Debating the Keynesian Multiplier

The old joke about economists is that if you laid them all together from head to toe they still wouldn't reach a conclusion. While there are many areas where economists broadly agree, the virtues of economic stimulus is not one.

The latest salvo in this rather un-gentlemanly (and gentlewomanly) debate comes via Harvard's Robert Barro, writing in the Wall Street Journal:

"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 is summarizing his research into the size and impact of multipliers, in which he analyzed US GDP and changes in government spending data over time. Increases in government spending, according to Barro, haven't led to proportionally larger increases in GDP, as Keynesian analysis might suggest.

Mark Thoma chastens Barro for essentially re-cycling an op-ed (compare his new piece to this article from January) and, in response, re-posts some of the criticisms made at the time by people like Paul Krugman, Brad DeLong and Christina Romer.

For as important an issue as fiscal stimulus is, there is surprisingly scant research into its effectiveness. The best work is by David and Christina Romer, but they look at tax cuts as opposed to government spending.

Fortunately, Ethan Ilzetzki, Enrique G. Mendoza and Carlos A.Vegh have just published some new research, which looks at the impact government spending on GDP for a panel of 45 countries (20 developed, 25 developing). Their conclusions include:

1. In developing countries, the response of output to increases in government spending is smaller on impact and considerably less persistent than in high income countries.
2. The degree of exchange rate flexibility is a critical determinant of the size of fiscal multipliers. Economies operating under predetermined exchange rate regimes have long-run multipliers of around 1.5, but economies with flexible exchange rate regimes have essentially zero multipliers.
3. The degree of openness to trade (measured as exports plus imports as a proportion of GDP) is another critical determinant. Relatively closed economies have long-run multipliers of around 1.6, but relatively open economies have very small or zero multipliers.
4. In highly-indebted countries, the output response to increases in government spending is short-lived and much less persistent than in countries with a low debt to GDP ratio.
5. The multipliers for the US in the post-1980 period are rather small (in the range 0.3-0.4) both in the short and long-run. On the other hand, multipliers for government investment are large (around 2).

While far from the last word on the issue, the Ilzetzki, Mendoza and Vegh (IMV) work provides us with a much more subtle analysis of the nature of the Keynesian multiplier. It suggests that developed countries can use fiscal stimulus to boost employment in recessions, particularly if the spending takes the form of government investment. Interestingly, IMV's conclusions support Keynes' original claims. I'm currently reading Keynes' "The General Theory" and stumbled upon these passages:

Fiscal stimulus in rich vs. poor countries:

"Thus whilst the multiplier is larger in a poor community, the effect on employment will be much greater in a wealthy community, assuming that in the latter current investment represents a larger proportion of current output." (p126)

Trade openess and fiscal stimulus:

"In an open system with foreign trade relations, some part of the multiplier of the increased investment will accrue to the benefit of employment in foreign countries... so that if we consider only the effect on domestic employment as distinct from world employment, we must diminish the full figure of the multiplier." (p120)

It seems that Keynes, writing in 1935, predicted findings (1) and (3) in IMV.

Finally, as one might expect, Paul Krugman weights in, yet again:

"On a happier note, this piece by Ilzetzki et al is interesting, and offers a wide range of multipliers depending on a country's situation. The question for the United States is which estimate is most relevant.

I'd say it's the fixed exchange rate estimate. Yes, I know, we have a floating rate. But they explain the relatively high fixed-rate number by pointing to Mundell-Fleming, which says that fiscal policy is effective under fixed rates because it doesn't drive up interest rates (capital flows in). We're in a similar position for a different reason: fiscal expansion doesn't drive up rates because we're at the zero bound.

Oh, we're also relatively closed.

The thing is that both the fixed rate and closed multipliers are around 1.5 — which so happens to be just about the number assumed by Christina Romer in her analysis for the Obama administration. Just saying."

Confusion about the New Deal

Steven Colbert interviews Jonathan Chait of the New Republic about the New Deal:

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People tend to talk about the "New Deal" as if it were one policy, when in reality it was a hodgepodge policies, regulations, and spending - some of which worked, some of which didn't. Many of the regulations did create serious market distortions, which impeded recovery, as Harold Cole and Lee Ohanian note:

"The most damaging policies were those at the heart of the recovery plan, including The National Industrial Recovery Act (NIRA), which tossed aside the nation's antitrust acts and permitted industries to collusively raise prices provided that they shared their newfound monopoly rents with workers by substantially raising wages well above underlying productivity growth. The NIRA covered over 500 industries, ranging from autos and steel, to ladies hosiery and poultry production. Each industry created a code of "fair competition" which spelled out what producers could and could not do, and which were designed to eliminate "excessive competition" that FDR believed to be the source of the Depression.

These codes distorted the economy by artificially raising wages and prices, restricting output, and reducing productive capacity by placing quotas on industry investment in new plants and equipment. Following government approval of each industry code, industry prices and wages increased substantially, while prices and wages in sectors that weren't covered by the NIRA, such as agriculture, did not. We have calculated that manufacturing wages were as much as 25% above the level that would have prevailed without the New Deal. And while the artificially high wages created by the NIRA benefited the few that were fortunate to have a job in those industries, they significantly depressed production and employment, as the growth in wage costs far exceeded productivity growth."

Further, economist Robert Higgs provides evidence that the uncertainty created by the Roosevelt administration spooked businessmen, stifling investment.

Of course, that's not what the commentators in the clip are harping on. Their concern is the spending in the new stimulus plan; and on that, they have things mixed up. Both George Will and Sean Hannity are shown arguing that it was World War II, not the New Deal, that brought us out of the Depression. But how could a war bring the country out of the Depression? Through large-scale expansion of government spending! Bruce Bartlett explains:

"The [Great Depression] didn't really end until both monetary and fiscal policy became expansive with the onset of World War II. At that point, no one worried any more about budget deficits, and the Fed pegged interest rates to ensure that they stayed low, increasing the money supply as necessary to achieve this goal.

It was then and only then that the Great Depression truly ended. As a consequence, economists concluded that an expansive monetary and fiscal policy, which had been advocated by economist John Maynard Keynes throughout the 1930s, was the key to getting out of a depression."

So if you're arguing against the stimulus, you don't want to say that the War got us out of the Depression; if you do, you'll kind of undermine your entire argument.

Who are you calling Socialist?

If I didn't watch Fox News, I'd have no idea that we were in the midst of an American-version of the Russian Revolution. Didn't you hear? The new administration is looking to turn our country into a worker's paradise! As Mike Huckabee lamented to the Conservative Political Action Conference, “Lenin and Stalin would love this stuff.”

In the interest of fairness, moderate conservative David Brooks gave the Obama administration space to respond to these accusations. Here's Brooks' recap of what they said:

"In the first place, they do not see themselves as a group of liberal crusaders. They see themselves as pragmatists who inherited a government and an economy that have been thrown out of whack. They’re not engaged in an ideological project to overturn the Reagan Revolution, a fight that was over long ago. They’re trying to restore balance: nurture an economy so that productivity gains are shared by the middle class and correct the irresponsible habits that developed during the Bush era.

The budget, they continue, isn’t some grand transformation of America. It raises taxes on energy and offsets them with tax cuts for the middle class. It raises taxes on the rich to a level slightly above where they were in the Clinton years and then uses the money as a down payment on health care reform. That’s what the budget does. It’s not the Russian Revolution.

Second, they argue, the Obama administration will not usher in an era of big government. Federal spending over the last generation has been about 20 percent of G.D.P. This year, it has surged to about 27 percent. But they aim to bring spending down to 22 percent of G.D.P. in a few years. And most of the increase, they insist, is caused by the aging of the population and the rise of mandatory entitlement spending. It’s not caused by big increases in the welfare state."

I think it's time for conservatives to take a deep breath. Whether or not you like the Obama economic agenda, this is hardly a revolution. If the budget projections are correct, we'll soon be back to levels of government spending, budget deficits and marginal tax rates in line with the past 30 years.

Of course, there has been a lot of hand-wringing over the plan to raise the top marginal tax rate. But people forget that as recently as the Reagan presidency, the top marginal rate was 50%, 10 percentage points higher than what Obama is proposing. We've come a long way on taxes, baby.

Keynesian questioning of the stimulus

Arnold Kling has a terrific essay on the stimulus bill. The essay provides background on the different traditions in macroeconomics (Classical, Keynesian, Monetarist) and how they view the current crisis. He also gives some reasons why Keynesians themselves might not like the stimulus bill as is:

"Another group of skeptics is concerned about the timing of the fiscal stimulus. Even some economists on the left, including Alice Rivlin and Jeffrey Sachs, have made the point that the long-term spending in the stimulus bill is inappropriate and even counterproductive from a stimulus perspective. I share this concern. President Obama said that his goal is to have 75 percent of the stimulus take effect before the end of 2010. Instead, I would argue that we should have 100 percent take effect by then, and 75 percent take effect by the end of 2009...

Textbook Keynesian economics says that a spending increase will stimulate more powerfully than a tax cut, because part of a tax cut will be saved rather than spent. However, this same textbook analysis says that a stimulus now is more powerful than a stimulus that kicks in two years from now. Even though the multiplier for a spending increase may be higher than that for a tax cut that is enacted at the same time, we can be certain that the “multiplier” for a tax cut in 2009 is greater than the multiplier for a spending increase in 2011."

There's an old joke about how using government spending to stimulate the economy is like notifying the Fire Department of a fire via the mail. It's really hard to spend that much money that quickly and it's even harder to spend it well. Kling notes that there are other ways to do fiscal stimulus beyond digging ditches:

"A traditional stimulus proposal, going back to the 1960s, is a temporary investment tax credit. With such a credit, the government in effect provides matching funds for firms that undertake investment while the tax credit is in effect (say, through March of 2010). This would lead to spending increases that are a multiple of what the government contributes.

Another proposal, which George Mason University’s Bryan Caplan has suggested, is a cut in the employer portion of the payroll tax. The extra kicker here is that it reduces the employer’s cost of labor, thereby stimulating hiring. I think an additional kicker is that this would restore profitability in the nonfinancial sector, helping to boost investment."

I personally agree with the need for government provided fiscal stimulus. I think many parts of the stimulus bill are good and worthwhile--unlike Louisiana governor Bobby Jindal, I think that volcano monitoring is a legitimate government function. But if more stimulus is needed--and many people think that it will be--something like Caplan's payroll tax cut is worth trying. The payroll tax is a 13% tax shared by employers and employees. If you cut the employer portion, you make firms more profitable and encourage hiring by making labor less expensive; if you cut the employee portion, you have substantial a tax cut on a regressive tax paid by all working Americans, no matter how poor. If you cut both, you can support employment and consumer spending.

Where I disagree with Kling is on his dislike for aid to state and local governments. While he is right to argue that the private sector has seen much more layoffs than the public sector, I don't think that means that money spent on the public sector is wasted. First, aid to state and local governments will prevent layoffs, and jobs saved are good no matter what sector they're in; and second, the aid will help support Medicaid, food stamps and other programs for the poor.

"Buy American" debate

Over at the New York Times "Room for Debate" blog, a number of commentators take up the "Buy American" provision in the stimulus. There are some interesting points on both sides:

• Jagdish Bhagwati: "The buy-American provisions unravel previous trade agreements unilaterally and in violation to the concessions we made."
  
  
• Ha-Joon Chang: "Some people worry that this will lead to a 1930s-style all-out trade war. But in the short run, there is actually no danger of that. Now we have the World Trade Organization, the European Union and many other regional trade agreements that limit protectionism. Of course, in the longer run, if veiled protectionism continues, we run the risk of making a mockery of these agreements and destroying the global trading system....the solution to this problem should not be an adherence to the principle of free trade, which is not workable in practice anyway, but instead to establish a new international agreement that allows a transparent, forward-looking and time-bound protectionism as well as more infant-industry protection for developing countries. In other words, by allowing more protectionism now in a controlled way, we will be able to preserve the international trading system better in the longer run."

• Anne Krueger: "The buy-American measure in the stimulus package would do little, in part because few imports are used in construction projects. But the signal that it would send to other countries would invite protective measures to the detriment of American exports and employment. Once protectionist measures are adopted, they are difficult to remove. In the long run, choking off through protection the integration of the world economy reduces productivity and prospects for future growth of all economies. It does not make any sense to sacrifice longer term growth prospects for measures that, even in the short run, offer very little prospect except for the very few at the cost of many others."
  

• Robert E. Scott: "When the government buys steel for a bridge, for example, it has several objectives. Minimizing costs is one, but when the economy is in recession, there is added incentive to stimulate domestic employment. And when steel is purchased from a domestic producer the workers’ wages generate further spending, which supports yet more jobs in the domestic economy."

Bhagwati and Kreuger are ardent free trade supporters, while Chang and Scott support selective protectionism, particularly for developing countries.

I agree with Kreuger that this won't have a huge economic impact and I agree with Chang that this probably won't cause a trade war, given our international institutional structure. Chang is also right about the dangers of "veiled protectionism", but I disagree that infant industry protection is the right solution.

Scott's argument breaks down if there's a big difference between domestic and foreign components. As I've said before, if we pay a lot more for inputs to construction projects, we can't do as many projects and can't hire as many workers. My feeling is that this is a gift to domestic steel producers. It could ultimately end up costing jobs and impeding the stimulus.

Lawrence Lindsey on the Daily Show

Lawrence Lindsey, former Chief of the President's Council of Economic Advisers, stopped by the Daily Show last night to talk about the stimulus package:

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Lindsey brings up several interesting points during this interview. First, he warns against grandstanding politicians harping on symbolic, but ultimately minor points. We all might cringe at the sight of the CEOs from the Big Three traveling to Washington via private jets to ask for a handout; but as an economic issue, it's minor and a waste for Congress to focus so intently on it at the expense of actual issues facing the economy.

Second, Lindsey advocates for providing tax relief via the payroll tax, a policy that is gaining support among economists. While not everyone pays income tax, all workers pay payroll taxes. According to Lindsey, we can temporarily cut this tax and put $1,500 in every working American's pocket over the next year.

The case for protectionism (sort of)

Paul Krugman adds some nuance to our recent discussion on protectionism and the stimulus:

"...one part of the problem facing the world is that there are major policy externalities. My fiscal stimulus helps your economy, by increasing your exports — but you don’t share in my addition to government debt. As I explained a while back, this means that the bang per buck on stimulus for any one country is less than it is for the world as a whole.

And this in turn means that if macro policy isn’t coordinated internationally — and it isn’t — we’ll tend to end up with too little fiscal stimulus, everywhere.

Now ask, how would this change if each country adopted protectionist measures that “contained” the effects of fiscal expansion within its domestic economy? Then everyone would adopt a more expansionary policy — and the world would get closer to full employment than it would have otherwise. Yes, trade would be more distorted, which is a cost; but the distortion caused by a severely underemployed world economy would be reduced. And as the late James Tobin liked to say, it takes a lot of Harberger triangles to fill an Okun gap."

Krugman is quick to point out that this is not an argument in favor of long-term protectionism or even that protectionism is the best possible policy. The crux of his argument is the last sentence of the quote: the negative effect of a tax (like an import quota) is smaller than the negative effect of unemployment due to reduced total output.

Do some countries free ride on the fiscal stimulus of their partners? Probably. So in that sense, anything that encourages coordinated stimulus is a good thing. The clear downside is the risk of a trade war. Hopefully, we now have the global regulatory structure in place (such as the WTO) to prevent things from devolving into a situation like we saw in the 1930s.

I'm more pessimistic than Krugman about the potential for a trade war; but then again, he just won a Nobel Prize for his work on trade theory.

Getting more bang for the buck

Following up on the "Buy American" provisions in the stimulus package, Douglas Irwin points out of the pitfalls of lacing stimulus with protectionism:

"In rebuilding the San Francisco-Oakland Bay Bridge in the 1990s, the California transit authority complied with state rules mandating the use of domestic steel unless it was at least 25 percent more expensive than imported steel. A domestic bid came in at 23 percent above the foreign bid, and so the more expensive American steel had to be used. Because of the large amount of steel used in the project, California taxpayers had to pay a whopping $400 million more for the bridge. While this is a windfall for a lucky steel company, steel production is capital intensive, and the rule makes less money available for other construction projects that can employ many more workers."

The more money we pay for inputs, the less money we have for infrastructure projects that will hopefully create jobs, and lay the foundation for future growth, to steal a phrase from the President. We can't do that if the steel industry (or any other industry for that matter) uses the stimulus bill to buffer their profits to the detriment of American welfare. 

A lot of Americans are employed using steel. But if the price of steel goes up, fewer of these people will keep their jobs. It's that simple.

Who's going to spend the money?

As I've written before, one of the big debates in the stimulus is whether tax cuts or government spending are more effective for boosting short-term demand. Paul Krugman weighs in:

"...one way to explain why government spending is better than tax cuts as a stimulus is to say that temporary tax cuts aren’t effective at increasing demand, but temporary spending increases are.

Here’s the logic (which follows directly from Milton Friedman’s permanent income hypothesis, by the way): suppose that the government introduces a new program that will cause it to spend $100 billion a year every year from now on. To pay for this, it will have to raise taxes by $100 billion a year, permanently — and if consumers take this into account, they might well cut their spending enough to offset the increase in government purchases.

But suppose the government introduces a one-time, $100 billion program to repair bridges over the next year. The government will have to issue debt to pay for this, and will have to service that debt, requiring higher taxes — say, $5 billion a year. That’s a much smaller impact on consumers’ future after-tax income than the permanent program. So much less of the spending rise will be offset by a fall in consumer demand. (I’m not considering the effect of the spending in raising income, which would probably cause consumer demand to rise rather than fall.)

So economic theory — Milton Friedman’s theory! — says that spending is a more effective form of stimulus than tax cuts."

According to Friedman's "Permanent Income Hypothesis" spending decisions are not based on transitory income gains (windfalls, such as tax rebates), but by a person's real wealth. This is why tax rebates tend to get put in the bank, rather than spent.

Tax rebates were ineffective as fiscal stimulus in 2007 for exactly the reasons Friedman's theory would have predicted. Of course Friedman would not have been in favor of large government spending, either. But it's interesting to consider the full implications of a theory.

And so it begins...

Most economists, even on the left, are not going to be happy about the "Buy America" provisions within the new stimulus package.  

Proponents naturally argue that the only way to create American jobs is to ensure that the money gets spent on American goods and services. Simple enough, right?

Opponents of the provision counter with two main arguments. The first is the threat of a trade war. In the 1930s, the Hoover administration, mired in the beginning of the Great Depression, signed into law the Smoot-Hawley Act, significantly raising American tariffs. Europe, similarly dealing with the economic downturn, enacted their own tariffs. In the end, everyone got poorer. 

The second argument is that it simply won't work, for a variety of reasons having to do with the dynamics of international trade and capital mobility. As Nick Rowe explains:

"A 'buy domestic' policy will not shift demand towards domestic goods. If it did, so that imports fell and net exports increased, the current account surplus would merely cause the exchange rate to appreciate so that net exports fell to their original level. The current account must stay the same, because the capital account stays the same, because the interest rate differential stays the same, because interest rates stay the same."

Brad DeLong adds:

"If there's little excess capacity in the U.S. steel industry--so that the price of steel is high enough to induce people to look outside for suppliers--then a stimulus won't be much needed. If there's a lot of excess capacity so that a stimulus is needed, then steel customers should be able to bargain prices down to marginal cost--in which case foreign producers will have an extremely difficult time competing on price given that steel is heavy and distances are great. "Buy American" seems mostly designed to allow the steel producers to collude and push their profits up--at the expense of American taxpayers." (emphasis added)

Much has been made about the Obama administration's attempts to keep the stimulus package pork-free. But trade restrictions benefit well connected constituencies and are politically popular (usually); it's hard to think we were going to get a an $800 billion stimulus package without pork. As Russ Roberts says, you're better off hoping for a ham sandwich without pork.

Can we get a little objectivity, please?

Is economic analysis driven by science or by ideology? That seems to be a hot topic this week.

In the New York Times today, Paul Krugman claims that many anti-stimulus arguments are not made in "good faith":

"Some of these arguments are obvious cheap shots. John Boehner, the House minority leader, has already made headlines with one such shot: looking at an $825 billion plan to rebuild infrastructure, sustain essential services and more, he derided a minor provision that would expand Medicaid family-planning services — and called it a plan to 'spend hundreds of millions of dollars on contraceptives.'"

On the opposite end of the ideological spectrum, Russ Roberts argues that economists' positions on the stimulus have less to do with their reading of the empirical data than their feelings about markets in general:

"As far as I know, no prominent market-oriented economist has come out in favor of a trillion dollar increase in government spending as a way to improve the economy. Every market-skeptical economist that I have heard is in favor of it on the grounds that it will improve the economy. Each side claims to have empirical support for its position."*

Additionally, the focus of this week's episode of EconTalk, Robert's weekly economics podcast, is the role of empirical evidence in economics.

How pervasive is the issue of bias within economics? Nate Silver over at FiveThirtyEight.com has some evidence on the subject. Looking at the Wall Street Journal's monthly economic forecasting survey, Silver produces the following chart of growth forcasts by economists in different sectors, including finance, consulting and academia:



It's a small sample (55 economists), but it illustrates the point. The most optimistic growth forecasts come from economists in the financial sector, who perhaps have institutional incentives pushing them toward optimism, while the most pessimistic forecasts come from academia. Typical liberal academics, some might say!

This is not entirely new. In 2006, David Lereah, former Chief Economist for the National Association of Realtors, wrote "Why the Real Estate Boom Will Not Go Bust - And How You Can Profit From It". This was hardly an unbiased work. An economist representing the interests of realtors has a strong incentive to promote the real estate industry. Of course, less then a year after the book was published, the market started to go south and... well, you know the rest.

It's entirely likely that ideology clouds the minds of even the best economists. But is it just economists who suffer from a lack of objectivity? A recent survey of scientists' views on global warming suggests not:

"In analyzing responses by sub-groups, Doran found that climatologists who are active in research showed the strongest consensus on the causes of global warming, with 97 percent agreeing humans play a role. Petroleum geologists and meteorologists were among the biggest doubters, with only 47 and 64 percent respectively believing in human involvement." (emphasis added)

Scientists and economists are people too. People are affected by biases in subtle and unconscious ways. This, however, does not mean that there is no objectivity out there. The peer review process, for example, is designed for just this purpose: to reanalyze and replicate results and to ferret out unsubstantiated claims. As long as everyone gets to look at the same data, we should be able to find some areas of common understanding.

That being said, it's wise to listen to more than one expert and more than one perspective.

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*It should be noted that Martin Feldstein, a prominent center-right economist at Harvard, has come out in favor of fiscal stimulus.

Monopoly Money

This week's issue of Rolling Stone features an open letter from Paul Krugman to Barack Obama. In it, Krugman outlines the case for a mammoth stimulus package:

How much spending are we talking about? You might want to be seated before you read this. OK, here goes: "Full employment" means a jobless rate of five percent at most, and probably less. Meanwhile, we're currently on a trajectory that will push the unemployment rate to nine percent or more. Even the most optimistic estimates suggest that it takes at least $200 billion a year in government spending to cut the unemployment rate by one percentage point. Do the math: You probably have to spend $800 billion a year to achieve a full economic recovery. Anything less than $500 billion a year will be much too little to produce an economic turnaround.

Krugman advises sitting down before listening to the price tag; I had to go get a beer.

No one can really visualize the vast sums of money currently being discussed. Our brains didn't evolve to deal with numbers larger than hundreds, or maybe thousands. But public spending is orders of magnitude higher. So how much is the nearly $1 trillion package Krugman suggests? According to Barbara Kiviat, a stack of 1 trillion dollar bills would reach a quarter of the way to the moon.

And yet, Krugman articulates a compelling case for such a large stimulus package and helps put the gargantuan sums into perspective:

It's possible that reviving the economy might cost as much as a trillion dollars over the course of your first term. But the Bush administration wasted at least twice that much on an unnecessary war and tax cuts for the wealthiest; the recovery plan will be intense but temporary, and won't place all that much burden on future budgets. Put it this way: With long-term federal debt paying the lowest interest rates in half a century, the interest costs on a trillion dollars in new debt will amount to only $30 billion a year, about 1.2 percent of the current federal budget.

In fact, Krugman is being conservative with his estimate on the war in Iraq.  Joseph Stiglitz puts the total cost of the war (including indirect costs) at $3 trillion.  I don't know that that completely alleviates my sticker shock, but it helps.   

Ed Glaeser on "Libertarian Progressivism"

Is it possible to be in favor of small-government and be pro-egalitarian at the same time? Ed Glaeser thinks so:

"The supposedly more progressive side wants the stimulus package to take the form of government spending, while their opponents want bigger tax cuts for businesses and more prosperous Americans.

The missing movement, small-government egalitarianism, would favor tax cuts, but only if they were aimed at ordinary Americans.

Libertarian progressivism distrusts big increases in government spending because that spending is likely to favor the privileged. Was the Interstate highway system such a boon for the urban poor? Has rebuilding New Orleans done much for the displaced and disadvantaged of that city? Small-government egalitarianism suggests that direct transfers of federal money to the less fortunate offer a surer path toward a fairer America."

I struggle to reconcile the libertarian and big-government/egalitarian sides of my brain, so I find Glaeser's argument appealing. While the public works projects favored by many liberals may very well stimulate the economy, they aren't necessarily egalitarian. Much of the benefits of infrastructure spending will accrue to the owners of contracting firms and higher-skill workers like engineers, architects, welders and the like; they will also create jobs for low-skill individuals, but in no less of a trickle-down fashion than business tax cuts aimed at encouraging hiring.

Glaeser favors direct cash transfers to low-income individuals and removing regulations that negatively impact the poor. Certain provisions in the Obama team's proposed stimulus plan fit this bill, particularly cuts in the payroll tax.

Glaeser's concept of "libertarian progressivism" can help square the circle for anyone who is pro-egalitarian, but also tends to favor smaller government (or at least government that is no larger than it has to be). Maybe it will catch on. If nothing else, people like me will find it cathartic.

Making a deal with our future selves.

Alan Kreuger points out two separate challenges that must be solved at once: first is the "paradox of thrift", in which jobs are lost, causing people to cut back on spending, which causes more businesses to close, which causes more jobs to be lost, which causes... well you get the picture. The second is that the US long-term budget outlook is downright scary.  Stimulating the economy will likely help the first problem, but will greatly exacerbate the second problem. Conversely, cutting spending in an attempt to balance the budget might just send the economy off a cliff.  Fortunately, Kreuger has an idea:

"Here is a suggestion to address both the short-run and long-run problems. I pose it only as a suggestion for serious discussion; I’m not sure it is the best way to go. But here goes: Why not pass a 5 percent consumption tax to take effect two years from now?

...In the short run, the anticipation of a consumption tax would encourage households to spend money now, rather than after the tax is in place. Along with the rest of the economic recovery package, this would help jump-start spending in the economy and thereby increase production and employment.

In the long run, a 5 percent consumption tax would raise approximately $500 billion a year, and fill a considerable hole in the budget outlook. In addition, a consumption tax would encourage more saving in the long run. Many economists consider a consumption tax an efficient way of raising tax revenue, especially in a global economy. The prospect of greater revenue flowing into federal coffers would probably help lower long-term interest rates because the government would need to borrow less down the road, and further bolster the economy."

There's certainly something to this plan.  My main concern would be whether the government could credibly commit to a future tax increase.  It's like promising yourself you'll go on a diet starting tomorrow...err the next day.  Unless consumers really believe that a consumption tax is coming in a few years, they won't change their spending behavior.

It would be interesting if Congress could put a stipulation on a bill like this that any amendments would require a 2/3 majority vote, or some other provision that would make it more likely that the law would actually stand when it comes time to pay up.

Where do we go from here?

MIT economist (and 2005 John Bates Clark medal winner) Daron Acemoglu just published an essay on what the economic crisis means for economists and economic theory. It's a terrific piece in both its insight and honesty. In particular, I think two points are worth highlighting. First, Acemoglu writes:

"Our second too-quickly-accepted notion is that the capitalist economy lives in an institutional-less vacuum, where markets miraculously monitor opportunistic behavior. Forgetting the institutional foundations of markets, we mistakenly equated free markets with unregulated markets. Although we understand that even unfettered competitive markets are based on a set of laws and institutions that secure property rights, ensure enforcement of contracts, and regulate firm behavior and product and service quality, we increasingly abstracted from the role of institutions and regulations supporting market transactions in our conceptualization of markets."

It's easy to forget the institutional context of economics, particularly in the developed world.  But one lesson from this crisis is that we cannot simply take institutions for granted.  "Free markets" require institutions to work, including formal institutions (the courts) and informal ones (norms governing business practice).  It's good to think that moving forward we'll pay more attention to these factors.

Second, Acemoglu writes:

"In my opinion, however, the greater danger from an expectational trap and a deep recession lies elsewhere. 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."

Again, this highlights the difference between "free" and "unregulated" markets.  Any response to this crisis will inevitably result in a larger role for government in the economy.  This is not necessarily a bad thing.  A renewed commitment to proper regulation can strengthen our economic system.  At the same time, interfering with the "free" aspect of the economy--that is, the decentralized system of allocating resources--can reduce prosperity for all.  

The process of economic change can be painful, and certainly there is a role for government in helping to reduce individual suffering by providing social insurance and opportunities for education and retraining.  But it's also the process that creates wealth in society.  The government, by sheer force of will, can keep jobs in Detroit or any other area of the economy.  But it can't make inefficient industries viable again.  It can kick the can down the road, but eventually we'll all be paying for our mistakes.

Capitalism has taken a bit of a beating in the past year.  But we should separate out what we did badly from what we do well.  Let's not throw the baby out with the bath water.

It is (sometimes) easy being green

President-elect Obama is facing many tough challenges, not the least of which is how to spend a roughly $700 billion stimulus package. Yes, it's harder than it seems.

On a basic level, anything that spurs the economy is worthwhile. The government could buy $700 billion worth of Hannah Montana merchandise or buy every US citizen a haircut. But many people want to see the money spent to further other long-term policy goals. In particular, there has been a strong push to use the stimulus to jump-start "green" industries through the creation of "green-collar jobs". We can call it "green stimulus".

The appeal of green stimulus is understandable: we need to create jobs and we need to become more energy efficient. Why not use this as an opportunity to do both?

Unfortunately, it's not that simple, especially in the case of subsidizing green energy production. As John Whitehead, writing at Environmental Economics, says:

Unless consumers decide to increase their overall use of energy products (and they might ...) then the demand for brown energy (i.e., coal and oil) will decrease resulting in a decrease in price and a decrease in quantity (see the second figure to the right). The number of brown jobs in the energy sector falls as a result of the reduction in quantity produced and consumed.

When we talk about the jobs created from green energy production, we forget the jobs lost at coal plants. In the long-term, technological changes in green technology will likely create new jobs. But in the short-term, stimulus spending on green energy will likely just change the composition of jobs, not create new ones. Of course, spending on green energy is still good for the environment and should be justifiably on those grounds alone.

The good news is that there are some ways for green stimulus to work. In particular, the Obama administration has been talking about using stimulus money to make homes more energy efficient, and Congress added $250 million to the budget in October to weatherize 140,000 houses. This plan has several advantages. First, rather than subsidize the energy usage of low-income individuals, this strategy will reduce energy consumption. Second, weatherizing 140,000 homes would create 8,000 new jobs at a cost-effective $31,250 per job. The Obama administration wants to expand the program to 1,000,000 houses, which will create 78,000 jobs.

So there you have it. With the right policies, it can be easy being green.

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!