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January 26, 2008

Economist's View - 3 new articles

Andrew Samwick: A Better Way to Respond to Downturns

Here's Andrew Samwick on fiscal policy. I disagree with some of this, e.g. if you wait until you know if monetary policy works then it's too late for fiscal policy. Also, it's not clear that monetary policy works faster than fiscal policy. Monetary policy can be put into place faster than fiscal policy, but once in place it takes longer to impact the economy. When you put the implementation and effectiveness lags together, there is no necessary winner between the two types of policies.

In the post below this one on the same topic, I didn't do a very good job of separating the focus of the short-run stabilization policy (whether to try to change C, I, G, or NX) from its consequences (crowding out and crowding in), so let me try to clear that up here. I covered crowding out and crowding in the next post, so the focus here is on whether policy ought to be directed at C or I, or even G (G can be either consumption or investment; also, NX is harder to change, but policies can also be directed at NX, e.g. subsidizing exports).

Andrew recommends focusing on government investment when implementing stabilization policy. I have no problem with spending on infrastructure rather than giving tax rebates so long as such policies can be put into place quickly enough. Andrew's advance planning (see below) is supposed to make the policies easy to implement quickly, but I have some doubts about how well that would work, though I have also made the point that some of these projects are implementable on short-notice (and some, e.g. grants to state and local government, can prevent existing projects from being shut down and can be accomplished very quickly). I am less concerned with whether stabilization policy stimulates private consumption, private investment, or government investment than others seem to be, the important thing is to increase aggregate demand as fast as possible and get the economy moving again, and it doesn't much matter which component of aggregate demand, C, I, G, or NX is behind the stimulus. If you believe theory, which component is changed won't have much long-run impact on investment anyway. Real output growth is independent of demand changes in the long-run in most, but not all macro models. Demand shocks change short-run conditions, but the economy eventually finds its way back to the long-run path (assuming government provides the supporting infrastructure, but that doesn't have to be done with stabilization policy). Stabilization policy simply changes the speed at which you return to the long-run path, but its impact on the path itself is minor or non-existent. So the important thing is to get incentives or money to the people most likely to impact aggregate demand quickly which, fortuitously, is also happens to be the people most in need of help:

A Better Way to Deal With Downturns, by Andrew A. Samwick, Commentary, Washington Post: ...While politically expedient, the stimulus package is unjustified in the short run and harmful in the longer term. ...

The $150 billion agreement calls for tax rebates to low- and middle-income households as well as business incentives. Doubtless, this will boost economic activity. If you pull levers, you get movement. Personal consumption and business investment will increase relative to what they might otherwise have been. But there is no discussion of repaying the money through higher taxes in the near term. Let's drop the euphemism of "stimulus package" and call this agreement by its proper name: "deficit spending."

It is ironic that additional borrowing is prescribed as the remedy for a malady that arose from unwise borrowing. ... If we acknowledge that bad loans fueled the activity, why is it now a widely shared policy objective to maintain that level of activity?

The answer is a combination of three factors. The first is elected officials' fear that they will be punished in November for an economic downturn unless they do "something" to avoid it. Few things precipitate bipartisan agreement so quickly. Using the incomes of future taxpayers to purchase reelection today is irresponsible but common public policy.

The second factor is policymakers' fear that unless "something" is done, a temporary economic downturn could become more protracted. This fear, to the extent that it is justified, is better addressed by the Federal Reserve lowering short-term interest rates, which would stimulate the economy more quickly and comprehensively than would fiscal policy. The Fed did just this on Tuesday. Yet the fiscal-policy lever has been yanked before any data have indicated whether the Fed's stimulus has had its intended effect.

The third factor is the recognition that some households will bear a disproportionate burden of an economic downturn, combined with a belief that "something" should be done to help them. Government has a choice in whom it taxes to finance this relief -- other taxpayers today or all taxpayers in the future. That the agreement holds the former group harmless was also praised by Bush. This "stimulus bill" is really $150 billion worth of some future generation's resources appropriated to finance our own consumption. Why are we entitled to pass on this additional debt? ...

In political arguments, you can't beat something with nothing. But we can learn from this experience to have a better menu of fiscal policy options the next time around. Two changes to our budget policy would go a long way toward that goal.

First, we should rule out deficit spending to finance a consumption binge. As the economy slows, the deficit will widen even without changes in fiscal policy. But an honest budget policy would be calibrated to balance the budget over a complete business cycle. Years of cyclical deficits will be offset by years of cyclical surpluses. As a corollary, we must not waive pay-as-you-go rules that require spending that increases the current deficit to be offset later, when the economy is stronger.

Second, we can plan well in advance. The federal government has a critical role in maintaining and developing public infrastructure, whether in transportation, telecommunications or energy transmission projects. A sensible capital budget would include a prioritized list of projects that need attention. Some would be slated for this year, some for 2009 and so on, over the useful lives of the projects. When economic growth falters, the government would be in a position to move some of the projects from later years into the present year.

This approach to counter-cyclical fiscal policy has several advantages. Perhaps most obvious is that it forces the government to establish priorities for capital projects. It reduces overall expenditures by doing more of the work in times of economic slack, when costs are lower. It also abides by pay-go rules, since projects moved up to 2008 need not be done in 2009. With a little forethought, short-term economic concerns and long-term budget goals need not be in conflict.

Landsburg: Why the Stimulus Shouldn't Stimulate You

Steven Landsburg on the stimulus package. My comments along the way:

Why the Stimulus Shouldn't Stimulate You, by Steven E. Landsburg, Commentary, Washington Post: As a general rule, economic policies command bipartisan support only when they're incoherent. Take, for example, the fiscal stimulus package now bulldozing its way through the legislative process. It's poorly conceived, it's unlikely to work, and it's sure to do a lot of collateral damage.

I agree - it's not the best plan.

The idea, we're told, is to stave off an all-out recession by stimulating both investment (through tax cuts for businesses) and consumption (through tax rebates to individuals). But hold it right there.

Investment and consumption are natural rivals.

Investment means converting resources into machines and factories; consumption means converting those same resources into TV sets and motorboats. In anything but the very short run, more of one means less of the other. ...

The reference here is to "crowding out". The idea that when the government spends or cuts taxes and increases the deficit, it competes for financial assets driving interest rates up. The rise in interest rates then chokes of (crowds out) private consumption of durables and business investment so that, treating consumer durables as an investment good, the rise in government deficit causes investment to decline.

But a key part of the crowding out story is that interest rates rise in response to the increase in deficits. However, under globalization, this has not been happening. Foreigners have been very wiling to lend us money and that has kept interest rates down. So crowding out is not much of a worry.

And there is something else to consider. There is also a phenomena called "crowding in". This is, in essence, the increase in investment that comes from having a stronger economy, i.e. from increased output and employment. Because crowding out has been so small, one could plausibly argue that crowding in has dominated in recent years so that deficit spending that bolsters GDP out of a recession actually brings about an increase, not a decrease, in investment.

Fine, but what makes you think that this package will put anyone to work? The idea behind the stimulus deal is to give people tax cuts so they'll feel richer and spend more. But government can't make people richer on average; all it can do is shuffle wealth around. To pay Peter, you must tax Paul (or at least promise to tax Paul in the future, when your debts come due). Peter spends more, but Paul spends less.

Now maybe you can time things so Peter goes on a spending spree today but Paul doesn't tighten his belt until next month. (Then again, maybe you can't: Paul's no fool, and he's likely to start cutting back as soon as he sees higher taxes on the horizon.) But even if you manage to pull this trick off, sooner or later you must tax Paul. So today's fiscal stimulus comes at the expense of tomorrow's fiscal drag.

A couple of things here. He is referring to "Ricardian equivalence." This is the idea that people will understand that any increase in the deficit will mean higher taxes in the future. In fact, in a perfectly functioning market economy (and with other conditions on things such as the "connectedness" of generations) the present value of the future tax burden is equal to the increase in the deficit. If this is the case then, in aggregate, policies such as a tax rebate won't stimulate the economy because the rebate is exactly canceled by the present value of the expected increase in taxes in the future.

There are (at least) two reasons to doubt this works perfectly. First, pure Ricardian equivalence requires perfect capital markets, and there is evidence that this condition is not satisfied. Second, it it possible to give this generation a tax cut, then pass along the burden to future generations. But so long as this generation cares about the next generation, then this will not work - the present value of the taxes the next generation pays matters to us and offsets the rebate as before. However, generations are imperfectly connected so that the pass through is not 100%.

In any case, if you look at the voluminous evidence on this topic, it is somewhat mixed, but overall you will find that people think there is partial, but not full Ricardian equivalence. There is some offset to government spending or tax cuts/rebates because of the expected tax burden policies that increase the deficit bring about, but it is not 100% and fiscal policy is still sufficiently stimulatory.

Finally on this point, the idea that deficit spending now means we will have to raise taxes and lower GDP in the future is exactly right - that's the point of stabilization policy, to shave the peaks and fill the troughs. When the economy is having trouble, we deficit spend to bring up GDP, then when things are so good that the economy is beginning to overheat we run a surplus (raise taxes) to bring GDP down closer to trend. Since deviations from the long-run trend rate of growth are costly whether you are above or below trend, this type of stabilization raises economic welfare.

Continuing:

Moreover, even if you do somehow manage to increase spending, that doesn't mean you'll put Americans to work. More likely, you'll put Asians to work producing goods for the U.S. market.

This current plan is not necessarily the best way to do this, but it's pretty easy to make sure a stimulus plan only increases employment domestically. That's just a matter of targeting (tax cuts to cement companies are unlikely to result in any jobs being offshored, and if government hires people temporarily itself, it's also easy to make sure the jobs are domestic).

President Bush seems to have become confused on this key point because he misunderstands supply-side economics. He has vaguely remembered that tax cuts put people to work, but he's forgotten that only marginal tax cuts put people to work. Non-marginal tax cuts -- such as the ones in the stimulus package -- have exactly the opposite effect, when they have any effect at all.

The reason: When people feel richer, they're less eager to work. An unemployed laborer with a tax rebate in his pocket might well feel less urgency about getting retrained or finding a new job. (Not every unemployed laborer will react this way, but you can be sure that some will.) If Americans demand more but produce less, the difference has to come from abroad.

Here, then, is the great irony: To stimulate spending, tax cuts have to make people feel richer -- but the richer people feel, the slower they'll be to rejoin the workforce. The more effective the tax cuts, the longer they threaten to prolong the expected recession. ...

Yeah, I'm pretty sure giving people a few hundred extra bucks is going to stop them from looking for a job, they can live for months on that. Never mind that most of the people receiving the benefit are already employed. Now if we had extended the length of time for unemployment compensation, we'd have something to talk about - there is evidence on this point, lots and lots of it, but we didn't. Republicans would not allow one of the best means of stimulating the economy (e.g. see the rankings of programs at the CBO) to be part of the bill.

Now let's talk about why we shouldn't want it to [stimulate consumption]. ...

He simply makes the crowding out point again and concludes, wrongly as noted above, that:

If you care about your grandchildren, you should be encouraging everyone else not to consume, but to save.

But much of the stimulus package is designed to achieve exactly the opposite: It encourages consumption, not saving. Not that there's anything wrong with consumption; it's what makes life worth living. But my consumption benefits me, while my saving benefits you.

I've already got plenty of incentive to consume. What you should be worrying about is my incentive to save. To say it again: The more I consume, the poorer your grandchildren will be; the resources I use won't be available to build machines that make your grandchildren more productive. It's all well and good to worry about the people who are struggling today, but let's also remember the people who will be struggling in the future. The worst thing we can do for them is to encourage consumption.

My resources may not be available, but the immense savings in Asia and among oil producing nations are still there waiting to be borrowed at attractive rates.

And while we're thinking about our grandchildren, let's also think about our contemporaries. Over the course of a typical decade, millions of people lose their jobs one at a time. In a severe recession, millions lose their jobs all at once. But it's no more painful to be unemployed for five weeks in the middle of a recession than it is to be unemployed for five weeks at the height of a boom. In fact, it's arguably less painful: Isn't it better to be unemployed at a time when unemployment carries less stigma and when you've got unemployed friends to hang around with? (Ask those striking Hollywood writers.) So it's hard to argue that we should do more for displaced workers during a recession than we do at any other time -- especially when people who lost their jobs a few years ago, and others who will lose them a few years hence, are footing a good chunk of the bill. ...

Suppose that it takes longer to get a job in a recession, a reasonable assumption. Then extending the time period covered by unemployment benefits, increasing the resources available to programs that help to reemploy workers, hiring some of the excess workers into temporary government employment, using tax rebates to stimulate the economy and employment, and so on to compensate for the lowered probability of finding a job during a recession, i.e. implementing policies that make it equally likely that unemployed workers in recessions and unemployed workers during boom times will find a job is not preferential treatment.

Ultimately, the only solution to unemployment is for displaced workers to get retrained and find their way back into the workforce. The new stimulus package only delays that process by propping up dying industries for a while and postponing the day of reckoning. Ultimately, there will be just as much hardship because the stimulus package can't last forever. Why spend all this money trying -- and probably failing -- to delay the inevitable?

Uhm, because it's not inevitable?

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