Wednesday, December 31, 2008

No, dig up stupid!

When I meet people at parties and tell them I'm an economist, they inevitably ask me how we can get out of the economic hole we've dug for ourselves.  The problem is, I'm still a PhD student, and this is a bit above my pay-grade.  So I thought I could provide some context via two of the country's top economists, Paul Krugman and Greg Mankiw.  Krugman and Mankiw are the most eloquent and succinct advocates of the two major plans currently on the table.

At this point it's a forgone conclusion that the government will implement some sort of stimulus plan early in 2009 (eg, in the next month).  With demand faltering, the government has been called upon to pick up the slack.  Unfortunately, that's where the agreement ends (insert "one-armed economist" jokes here).  One idea is fiscal expansion, or more simply having the government buy a lot of stuff: infrastructure, military equipment, healthcare, it almost doesn't matter.  This was the common perspective during the Great Depression, when John Maynard Keynes even went so far as to advocate burying money and paying people to dig it up.

The other plan is to stimulate the economy through tax cuts.  Under this plan, the same amount of money that would have gone into fiscal expansion is used to provide tax rebates.  That way the money gets spent in the economy, but the spending is done by ordinary citizens, who presumably can spend it better than the government.

The crux of the issue is whether the government or private citizens will get more bang for the buck out of the stimulus spending.  There are good arguments on both sides.  Government money will get spent, whereas tax rebates may simply be put in the bank.  Plus, government spending on infrastructure and education will yield long-term benefits.  On the other side, empirical evidence from Christina Romer (recently appointed to head Obama's Council of Economic Advisors) suggests that tax cuts boost economic growth by more than government spending.  Moreover, government spending is channelled through the political process, which means funds may get misallocated.

Of course the two plans are not mutually exclusive.  Krugman has noted recently that while FDR expanded government spending, he also raised taxes to maintain a balanced budget, limiting the effect of the stimulus.  The current prevailing view is that government can (and indeed should) run deficits in a recession in order to stimulate the economy.  So we'll probably get combination of both.  The tough part is figuring out the right mix.

As I watch the ball drop tonight, I'll be thinking about 2009 and the way forward for our economy.  Like I said, this is above my pay grade.  I'm just glad I don't have to make the decision.

Happy New Year!

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