there and within the circle of advisers Obama has assembled.

I work for the DoD and when the Department of Homeland Security was established,we helped them with many things, not the least of which was contracting. To make a long story short, you cannot juice up a government agency's budget by tens of billions (or in the case of the stimulus package, hundreds of billions) and expect them to be able to process the paperwork to contract it out, much less oversee the projects or even choose them with any kind of hope for success. It's like trying to feed a Pomeranian a 25 lb turkey. It's madness.

It was years before DHS got the situation under control and between the start and when they finally assembled a sufficiently capable team of lawyers, contracting officials, technical experts and resource managers, most of the money was totally wasted. Now take the DHS situation and multiply it by 20 and you've got the Obama stimulus package. Even if they hand the money to existing governmental agencies, the situation will be the same. Those existing agencies are working full time administering the
budgets they have. They can't just add a zero at the end of each contract and be done with it.

Lastly, I've seen no business case analysis for this investment. I've seen lots of people referring to models and charts and graphs and history, but I've seen no analysis indicating that any of this will give you even a modest ROI....

Stop looking at models and equations and theoretical constructs for a while and look at the practical considerations of the stimulus package. I've been doing this sort of thing for quite a while and I'm convinced it's doomed from the start. If they feel the need to blast a trillion dollars into confetti, then tax cuts would make the most sense. Even if the public used the money to pay down debt, that would be a good thing as it would transfer the debt burden from the consumer to the government making the consumer feel a little bit like spending again.

Proposed Fiscal Stimulus: My View

Several reporters have called or emailed to get my view of the fiscal stimulus agreement announced today. Here it is.

I am personally skeptical that the economic weakness is sufficient at this point to justify such a package. Yesterday CBO came out with its forecast, including "growth for the year as a whole of under 2 percent and an increase in the unemployment rate to an average of 5.1 percent." That is similar to the current predictions of some of the best private forecasters, who put near-term growth between 1 and 2 percent.

In this environment, I would prefer to rely on monetary policy as the main source of macroeconomic stimulus. If there were a stronger case for a short-run demand-oriented fiscal stimulus, I would view the compromise package announced today as reasonable. But given where the economy is right now and the best forecasts of where it is heading, the fiscal package seems unnecessary as a short-run measure, while in the long run adding to the debt burden without doing anything to improve incentives for economic growth.

Addendum: The fact sheet says, "This relief would be available to everyone with adjusted gross income less than $75,000 for singles and $150,000 for married couples filing jointly. It will be phased out for taxpayers above those income thresholds". The phase out is an increase in the effective marginal tax rate. So while the plan gives a short-run boost to aggregate demand, it has a short-run depressing effect on aggregate supply.

The Bils-Klenow Stimulus Plan

Economists Mark Bils of the University of Rochester and Pete Klenow of Stanford say we should cut the payroll tax to stimulate the economy. They email me their rationale:

Greg,

As part of a temporary fiscal stimulus, we would argue for subsidizing the payroll tax (employer and employee portions) out of general revenue over some sustained period, say calendar year 2009. It has some distinct advantages:

(1) Like previous stimulus efforts, it has the standard demand side impact (same as cutting checks). But it also stimulates employment directly by reducing the tax penalties for working and for hiring workers. Related, it works under all business cycle models (even including those obeying Ricardian Equivalence).

(2) It targets domestic production better than sending out checks (or a sales tax cut).

(3) It targets lower income households, due to the cap on social security taxes. These households may respond more in both their consumption and employment decisions.

Now, it does not target the unemployed. But, in combination with extension of unemployment benefits, those with labor force attachment are still covered. In fact, it helps limit the damaging effects of extending the duration of unemployment benefits in terms of distorting reentry and job creation decisions.

Mark and Pete

Intriguing idea. In light of my post from yesterday on fiscal policy puzzles, I am especially attracted to the goal of robustness: we should try to find a stimulus plan that works under a variety of alternative business cycle models.