Is This Recovery Or 1937 Again?

The President laid out a series of policy measures in Thursday’s speech which are, by textbook standards, entirely reasonable. And yet, many have been declared by the pundits to be DOA. I’ll leave the assessment of political feasibility to others, but the very fact that these specific measures [0] are so reasonable by textbook standards makes me wonder if we have in fact experienced technological regress in our politico-economic discourse. Maybe those shocks in RBC models are just the fact that so many individuals with influence never took an intermediate macro course, let alone an economics course [1] (I highly recommend Robert Hall and John Taylor‘s Macroeconomics, or the later editions, by Hall and David Papell).

The Context: The Stimulus Package of 2009

To begin with it’s useful to review a little history, given the heated rhetoric that has been used in the past few years. From Chapter 5 of Lost Decades (forthcoming 9/19, W.W. Norton), written by me and Jeffry Frieden:

The standard macroeconomic view is that in recessionary conditions, incremental government spending and tax cuts can stimulate the economy. If the government spends an additional million dollars to build a bridge, that spending directly adds to GDP. But that is only the beginning: the spending on materials and labour is income to suppliers, contractors, and workers, and some of this income will be spent on consumer goods and services, which then further increases GDP. This in turn becomes income for other workers, who similarly increase their spending, again adding to GDP. This process suggests a “fiscal multiplier,” typically associated with Keynesian macroeconomics, such that every one-dollar increase in government spending results in a greater-than-one-dollar increase in GDP. Especially when the economy is stuck at ZIRP, so that private borrowing and spending are particularly weak, the multiplier can be large…

Even before the new administration took office, its economic team had been considering a fiscal stimulus. Romer’s evaluation indicated that a $1.2 trillion package was needed. However, President-elect Obama’s political advisers insisted that this was not feasible, and the numbers were shaved. Once in office, President Obama proposed a $675–$775 billion package to stimulate the economy.32

Intervention here: When I hear statements that “the stimulus failed”, I think it important to recall that between the election and inaugural day, business economists revised downward their estimates of GDP [2]. The proper metric is then to compare against the counterfactual as of the time of implementation, as described in here,here and here.

Some policymakers and economists believed that any government intervention, even in so troubled an economy, was unjustified. Congressman Ron Paul (R-Tex.) complained that “the US government just won’t allow the correction the economy needs.” He invoked the recession of 1921, which was deep but short, in Paul’s view because the government permitted insolvent companies to fail. “No one remembers that one,” he averred. “They’ll remember this one, because it will last 15 years.”34 Paul’s view was reminiscent of the position of the “liquidationists” of the early 1930s, who were led by Treasury Secretary Andrew Mellon. Mellon’s advice to President Herbert Hoover was typical: “Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate … purge the rottenness out of the system.”35 The idea was almost moralistic: bad loans, bad debts, bad businesses, and bad deals had to be exorcised before the economy could right itself. Satisfying as such a scorched-earth policy might be (at least to those not caught in its path), few serious economists or policymakers ever considered it.36

Some theoretical objections to an active fiscal stimulus were based on the view that government spending would inevitably be wasteful, providing no real benefit to the population. Others emphasised the expectation that increased government spending would be counteracted by an offsetting reduction in private spending. The budget deficits that would result from tax cuts or more government spending would drive interest rates higher and reduce, or “crowd out,” private investment and spending. The economists who held these positions were generally hostile to traditional Keynesian views, especially because of the Keynesian inclination to assume that there were market failures that government could correct…

But among most economists, there was a general consensus on the desirability of some form of active fiscal policy. In a February 2009 Wall Street Journal poll of economists, 68 per cent said that the proposed stimulus package was about the right size or too small. Only 31 per cent said that it was too large. Most economists in the policy and business circles viewed a stimulus package as something that could soften the blows of a deep downturn and hasten the arrival of a recovery.38

Well, we know about how much interest rates have risen in response to the stimulus package [3] [4]. And with that decline in long term interest rates, we know how much interest-rate-induced crowding out of investment has occurred: nil. Instead, the drama we seem to be witnessing now is a replay of 1937 [Krugman], when policymakers overly worried about inflation and deficits withdrew stimulus too early. Whether we will (re-)learn that lesson is the question of the moment.

The President’s Proposals: The Textbook Approach

In a standard aggregate demand/aggregate supply model [5] [5a] [6], output is demand determined in the short run, and supply determined in the long run. The President’s proposals focus, appropriately, on the short run, given the large output gap.


Figure 1: Log GDP (blue), potential GDP from CBO (grey), cubic trend in log GDP estimated over 1967-2011Q2 (grey-green), and forecasted GDP according to mean of August WSJ survey (red) based on July GDP release, all in Ch.2005$, SAAR. Source: BEA, CBO, WSJ, author’s calculations.

Using the CBO’s measure of potential, the lost output has been $2.8 trillion (Ch.2005$) through 2011Q2. Using the WSJ mean forecast, another $1.4 trillion will be lost by 2012Q4. The CBO-implied output gap as of 2011Q2 is 7.1% (log terms). Using a cubic in time trendline, the gap is still 3.4% (and then one has to believe that output was above potential 3.3% in 2007Q3).

Extended unemployment insurance, extension of the payroll tax holiday [CBPP], and infrastructure spending are all means by which aggregate demand can be sustained. To the extent that extended UI and payroll tax holiday benefit lower income/liquidity constrained individuals, the marginal propensity to consume is relatively high and hence the multiplier fairly large. Investment in infrastructure also makes a lot sense given the multiplier is fairly large for direct spending. The multiplier ranges are depicted in the below table (they are from a January 2010 report, so the dates relate to proposals implemented in 2010).


I’ll note these ranges pertain to a situation where the Fed is assumed to tighten a year after implementation. To the extent that the Fed has committed to keeping the Fed funds rate close to zero to mid-2013, the relevant upper end of these ranges is probably higher.

Transfers from the Federal government to the states also has a high multiplier. Since the states are typically constrained in terms of borrowing, either due to constitutional or credit constraints, it makes sense for the Federal government to share revenues with them during times of fiscal stress.

The policies also make sense from a supply side perspective. Here I want to distinguish between faux supply siders, who think supply can only be augmented by reduced tax rates or reduced regulatory burdens, and those who have a broader interpretation of what factors determine supply. Clearly, investment in infrastructure increases the productive capacity of the economy. But some of the other measures also work on that margin. So when the President aims to retrain workers, or keep employed workers who otherwise might undergo long periods of joblessness, this is working on the supply side by enhancing human capital. (See these posts and conference proceedings regarding the impact of long term unemployment [7} [8] [9] [10]).

From the Public Finance Textbook

The employment tax credit is not straight out of the macro textbooks, but the rationale can be found in most standard public finance textbooks, specifically the analysis of an investment tax credit (ITC). An ITC reduces the cost of capital facing the firm, increasing the optimal capital stock. The cost per unit of additional investment is in principle low because only the marginal investment spending requires tax expenditures; there is no rent going to other units of capital already in place. The logic for employment is the same.

Summing Up

The President’s proposal will probably not have an enormous impact on GDP (in principle, it should have been larger, but I bow to political realities), although the estimates vary since the details are still coming out.Macroeconomic Advisers guessed about a percentage point acceleration, more than a week before the speech (they are to have a more specific estimate soon). Mark Zandi from Moody’s, with more details at hand, estimated 2 ppts acceleration relative to baseline, according to Bloomberg. What perhaps is of key importance is that these measures prevent the economy from falling below stall speed. [11]

Addendum: Replaying 2008?

On a slightly different note, I note that the opposition to adequately funding the new consumer financial protection bureau, and confirming the new head [12], seems to signal an intent to let the financial sector “self-regulate”. Well, that turned out well. Once again, from Chapter 8 of Lost Decades, our assessment of why the financial crisis was so devastating:

… Lawmakers disarmed financial regulators, who in turn used few of the weapons left in their arsenals, allowing financial institutions to develop new instruments that were largely untested and wholly unsupervised. Financial institutions worked madly to increase their profits in a low-interest-rate environment by taking on ever riskier assets, insisting that they had mastered risks they barely understood.

In our view, the argument that one can “just say no” to future bailouts, and eschew regulation represents a willful misreading of the lessons of history, or a deliberate attempt to obscure the buildup of contingent liabilities that will be paid by ordinary taxpayers, while spewing platitudes about free markets — in other words, and excuse for Akerlof-Romer type “looting” [13].

Update, 9/9, 7:30AM Pacific:

Estimates suggest a more substantial boost than early assessments (including mine). From Macroeconomic Advisers:

American Jobs Act: A Significant Boost to GDP and Employment

We estimate that the American Jobs Act (AJA), if enacted, would give a significant boost to GDP and employment over the near-term.

  • The various tax cuts aimed at raising workers’ after-tax income and encouraging hiring and investing, combined with the spending increases aimed at maintaining state & local employment and funding infrastructure modernization, would: Boost the level of GDP by 1.3% by the end of 2012, and by 0.2% by the end of 2013. Raise nonfarm establishment employment by 1.3 million by the end of 2012 and 0.8 million by the end of 2013, relative to the baseline.
  • Boost the level of GDP by 1.3% by the end of 2012, and by 0.2% by the end of 2013.
  • Raise nonfarm establishment employment by 1.3 million by the end of 2012 and 0.8 million by the end of 2013, relative to the baseline.
  • The program works directly to raise employment through tax incentives and support to state & local governments for increasing hiring; it works indirectly through the positive boost to aggregate demand (and hence hiring) stimulated by the direct spending and the increase in household income resulting from lower employee payroll taxes and increased employment.

Because the package is some $100-$150 billion larger than the proposal widely reported in the press and that we wrote about two weeks ago, these effects are expected to be significantly larger than previously expected.

This simulation did not incorporate potential incentive effects on employment from the payroll tax credit for new hires.

  • Studies have found that such credits do incent increased hiring.
  • However, it is difficult to know the employment base of the firms eligible to receive the credit, hence we could not form an estimate of the aggregate employment gain
  • That we did not allow for these effects suggests some upside risks to these employment estimates presented here.

Because these initiatives are planned to expire by the end of 2012 — except for the infrastructure spending, which has a longer tail — the GDP and employment effects are expected to be temporary.

  • That is, these proposals will pull forward increases in GDP and employment, not permanently raise their level.
  • Nevertheless, there may be good reasons to want to implement such programs today, if the government can follow through on the commitment to trim deficits later: There remains considerable slack in the economy and nearly all forecasts anticipate only a gradual decline in the unemployment rate over the next couple of years. Given the elevated risk of recession the U.S. faces today, additional near-term stimulus reduces that risk. Given the deleterious effects of long-term unemployment on an individual’s skills and long-term employment prospects, speeding a return to employment is both individually and socially beneficial. With monetary policy’s limited room to lower rates and stimulate demand, there is a role for counter-cyclical fiscal policy.
  • There remains considerable slack in the economy and nearly all forecasts anticipate only a gradual decline in the unemployment rate over the next couple of years.
  • Given the elevated risk of recession the U.S. faces today, additional near-term stimulus reduces that risk.
  • Given the deleterious effects of long-term unemployment on an individual’s skills and long-term employment prospects, speeding a return to employment is both individually and socially beneficial.
  • With monetary policy’s limited room to lower rates and stimulate demand, there is a role for counter-cyclical fiscal policy.

Ezra Klein summarizes the plan, and economists reactions:

The plan shows that Obama gets how dire the jobs situation is, writes Paul Krugman: “I was favourably surprised by the new Obama jobs plan, which is significantly bolder and better than I expected. It’s not nearly as bold as the plan I’d want in an ideal world. But if it actually became law, it would probably make a significant dent in unemployment…Some of its measures, which are specifically aimed at providing incentives for hiring, might produce relatively a large employment bang for the buck. As I said, it’s much bolder and better than I expected. President Obama’s hair may not be on fire, but it’s definitely smoking; clearly and gratifyingly, he does grasp how desperate the jobs situation is. But his plan isn’t likely to become law, thanks to Republican opposition. And it’s worth noting just how much that opposition has hardened over time, even as the plight of the unemployed has worsened.”

There’s some question as to whether payroll tax cuts are effective, reports Brad Plumer: “Chad Stone, an economist at the centre on Budget and Policy Priorities, points out that the payroll tax cut does tend to get money in the hands of lower-income workers, who are more likely to spend their savings, which means that the CBO tends to score it as relatively effective economic stimulus….Still, Stone adds, there are other tax credits that are better designed for providing stimulus — say, a refundable tax credit that more narrowly targets low-income workers…Former Reagan adviser Bruce Bartlett has argued that the measure doesn’t help the unemployed (who are most likely to spend any additional income), that it hits many higher-income Americans who don’t need the relief, and that many workers are more likely to pocket the savings than spend the money…There are two counterarguments here. One, even if workers are saving the money, that may not be so terrible.”

Obama’s setting up a win-win scenario for himself, writes Mark Schmitt: “Obama’s new approach, though, sets up, in theory, a different hypothetical win-win than the one we’ve been operating under for almost three years. One possibility is that Republicans have some qualms about a wholly obstructionist agenda, Congress passes some or most of the American Jobs Act, the economy improves (likely with some help from the Federal Reserve, international circumstances, and good fortune), and actual conditions get Obama out of the box he’s in. Failing that, if the White House and Democrats can keep their focus on the American Jobs Act (and if the left can avoid getting distracted by Obama’s wise concessions to reality, such as long-term reductions in Medicare spending), then Republican obstruction takes a new form. It’s not just blocking Obama, or his agenda–it’s blocking economic recovery, systematically, including ideas that Republicans have embraced in the past and will embrace again.”

The package is the right size, writes Jonathan Cohn: “The numbers I got from economists varied, but the rough consensus was that an investment in the neighbourhood of $400 to $500 billion (including renewal of the existing payroll tax cut and unemployment insurance extension) would reduce unemployment by roughly a percentage point over the next year, relative to what it might otherwise be. If the current projections are right — always a big if — that’d still leave unemployment at close to 8 per cent, which would be too high. But it’d be a whole lot better than 9 per cent, which is where it’s stuck now. Would the American Jobs Act accomplish that?…Add it up and you get close to $450 billion, very much in the ballpark of what those economists had recommended.”

It’s too tax cut heavy, writes Jeff Madrick: “I do have some reservations about what the president said. One is the large majority of this plan is about tax cuts and tax credits, not real spending. We get much more bang for the buck with spending on infrastructure–with spending on unemployment insurance and sending more money to state and local government than we do for tax cuts for business. For the most part, we’ve had those and it hasn’t worked. But these tax cuts for business and workers will not have the pop per dollar that direct spending would have had–direct spending on infrastructure, on education and so on. For every dollar of direct spending, you get more GDP than you do for every dollar of tax cuts. So that was disappointing–that was the same old stuff. The other thing that was disappointing to me was that he mentioned that if we didn’t reform Social Security, it wouldn’t be here–that is totally not true.”

It won’t work, writes Douglas Holtz-Eakin: “The president has ducked entitlement reform and believes that government spending is growth, so there was no chance of spending offsets. That means that to provide the offsets would mean he had to come clean with the fact that this is just another tax and spend effort. So we got another speech with more promises and fundamentally mediocre substance. Indeed, even by late August ‘Macroeconomic Advisers’ was warning that a similar package would generate under 40,000 new jobs per month between now and the end of 2012. This package is ‘bigger’ and would like get scored differently, but the bottom line would be the same. Details aside, one knew in advance that the president wanted to spend nearly another half trillion dollars and not move the dial on unemployment. We didn’t know that it would be spend and promise to tax, but the shock value is small.”

AP via Chicago Sun Times, Globe and Mail and Izzo/WSJ RTE also summarize economic assessment

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