Fiscal Policy

I have not taught fiscal policy in my principles classes for some time.  There seemed little need.  My reading of the macroeconomics literature was that the efficacy of fiscal policy was limited to the rare occurrence of a deep and long recession.  Based on the length of the Great Moderation, a period of low inflation, strong economic growth and high employment, I believed that monetary economists working inside the Federal Reserve had learned to better manage the business cycle.

A recession began when the housing bubble burst in 2007, straining our highly leveraged financial sector.  The economy headed south, leaving the desiccated memory of the Great Moderation in the dust, and beginning what many have termed the Great Recession, both long and deep, the conditions required for effective fiscal policy.

Fiscal policy is the sue of the federal government's taxing and spending authority to achieve or maintain full employment or price stability.  In times of recession, the government creates or enlarges deficits to maintain aggregate demand, the total level of demand for all goods and services throughout the economy.  Policy makers can cut taxes, increase spending or some combination of the two to reach desired deficits.  The additional spending by the government or recipients of tax cuts has a multiplied impact through the economy.  For example, Ben gets a $100 tax cut which he uses to buy a new Sony DVD player.  Sony uses the extra money to buy $90 of labor.  The $90 of wages buys $80 of groceries and so on. 

All theories are just good stories until empirically verified.  The focus of the empirical debate has turned on the size of the multipliers.  Multipliers greater than one stimulate growth while those less than one restrain growth.  Robert Barro and Charles Redlick describe the literature on empirically estimated multipliers as "thin" in "Macroeconomic Effects from Government Purchases and Taxes," NBER Working Paper No. 15369.  The authors estimate the multiplier at .7 when the economy is experiencing unemployment of 5.6%.  It increases .1 for every 2% increase in unemployment, implying that stimulus spending becomes beneficial (multiplier greater than 1) when the economy is experiencing 12% or greater unemployment.  In a Wall Street Journal article (Stimulus Spending Doesn't Work) that presents their findings, they conclude,

The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP. 

Barro and Redlick have not given the final word on multipliers but their research is a good starting point for evaluating the effectiveness of fiscal policy and the size of multipliers
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Murtha's Airport and the Stimulus Debate

Over the course of his congressional career, John Murtha has funneled nearly $200 into the Johnstown-Cambria Co-Murtha Airport.  The airport has three flights per day.  The FAA has approved an $800,000 "shovel ready" project to repave a crosswind runway that's used as a backup to the main landing runway (Jim Acosta and Janet Rodriguez.  "Remote Murtha airport lands big bucks from Washington," CNNPolitics .com, April 23, 2009 or the video link). 

The project illustrates differences between economists supporting and opposing the stimulus.  Economists supporting the stimulus argue that even bad projects create jobs now and replace a vicious cycle of market psychology in which bad news feeds retrenchment which engenders more bad news with a virtuous cycle.  Economists who support the stimulus might support the project if it employs mostly idled resources.  Economists opposing the stimulus argue that the government's inherent inefficiency in selecting good investment projects, the deadweight loss from taxation, and the high percentage of employed resources imply that few new resources will be employed and any recovery will be weak because of the size and scope of wasted resources.  Good investment projects would employ idled resources and have good long run return on investment.  This project would not pass their scrutiny.

I believe that most economists see a need for airport expansion (Paul Joskow, Deregulation, AEI Event, February 10, 2009, Minutes 29:50-32:45.  The link provides a link to the audio of the lecture).  The lack of airport expansion, particularly the building of new hubs, is a factor limiting the success of Carter era price deregulation.  I would guess that most economists would not like the rate of return on the Murtha airport project.  As of March 2009, Pennsylvania's unemployment rate was 7.8%. 

Brad DeLong who supports the stimulus and Kevin Murphy who opposes it are typical of the debate.  DeLong failrly summarizes Kevin Murphy's arguments against it and his support for it ("Best Anti-Stimulus Argument: from Kevin Murphy, Brad DeLong's Semi-Daily Journal.)

I think he [Murphy] overstates the deadweight loss effect and is working with the wrong conception of “efficiency” for these purposes when he claims that government is inefficient, so the odds of a stimulus being successful therefore aren’t as bad as he indicates. And this doesn’t change the fact that I haven’t heard any better ideas than doing a big stimulus. But this is a sobering reminder that a big stimulus doesn’t guarantee success—very hard work needs to be done on making sure that stimulus funds target genuinely idle resources rather than diverting non-idle resources while leaving the idle ones as idle as ever.

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Fixing The Financial Sector

George Bittlingmayer and Thomas Hazlett are at it again, criticizing the stimulus by looking at its impact on capital markets ("The markets do not believe the 'stimulus'," Chicago Tribune, March 8, 2009.). I will highlight two points from the article and make an additional observation.

It is sometimes difficult to interpret market swings. They are the combined reactions of thousands of thousands of buyers and sellers. With that caution in mind, forward looking markets would respond positively to policies or events that signal a resolution to the financial crisis and negatively to policies or events that signal continued turbulence.

Many factors move markets, but investors would respond enthusiastically to signs the government was solving the economic crisis. Indeed, news that the experienced, moderate Timothy Geithner would be Treasury chief lifted the Dow 6.5 percent Nov. 21 (and an additional 4.9 percent when the choice was confirmed by Obama Nov. 24). Geithner's glow has since dimmed; the Dow dropped 300 points when his Feb. 10 news conference revealed that little progress had been made in crafting a solution to the banking crisis. And today the evidence is that investors do not believe that the massive new debt will spur economic growth.

Event studies are a type of opinion pool by people who have money in the game and politicians realize their value in forecasting policy outcomes.

The point is not that economic policies should be crafted to benefit shareholders. It is that financial markets offer important evidence about the effect of different choices on the overall health of the American economy. Former President Bill Clinton harks back to the good times in the 1990s when equity valuations were booming. Last fall, conversely, House Republicans and Blue Dog Democrats blocked the banking bailout requested by Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, only to see the Dow decline nearly 7 percent on Sept. 29. That was a signal. House opposition quickly collapsed and the bill passed.

The Obama administration has much to blame on its predecessor. But its own fiscal strategy is highly leveraged on a theory that has not scored well in previous runs. Markets are dubious that the "stimulus" will stimulate. And investors are losing patience with the federal fixes offered for the banking crisis. If the warning signs of the Dow are not heeded by policymakers, they will be by others. Ask Sen. John McCain.

Investors also respond to unexpected market driven events such as Citigroup turning a profit (Lepro, Sara and Paradis, Tim, AP Business Writers. "Dow ends up nearly 380 on Citigroup profit news," Yahoo Finance, March 10, 2009.)(HT Drudge.)

NEW YORK (AP) -- Wall Street has had its best day of the year, storming higher after some good news from Citigroup. Citigroup Inc. says it operated at a profit during the first two months of the year. That energized financial stocks and in turn, the entire stock market. Surprised investors drove the major indexes up more than 5.5 percent to their biggest one-day rally of the year. The Dow Jones industrials shot up nearly 380 points.

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No Bailout For East Europe

(HT Drudge) Charles Forelle, reports for the Wall Street Journal in "EU Rejects a Rescue of Faltering East Europe,"

European Union leaders, led by German Chancellor Angela Merkel, rejected a call by Hungary for a sweeping bailout of Eastern Europe, as the bloc struggled to find consensus on an approach to the spiraling financial crisis at a summit Sunday.

The global recession has greatly strained the bonds holding together the 27 nations that now make up the European Union, formed in the wake of World War II, and poses the most significant challenge in decades to its ideals of solidarity and common interest.

Ms. Merkel said she couldn't see the need for a broad grant of aid to Eastern Europe. "The situation is very different" in Europe's economies. "We cannot compare Slovakia nor Slovenia with Hungary," she told reporters.

Hungarian Prime Minister Ferenc Gyurcsany, who proposed a bailout package of up to €190 billion ($240.84 billion), warned that without aid a "new Iron Curtain" would descend on Europe and again separate East from West. Hungary has been battered by declining demand for its exports and a plummeting currency -- straining Hungarians who borrowed in euros to buy houses that have now sunk in value.

It gets worse. Some European countries seem to have forgotten the begger-thy-neighbor policies of the Great Depression.

The summit was originally called by Czech Prime Minister Mirek Topolanek to discuss concerns about rising protectionism in stimulus plans being proposed by individual nations...

The EU resolved one contentious issue on the eve of the summit: It approved France's much-criticized plan to give €6 billion in low-interest loans to domestic car makers. The French plan had drawn howls of protectionism -- particularly from the Czech Republic, where PSA Peugeot Citroen SA makes small cars -- since it made the aid contingent on the car makers keeping French factories open.

Who would have thought that subsidizing or restructuring automakers could be protectionist? Perhaps the next time
American steel producers complain about other countries dumping subsidized steel in our country, we will be a little more circumspect.

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Bittlingmayer and Hazlett on the Stimulus

Bittlingmayer has written frequently on antitrust activity, and Hazlett, on cable television and other telecommunication issues. Both are keen observers of the interaction of the relationship between stock markets and economic and political events, and they have frequently collaborated to the benefit of their readers. Their latest collaboration, "The Market Is Shorting Obama's 'Stimulus'," examines investors' reaction through the DJI to the Obama stimulus bill as it passed through Congress. By increasing government spending through deficit spending, the administration hopes to boost economic activity by more than the spending itself through a multiplier effect. Bittlingmayer and Hazlett emphasize that investors aren't buying the economic theory; at least they are not buying its political manifestation.

Government deficits are nonetheless being sold as doctor’s orders, an elixir that – while it looks ugly and tastes bitter – will propel us back to economic health. Yet the best forecast currently on the table is the one made by investors risking their own money. They are shorting the “stimulus.”

The skepticism is huge.

[K]ey political victories for the Team Obama spending plan have not been viewed as buying opportunities on Wall Street. A string of negative market reactions began with the December 18 announcement of a stimulus bill of $700 billion (Dow down 2.5%), continued with the January 7 announcement that the actual plan would be “on the high side” (-2.7%) and continued with last week’s 61-36 Senate vote supporting the Administration’s fiscal plan. The White House victory and the new bank bail-out plan announced the following day by Treasury Secretary Geithner were met with a 5% wipe-out in the DJI, and a decline in Treasury bond yields, indicating a “flight to quality.”

Are investors truly the best forecasters? Economists place a great deal of value in betting and prediction markets. They have been more accurate in predicting the outcome of elections and sporting events than experts, presumably because investors have money in the game and their earnings are dependent on correctly predicting outcomes. Experts are paid for expressing their opinions whether they are correct or not.

A skeptic will note that investors did not do well in predicting the value of housing and stock market in the recent past, but neither did our elected representatives and government regulators, who created perverse incentives in the housing and banking industry.

Bittlingmayer and Hazlett suggest a reason for investors' doubt.

How do economists know that, while a deficit amounting to 6% of GDP budget was sufficient to spur the economy back to health in 1983, it will take more than twice that federal borrowing to do the same now? They don’t. Economic models are all over the place in their projections. Indeed, Prof. Barro’s cutting edge analysis of fiscal policy finds no historical stimulus from peacetime deficits. Of course, we’ve never seen so massive a deficit – one that would bar the U.S. from membership in the European Union, on grounds that our government finances are a mess -- and so we lack empirical evidence to inform the precise experiment we’re running today.

We do, however, know the accounting trends: our government faces massive new spending increases as Baby Boomers retire and their Social Security and Medicare bills come due. Market investors are wary of new spending, guaranteeing either future tax increases or inflation, as a run-up to the demographically guaranteed spending spiral. The quest for “shovel-ready” projects makes one think, Where’s Senator Ted Stevens when we need him? In any event, this fiscal bridge to nowhere is not spurring markets.

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What Should Have Been Done

The stimulus bill has been a controversial topic in the economics profession. Given that it has probably been a done deal since President Obama was elected in November, I hope my colleagues supporting the stimulus are right about its impact. I believe that most observes have some problems with the way the bill was shaped and passed, and I will only make one irrelevant comment about what should have been.

According to CNSNews.com, in an article titled, "Democratic Senator Predicts None of His Colleagues 'Will Democratic Senator Predicts None of His Colleagues "Will Have the Chance' to Read Final Stimulus Bill Before Vote',"

The final bill, crafted by a House-Senate conference committee, was posted on the Website of the House Appropriations Committe late Thurday in two PDF files.
The first PDF was 424 pages long and the second PDF was 575 pages long, making the total bill 999 pages long. The House is expected to vote on this 999-page bill Friday, and the Senate either later Friday or Saturday. [Editor's note: The first PDF, as posted on the House Appropriations Committee website as of 8:20 AM Friday morning, had grown by 72 pages to 496 pages, increasing the length of the total document to 1,071 pages.]

The same article quotes Senator Frank Lautenberg (D-N.J.) as predicting

[N]one of his Senate colleagues would "have the chance" to read the entire final version of the $790-billion stimulus bill before the bill comes up for a final vote in Congress.

Alec MacGillis, writing, "Democrats Among Stimulus Skeptics," for the Washington Post reports that Alice M. Rivlin, President Clinton's budget director, suggested splitting the plan by implementing immediate stimulus components now and taking more time to plan the longer-term transformative spending. I wish that Congress had listen to her.

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Acemoglu, The Financial Crisis and The Stimulus

In a recent post, "Acemoglu on Greed," I tried to highlight the difference between economists and others on the impact of greed on society.  His paper, "The Crisis of 2008: Structural Lessons for
and from Economics," is the best of two worlds: short on words but long on economic content, and I wish to share with my students and other readers a few of this thoughts, and recommend the entire paper.  To cut to the chaff, he gives guarded support for the stimulus as a way to avoid an "expectational trap" in which consumers and policymakers turn away support from a market system.

Acemoglu believes that preserving and strengthening market institutions and regulatory underpinnings of free markets is more important than escaping from the current recession.  

[I]t is obvious why we should heed issues of economic growth. Barring a complete meltdown of the global system, even with the ferocious severity of the global crisis, the possible loss of GDP for most countries is in the range of
a couple of percentage points, and most of this might have been unavoidable given the overexpansion of the economy in the prior years. In contrast, modest changes in economic growth will accumulate to much larger numbers
within one decade or two. Thus, from a policy and welfare perspective, it should be self-evident that sacrificing economic growth to deal with the current crisis is a bad option.

In an expectational trap, consumers and policymakers become pessimistic about "future growth and the promise of markets." 

We may see consumers and policymakers start believing that free markets are responsible for the economic ills of today and shift their support away from the market economy. We would then see the pendulum swing too far, taking us to an era of heavy government involvement rather than the needed foundational regulation of free markets.  I believe that such a swing and the anti-market policies that it would bring would be the real threat to the future growth prospects of the global economy.  Restrictions on trade in goods and services would be a first step. Industrial policy that stymies reallocation and innovation would be a second equally damaging step. When the talk is of bailing out and protecting selected sectors, more systematic proposals on trade restrictions and industrial policy may be around the corner.

He offers guarded support for the stimulus package.

A comprehensive stimulus plan, even with all of its imperfections, is probably the best way of fighting off these dangers, and on balance, there are sufficient reasons for academic economists as well as concerned citizens to support current efforts as insurance against the worst 0utcomes we may face.  Nevertheless, the details of the stimulus plan should be designed so as to cause minimal disruption to the process of reallocation and innovation. Sacrificing growth out of our fear of the present would be as severe a mistake as inaction.

In addition to the paper, interested readers would profit from listening to Russ Roberts interview with Daron Acemoglu. 

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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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Finn Kydland and the Stimulus

In a December 9, 2008, Andina article titled, "Infrastructure investment, best way to face financial crisis", says Nobel in Economics" Finn Kydland gives what sounds like guarded advice on dealing with the international financial crisis. The article reads

Infrastructure investment is one of the best ways to face the international financial crisis due to its long term positive effects on the productivity of the country, Nobel Prize in Economics for 2004, Finn Kydland, stated Tuesday.

"I do not trust too much on measures addressed to aliviate situations in the short term since, usually, these measures are likely to have negative effects in the long term, and long term is what really matters”, señaló.

For example, he said, a fiscal policy such a temporal reduction of taxes has little effect, so that infrastructure investment is better to face financial crisis.

“When the economy grows and the highways do not progress accordingly, the economy becomes ineffective, hence, investing in transport is a good idea", he stated.
He said infrastructure investment is one of the most recommended measures by the
Copenhagen Consensus (2004) for Latin America, and is also mentioned in the Consulta de San José en Costa Rica (2007).

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Phat Phee?

In a Timesunion.com article, James M. Odato described New York's governor, David Paterson's, first budget plan (HT to Drudge). Given the troubled economic times, it contains a mixture of spending cuts and tax increases designed to close a $12.5 billion dollar deficit. Among the tax increases is a $404 million tax on non-soda drinks that some are calling an obesity tax and which I shall call a phat Phee in a probably vain attempt to be more hip.

I find the article interesting for a couple of reasons. First, President Elect Obama is contemplating $1 trillion stimulus package of tax breaks and spending cuts. Economists have long recognized that state budgetary constraints at times force state governments to work at cross purposes with the federal government. Even if the incoming Obama administration successfully enacts a stimulus package, its effectiveness will be limited by state governments attempting to balance budgets.

Even on a micro level the New York seems to be working at cross purposes with the federal government: one likes domestic sugar growers, the other does not, but both seem aimed at punishing sugar consumers.

The federal government protects domestic sugar producers through a system of quotas that limit the amount of sugar that foreign countries can sell in the United States. These quotas raise the cost of all goods that use sugar and sugar substitutes (I shall refer to both as sugar, the reasoning doesn't change). The benefits of the quotas accrue to a few sugar growing states and are paid for by consumers in sugar consuming states. The federal governments favors sugar growers over consumers.

New York does not like sugar growers. Why should it? It doesn't have many. By taxing a product with a lot of sugar, New York mitigates the flow of federal dollars leaving the state. Its consumers are hurt yet again.

I recommend that people who prove that they lost weight through diet and exercise deserve a tax break. It would be the Phat Pharm Phat Phree Phat Phee tax break.

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