(Keith Hennessey was the director of the National Economic Council under President George W. Bush. This post originally appeared on his blog, keithhennessey.com.)
The recent anniversary of the stimulus law reminded me that I need to recap my views. I will highlight a point I think is being overlooked in the historic debate and comment briefly on the pending “jobs” bills.
Recap: my views on fiscal stimulus
Unlike many critics of the stimulus law, I think that fiscal policy can increase short-term economic growth, especially when the economy is in a deep recession. In other words, I think that fiscal stimulus is a valid concept. This does not mean that I think that every increase in government spending, or every tax cut, (a) increases short-term economic growth or (b) is good policy.
In the world of fiscal stimulus there is a tradeoff between speed and power. Putting money directly into people’s hands is fast – people immediately change their behaviour. We saw this on a much smaller scale with Cash-for-Clunkers: as soon as the incentive was out there, people sprinted to the dealership to take advantage of it. “Putting money directly into people’s hands” includes tax cuts, payments to individuals mislabeled as tax cuts, and entitlement spending like unemployment benefits and food stamps. The challenge with these options is that if the payment stream is temporary, people don’t spend 100 cents on the dollar of the money they get. They instead save a fairly big portion of it (probably between 60 and 75 per cent). So if you’re trying to increase short-term consumption, a temporary tax cut or temporary benefit spike is fast but not powerful. Then again, in the current recession where many family balance sheets were decimated by a severe decline in the value of their home, rebuilding those losses with increased saving is a good thing, too. If the Administration had instead put $862 B directly into people’s hands, you would have seen more immediate spending and economic growth than we did, even if people had saved most of it.
In contrast, government spending is powerful but painfully slow. If the government spends $1 on building a road, eventually that entire $1 will enter the economy and increase GDP growth. Your bang-for-the-deficit-buck is extremely high. The problem is that bang-for-the-buck doesn’t help us if that bang occurs two or three or four years from now. Last year’s stimulus contained $8 billion for high speed rail and $1.5 billion for intermodal transportation grants. Not one dollar of that $9.5 billion has yet been spent. If you look at all $48 B in transportation spending in last year’s stimulus law, as of mid-January less than 20 per cent had entered into the economy. Power does you no good if it comes too late.
There are other differences between spending stimulus and cash-in-people’s-hands stimulus. The Administration and its allies emphasise what they see as the non-stimulus policy benefits from their increased government spending (environmental, education). I would instead prefer that people be allowed to spend and save the money how they best see fit. My preferred path also has less waste and bureaucracy. These debates are unrelated to the macroeconomic questions and are a distraction from them.
As with a double espresso or an energy drink, there’s a post-stimulus letdown problem with any temporary stimulus. We’re going to see some of that effect this year.
Last year’s stimulus law
I agree with the Administration that last year’s stimulus law increased economic growth above what it otherwise would have been. I agree that employment is higher than it would have been without a stimulus.
At the same time, I think their estimates of how much the stimulus helped are exaggerated, confused, and misleading. The law was poorly designed and inefficient. The money has been slow to spend and filtered through federal and state bureaucracies. As a result, the macroeconomic benefits were diluted and mistimed (and timing is everything in stimulus) and tens of billions of dollars are being wasted.
Most conservatives and Republicans say what they don’t like – the stimulus law. Few argue what they would have done instead. It’s easy for outsiders (including me) to complain about the actions taken. Ask a critic: If you were in charge, would you instead have done nothing? Do you think you could have sustained that position politically throughout 2009?
Given a decision last year to do a big fiscal stimulus, I would have preferred, in this order:
- putting all the money into a permanent reduction in income and capital taxes;
- putting all the money into a a temporary reduction in income and capital taxes;
- putting all the money into transfer payments;
- what Congress and the President did.
Given the policy preferences of the President, his team’s big policy mistake last year was to let Congress turn a reasonable macroeconomic fiscal policy goal into a Congressional spending toga party. Given his policy preferences, the President should have insisted that Congress put all the money into (2) and (3) above. He would have had a bigger macro stimulus bang earlier.
Team Obama’s even bigger mistake was in overselling their policy. They made the classic mistake of overpromising and underdelivering. The political system is punishing them and their allies for this error.
Their messaging had and still has two fatal flaws:
- They created expectations of a net result, rather than an increment. This is the infamous graph in which they “promised” that their policy would result in an unemployment rate that would now be below 8%.
- They are attributing whatever economic recovery is happening solely to the stimulus law.
Only the first has been sufficiently debated. No one knows how big of a positive effect the stimulus had, since no one knows the counterfactual of what economic and job growth would have been had there not been a stimulus law. This unknown aspect always exists. The Administration tried to game it with their unemployment graph and their “jobs saved or created” measure, and they have gotten politically burned because of it.
The second flaw is important and insufficiently discussed. I’ll show it with a picture.
Problem #1 above is that we can’t measure the increased economic growth since we don’t know the baseline from which we’re measuring. We don’t know what numbers we should put in the rounded rectangle on the right.
Problem #2 is that the Administration suggests that all of that growth resulted solely from the stimulus (blue box). It is instead the result of the natural recovery that happens in any business cycle (green box), plus the stimulus, plus all the other policies that are contributing to economic growth. We cannot know how much of the economic recovery is the result of policy, and how much would have happened naturally in the absence of any policy changes. We also cannot know the relative importance of various policy changes in contributing to increased economic growth.
As an example of an alternate viewpoint, I think the financial crisis beginning in September 2008 turned a mild recession into a severe recession. The severe recession was caused by a financial wound. I believe the most important policy actions to address the severe recession and its cause were (1) preventing the collapse of the financial system, (2) recapitalizing the banks, and (3) pumping tremendous amounts of liquidity into the financial system. These actions (which were concentrated in Q4 2008 and Q1 2009 and spanned the Bush and Obama Administrations) treated, cleaned, and dressed the financial wound. This put the patient on the path to a painful, slow, natural recovery.
I think that much of the recovery we have seen would have occurred even without the $862 B law, because I think the first three white boxes and the green box are what mattered most.
Fiscal stimulus could have helped a lot more than it did had it been designed correctly. And I do believe that it was a contributing factor, but nowhere nearly as much as the Administration would have you believe.
Reasonable people can disagree on the relative contributions of the business cycle and policy, and on the relative contributions of different policy actions taken. At the same time it is clearly incorrect to attribute all of the economic improvement to the stimulus law or even to policy.
Insanity: doing the same thing over and over again and expecting different results. (Albert Einstein)
The Department of Transportation’s “Progress report on the American Recovery and Reinvestment Act of 2009” (p. 33) shows that after one year fewer than 20% of transportation infrastructure stimulus dollars have entered the U.S. economy. So what does Congress want to do in their next stimulus (sorry, “jobs”) bill? Increase transportation infrastructure spending, of course.
The pending House and Senate stimulus/jobs bills are political exercises more than policy efforts. The Reid bill is particularly laughable. In a nearly $15 trillion economy, a $15 billion bill is a rounding error. Its effects will be so small that no one will be able to measure it.
These bills have three problems:
- Their effects would be small relative to the size of our economic problem. This doesn’t mean you shouldn’t do them, just that you need to be careful you don’t lead people to believe that things will get much better if you’re successful. You need to be careful not to overpromise. The Administration’s track record here is poor.
- The policies they are including are, like last year’s law, slow, wasteful, and inefficient. Here we go again.
- They are trying to directly stimulate job creation rather than just trying to increase economic growth. This is hard to do.
Traditional macroeconomic stimulus focuses on increasing economic growth. If firms expect that they will sell more stuff in the future, then they will hire people to ramp up production. Short-term stimulative monetary policy tries to increase the purchase of stuff that is sensitive to interest rates. Short-term stimulative fiscal policy tries to increase broadly the purchase of goods and services in the economy. Increased job creation, should it occur, comes as firms hire workers in anticipation of greater demand for what they sell.
The pending legislation is basically trying to bypass this and instead directly change the hiring decisions of firms by temporarily reducing the costs of hiring a new worker. They are taking the future path of economic growth as a given and trying to increase the number of workers who will be employed within that growth path.
Will private employers hire a lot more people if the costs of doing so are temporarily lowered? I am highly sceptical. Even in the best case, the number being bandied around by the Administration (+600K jobs over the next year) is small relative to the size of the unemployment problem. That might knock half a percentage point off the unemployment rate.
When faced with a choice between doing something inefficient, wasteful, and directionally correct, or instead doing nothing, Congress will always choose the former. That’s what they are doing now. Does the Administration and Congress expect a different result from doing largely the same thing on a smaller scale?
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