Summers or Taylor

The effectiveness of fiscal policy is an issue that divides macroeconomists.  “Tinkerers” believe that aggregate demand can be stimulated by federal deficit spending and cutting taxes.  Larry Summers is a well respected economists that supports active fiscal policy to improve economic outcomes.  In an interview with Charlie Rose, he describes the policies he believes that are or would be helpful in today’s economy.  Please keep in mind that Summers was an important policy maker in both the Clinton and Obama administrations and that he has acquired a tendency to blame Republicans for bad outcomes rather than stick strictly to the economics of policy options.  While the tendency is natural and appropriate for a policymaker, it is sometimes a distraction.  Please ignore the politics and stick to the economics.     

Another group of macroeconomists believe in “rules” and doubt the effectiveness of tinkering.  These rules are largely attempt to build stability and predictability and abandon stimulus policies.  John Taylor argues for rules and against discretionary fiscal and monetary policy in an EconTalk interview with Russ Roberts.  Rather than increase deficit spending to stimulate aggregate demand, he argues that cutting deficits would create a more stable governmental fiscal environment allowing market participants to operate with less risk.   
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Vernon Smith on QE2

Vernon Smith is a Nobel Laureate in Economics and one of my favorite economists.  He has written on the root causes of the housing bubble which ties into his experimental research on asset pricing.  In his Wall Street Journal article, “What Ben Bernanke May Be Thinking,” he identifies a common feature of the Great Depression and the Great Recession, questionable housing loan assets that have not been revalued, and suggests that Fed Chairman Ben Bernanke may be attempting to deal with this problem with Quantitative Easing 2 (QE2).

In both the Depression and the post-World War II era, recovery from a recession has been regularly signaled by an increase in housing investment. But new housing construction expenditures have remained stubbornly flat since the Great Recession was declared over in the second quarter of 2009.

Housing and aggregate demand have not recovered because nearly 15 million owners are estimated to owe about $771 billion more on their homes than they are worth. The banks are on the other side of this crunch, holding overvalued mortgage assets. This fuels doubt about the balance sheets of the big banks… …QE2 just might work if it is implemented as a surgical strike at the still-unresolved problems of negative equity in housing and banks. Mr. Bernanke's first round of quantitative easing in 2008-09 lifted about $1.2 trillion of shaky assets off the balance sheets of banks, replacing them with nearly a trillion dollars in excess reserve deposits. The second round will further expand these deposits.

So perhaps the Bernanke message here is for the banks to deploy those excess reserves to reset the value of their loan assets to current housing prices. They could do so by issuing new mortgages with lower principal amounts. While they would take short-term losses, this action could allay doubts about the value of the assets on bank balance sheets and would help the balance sheets of homeowners as well.

Is this what Mr. Bernanke is thinking? The rollout of QE2 was coupled with a Nov. 17 Fed announcement requiring the large banks to undergo another review of their capital and ability to absorb losses.

There is good reason for Mr. Bernanke to be worried.

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An Open Letter to Ben Bernanke

The following letter was signed by economists, investors, and political strategists.  The Wall Street Journal (“Open Letter to Ben Bernanke”) notes that most of them have close ties to the Republican party.  It should be noted that Chairman Bernanke was appointed to the Board of Governors by a Republican.  Many of the economists who signed specialize in banking and monetary policy. 

We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued.  We do not believe such a plan is necessary or advisable under current circumstances.  The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.”  In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.

The Fed spokeswoman responded.

As the Chairman has said, the Federal Reserve has Congressionally-mandated objectives to help promote both increased employment and price stability. In light of persistently weak job creation and declining inflation, the Federal Open Market Committee’s recent actions reflect those mandates.  The Federal Reserve will regularly review its program in light of incoming information and is prepared to make adjustments as necessary.  The Federal Reserve is committed to both parts of its dual mandate and will take all measures to keep inflation low and stable as well as promote growth in employment.  In particular, the Fed has made all necessary preparations and is confident that it has the tools to unwind these policies at the appropriate time. The Chairman has also noted that the Federal Reserve does not believe it can solve the economy’s problems on its own.  That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators, and the private sector.

Greg Mankiw, who also has ties to Republicans, explains why he did not sign (“QE2”).

My view is that QE2 is a modestly good idea.  I say it is a "good idea" because, like Ben Bernanke, I am more worried at the moment about Japanese-style deflation and stagnation than I am about excessive inflation.  By lowering long-term real interest rates below where they otherwise would be, QE2 should help expand aggregate demand.  I include the modifier "modestly" because I don't expect these actions to have a very large effect.

Moreover, I do see some potential downsides.  In particular, the Fed is making its portfolio riskier.  By borrowing short and investing long, the Fed is in some ways becoming the hedge fund of last resort.  If future events require higher interest rates, the Fed will end up making losses on its portfolio.  And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds.  Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles).  Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.  I trust the team at the Fed enough to think they will avoid that mistake.

So, in the end, I judge QE2 to be a small but risky step in the right direction.

.
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Quantitative Easing: Rules Vs. Discretion

The use of monetary policy such as quantitative easing, the purchase of securities by the Federal Open Market Committee, is standard theory in Macroeconomics.  The policy can be implemented using discretion of Fed officials or through the use of rules like the Taylor rule and this is the source of controversy among economists.  Former Fed Chairman, Alan Greenspan, outlined many issues of the debate “Rules vs. discretionary monetary policy,” a speech delivered in 1997. 

Policy rules, at least in a general way, presume some understanding of how economic forces work. Moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly. Use of a rule presupposes that action x will, with a reasonably high probability, be followed over time by event y.

Another premise behind many rule-based policy prescriptions, however, is that our knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. In this view, ad hoc or discretionary policy can cause uncertainty for private decision makers and be wrong for extended periods if there is no anchor to bring it back into line. In addition, discretionary policy is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't those of elected representatives supersede those of unelected officials?The monetary policy of the Federal Reserve has involved varying degrees of rule- and discretionary-based modes of operation over time. Recognizing the potential drawbacks of purely discretionary policy, the Federal Reserve frequently has sought to exploit past patterns and regularities to operate in a systematic way. But we have found that very often historical regularities have been disrupted by unanticipated change, especially in technologies. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Accordingly we are constantly evaluating how much we can infer from the past and how relationships might have changed. In an ever changing world, some element of discretion appears to be an unavoidable aspect of policymaking.

Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy. Still, sensible policy does presuppose a conceptual framework, or implicit model, however incompletely specified, of how the economic system operates. Of necessity, we make judgments based importantly on historical regularities in behavior inferred from data relationships. These perceived regularities can be embodied in formal empirical models, often covering only a portion of the economic system. Generally, the regularities inform our interpretation of "experience" and tell us what to look for to determine whether history is in the process of repeating itself, and if not, why not. From such an examination, along with an assessment of past policy actions, we attempt to judge to what extent our current policies should deviate from our past patterns of behavior.

The current policy of monetary easing is discretionary and has a political problem not identified by Greenspan.  It is widely unpopular with leaders in exporting countries who view it as an attempt to devalue the dollar relative to their currency reducing their exports to the United States and increasing the attractiveness of our imports in their countries.  Will these countries use discretionary policy to reduce the value of their currencies and ignite a trade war through monetary debasement?
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Quantitative Easing

On November 3, the Federal Open Market Committee announced a plan to implement a second round of quantitative easing, an idea floated by Fed Chairman Ben Bernanke in his speech at Jackson Hole on August 27, 2010.  The Fed will increase its holdings of bonds by $600 billion before the second quarter of 2011.   
Economists are not certain of exactly how quantitative easing increases economic activity, but those who support it illustrate how it works by lowering interest rates throughout the economy using the following story. 

The value of any asset is equal to the discounted value or present value of all payments earned from that asset.  In the formula, PV represents the present value or market value of an asset and it is equal to the sum of the annual payments (P1 through Pn) and the sales price of the asset (Sn) discounted by the market interest rate ((1+i).  For a bond, dividends represent the annual payments and the sales price, the value of the bond in the nth year.

When the Fed buys bonds, it must convince current bondholders who were satisfied holding bonds at the existing market price to sell.  It does this by offering a higher price than the current market price.  To keep the present value in balance, the part of the equation to the right of the equality sign must increase.  Because the payments are fixed, and because the Fed has little ability to control the sales price of the bond for reasons I will not explain here, increases in the right-hand side of the equation must come through a decrease in the market interest rate, i.  Lower interest rates affect not only bonds, but all other assets in the nation’s investment portfolio as well.  Prior to the Fed’s quantitative easing, individual investment portfolios were in equilibrium, meaning that investors were satisfied with the risk/return tradeoffs of the investments they held.  As bond prices rise, current bondholders earn higher than expected profits on their bond investments if they sell.  They are left with cash holdings which earn little, and because of the flood of new cash into investor portfolios from the sale of bonds, the interest earned on these holdings fall.  Investors reexamine investment alternatives, and given current conditions in the bond and cash holdings market, find other investments such as stock or real estate relatively more attractive.  Investors bid up the prices of the other investment to induce the current owners to sell, thus forcing down market interest rates for these assets.  Increases in wealth encourage people to spend and invest more.

Not all investments will be from the purchase of existing assets.  Some will be made in the production and sale of new goods and services or the construction of new assets which become  more profitable because of lower interest rates throughout the economy.

Quantitative easing also affects the interest rates because it increases the probability of inflation as demonstrated with asset prices.  The nominal exchange rate (e) is the amount of a foreign currency we can buy with a dollar.  It is equal to the real exchange rate (RE), the real or inflation adjusted amount of foreign currency we can buy with a dollar, multiplied by the ratio of a foreign price index and dividend by the U.S. price index (PF/PD). 

Because policy does not affect the real price index and does not directly affect foreign prices, increases in domestic prices lower the real exchange rate; the dollar now purchases less foreign currency than before.  Conversely, foreign currency can buy more dollars.  Because foreign currency if more expensive, foreign goods, our imports, are more expensive, and our exports are cheaper in foreign markets.  If other countries through their central banks do not respond by lowering their interest rates, our exports will increase, expanding economic activity at home.

I will reserve criticisms of quantitative easing for future blog posts. 
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Monetary Easing?

Jon Hilsenrath wrote a good article for the Wall Street Journal describing remarks by Federal Reserve Chairman Ben Bernanke (“Bernanke Makes Case for Further Fed Moves to Boost Economy”).  Bernanke believes that inflation is well contained and economic activity is weak justifying monetary easing (actions by the Fed Open Market Committee to increase economic activity).  Bernanke suggested that the Fed might purchase long-term Treasury bonds to push down long-term interest rates.  He also suggested that the Fed would proceed with caution because of uncertainty about the program’s effectiveness. 

Let me reassert my belief that short-term policy instruments are not as effective as sometimes advertised and my belief that policy should focus on creating long-term growth.Replace this text with...
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Rogoff Compares Japanese, U.S., and European Financial Crises

Kenneth Rogoff is one of the nation's foremost scholars on financial crisis. With Carmen Reinhart, he coauthored the popular and widely cited book "This Time is Different: Eight Centuries of Financial Folly." Rogoff has the talent of engaging in politically charged economic debate without partisan rancor.  Rogoff compares the ongoing financial crises in the United States and Europe to the crisis in Japan that evolved into the "lost decade" in "An Age of Diminished Expectations?"  The article is short and well worth the time to read highlighting similarities and many differences between the economies as they entered their financial crises.  I have focused on paragraphs that describe policies that might help the United States exit the Great Recession and resume more robust growth. 

As the United States and European economies continue to struggle, there is rising concern that they face a Japanese-style “lost decade.” Unfortunately, far too much discussion has centered on what governments can do to stimulate demand through budget deficits and monetary policy. These are key issues in the short term, but, as every economist knows, long-run economic growth is determined mainly by improving productivity...

In the short term, it is important that monetary policy in the US and Europe vigilantly fight Japanese-style deflation, which would only exacerbate debt problems by lowering incomes relative to debts. In fact, as I argued at the outset of the crisis, it would be far better to have two or three years of mildly elevated inflation, deflating debts across the board, especially if the political, legal, and regulatory systems remain somewhat paralyzed in achieving the necessary write-downs.

With credit markets impaired, further quantitative easing may still be needed. As for fiscal policy, it is already in high gear and needs gradual tightening over several years, lest already troubling government-debt levels deteriorate even faster. Those who believe – often with quasi-religious conviction – that we need even more Keynesian fiscal stimulus, and should ignore government debt, seem to me to be panicking.

Last but not least, however, it is important to try to preserve dynamism in the US and European economies through productivity-enhancing measures – for example, by being vigilant about anti-trust policy, and by streamlining and simplifying tax systems.

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Parallels Between the Great Depression and Great Recession

Growth in the U.S. gross domestic product was revised downward to 3.0% from 3.2% for the first quarter of 2010.  Initial claims for unemployment remain stubbornly high, falling 15, 000 to 460,000, but the 4-week moving average of initial claims climbed 2,250 to 454,250 (Jeannine Aversa, "Slow-motion recovery keeps unemployment high").  British and European monetarist have a possible explanation, the money supply as measured by M3 is falling at rates not seen since the Great Depression.  Ambrose Evans-Pritchard summarizes monetarist research in "US money supply plunges at 1930s pace as Obama eyes fresh stimulus" noting that M3 fell from $14.2 trillion to $13.9 trillion or 9.6% in the first quarter and the assets of institutional money market funds fell by 37%, the biggest decline ever.  As money assets contract, government debt swells.  Gross public debt will reach 97% of GDP in 2011.

The economy could slip back from weak recovery into recession with another negative shock.  The administration is pushing a $200 billion stimulus to sustain the growth that they believe that the original stimulus created.  Evans-Pritchard quoted Larry Summers, whose words acknowledge the dangers of the expanding deficit, as stating that Congress must "grit its teeth" to pass the stimulus and that it would be "pennywise and pound foolish" to fail to pass it.

In "Crisis and Leviathan," Robert Higgs proposed the crisis hypothesis which states that national crisis increase both the demand for and supply of government regulation of the economy.  Evans-Pritchard also interviewed Tim Congdon who believes that regulation comes at a cost...

"It’s frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said.

Steven Gjerstad and Vernon Smith see other parallels between the Great Depression and the Great Recession ("Monetary Policy, Credit Extension, and Housing Bubbles: 2008 and 1929," Critical Review, 21(2-3), 269-300).  They document how housing bubbles formed in both 1929 and 2008 based on expansion of housing and mortgage financing for the least qualified borrowers.  They describe the boom and bust cycle.

The massive bubble in housing prices(driven by self-reinforcing price expectations) and the supporting expansion of credit, undisciplined by traditional equity requirements, as well as tiered internal structure of the housing market, had all depended on further unsustainable housing-price growth, premised on unfathomable easy mortgage credit--fueled by easy money.  Once that momentum turned negative, buyers of homes, mortgages, and bank obligations reined in their activity, the stock market plummeted, and monetary policy was impotent to stem the collapse.  Monetary policy was "pushing on a string" that only absent buyers could have pulled.

Traditional policy tools, fiscal policy, monetary policy and regulation seem limited and ineffectual at best and counterproductive at worst.  It is the actions of economic agents working through markets that will end the recession. 
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Blinder: The End (of the Recession) Is Near!

It is near Christmas, a time of optimism and hope for many Americans.  Alan Blinder feeds that hope by focusing on positive developments in recent economic data in his Wall Street Journal column, "The Case for Optimism on the Economy."  His byline states that he is "a professor of economics and public affairs at Princeton University and vice chairman of the Promontory Interfinancial Network, is a former vice chairman of the Federal Reserve Board."  He starts by describing the state of the economy and reasons for optimism.

The U.S. economy is digging itself out of a deep hole. You have probably heard a lot of doom and gloom lately, including talk of a jobless recovery, an L-shaped recovery (which means no recovery at all), or even a W—the feared double-dip recession. The Scrooges have a point: There are serious dangers to the nascent recovery. But you've heard all that many times. Let me offer instead, in deliberately one-sided fashion, the case for optimism. It is, after all, the holiday season.

The case begins with the "slingshot effect" I wrote about on this page last summer ("The Economy Has Hit Bottom," July 24, 2009). When the growth rate of any component of GDP rises, it gives overall GDP growth a boost. And going from sharply negative growth to zero is a notable rise. In July, the slingshot scenario was hypothetical—though likely. In today's economy, it's a real phenomenon...

The second major source of optimism is the amazing performance of productivity during the recession. To be sure, that performance had a downside: While real GDP was falling 3.7%, payroll employment dropped 5%, devastating many American families. But by definition, that discrepancy means that productivity—output per hour of work—rose substantially during the recession, which is pretty unusual.

The last two quarters were even more extreme: Productivity in the nonfarm business sector grew at a shocking 8.1% annual rate. There are two possible explanations. One: The last two quarters were among the most technologically innovative and entrepreneurial in the history of the United States. Two: Fearful businesses pared payrolls to the bone. If the second is closer to the truth, payrolls are extraordinarily lean right now. Which means that firms will need to hire more workers as their sales and production grow. Which means that employment may start growing sooner than the pessimists think...

There is more to the case for optimism. For one thing, less than 30% of February's $787 billion fiscal stimulus has been spent to date; over 70% is still in the pipeline. Pessimists dote on the fact that the rate of increase of stimulus spending has probably peaked and will be lower in 2010. True. But the level of GDP will continue to get support from fiscal policy, and a second job-creation package ("Please don't call it a stimulus!") looks to be in the works.

Then there is the Federal Reserve's stupendously expansionary monetary policy. It is well known that interest rates work on the economy with long lags. But the Fed's last rate cut came a year ago. So isn't the monetary policy pipeline empty? The answer is no, for at least three reasons. First, history suggests that the time lag is closer to two years than to one. So even the normal policy lags are not over...

Blinder states his expectation of growth.

I warned at the outset that I would present a deliberately biased case. So let me admit, once again, that serious downside risks remain. The investment slingshot and the fiscal stimulus will both peter out in 2010. Consumer finances and confidence are shaky. Banks are still failing and commercial real estate is a mess. We cannot count on exports to pull us out of this slump. All true. And all reasons not to expect the kind of exuberant boom that typically follows a deep recession—such as the 7.7% growth spurt in the six quarters following the 1981-82 slump. No one expects that.

So my optimism is guarded. The 3%-4% growth rate that I anticipate for the rest of this year and for 2010 is a lot worse than 7.7%, to be sure. But compared to what we've been through, it will feel a whole lot better.

I agree that 3%-4% growth will make us feel a "whole lot better."
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Bernanke As A Deficit Hawk

Craig Torres and Brian Faler writing in "Bernanke Warns Deficits Threaten Financial Stability (Update4)," for Bloomberg on June 3 describe Federal Reserve Chairman Bernanke's most recent comments before the House Budget Committee.  I have bolded several phrases to highlight the Chairman's concern is long term, that deficits, if not dramatically reduced, will affect long term financial stability and economic growth.  Deficit reduction must come from increasing taxes or reducing spending.

Federal Reserve Chairman Ben S. Bernanke said large U.S. budget deficits threaten financial stability and the government can’t continue indefinitely to borrow at the current rate to finance the shortfall.

“Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth,” Bernanke said in testimony to lawmakers today. “Maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance.”...

...He said the Fed won’t finance government spending over the long term, while warning that the financial industry remains under stress and the credit crunch continues to limit spending...

The budget deficit this year is projected to reach $1.85 trillion, equivalent to 13 percent of the nation’s economy, according to the nonpartisan Congressional Budget Office.

“Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation,” Bernanke said in response to a question. “The Federal Reserve will not monetize the debt.”...

Rising government spending, forecasts for a record fiscal deficit and an unprecedented expansion of central bank credit have also fueled investor concerns that inflation will rise. Bernanke said inflation “will remain low” as the economy operates with slack resource use.

I have a modest suggestion for cutting spending now.  Recent improvement in economic conditions is not a result of February's emergency $787 billion stimulus package.  As Russ Robert reports at Cafe Hayek, only $36.7 billion of the stimulus has been spent.  Take President Clinton's budget director Alice Rivlin's advice and divide the stimulus into immediate stimulus measures and long term transformative spending.  Take more time examining the transformative spending.  Most if it can be cut.  Rivlin's advice is not draconian as it would preserve much of the stimulus, but acknowledges weaknesses of fiscal policy: it crowds out private investment lowering long term economic growth, is slow to evolve, and almost always results in wasteful spending.  
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Who Is Right?

Carter Dougherty describes differences in monetary policy between the orthodox European Central Bank and less orthodox central banks in the United States, Britain and Japan in “European Central Bank resists rush to print money” (The International Tribune, March 24, 2009).

FRANKFURT: At the European Central Bank, being a maverick means holding steady as others bow to the prevailing winds.

With its peers in the United States, Britain and Japan cranking up monetary printing presses in a bid to prevent their economies from falling into deeper holes, the E.C.B. is resisting the rush into the least orthodox central banking policies in contemporary history.

"Exaggerated swings without perspective," Jean-Claude Trichet, the E.C.B. president, said recently, "would delay the return of sustainable prosperity because they would undermine confidence, which is the most precious ingredient in the current circumstances."

When others sharply cut interest rates, the E.C.B. was slower to act. When others stepped in to bail out financial institutions, the E.C.B., constitutionally limited in its powers, left that to national governments.

And now, with other central banks acting to create money out of thin air because they cannot prime the lending pumps by lowering short-term interest rates any further, the E.C.B. remains wary of the specter of future inflation.

Beneath it all is an aversion to anything that smacks of "printing money," a phrase that evokes Europe's worst economic nightmares, everything from kings debasing their currencies so they could fight endless battles to the hyperinflation and currency collapses in Germany after it lost two wars in the 20th century.

Which policy course will more effectively restore economic activity?

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Brad DeLong On The Stimulus As It Passed

To my recollection, there has never been an issue as contentious between economists as the merits of the stimulus bill. I began posting about economists supporting some type of stimulus package, followed by a spate of posts by skeptics. I thought that it was time to post on an economist supporting the stimulus bill as it passed Congress. Brad DeLong is a macroeconomist who gracefully and persuasively crafts words. He writes,

Will the Obama deficit-spending plan work? Will throwing $800 billion—$500 billion in extra government spending, and $300 billion in tax cuts—at the economy produce a world in which production and employment are higher and unemployment lower than would otherwise have been the case?

The short answer is yes. The short reason is that spending works—eras in which some group or other gets excited about future prospects and starts madly spending money are eras in which production and employment are high and unemployment is low. And the government, in this respect, is just like any other group of starry-eyed optimists whose eagerness to spend pulls the economy into a high-employment, high-pressure boom...

DeLong provides three examples of spending sprees increasing employment: the 2003-2005 housing boom supported by an easy money policy of the Fed, the 1996-1998 Internet boom, and the 1982-1986 boom led by monetary easing, increases in defense spending and tax cuts.

In a small gotcha moment, DeLong quotes Mankiw, a leading skeptic of the Obama stimulus bill, presumably supporting the Reagan fiscal stimulus, who said in 1983, "There is nothing novel about this. It is very conventional short-run stabilization policy: You can find it in all of the leading textbooks."

Many economists opposing the stimulus claim that the large debt will lower future growth. DeLong address these concerns with the typical serenity of an empirical economist waiting for data.

But there is a relevant question outstanding: Will there be some sort of a hangover after this Obama spending binge—some debt-induced, groggy morning after? And if there is a hangover how bad will it be? For the answer to that, we will have to wait and see.

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Robert Barro On The Economic Stimulus And Other Topics

On January 22, 2009, the Wall Street Journal published "Government Spending Is No Free Lunch: Now the Democrats are Peddling Voodoo Economics," by Robert Barro. The article touched off a small maelstrom between economists who support the stimulus and those who do not.

Barro's disagreement is with multipliers estimated using a Keynesian model and used by Team Obama to justify the $800 billion stimulus package winding its way through Congress. The administration claims that every dollar of stimulus spending will have a multiplied effect, increasing GDP by 1.5 dollars. Barro begins by examining multipliers from the wartime fiscal expansion and explains why.

Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.

He estimates the WWII multiplier at .8; a dollar spent on wartime activities produces only an 80 cent increase in overall economic activity. The resources used by the government must come from somewhere, and that is from other productive uses. Barro then describes what he believes is a flaw in the model used to support the administration's stimulus plan.

The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.

Barro ends with several suggestions for a stimulus plan.

Much more focus should be on incentives for people and businesses to invest, produce and work...Eliminating the federal corporate income tax would be brilliant. On the spending side, the main point is that we should not be considering massive public-works programs that do not pass muster from the perspective of cost-benefit analysis.

His critics believe that WWII was not a good choice for estimating multipliers. Matthew Yglesias gives a clever and oft cited criticism on his Think Progress post, "Multipliers and Diminishing Returns".

I think this is running together two separate issues. One is “whether a large multiplier ever exists” and one is whether such multipliers suffer from diminishing returns. World War II spending was enormous relative to GDP. Wartime spending on that kind of scale goes way beyond the conversations we’re having right now about fiscal stimulus—the equivalent today would be something like a $5.2 trillion package rather than the $800 billion or so we’re talking about...The 0.8 multiplier is probably the result of diminishing returns.

Conor Clarke of the Atlantic, in "A Brave New Deal" conducts an interview with Barro, providing a forum to defend his research against blog attacks.

Most economists haven't really been thinking about this issue, they haven't really focused on it. It's not their specialty. Most economists today, they haven't really been thinking about this kind of multiplier issue. Which goes back to that first question you asked about how come now we're so worried about this. I don't think most economists are focused on this, or that they're familiar with the empirical evidence. I don't think they've really worked on the theory. So I don't know, maybe they have some opinion that they got from graduate school or something.

I think my sense is that the sentiment has been moving against this kind of approach both within the economics profession and more broadly. I think the initial view was that "yeah, this is a terrible situation" -- which I agree with -- "and we've got to do something about this, and maybe this will work." I think there was support in that sense.

I would fall into the group of economists who are trying to dredge up old memories from graduate school. Being a micro guy, there isn't too much to dredge. He also states that more can be done with monetary policy.

There are things that they can still do...The Federal Reserve is buying up all kinds of other assets, like long-term government bonds. But they are also buying a lot of private stuff, and that will presumably have a substantial impact. I mean there's a downside to doing all this, but it should certainly have effects. So in that sense they haven't run out of ammunition.

He expresses the view that the recession will not end until credit markets are fixed and praises the appointment of Jeremy Stein.

Larry Summers did bring in Jeremy Stein, who is probably one of the best people in the area. I think he's going to have a lot of impact on that design. I hope so. That's another person they hired recently. Summers brought him in to advise particularly on the financial and housing issues, the design of the new regulations structure. That was an excellent appointment. That's the stuff that's really going to count.

Because I am not a macroeconomist, I will keep my observations brief. I think Yglesias' comments are valuable, but for Barro's critics, it is a Goldilocks argument. Peace time deficit spending during the Great Depression was too small to be effective, and the effective war time expenditure was too big to have a big multiplier. If this argument is correct, the peace time multiplier must be large. The problem is one of measurement. The multiplier impact of expenditures could easily be overwhelmed by other economic events.

I am concerned about the quality of WWII data. But if Robert Higgs is correct, and real GDP was overestimated during the war period [1], possible multipliers would be overestimated as well. The mismeasurement of GDP might also have inflated the value of war production and deflated he valued of consumer production. In this case, the crowding out impact of war expenditures would be smaller than Barro estimated.

[1] Higgs, Robert. "Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s," The Journal of Economic History, 1992.

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