Recovery, or Replaying 1937 (and 2008)?

The President laid out a series of policy measures in yesterday’s speech which are, by textbook standards, entirely reasonable. And yet, many have been declared by the pundits to be DOA. I’ll leave the assessment of political feasibility to others, but the very fact that these specific measures [0] are so reasonable by textbook standards makes me wonder if we have in fact experienced technological regress in our politico-economic discourse. Maybe those shocks in RBC models are just the fact that so many individuals with influence never took an intermediate macro course, let alone an economics course [1] (I highly recommend Robert Hall and John Taylor’s Macroeconomics, or the later editions, by Hall and David Papell).

The Context: The Stimulus Package of 2009

To begin with it’s useful to review a little history, given the heated rhetoric that has been used in the past few years. From Chapter 5 of Lost Decades (forthcoming, W.W. Norton), written by me and Jeffry Frieden:

The standard macroeconomic view is that in recessionary conditions, incremental government spending and tax cuts can stimulate the economy. If the government spends an additional million dollars to build a bridge, that spending directly adds to GDP. But that is only the beginning: the spending on materials and labor is income to suppliers, contractors, and workers, and some of this income will be spent on consumer goods and services, which then further increases GDP. This in turn becomes income for other workers, who similarly increase their spending, again adding to GDP. This process suggests a “fiscal multiplier,” typically associated with Keynesian macroeconomics, such that every one-dollar increase in government spending results in a greater-than-one-dollar increase in GDP. Especially when the economy is stuck at ZIRP, so that private borrowing and spending are particularly weak, the multiplier can be large…

Even before the new administration took office, its economic team had been considering a fiscal stimulus. Romer’s evaluation indicated that a $1.2 trillion package was needed. However, President-elect Obama’s political advisers insisted that this was not feasible, and the numbers were shaved. Once in office, President Obama proposed a $675–$775 billion package to stimulate the economy.32

Intervention here: When I hear statements that “the stimulus failed”, I think it important to recall that between the election and inaugural day, business economists revised downward their estimates of GDP [2]. The proper metric is then to compare against the counterfactual as of the time of implementation, as described in here, here and here.

Some policymakers and economists believed that any government intervention, even in so troubled an economy, was unjustified. Congressman Ron Paul (R-Tex.) complained that “the US government just won’t allow the correction the economy needs.” He invoked the recession of 1921, which was deep but short, in Paul’s view because the government permitted insolvent companies to fail. “No one remembers that one,” he averred. “They’ll remember this one, because it will last 15 years.”34 Paul’s view was reminiscent of the position of the “liquidationists” of the early 1930s, who were led by Treasury Secretary Andrew Mellon. Mellon’s advice to President Herbert Hoover was typical: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … purge the rottenness out of the system.”35 The idea was almost moralistic: bad loans, bad debts, bad businesses, and bad deals had to be exorcised before the economy could right itself. Satisfying as such a scorched-earth policy might be (at least to those not caught in its path), few serious economists or policymakers ever considered it.36

Some theoretical objections to an active fiscal stimulus were based on the view that government spending would inevitably be wasteful, providing no real benefit to the population. Others emphasized the expectation that increased government spending would be counteracted by an offsetting reduction in private spending. The budget deficits that would result from tax cuts or more government spending would drive interest rates higher and reduce, or “crowd out,” private investment and spending. The economists who held these positions were generally hostile to traditional Keynesian views, especially because of the Keynesian inclination to assume that there were market failures that government could correct…

But among most economists, there was a general consensus on the desirability of some form of active fiscal policy. In a February 2009 Wall Street Journal poll of economists, 68 percent said that the proposed stimulus package was about the right size or too small. Only 31 percent said that it was too large. Most economists in the policy and business circles viewed a stimulus package as something that could soften the blows of a deep downturn and hasten the arrival of a recovery.38

Well, we know about how much interest rates have risen in response to the stimulus package [3] [4]. And with that decline in long term interest rates, we know how much interest-rate-induced crowding out of investment has occurred: nil. Instead, the drama we seem to be witnessing now is a replay of 1937 [Krugman], when policymakers overly worried about inflation and deficits withdrew stimulus too early. Whether we will (re-)learn that lesson is the question of the moment.

The President’s Proposals: The Textbook Approach

In a standard aggregate demand/aggregate supply model [5] [6], output is demand determined in the short run, and supply determined in the long run. The President’s proposals focus, appropriately, on the short run, given the large output gap.

Figure 1: Log GDP (blue), potential GDP from CBO (gray), cubic trend in log GDP estimated over 1967-2011Q2 (gray-green), and forecasted GDP according to mean of August WSJ survey (red) based on July GDP release, all in Ch.2005$, SAAR. Source: BEA, CBO, WSJ, author’s calculations.Using the CBO’s measure of potential, the lost output has been $2.8 trillion (Ch.2005$) through 2011Q2. Using the WSJ mean forecast, another $1.4 trillion will be lost by 2012Q4. The CBO-implied output gap as of 2011Q2 is 7.1% (log terms). Using a cubic in time trendline, the gap is still 3.4% (and then one has to believe that output was above potential 3.3% in 2007Q3).

Extended unemployment insurance, extension of the payroll tax holiday [CBPP], and infrastructure spending are all means by which aggregate demand can be sustained. To the extent that extended UI and payroll tax holiday benefit lower income/liquidity constrained individuals, the marginal propensity to consume is relatively high and hence the multiplier fairly large. Investment in infrastructure also makes a lot sense given the multiplier is fairly large for direct spending. The multiplier ranges are depicted in the below table (they are from a January 2010 report, so the dates relate to proposals implemented in 2010).

Source: CBO (2010).
I’ll note these ranges pertain to a situation where the Fed is assumed to tighten a year after implementation. To the extent that the Fed has committed to keeping the Fed funds rate close to zero to mid-2013, the relevant upper end of these ranges is probably higher.

Transfers from the Federal government to the states also has a high multiplier. Since the states are typically constrained in terms of borrowing, either due to constitutional or credit constraints, it makes sense for the Federal government to share revenues with them during times of fiscal stress.

The policies also make sense from a supply side perspective. Here I want to distinguish between faux supply siders, who think supply can only be augmented by reduced tax rates or reduced regulatory burdens, and those who have a broader interpretation of what factors determine supply. Clearly, investment in infrastructure increases the productive capacity of the economy. But some of the other measures also work on that margin. So when the President aims to retrain workers, or keep employed workers who otherwise might undergo long periods of joblessness, this is working on the supply side by enhancing human capital. (See these posts and conference proceedings regarding the impact of long term unemployment [7} [8] [9] [10]).

From the Public Finance Textbook

The employment tax credit is not straight out of the macro textbooks, but the rationale can be found in most standard public finance textbooks, specifically the analysis of an investment tax credit (ITC). An ITC reduces the cost of capital facing the firm, increasing the optimal capital stock. The cost per unit of additional investment is in principle low because only the marginal investment spending requires tax expenditures; there is no rent going to other units of capital already in place. The logic for employment is the same.

Summing Up

The President’s proposal will probably not have an enormous impact on GDP (in principle, it should have been larger, but I bow to political realities), although the estimates vary since the details are still coming out. Macroeconomic Advisers guessed about a percentage point acceleration, more than a week before the speech (they are to have a more specific estimate soon). Mark Zandi from Moody’s, with more details at hand, estimated 2 ppts acceleration relative to baseline, according to Bloomberg. What perhaps is of key importance is that these measures prevent the economy from falling below stall speed. [11]

Addendum: Replaying 2008?

On a slightly different note, I note that the opposition to adequately funding the new consumer financial protection bureau, and confirming the new head [12], seems to signal an intent to let the financial sector “self-regulate”. Well, that turned out well. Once again, from Chapter 8 of Lost Decades, our assessment of why the financial crisis was so devastating:

… Lawmakers disarmed financial regulators, who in turn used few of the weapons left in their arsenals, allowing financial institutions to develop new instruments that were largely untested and wholly unsupervised. Financial institutions worked madly to increase their profits in a low-interest-rate environment by taking on ever riskier assets, insisting that they had mastered risks they barely understood.

In our view, the argument that one can “just say no” to future bailouts, and eschew regulation represents a willful misreading of the lessons of history, or a deliberate attempt to obscure the buildup of contingent liabilities that will be paid by ordinary taxpayers, while spewing platitudes about free markets — in other words, and excuse for Akerlof-Romer type “looting” [13].

This post originally appeared at Econbrowser and is reproduced here with permission.