Showing posts with label fiscal policy. Show all posts
Showing posts with label fiscal policy. Show all posts

Friday, May 2, 2014

Cassidy on Keynes and Reagan

Econ 302 midterm question 2(a):
The fiscal policies enacted by the Reagan administration included significant cuts in taxes and increases in (military) spending. Illustrate the effects of this fiscal policy using an IS-LM diagram. 
While my students were asked to work out the results in (Keynesian) theory, the data are consistent with its prediction:
The red line (right-hand scale) is GDP growth, which is negative in 1982, but strongly positive in 1983 and 84 ('Morning in America'), and the blue line is the federal deficit as a percentage of potential GDP, which shows the effect of Reagan's fiscal policy.

Apropos of this, John Cassidy has a nice post arguing that Reagan was a closet Keynesian:
In strict terms, Reagan’s neglect of the deficit wasn’t Keynesian. Keynes himself believed in letting the deficit rise in a recession and paying down debts in the good times. In America, though, Keynesianism has always been associated with stimulus programs, big government, and deprioritizing the deficit. In all of these ways, Reagan was a Keynesian. But a word to the wise: don’t waste your time trying to tell that to anybody in the Republican Party.

Wednesday, September 19, 2012

Actual Politician for State-Contingent Fiscal Policy!

Matthew Yglesias points to Maine Senate candidate Angus King's views on the expiration of the Bush tax cuts:
I was in favor of ending the Bush-era tax cuts immediately, but after continued poor employment numbers, we need a more nuanced approach. We should consider pegging the sunset of these tax cuts to something non-arbitrary, like a certain amount of GDP growth, or a lower level of unemployment. This would avoid the unproductive brinkmanship that Congress engages in over this issue – and could prevent our fragile recovery from being further slowed down.
This is essentially what I suggested in June (HC op-ed, blog post).  Nice to see someone who might actually be in a position to do something having similar thoughts.

Thursday, September 6, 2012

The Fiscal Trigger Finger That Did Not Itch

In April, 2011, I suggested that the biggest flaw in the 2009 fiscal stimulus effort was that it wasn't "state-contingent" - i.e., that it should have been designed to automatically adjust with circumstances (which turned out to be much worse than expected when the administration first proposed the recovery act).  

That was an idea that came to my mind with the benefit of hindsight, but now Matthew Yglesias informs us that the idea of putting "triggers" in the stimulus was considered at the time.  I'd really like to know why they didn't include them - I think the US economy would be in much better shape if they had.

They - or the incoming Romney administration - may want to consider state contingent fiscal policy again when they deal with the "fiscal cliff" at the end of the year.

Saturday, June 23, 2012

A Trigger for the "Fiscal Cliff"

Under current law, taxes will rise significantly and government spending will be cut next year.  This scenario has been called the "fiscal cliff" and the CBO recently estimated it would lead to a recession in early 2013.

In the Hartford Courant, I suggest going over it, but gradually, when the circumstances are more favorable:
The tax increases could be made to occur at a more appropriate time by instituting triggering criteria that would delay them until the state of the economy has improved and then phase them in. For example, the tax changes could be set to begin once the unemployment rate has fallen to a more reasonable level, like 5.5 percent, and remained there for six months. At that point, the increases could occur in three or four steps, with each one occurring as long as the unemployment rate has remained below a specified level for six months.

This would minimize the risk of pushing the economy back into recession by waiting until the economy has recovered enough to bring the unemployment rate down to a level more consistent with a healthy economy. It would also create confidence that the U.S. is not headed for a debt crisis (though low interest rates suggest that financial markets are not worried about this now). An automatic trigger would take the guesswork out of deciding on an appropriate time frame for an extension of the tax cuts, and spare the country further political brinksmanship over renewing them again.
This is another form of "state contingent" fiscal policy that I've suggested previously on this blog.

In the piece, I asserted that allowing the 2001/03 income tax cuts and the 2010 temporary payroll tax cuts to expire would generate revenue "roughly consistent with the amount of spending required to maintain current programs." This is based on the idea that this would be pretty close to the "extended baseline scenario" in the CBO's projections where the US debt-to-GDP ratio gradually declines over time.  As Jared Bernstein notes, the implication is that the US can afford its current entitlement programs, if it allows scheduled tax increases to take place.

In addition to the tax increases - essentially a reversion to the tax code at the end of the Clinton administration (we did pretty ok back then, didn't we?) - the "fiscal cliff" scenario also involves some spending cuts under the "sequester" mandated by last summer's debt ceiling deal.  Since I was trying to keep the piece to op-ed length, I focused on the tax part because it is larger, but similar logic could be applied to the spending aspects.

The argument is not that this is an ideal economic policy - I'd like to see more stimulus now, and a simpler, more progressive tax code in the long-run; others would like cuts to entitlement programs and lower taxes - but rather that, as a modest change to existing law, it might be a politically feasible alternative to unrealistic hopes of a fiscal "grand bargain" that can achieve a "not bad" outcome in the short- and long-run.

Sunday, March 25, 2012

Summers for State-Contingent Macro Policy

In the Washington Post, Lawrence Summers writes:
How then to respond to valid concerns about fiscal sustainability, excessive credit creation and the eventual return to normality in a world where policy credibility is essential? The right approach is policies that commit to normalizing conditions but only when certain thresholds are crossed. The Federal Reserve might commit to maintain the current Fed funds rate until some threshold with respect to unemployment or expected inflation is crossed. Commitments to fund infrastructure over many years might include a financing mechanism such as a gasoline tax that would be triggered when some level of employment or output growth has been achieved. Tax reform could phase in new rates in pace with the rising economic performance.

Contingent commitments have the virtue of providing clarity to households and businesses as to how policy will play out, and in areas where legislation is necessary, eliminating political uncertainty. They allow policymakers to project a simultaneous commitment to near-term expansion and medium-term prudence — exactly what we require right now.
Like I said back in April 2011, my idea of how I wished the ARRA (the "stimulus bill" at the beginning of the Obama administration) had been different would have been for it to be "state contingent" because it was clear by then that the downturn was deeper and longer-lasting than policymakers understood when they designed the policy.  As I noted here, Peter Orzag has also been arguing the same point.  Of course Orzag and Summers would have been in a position to do something about it had this occurred to them in 2009.

In this earlier post, I argued state-contingent policies could potentially address some of John Taylor's objections to fiscal policy.  Chicago Fed President Charles Evans has been advocating state-contingent monetary policy.

Wednesday, January 25, 2012

Steve "Jobs" versus Barack "US" Jobs

Indiana Governor Mitch Daniels, Republican response to the State of the Union:
Contrary to the President's constant disparagement of people in business, it's one of the noblest of human pursuits. The late Steve Jobs - what a fitting name he had - created more of them than all those stimulus dollars the President borrowed and blew.
Perhaps he missed this, in a fascinating story about Apple in Sunday's New York Times magazine:
[A]s  Steven P. Jobs of Apple spoke, President Obama interrupted with an inquiry of his own: what would it take to make iPhones in the United States?

Not long ago, Apple boasted that its products were made in America. Today, few are. Almost all of the 70 million iPhones, 30 million iPads and 59 million other products Apple sold last year were manufactured overseas. 

Why can’t that work come home? Mr. Obama asked. 

Mr. Jobs’s reply was unambiguous. “Those jobs aren’t coming back,” he said, according to another dinner guest.
Apple employs 43,000 people in the United States and 20,000 overseas, a small fraction of the over 400,000 American workers at General Motors in the 1950s, or the hundreds of thousands at General Electric in the 1980s. Many more people work for Apple’s contractors: an additional 700,000 people engineer, build and assemble iPads, iPhones and Apple’s other products. But almost none of them work in the United States. Instead, they work for foreign companies in Asia, Europe and elsewhere, at factories that almost all electronics designers rely upon to build their wares.  
As for those dollars we "borrowed and blew," according to the Congressional Budget Office:
CBO estimates that ARRA’s policies had the following effects in the third quarter of calendar year 2011 compared with what would have occurred otherwise:
  • They raised real (inflation-adjusted) gross domestic product (GDP) by between 0.3 percent and 1.9 percent,
  • They lowered the unemployment rate by between 0.2 percentage points and 1.3 percentage  points,
  • They increased the number of people employed by between 0.4 million and 2.4 million,
(According to the CBO's estimates, the impact of the stimulus peaked in the third quarter of 2010 at 0.7-3.6 million).

To summarize, US jobs:
  • Steve Jobs' "noble pursuit": 43,000* 
  • Barack Obama "borrowed and blown": 400,000-2,400,000
Maybe it would be fitting to call the President Barack "US" Jobs.

*Don't get me wrong - I'm a fan of his computers.  There's alot to think about in the Times article - see Paul Krugman and Ryan Avent. However, many of the issues raised by it, and by the President's speech, about trade, education and "industrial policy," are really about the composition of employment.  The total number of jobs at any time depends mainly on aggregate demand - and when there is a slump (particularly one the Fed can't handle), the appropriate fiscal policy response is indeed for the government to borrow some money and "blow" it.

Update (1/27): Paul Krugman noticed the same thing, and wrote a column about it.

Saturday, September 10, 2011

The American Jobs Act

The big ticket items in the $447 billion stimulus recovery jobs act that President Obama announced in his address at the Capitol on Thursday include:
  1. $65 billion in cuts to employer payroll taxes
  2. $35 billion for employment of teachers, police and firefighters
  3. $30 billion for school modernization
  4. $50 billion infrastructure investment
  5. $175 billion in cuts to employee payroll taxes
  6. $49 billion for extended unemployment insurance/UI reforms
The most straightforwardly effective components of the package for increasing aggregate demand are #2, #3, #4 and #6. Direct spending on school buildings (#3) and infrastructure (#4) increase the government purchases component of demand (and "Ricardian" or "crowding out" effects that would reduce the impact in some models are irrelevant now). Cutbacks by state and local governments have become a big drag on the economy - state and local governent employment has fallen by over 650,000 over the past three years. The funding for employing teachers and "public safety and first responder personnel" (#2) will put a brake on that trend. That is, it will be an increase in demand (again through the government purchases component) and employment relative to what would occur otherwise.

Extending unemployment insurance (#6) is effective because much of the money goes to people who will spend it (i.e., people who are "credit constrained" from smoothing out their consumption over time).  This increases the consumption component by raising disposable income.  The release from the White House discusses some possible reforms to the unemployment insurance program as well - these are not detailed enough to evaluate, but possibly they might help mitigate one of the downsides of unemployment insurance, which is that it can reduce incentives to work (though I don't think that is a really significant contributor to unemployment now).

There is more uncertainty about the effectiveness of the social security payroll tax components.  Payroll taxes are the "contributions" paid equally by employers and employees (although employees only observe half of the tax through the "FICA" line on their pay stubs, in the long run, the burden of the entire tax - the "incidence" - largely falls on employees because their wages would be higher if employers did not have to make their contribution).

The largest part of the act (#5) is a one-year reduction in the employee contribution to 3.1% - the standard contribution is 6.2%, but was temporarily cut to 4.2% for this year in the deal that was struck in late 2010.  So, basically, this extends the existing cut, and adds another 1.1% to it.  As with unemployment insurance, the effect of a tax cut in increasing consumption depends on whether it is spent.  Households that are credit-constrained (living "paycheck to paycheck") are more likely to change their behavior.  In this regard, it is less well targeted than the unemployment insurance extension, but it is superior to an overall income tax cut. Because the payroll tax is somewhat regressive, only applying to the first $106,800 of wages (and not at all to capital income), the benefits go largely to the "middle class."  Although the primary desired effect is to increase consumption demand, even the parts of the tax cut that are not spent do have the benefit of helping improve the financial position of households.  Large debt burdens are part of the reason recoveries from "balance sheet recessions" are typically slow, so if part of the tax cuts goes to pay down debt, that could serve to hasten the return to normal household spending behavior.

The employer part of the payroll tax cut (#6) can be thought of as a positive "supply shock" lowering unit labor costs (in the short run, with lots of labor market slack, it won't lead them to raise wages).  In a traditional Keynesian framework, this would shift out the aggregate supply curve (or, equivalently, shift down the Phillips curve).  In a "New Keynesian" model, this is a reduction in the real marginal cost term in the New Keynesian Phillips Curve.  Since the binding constraint on the economy is on the demand side, the usefulness of this part of the policy appears questionable.  Indeed, reducing costs is deflationary, and deflation is a very bad thing.  But it is a bad thing that the Fed is determined to prevent, and that is why this part of the package may have a positive effect.  The Fed seems very averse to letting inflation become negative, but also very careful to try to keep it from going above 2% (in doing so, its placing too much weight on the "price stability" part of its mandate relative to the "maximum employment" part, as this justly-praised speech by Chicago Fed President Charles Evans argued). By putting downward pressure on costs, and therefore prices and inflation, the employer-side tax cuts may create more space for the Fed to act more aggressively.

An important part of the proposal is still to come - President Obama said that he would deliver plans to "pay for" the jobs act (i.e., offsetting tax and spending changes, presumably within the standard 10-year window customarily used to assess budget proposals).  This may be politically necessary, but, as I argued recently, there is no economic urgency for doing this, and I worry that political gridlock over paying for the bill could derail taking action now, which is urgent.

Its also worth noting that, while the exact timing of some of the provisions is unclear, it looks like most of the effect occurs in 2012.  That's a good thing, but even under the optimistic assumptions that something like this bill is enacted, and the Fed finds a will and a way to take more effective action, the economy is in a very deep hole and unemployment will still be elevated at the end of 2012. The expiration of the tax cuts puts in place an automatic fiscal contraction for 2013 (this is where the idea of "state contingent" policies would help, but would raise the headline cost, which is politically unpalatable right now).

Private-sector estimates suggest the bill would have a significant impact: Macroeconomic Advisors says it will raise GDP by 1.3% and increase employment by 1.3 million next year; Moody's (via Brad Plumer) puts it at 2% of GDP and 1.9 million jobs.  See also: Gavyn Davies, Paul Krugman, Ezra Klein, Mark Thoma.

Tuesday, August 23, 2011

A Better Analogy for the Deficit?

The recurrent "government should balance its budget like a household" trope has been one of the more infuriating aspects of recent debates over economic policy.  Its easy to see the appeal for politicians who want to appear to be talking "common sense," but the policy implications are destructive.  In the LA Times, I suggest a different analogy:
Politicians of both parties have furthered the misunderstanding by frequently drawing an analogy between the federal budget and household budgets. "Families across this country understand what it takes to manage a budget," President Obama declared in a February radio broadcast. "Well, it's time Washington acted as responsibly as our families do." While this comparison appeals to a general belief that we should "live within our means," it's also misleading.

Decisions about the federal budget are fundamentally different from those of individual households, because policymakers need to account for how their choices affect the economy as a whole. It is more appropriate to liken government budget deficits to prescription medicine. Just as medication can be helpful to a sick patient, deficits can aid a failing economy.
The debt ceiling debate showed how hard it is for the political system to deal with something that can be good in some circumstances, bad in others.  I hope this is a way of thinking of it that is simple and intuitive, but also right.

Of course, the ideal is to simultaneously have an expansionary policy now, but also a plan for a (roughly) balanced budget in the long run (i.e., after the economy has returned to health).  But the debt ceiling fight illustrated how raising the issue of long term projected imbalances starts a big fight over the ultimate size of government (which isn't what countercyclical policy is about).  With 14 million people unemployed - and interest rates very low - that is a dangerous distraction.

Friday, August 5, 2011

S&P Downgrade: Its the Institutions, Not the Debt

S&P just downgraded US government bonds from "AAA" to "AA+".  Their explanation:
We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.
That is, the downgrade has as much to do with the US political system as it does with debt levels.  The ugly spectacle of a faction of one political party taking the economy hostage in the debt ceiling debate has trashed the rating agency's (and everyone else's) confidence in Washington's ability to make difficult compromises.

Thursday, July 21, 2011

Rules-based Keynesian Policy?

John Taylor, who is one of the most prominent academic critics of administration and Fed policy over the past several years, grapples with the label "anti-Keynesian" that was pinned on him by The EconomistHe writes:
In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view. 
"Keynesian" means different things to different people - at its broadest, it means accepting that there are frictions in the economy which mean that aggregate demand matters and policy can have real effects.  This is in contrast to the pure classical view, in which Say's law holds, demand is irrelevant, and output depends on technology and preferences.  In the version of Keynesian economics in our undergraduate textbooks - the IS-LM/AS-AD framework - the frictions are nominal rigidities and the Keynesian model deals with "short run" fluctuations around a "long run" equilibrium determined by the classical model.  In this setting, both monetary and fiscal policy matter (by shifting the LM and IS curves, respectively), though early Keynesians emphasized fiscal policy and "monetarists" (most prominently Milton Friedman), gave primacy to monetary policy.  The version of Keynesian economics in our graduate textbooks and academic journals - "New Keynesian" - combines dynamic optimization with sticky prices, and explicitly addresses the lack of "forward looking expectations" in the traditional textbook version.  Furthermore, some argue that both the IS-LM and New Keynesian incarnations really miss the point and gloss over more fundamental irrationality and instability Keynes saw in the capitalist system.

As Taylor describes his views of the economy (and from what I know of his academic work), it seems consistent with mainstream New Keynesian economics (though his version has been less favorable to fiscal policy than some others).   His criticism of recent fiscal and monetary policy grows out of another longstanding conundrum in macroeconomics, "rules versus discretion."  He is not claiming that countercyclical fiscal and monetary policy are fundamentally impossible, which is what I would say is the true "anti-Keynesian" view.  Rather, he is arguing that discretionary policy may do more harm than good, and policy should be based on stable, predictable rules. 

A primary argument for rules is that discretionary "fine tuning" is impractical based on "long and variable" lags associated with (i) recognizing the state of the state of the economy, (ii) designing and implementing a policy and the (iii) the policy's impact reaching the economy.  Often lurking behind this argument is a political philosophy that is skeptical of government (no coincidence that Milton Friedman was the most famous proponent of rules - Brad DeLong recently argued this is how he resolved the contradiction between an economics that said monetary policy can be effective with a libertarian political philosophy).

Taylor is careful to say that he opposes "discretionary Keynesian policy" - I think "anti-discretion" might be a better characterization of his critique than "anti-Keynesian."  Of course, that only matters if it is possible to be "anti-discretion" without being "anti-Keynesian."  I think it is.

I don't share the political philosophy, but the experience of the last several years has underscored the practical difficulties of discretionary policy.  The early-2009 Obama administration with large congressional majority is about as close to government by center-left mainstream Keynesian technocrats as the American political system is likely to ever give us.  In retrospect, it is clear they misjudged the scope and duration of the downturn and were not able make adjustments as that became apparent.

Monday morning quarterbacking in April, I suggested that the stimulus should have been designed in a "state-contingent" fashion to remain in place until the recovery reached certain benchmarks.  It is a small step from there to a "rules based" countercyclical fiscal policy - policies like aid to state governments, extended unemployment benefits, payroll tax cuts and even increased infrastructure spending could be designed to kick in and ramp down automatically based on the state of the economy (e.g., with triggers based on the unemployment rate).   To me, that's very "Keynesian", but also "rules-based", and its easy to imagine that might have worked better than the actual policies that were put in place. 

Tuesday, July 19, 2011

Practical Lessons in Keynesian Economic Policy

Ezra Klein writes:
Keynes — and others who later elaborated on his work, like Hyman Minsky — taught us that although markets are usually self-correcting, they occasionally enter destructive feedback loops in which a shock to, say, the financial system scares business and consumers so badly that they hoard money, which worsens the damage to the system, which further persuades other economic players to hoard, and so on and so forth.

In that situation, the role of the government is to break the cycle. Because businesses and consumers have stopped spending, the government breaks the cycle by spending. As clean as that theory is, it turned out to be a hard sell.

The first problem was conceptual. What Keynes told us to do simply feels wrong to people. “The central irony of financial crises is that they’re caused by too much borrowing, too much confidence and too much spending, and they’re solved by more confidence, more borrowing and more spending,” Summers says.

The second problem was practical. “What I didn’t appreciate was the extent to which we only got one shot on stimulus,” Romer says. “In my mind, we got $800 billion, and surely, if the recession turned out to be worse than we were predicting, we could go back and ask for more. What I failed to anticipate was that in the scenario that we found we needed more, people would be saying that what was happening showed that stimulus, in general, didn’t work.”
Many of us economists believe Keynesian policies have been successful, and that more would have been better, but politics doesn't judge outcomes relative to a counter-factual scenario.  That is, the argument that things would have been far worse in the absence of a policy isn't a winner, even if it is correct.  Unfortunately, that means future policy makers are likely to draw exactly the wrong lessons, and do even worse next time (at least on the fiscal side; central bank independence gives monetary policy some space to follow academic rather than political views).

Furthermore, as Paul Krugman explains, the economics profession (or at least some parts of it) isn't playing an entirely helpful role.

Friday, July 1, 2011

Orzag for State-Contingent Stimulus

In a column for Bloomberg, former CBO chief and White House budget director Peter Orszag writes:
...[P]olicy makers should provide additional macroeconomic support in 2012 by extending the existing payroll tax holiday. But more than that, Congress should link the payroll tax to the unemployment rate. This would allow the tax holiday to automatically calibrate itself to existing conditions, providing support only when the economy is weak. If necessary, the underlying payroll tax rate could be raised to make this mechanism budget-neutral. 
As I said back in April, one of the main lessons I've drawn from recent experience is that the recovery act would have been much better if the support for the economy had been made state-contingent like this.  This is a way of overcoming two problems: (i) uncertainty about the speed of recovery (or lack thereof) and (ii) the political system's utter inability to deal with timing issues (nicely explained in Orszag's piece), as evidenced by the absurdity that it appears that we are heading for significant fiscal tightening even as nearly 14 million people remain unemployed.

Wednesday, April 27, 2011


Another round of Monday morning quarterbacking of the Obama administration's initial fiscal policy drive, which led to the $800bn "stimulus" (the American Recovery and Reinvestment Act - ARRA) in February 2009...

One criticism, made Paul Krugman and many others, is that it simply wasn't big enough - in retrospect, it looks like a field goal when we really needed a touchdown.

A natural villain is Larry Summers, in this case because he prevented Christina Romer's case for a bigger program from getting to the president (this doesn't look so funny now).  New York Magazine's Krugman profile has Summers' response:
"[T]here is some element of [Krugman] that is like the guy in the bleachers who always demands the fake kick, the triple-reverse, the long bomb, or the big trade."
Summers concedes that a bigger stimulus would have been the optimal policy in 2009. “The Obama administration asked for less than all that it recognized pure macroeconomic analysis would have called for, and it only got 75 cents on the dollar. But political constraints and practical problems with moving spending quickly constrained us. The president’s political advisers felt, and history bears them out on this since the bill only passed by a whisker, that asking for even more would have put rapid passage at risk.”
Ezra Klein suggests we should be asking a different question:
[T]he interesting counterfactual is not “what would have happened if the stimulus had been a bit bigger” but “what would have happened if Barack Obama had been inaugurated a couple of months later?” By June, unemployment was over 9 percent, and the full scope of the emergency was a lot clearer. If that had been the context behind the initial stimulus, I think it’s plausible to think it could’ve turned out very differently. 
His post illustrates one of the problems with discretionary economic policy - the "recognition lag" - that the state of the economy only becomes clear in retrospect, after the data comes in.  This is particularly difficult because, by the time sufficient information to identify trends and turning points is available, the economy may have changed directions again.  In most cases, that's a good argument against "fine tuning" macro policies.  But I think it was plenty clear in February 2009 that there was serious trouble - payroll employment had declined by over 400,000 in each month from September 2008 through January 2009, and the shock of the fall 2008 financial panic was still fresh in the collective consciousness.

What was unclear was the shape the eventual recovery would take. Some of us hoped that the economy would bounce back quickly, as it had from previous severe recessions (e.g., in 1982, unemployment peaked at 10.8%, but the recovery was brisk; real GDP grew 4.5% in 1983 and 7.2% in 1984).  However, the 1990-91 and 2001 recessions, which were much milder, had been followed by sluggish "jobless recoveries."  Moreover, as Reinhardt and Rogoff showed, the typical historical pattern is that recoveries in the wake of financial crises are very slow.

Therefore, looking back, in my capacity as another "guy in the bleachers," the main flaw I see is that the stimulus should have been state contingent.  That is, the aid to states and many other spending provisions, as well as tax cuts, could have been designed to stay in place as long as they were needed.  The act could have contained a trigger to phase out after some recovery benchmark had been achieved, e.g., after the unemployment rate has been below 7% for six months, the stimulus steps down by 50%, with the rest coming off after 6.5% or less unemployment is maintained for a period.  Some parts of it could have been tied to state, rather than national, conditions.  That might have spared us the ugly spectacle of severe cuts in state services, even as unemployment remains at an appallingly high level.  Moreover, knowing that the fiscal support would be in place as long as needed might have served to create more confidence in the recovery, leading to a stronger improvement in private activity.  (The natural counter-argument is that such an open-ended fiscal commitment would undermine confidence in the government's ability to handle its debt burden, but I don't think it would have been a problem).

I don't recall the idea of a state-contingent stimulus being raised anywhere at the time, and I have no idea whether it would have been politically feasible or not.  Arguably, its just an amplification of the "automatic stabilizers" already built in to the system.  Hopefully, there is no next time, but when it comes, perhaps we should give this aspect of the design of policy some further thought.

The Economist's Ryan Avent has another question:
[W]hat if Congress had failed to pass a stimulus at all? Would the Fed have acted sooner or more aggressively or both, and how might recovery have gone differently?
Which reminds me of the other thing the administration should have done differently (and this one is harder to explain) - they have allowed several seats on the Federal Reserve Board to remain unfilled for long periods.  I agree with Avent that "QE2" appears to have worked.  A different Board might have done more of it, sooner, and for longer, and that would have been better. On this point, Brad DeLong is yelling from the bleachers.

Tuesday, April 12, 2011

Two Notes on the Continuing Resolution

From the appropriations committee summary of the continuing resolution (i.e, the budget deal):
The legislation also eliminates four Administration “Czars,” including the “Health Care Czar,” the “Climate Change Czar,” the “Car Czar,” and the “Urban Affairs Czar.”
Anastasia screamed in vain.

For the Department of Transportation, the bill eliminates new funding for High Speed Rail and rescinds $400 million in previous year funds, for a total reduction of $2.9 billion from fiscal year 2010 levels.   
I didn't realize it was possible to throw trains under the bus.

Petty and shortsighted.

Saturday, April 9, 2011

Macroeconomic Impact of the Budget Deal: Very Quick Estimate

In the e-mail age, there aren't as many envelopes lying around to do calculations on the back of, but I've nonetheless managed to do some rough figurin':

Last night's deal on the budget cuts $37.8 billion in spending.  I haven't seen the exact composition yet, but most of it is presumably "domestic discretionary spending" - i.e., the stuff that counts as government purchases in the national income accounts.

Generally we do our macroeconomic calculations at 'annual rates', and since there is about six months left in the fiscal year covered by the budget (i.e., the government budgets start in October), the cut is $75.6 billion at an annual rate.  The most recent GDP estimate is an annual rate of $14,871 billion for the fourth quarter of 2010, so lets call it $15,350 billion for the second third quarters of 2011 (based on roughly 5% nominal GDP growth, consistent with FOMC members' forecasts); that implies the cuts are 0.5% of GDP at an annual rate.

If we put the multiplier at 1.75, which is the midpoint of the CBO's range of estimates, the cuts reduce GDP by 0.875% at an annual rate.  The rule of thumb known as Okun's law says that, for every percentage point less of GDP growth, the unemployment rate increases half a percentage point.  So, over the course of a year, that would put unemployment at 0.4375 higher.  Since this is over six months, we're talking about an 0.22 point increase in the unemployment rate.  On a labor force of 153.4 million, that translates to a loss of 337,500 jobs.

Like Ezra Klein says, 2011 is not 1995:
Right now, the economy is weak. Giving into austerity will weaken it further, or at least delay recovery for longer. And if Obama does not get a recovery, then he will not be a successful president, no matter how hard he works to claim Boehner’s successes as his own. Clinton’s speeches were persuasive because the labor market did a lot of his talking for him. But when unemployment is stuck at eight percent, there’s no such thing as a great communicator.
A more conservative multiplier estimate of 1 implies a job loss of about 191,750.

The macroeconomic argument for a positive effect from such a deal would rely on the idea that deficit reduction improves confidence in the future.  In particular, if the government's future borrowing needs are reduced, there would be less "crowding out" of investment, and if future taxes are reduced, then lifetime disposable income has increased, which would generate higher consumption today.  I don't think either of those are relevant to a short-term budget deal when there is significant slack in the economy.  However, since many Americans seem to erroneously believe that government spending is hurting the economy, perhaps they will also think this is good for it.  Confidence, even for the wrong reasons, matters...

Not much has been said about the composition of the cuts, but I suspect they will be uglier than people realize.  While $38 billion sounds small relative to some of the numbers that get thrown around in budget discussions, it is quite significant relative to "nondefense discretionary spending" - i.e., what people usually think of as "the federal government" (see this previous post).

Update (4/14): Maybe not so bad.  It appears that the actual cuts are significantly smaller - apparently a significant portion of the $38.5 billion in "budget authority" being cut is money that probably wouldn't have been spent this year anyway.

Friday, March 4, 2011

Scientists vs Engineers?

The House Republicans' plan to cut federal spending by $61 billion for the remainder of the fiscal year (i.e., the period between now and the end of October) will be a drag on the economy and reduce employment, according to both Goldman Sachs and Moody's Mark Zandi, who says:
The House Republicans’ proposal would reduce 2011 real GDP growth by 0.5% and 2012 growth by 0.2 percentage points This would mean some 400,000 fewer jobs created by the end of 2011 and 700,000 fewer jobs by the end of 2012.
This shouldn't come to a surprise to macroeconomics students, who know that a decrease in government purchases reduces aggregate demand and - outside of the special "classical" case of vertical aggregate supply - output.

John Taylor disagrees, however.  Ezra Klein explains:
Mark Zandi says the GOP's proposed spending cuts will cost about 700,000 jobs. John Taylor says they will "increase economic growth and employment." Both are respected economists who immerse themselves in data, research and theory. So how can they disagree so sharply?

The dispute comes down to how much weight you give to "expectations" about future deficits. Taylor's argument is that Zandi's model -- which you can read more about here -- doesn't account for the upside of deficit reduction -- namely, that when the government spends less, the private sector will spend more. Taylor thinks individuals and businesses are hoarding their money because they're afraid of the high taxes, sharp spending cuts and assorted other nastiness that deficit reduction will eventually require. "The high unemployment we are experiencing now is due to low private investment rather than low government spending," he writes. "By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment."
A similar disagreement is playing out over monetary policy.  In a recent NY Times column, Christina Romer wrote:
The debate is between what I would describe as empiricists and theorists.

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal.

Though there is much debate about what level of unemployment is now normal, virtually no one doubts that at 9 percent, unemployment is well above it. With core inflation running at less than 1 percent, empiricists are therefore relatively unconcerned about inflation in the current environment.

Theorists, on the other hand, emphasize economic models that assume people are highly rational in forming expectations of future inflation. In these models, Fed actions that call its commitment to low inflation into question can cause inflation expectations to spike, leading to actual increases in prices and wages. 
She sides with the "empiricists" and argues that the influence of the "theorists" has held the Fed back from taking bolder, more effective action.  Stephen Williamson begs to differ:
Romer says some things about economic history in her piece, but of course she is very selective, and seems to want to ignore the period in US economic history and in macroeconomic thought that runs from about 1968 to 1985. Let's review that. (i) Samuelson/Solow and others think that the Phillips curve is a structural relationship - a stable relationship between unemployment and inflation that represents a policy choice for the Fed. (ii) Friedman (in words) says that this is not so. There is no long-run tradeoff between unemployment and inflation. It is possible to have high inflation and high unemployment. (iii) Macroeconomic events play out in a way consistent with what Friedman stated. We have high inflation and high unemployment. (iv) Lucas writes down a theory that makes rigorous what Friedman said. There are parts of the theory that we don't like so much now, but Lucas's work sets off a methodological revolution that changes how we do macroeconomics. 
The divides between Goldman/Zandi and Taylor over fiscal policy and between Romer and Williamson over monetary policy both reminded me of Greg Mankiw's distinction between "scientific" and "engineering" macroeconomics. The models used by the "engineers" - the people in Washington and on Wall Street who need to make practical, quantitative assessments of the impact of policy alternatives on the economy - are more elaborate versions of the "textbook" Keynesian IS-LM aggregate supply and demand framework that most of us (still) teach our macroeconomics students.  As Williamson points out, the models used by academics - Mankiw's "scientists" - in our research are fundamentally different.

The engineering models are built on relationships among aggregate macroeconomic variables like the Phillips curve, which relates inflation and unemployment, and the consumption function, which connects consumption and disposable income.  As Williamson alludes to, Robert Lucas and others won a methodological war in the profession (or at least the academic branch of it) in the 1970s and 1980s.  The result of their victory is that the macroeconomic models published in leading journals today are expected to be grounded in the optimizing, forward-looking behavior of rational individuals.

Such individuals might believe, for example, a reduction in government spending today implies that their future taxes will be lower (because the government will be servicing a smaller debt burden).  The resulting increase in their lifetime disposable income means that they will immediately increase their consumption.  So any negative impact of a cut in government purchases is offset by an increase in consumption.  Rational, forward-looking optimizers might also recognize that any monetary expansion will erode their real wages and demand an offsetting increase in nominal wages.  This means that employment will remain unchanged (because the real cost to the firms of a worker is the same) even as inflation rises.

At its most extreme, the assumption of dynamic optimization under rational expectations was once believed to imply the Lucas-Sargent "Policy Ineffectiveness" proposition, which Bennett McCallum explained in a 1980 Challenge article:
Macroeconomic policies - sustained patterns of action or reaction - will have no influence because they are perceived and taken into account by private decision-making agents. Thus, the adoption of a policy to maintain "full employment" will not, according to the present argument, result in values of the unemployment rate that are smaller (or less variable) on average than those that would be experienced in the absence of such a policy.
Of course, in a world of rationally optimizing people, where prices adjust to clear markets, it is hard to explain how we could get to such large deviations from the natural rate of unemployment in the first place...

More generally, while macroeconomic science has continued on the methodological path established by Lucas, many of its practitioners have worked to re-incorporate real effects of monetary policy.  This is a large part of the "New Keynesian" project, which is arguably now the reigning paradigm and best hope for reuniting "science" and "engineering" (and arguably is as much "monetarist" as it is "Keynesian").

Fiscal policy has received less attention - the implausibility of managing aggregate demand through the slow, cumbersome and messy budget process means that, in general, the focus has been on the Fed.

That has started to change as the global slump has pushed conventional monetary policy to its limits (and beyond into unknown worlds of unconventional policy), and governments around the world have made fitful attempts at fiscal policy.  For example, recent papers by Christiano, Eichenbaum and Rebelo, Gauti Eggertson and Michael Woodford have shown that it is possible for fiscal policy to have significant multiplier effects when monetary policy is at the zero lower bound (as it is today) in New Keynesian models.

So, while, at a superficial level, it appears that the split between "scientists" and "engineers" persists, some of the "scientific" work being done today is finding that the remedies proposed by the "engineers" are not wholly inconsistent with forward-looking rational behavior after all.

Saturday, February 12, 2011

The Big Squeeze on Little G

When I introduce the GDP figures to my macroeconomics students, I point out that the federal government accounts for a much smaller portion of the economy than many believe.  Federal government purchases - i.e., the federal part of G in the national income accounts - was 8.3% of GDP in 2010, and more than two-thirds of that was military spending.  The federal nondefense part - all the stuff that we think of as "the federal government" like the FBI, NASA, the State Dept. and so on - was a mere 2.7% of GDP.

One reason that people think that the federal government is larger is that federal spending was $3.7 trillion last year, which would be 26.5% of GDP.  But most of that is transfer payments - money sent to people (and, to a lesser extent, state governments).  Mainly, this is social security and medicare.  In the national income accounts, most transfers end up in the "C" (consumption) component of GDP when the recipients spend the money.

The chart below, from BEA data, illustrates that nondefense federal government purchases are only about 10% of federal spending.
That is, the turquoise pie slice is $396.6 out of $3890.6 billion.

So when zealous congressional republicans say that they are going to cut our "big government" by $100 billion*, the consequences are quite severe because the cuts almost entirely come out of that small slice.  This analysis by the Center on Budget and Policy Priorities provides some of the bloody details, including cuts of 12.7% in Labor, Health and Human Services and Education, 14.5% in Interior and Environment and 26.1% in Transportation and Housing and Urban Development.

*It depends on how you measure it; as the CBPP analysis explains, the "$100 billion" figure is relative to the president's proposal and is for an entire fiscal year (which runs from October through September), while the cuts are for the remainder of fiscal 2011.

The CBPP analysis comes to my attention via the invaluable Ezra Klein.

Update: Paul Krugman has more. 
Update #2: So does Bruce Bartlett.

Wednesday, January 26, 2011


A couple of thoughts on the "State of the Union" -

As an economist, I don't find the rhetoric of "competitiveness" very appealing (see Paul Krugman's classic on this).  International trade is mutually beneficial* - not a zero sum struggle to beat other countries to the "good jobs."  From an economist's point of view, the rapid growth in China is a great story about an dramatic increase in human welfare.  However, while competitiveness rhetoric can be used to justify bad policies like subsidies and tariffs, Obama is employing it to promote policies like investment in infrastructure, basic research and education that are beneficial regardless of what is going on in other countries.  Though it is a mistake to feel threatened by the success of other countries, Obama seems to be exploiting this sentiment to embarrass us into getting our act together, which isn't entirely a bad thing.  He's like our national "Tiger mother."

Unfortunately, President Obama appears to have conceded the rhetorical war on two important fronts: global warming and the budget deficit.

On global warming, which is the most important policy issue we face, the President chose not to even mention it directly.  So much for having "adult conversations" in our politics...  Even if the towel has been thrown in on cap-and-trade, the administration does appear to be trying to confront the problem, sotto voce, in other, less efficient ways.  At least, that is how I interpret the call that 80% of energy should come from "clean sources" by 2035.

As for the deficit, the idea that the government is like a family that needs to "tighten its belt" seems to have won out.  That's simple, intuitive and wrong.  The basic principle of countercyclical fiscal policy - that when households are cutting back, government needs to step in and make up for it with offsetting spending increases or tax cuts - also seems simple and intuitive.  But apparently not enough so.  President Obama is a very good speech-maker, but has proven not to be enough of a great communicator to get the public thinking correctly about this.

It looks like we'll get some "cuts" and "freezes."  These may manage to be a drag on the recovery and damage some important government functions without making much of a dent in the real long run problem because domestic discretionary spending is a fairly small part of the overall budget (as Howard Gleckman says: "that makes Obama the anti-Willie Sutton. He is going whether the money isn’t").  It seems that we're done with counter-cyclical fiscal policy and its all up to the Fed now.  With 14.5 million still unemployed, that is a mistake, and a real shame.  While I hope (and believe) the President is correct in presuming the recovery will continue, it still could benefit from a fiscal push.

See also: Paul Krugman, Mark Thoma and Ezra Klein.

*There are number of possible caveats on that, including that while a country as a whole benefits, some within it are hurt (Stolper-Samuelson theorem) and that a trade deficit can reduce aggregate demand which is bad for employment in the short-run.

Wednesday, December 8, 2010

Stimulus III: Return of the EGTRRA

Not surprisingly, our political discourse has a hard time wrapping its head around the fiscal policy conundrum that we currently face, which is that we need more stimulus (bigger deficits) now, but long-run budget projections imply that we need to make future deficits smaller, because we are likely to still have a deficit when the economy returns to full employment and it may balloon further in the future mainly because of rising healthcare costs.

There is a valid concern that, when the economy recovers, the federal government's large borrowing needs could "crowd out" investment.  While there is absolutely no evidence that this is a problem now or in the immediate future (as evidenced by continued low Treasury yields), the scheduled reversion of the tax code to the status quo ante-Bushum does create a unique opportunity to deal with the long run problem.

As it happens, the projected level of revenue if the tax cuts expire looks close to about right in the long run (see the "extended baseline" in the CBO's long-run outlook).  While the Clinton-era tax code isn't ideal in terms of equity or efficiency, clearly we didn't do too badly when it was in effect.  The beauty of "current law" is that it makes Washington's natural tendency towards gridlock work for, rather than against, a solution.  All we need is for any of (i) congress to not agree, (ii) a Senate filibuster not to be overcome, or (iii) the president not to sign, and our deficit problem is largely solved.

If unemployment wasn't 9.8%, I might therefore be in the "let them expire" camp (even the "middle class" parts), but, as things stand, the economy urgently needs more fiscal policy support now.  A tax increase is the exact opposite of what we need in the short run.

Before this week's deal between the administration and Republican leadership, my preferred outcomes, in order of preference, would have been:
  1. The expiration of the tax cuts is used to force a tax reform that simplifies the tax code and eliminates tax expenditures (i.e., closes loopholes).  This broadening of the tax base could raise revenue, and maintain progressivity (since it is high incomes that benefit most from loopholes), while keeping marginal rates low.  The Bowles-Simpson proposal did move in this direction - on progressivity, it landed between the Clinton and Bush tax codes (according to the TPC) - but it had an arbitrary cap on revenue at a too-low level.  At full employment, the ideal reform would be revenue neutral compared to a "current law" baseline (i.e., it would bring in the same revenues as the Clinton tax code over the long-run).  The short-run negative effect of the resulting tax increase would be offset (and thensome) with explicitly temporary fiscal stimulus, perhaps with a built-in trigger mechanism to unwind it automatically as the economy recovers, which would serve to minimize the inevitable push for extensions.
  2. The tax cuts are allowed to expire, reverting to the Clinton-era tax code, but accompanied by the same type of stimulus described above.
  3. The original Obama-Democratic policy of making the "middle class" tax cuts permanent while reinstating the Clinton-era rates for income above $250K.  Raising taxes on the rich is anti-stimulative, but not very (the multiplier is low), so the long-run deficit reducing benefit outweighs the short-term cyclical cost.
  4. The whole thing expires (which may still happen - its not clear the deal will get through Congress), which solves our long run problem, but leaves us hoping even more fervently that Fed gets enough traction to keep the recovery going, even as the tax increase makes the headwinds stronger.
  5. The preferred Republican policy of making all the tax cuts permanent, which has the virtue of not making things worse in the short run, but will eventually lead us back to the low-investment economy of the late 1980's and have us talking about cutting social security and medicare.
I'd put this week's deal somewhere between #2 and #3, and given that #3, 4 and 5 seemed to be what was realistically on the table, I can't be too disappointed (even if I sympathize with the widespread concern that President Obama's poker skills seem to have mysteriously diminished).  One concern is that extending the Bush tax cuts entrenches them further and increases the risk that they become one of those features like the alternative minimum tax "patch" that we expect to be perenially "fixed." But the two-year extension does leave open the possibility of something like #1 or #2 happening in 2012, and at least we haven't decisively dug the long-term hole deeper as #5 (and, to be honest, #3) would.  We have also averted the short-run damage that would result from #4 (and to a much lesser extent, #3).  Not only have we avoided that anti-stimulus, but the deal includes other demand-enhancing provisions, like the one-year payroll tax cut (which replaces the expiring "making work pay" credit from the 2009 stimulus bill, but is bigger, though less progressive).

David Leonhardt calls it a "second stimulus" (third, if you count the spring 2008 tax rebate).  The Center for American Progress applied existing multiplier estimates to the deal's provisions to estimate that it would increase employment by about 2.2 million (relative to unemployment of 15 million). Macroeconomic Advisors estimates a GDP growth bump of 0.5-0.75 percentage points.  (Both of these come to my attention via the invaluable Ezra Klein).

Of course, it would be better still if the unemployment insurance extension was for two years (even if the recovery gathers steam, there will still be many people unemployed in 2012), and included something for the "'99ers" who have hit the 99-week limit on benefits (recall that the recession began at the end of 2007).  They also should have raised the debt ceiling, so it doesn't become the next "hostage".  One might hope the outrage of Congressional Democrats gives them some leverage to make improvements (indeed, if the Democrats were an organized political party, I might think there was a clever "good cop, bad cop" routine being employed here).

Note: the title of the post refers to the official name of the 2001 tax cut, the Economic Growth and Tax Relief Reconciliation Act.

Tuesday, December 7, 2010

Barack Obama's Time Consistency Problem?

When I explain the time-consistency problem to my students, I begin by asking them what the stated position of the government is about negotiating with hostage takers.  They know, of course, that the official line is that the government will not negotiate.

The reason why governments always say they will not negotiate with hostage takers is that, if they won't negotiate, there is no incentive to take them in the first place.  But, once hostages have been taken, the government has a strong incentive to negotiate because they don't want to be responsible for the hostages getting killed.  And the problem is that the would-be hostage takers understand this, and therefore do not believe the government will follow its announced policy of not negotiating.

That example may not work next semester, if my future students saw President Obama's press conference:

I’ve said before that I felt that the middle-class tax cuts were being held hostage to the high-end tax cuts.  I think it’s tempting not to negotiate with hostage-takers, unless the hostage gets harmed.  Then people will question the wisdom of that strategy.  In this case, the hostage was the American people and I was not willing to see them get harmed.  
One of the implications of the time consistency problem is that a better outcome would be achieved if the government didn't have discretion to negotiate with the hostage takers.  In the real world, no perfect "commitment technology" exists so, in practice, we think about "credibility".  That is, how can the government behave so that the prospective hostage takers believe the authorities really mean it when they say they won't negotiate?

So, the question is: did President Obama diminish his credibility, thereby increasing the likelihood of future political "hostage" situations, or did he just say what everyone already knows?  And was the Republican threat credible to kill the hostages let the tax code revert to its 2000 levels if the tax cut extension for incomes over $250,000 wasn't included?  (John Boehner's slip in September notwithstanding).

For background on time consistency and more examples, see Greg Mankiw, this speech by Charles Plosser, and the Nobel Prize information about Kydland and Prescott