Spending and the Great Depression

The stimulus debate has revealed some misunderstanding about the Great Depression, e.g.:

When Roosevelt did this, he put our country into a Great Depression. ... He tried to borrow and spend, he tried to use the Keynesian approach, and our country ended up in a Great Depression. That's just history. - US Rep. Steve Austria (R-OH)

A timely, useful corrective is supplied by Washington Post's Steven Mufson, who asked some economists:

But most mainstream economists say the lessons of the Depression, which didn't end until World War II spending kicked in, are different. They say New Deal spending programs instituted by President Franklin D. Roosevelt -- combined with moves to bolster the banking system, loosen monetary policy and end the gold standard -- did help put millions of people back to work. At the same time, they say that federal spending increases under Roosevelt before the war were modest compared with the size of the economy, and not a good test of stimulus spending.

Update (2/13): Bruce Bartlett offers an economically and historically literate conservative's interpretation of the lessons of the New Deal.

DeLong on "The Keynesian Escape Route"

It is a sad irony that some of the most shrill and ignorant critics of the fiscal stimulus bill seem to think it represents some kind of creeping Communism. It was such Keynesian policies that preserved the capitalist system from the more extreme alternatives that seemed to be on the march in the interwar period. In "Economic Possibilities for our Grandchildren" (1930) Keynes wrote:

I predict that both of the two opposed errors of pessimism which now make so much noise in the world will be proved wrong in our own time‑the pessimism of the revolutionaries who think that things are so bad that nothing can save us but violent change, and the pessimism of the reactionaries who consider the balance of our economic and social life so precarious that we must risk no experiments.

Brad DeLong explains how Keynesian policies helped prove their pessimism wrong:

The end in the Great Depression of laissez faire--the idea that the government should keep its hands off of the economy--as a doctrine for guiding economic policy did not mean the end of the market economy as a social resource allocation mechanism. "Keynesianism" and the doctrine of the "mixed economy" that it supported emerged in the nick of time, soon became the ruling ideologies in the industrial core of the world economy, and provided North America and western Europe with a Keynesian escape route from what had seemed the insoluble crises of the interwar period.

The Keynesian escape route opened up key ground in the middle between fascist-style regimentation and socialist-style national planning. Keynes argued that the market economy and capitalist order could be salvaged, and salvaged by relatively minor reforms. An activist welfare-state government with a commitment to full employment had the tools to eliminate Great Depressions, and could put economies back onto the road to Utopia. If only governments would reduce interest rates to get private agents or would themselves spend money freely (without raising taxes) in times when total demand was low, and raise interest rates to reduce private spending and themselves raise taxes (without raising spending) in times when total demand was high, then fiuctuations in employment and production could be greatly reduced, and Great Depressions avoided.

Belief in this escape route was strongly reinforced by facts. Those countries that had tried it by accident during the Depression--had infiated early, printed money, ensured low interest rates, and run large budget deficits--managed to survive the Depression much more easily than others. World War II provided final proof, were any necessary--"vindication by Mars," as John Kenneth Galbraith calls it. That component of unemployment, called "structural" or "permanent" during the 1930s, that was seemingly-immune to both the self-adjusting forces of the market and the armament of the New Deal vanished entirely in the 1940s as the federal budget deficit approached and then exceeded the levels that had long been recommended by John Maynard Keynes. And the United States fought World War II without reducing civilian consumption: all of U.S. war production came from new capacity or from capacity that stood idle at the end of the 1930s.

Demand expansion--deliberate attempts by governments to put the unemployed back to work by deficit spending and loose-money low interest rate policies--was successful in the 1930s and 1940s. It put the unemployed back to work. It did not contain within itself the seeds of a renewed Great Depression. It did not explode into hyperinflation. The coming of "stablization policy" enlarged the policy steps that could be undertaken without forcing a definitive break with the market-capitalist order, and without forcing a choice between Hitler's way and Stalin's.

New Banks?

The Obama administration is due to announce tomorrow what it will do with the second half of the the $700 bn financial sector rescue pot (a.k.a. the TARP). Rather than continuing to put more money into our troubled banks, Paul Romer and Willem Buiter argue for starting new ones. Romer says:

The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage. Right out of the gate, the newly created banks could do what the Fed has already been doing -- buying pools of loans originated by existing banks that meet high underwriting standards.

And:

The brewing backlash against the existing players from the financial sector is almost certain to burn hotter as the recession wears on, and new election campaigns get underway. If the new administration ties its fate to the existing players, it could lose its room to maneuver on countercyclical policy and be put under political pressure to intervene in bank decisions in ever more intrusive ways.

Because they can and will borrow, new banks will be much more effective in leveraging TARP funds. They will undertake more total lending, bring more trading to financial markets, and do more to limit the depth of the recession. As a result, investing the TARP funds in new banks will do more to help the troubled but potentially viable existing banks than giving funds directly to them.

Banks that are not viable, the ones with liabilities that substantially exceed their assets, will lobby vociferously against a return to historical patterns of bank regulation. They will say anything to postpone a looming FDIC takeover. The administration should not listen to threats and pleas from these doomed banks. It does not have to rely on them to get new lending going quickly and on a large scale. New entrants could give us a few good banks. That, plus an FDIC that can do its job, is all we need.

Update: A counterargument from Felix Salmon.

Earth to Senate

Headlines on the Washington Post website this morning:

and The Times reports on the unemployment numbers:

It was the biggest monthly job loss since the economy tipped into a recession more than a year ago, and it was even worse than most forecasters had been predicting.

In addition, the government revised the estimates for previous months to include another 400,000 job losses. For December, the government revised the job loss to 577,000 compared with an initial reading of 524,000. Over all, it said, the nation has lost 3.6 million jobs since it slipped into a recession in December 2007.

“Businesses are panicked and fighting for survival and slashing their payrolls,” said Mark Zandi, chief economist at Moody’s Economy.com. “I think we’re trapped in a very adverse, self-reinforcing cycle. The downturn is intensifying, and likely to intensify further unless policy makers respond aggressively.”

The Senate moderates, the folks who pride themselves on being the "sensible center" don't get it (and others really, really don't get it). Steven Pearlstein says the congressfolk need to hire personal economic trainers. As evidence, he provides a litany of economic stupidity from the stimulus debate, including:

"This is not a stimulus plan, it's a spending plan," Nebraska's freshman senator, Mike Johanns (R), said Wednesday in a maiden floor speech full of budget-balancing orthodoxy that would have made Herbert Hoover proud. The stimulus bill, he declared, "won't create the promised jobs. It won't activate our economy."

Johanns was too busy yesterday to explain this radical departure from standard theory and practice. Where does the senator think the $800 billion will go? Down a rabbit hole? Even if the entire sum were to be stolen by federal employees and spent entirely on fast cars, fancy homes, gambling junkets and fancy clothes, it would still be an $800 billion increase in the demand for goods and services -- a pretty good working definition for economic stimulus. The only question is whether spending it on other things would create more long-term value, which it almost certainly would.

Update: See Nick Kristof on one target of the moderates' misplaced "fiscal responsibility" - funding to help prevent state education cuts.

Update #2 (2/8):

Paul Krugman: That bill is our last hope.

Stan Collender: No, there is another.

The Rebate in Retrospect

One argument against the tax cut provisions in the stimulus bill under consideration in the Senate is that the last one - the spring 2008 tax rebate - was not followed by a significant increase in consumer spending. The right question, however, is how did the rebates affect spending compared to what would have happened in their absence. That is, relative to what we call the "counterfactual" scenario, which is unknown, though we can try to estimate it.

The Times' David Leonhardt revisits the issue, and finds some evidence that it was more effective than many think:

For one thing, growth in consumer spending was falling throughout 2007 and 2008. In 2007, it fell sharply between the first and second quarters, was flat from the second to the third, fell from the third to the fourth and then fell again from the fourth quarter of 2007 to the first quarter of 2008. It then rose, albeit not by much, in the second quarter — before plummeting, with a decline of 3.8 percent, in the third quarter. Those numbers seem to suggest that spending would not have risen 1.2 percent in the second quarter without the rebate.

The most compelling evidence, though, comes from a chart that we ran in The Times today. It separates consumer spending by those households below the 95th percentile of the income distribution from spending by those in the top 5 percent. Households in the bottom group generally received the rebate. Households in the top group generally did not.

Guess what? Spending by the bottom group spiked in the second quarter. Were it not for a big pullback by the top group, overall spending growth would have been much higher.

Speaking of the stimulus, President Obama makes his case in a Washington Post op-ed.

Knightian Uncertainty

One useful consequence of the financial crisis has been the revival of the concept of "Knightian Uncertainty." In a guest column for the Economist, Olivier Blanchard puts it thus:

What is at work is not only objective, but also subjective uncertainty, or what economists, following Chicago economist Frank Knight’s early 20th-century work, call “Knightian uncertainty”. Objective uncertainty is about what Donald Rumsfeld (in a different context) referred to as the “known unknowns”. Subjective uncertainty is about the “unknown unknowns”. When, as today, the unknown unknowns dominate, and the economic environment is so complex as to appear nearly incomprehensible, the result is extreme prudence, if not outright paralysis, on the part of investors, consumers and firms. And this behaviour, in turn, feeds the crisis.

He goes on to discuss the implications for economic policy, but the implications for economics itself are just as interesting. In a forum on Blanchard's column at Free Exchange, the Economist's Delhi correspondent writes:

Economists do not, in fact, follow Knight’s work very much. The discipline shys away from his concept of uncertainty (as distinct from risk), because it is, by definition, so hard to model. If economists could model it, then so could firms and investors. The future would be calculable, if not knowable, and there would be less excuse for bewildered inaction.

Paul Samuelson once went so far as to argue that economics must surrender its pretensions to science if it cannot assume the economy is “ergodic”, which is a fancy way of saying that Fortune’s wheel will spin tomorrow much as it did today (and that tomorrow's turn of the wheel is independent of today's). To relax that assumption, Mr Samuelson has argued, is to take the subject “out of the realm of science into the realm of genuine history”.

The scientific pose has great appeal. But this crisis is reminding us again of its intellectual costs. Knightian uncertainty may be fiendishly hard to fathom, but ignoring it, as economists tend to do, makes other phenomena devilishly hard to explain. The thirst for liquidity—the sudden surge in the propensity to hoard—is one example. If risks are calculable, then investors will place their bets and roll the dice. Only if they are incalculable will they try to take their chips off the table altogether, in a desperate scramble for cash (or near-cash). As Keynes put it, “our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.”

Indeed. However, there is an approach known as "robust control" that seems like it could provide a way of incorporating true uncertainty into formal economic models. I haven't read much of this literature, but perhaps it is time to give it a serious look.

Non-Satiation

Brad DeLong revisits "Economic Possibilities for our Grandchildren" -

Nearly eighty years ago, John Maynard Keynes did the math on economic growth and concluded that within a few generations—by the time his peers' great-grandchildren came of age in, say, the 2000's—the persistent economic problem of too-scarce resources and too-few goods would no longer bedevil a substantial portion of humanity. He was right—even in the midst of our current hard times, he is right.

The current recession may turn into a small depression, and may push global living standards down by five percent for one or two or (we hope not) five years, but that does not erase the gulf between those of us in the globe's middle and upper classes and all human existence prior to the Industrial Revolution. We have reached the frontier of mass material comfort—where we have enough food that we are not painfully hungry, enough clothing that we are not shiveringly cold, enough shelter that we are not distressingly wet, even enough entertainment that we are not bored. We—at least those lucky enough to be in the global middle and upper classes who still cluster around the North Atlantic—have lots and lots of stuff. Our machines and factories have given us the power to get more and more stuff by getting more and more stuff—a self-perpetuating cycle of consumption.

Our goods are not only plentiful but cheap. I am a book addict. Yet even I am fighting hard to spend as great a share of my income on books as Adam Smith did in his day. Back on March 9, 1776 Adam Smith's Inquiry into the Nature and Causes of the Wealth of Nations went on sale for the price of 1.8 pounds sterling at a time when the median family made perhaps 30 pounds a year. That one book (admittedly a big book and an expensive one) cost six percent of the median family's annual income. In the United States today, median family income is $50,000 a year and Smith's Wealth of Nations costs $7.95 at Amazon (in the Bantam Classics edition). The 18th Century British family could buy 17 copies of the Wealth of Nations out of its annual income. The American family in 2009 can buy 6,000 copies: a multiplication factor of 350.

Keynes was right about growth, despite predating the Solow growth model by a quarter-century. Some of his speculations about the social and cultural change that would follow in the wake of the end of scarcity have not panned out (so far, at least). DeLong believes we will never run out of things that we want:

Keynes thought that by today we would have reached a realm of plenty where "We shall once more value ends above means and prefer the good to the useful. We shall honour those who can teach us how to pluck the hour and the day virtuously and well, the delightful people who are capable of taking direct enjoyment in things, the lilies of the field who toil not, neither do they spin."

But no dice. I look around, and all I can say is: not yet, not for a long time to come, and perhaps never. I'm convinced that everyone I know can easily imagine how to spend up to three times their current income usefully and productively. (It is only beyond three times your current spending that people judge others' spending as absurd and wasteful.) And everybody I know finds it very difficult to imagine how people can survive on less than one-third of what they spend—never mind that all of our pre-industrial ancestors did so all the time. There is a point at which we say "enough!" to more oat porridge. But all evidence suggests Keynes was wrong: We are simply not built to ever say "enough!" to stuff in general.

In the Times, a while back, Bob Frank came to a similar conclusion.

A Case for the Stimulus

When I was in college, a female classmate once told me I reminded her of George Will. At the time, I took that as a complement, but my capacity for self-deception has since diminished... In any case, some years later, I have indeed landed on a newspaper opinion page. In today's Cincinnati Enquirer, I argue for the fiscal stimulus bill:

The Obama administration's plan, which includes $550 billion in spending and $275 billion in tax cuts, will provide a badly needed "shove" to help get the economy moving in the right direction. Trimming the size of the proposal or shifting the emphasis to tax cuts, as some have called for, would reduce its effectiveness.

The current recession is mainly the result of households cutting back on spending because two important sources of wealth, the value of homes and retirement savings, have taken a big hit. Moreover, in the face of uncertainty and rising unemployment, people have become more cautious about spending. While this behavior makes sense on an individual basis, when everybody is cutting back, the entire economy suffers....

Tax cuts only work to the extent that households spend them. This is why a broad-based reduction in income taxes would not be very effective as stimulus - many households would save the additional money. The main tax provision in the proposal, a credit of $500 for individuals and $1,000 for couples, will be more effective than a rate cut because more of the benefits go to lower- and middle-income households. Many of these families are struggling to meet their everyday needs, which means they are more likely to spend additional disposable income.

The spending elements include investments in transportation infrastructure and schools, improvements to the electricity grid and information technology upgrades for our healthcare system. Some in Washington reflexively attach the word "wasteful" to any government spending, and they have begun to attack the proposal. Those criticisms are irrelevant. For the immediate purpose of boosting economic demand, it doesn't much matter exactly how the money is spent - even "bridges to nowhere" work as fiscal stimulus.

The proposals also include federal grants to state governments, which will be a significant, immediate help. Because most states are limited by their constitutions from borrowing, they are forced to cut back when economic downturns reduce tax revenue. We are seeing this already in Ohio. In the absence of federal help, even more cuts in state services will be necessary.

While we must take seriously the need to reduce the deficit after the recovery takes hold, limiting the size of the stimulus now for the sake of "fiscal responsibility" would be self-defeating and might prolong the recession.

Incidentally, responsibility for the lame headline lies with the editors, not me. They also lopped off this point: "much of the proposed spending addresses longstanding needs and will have economic benefits that outlast the recession."

Fundamental Psychological Laws?

One of the building blocks of the Keynesian economic model is the consumption function, asserted by Keynes:

The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.

This turned out to be one of the weakest parts of the Keynesian edifice, as Modigliani and Brumberg's Life-Cycle Hypothesis and Friedman's Permanent Income Hypothesis showed in the 1950's. However, the modern view that has evolved from Friedman of rational, forward-looking agents choosing their consumption to maximize expected lifetime utility is also a bit hard to swallow.

The truth may lie somewhere in the middle, but exactly how consumption decisions are made has significant implications for the effectiveness of policies like the tax cuts in the fiscal stimulus package. The New Yorker's James Surowiecki reports on the implications of some research in behavioral economics, which is making a more serious go at uncovering the "psychological laws" that govern our behavior. Their findings imply that the stimulus will be more effective if it comes to us in small pieces, he writes:

The permanent-income hypothesis is elegant, but studies have shown that it’s not always an accurate description of the way people decide how to spend and save. A more compelling explanation for why rebates haven’t worked very well is that they have been handed out as lump sums. You might think that handing people a big chunk of change is a perfect way to get them to spend it. But it isn’t, because people don’t treat all windfalls as found money. Instead, in the words of the behavioral economist Richard Thaler, people put different windfalls in different “mental accounts,” which in turn influences what they do with the money...

The key factor in these kinds of distinctions, Thaler’s work suggests, is whether people think of a windfall as wealth or as income. If they think of it as wealth, they’re more likely to save it, and if they think of it as income they’re more likely to spend it. That’s because many people tend to base their spending not on their long-term earning potential or on their assets but on what they think of as their current income, an amount best defined by what’s in their regular paycheck. When that number goes up, so does people’s spending. In Thaler’s words, “People tend to consume from income and leave perceived ‘wealth’ alone.”

So what does this mean for making a rebate work? If you want people to spend the money, you don’t want to give them one big check, because that makes it more likely that they’ll think of it as an increase in their wealth and save it. Instead, you want to give them small amounts over time. And you want the rebate to show up as an increase in people’s take-home pay, because an increase in steady income is more likely to translate into an increase in spending. What can accomplish both of these goals? Reducing people’s withholding payments.

Methodenstreit!

Brad DeLong and Paul Krugman have vigorously criticized some prominent economists - particularly Eugene Fama and John Cochrane - who have offered apparently pre-Keynesian interpretations of the current economic mess. In particular, both seem to suggest that "Say's Law" holds, and therefore, fiscal policy cannot only reallocate - but not increase - output, an argument we thought Keynes had demolished in 1936. Krugman writes:

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

Or, as he said to Mark Thoma, economists who "have spent their entire careers on equilibrium business cycle theory are now discovering that, in effect, they invested their savings with Bernie Madoff." By "equilibrium business cycle theory," he means the modern incarnation of classical economics, where markets clear and economic fluctuations arise from the behavior of rational, optimizing agents. Greg Mankiw offers a more charitable interpretation:

It is funny. I have a similar pedigree as Paul. Both of us have PhDs from MIT, and we learned a lot of our macro there. Both of us see the world through the lens of the Keynesian framework (by which I mean the IS-LM model, etc.) But we have very different perspectives on the equilibrium business cycle theorists.

The difference may reflect our research paths. Most of Paul's research has been in international economics, and throughout his career, he could easily ignore equilibrium business cycle theory. By contrast, I have done a lot of work on "new Keynesian economics," which tries to fix the flaws in the Keynesian model that the equilibrium business cycle theorists pointed out. Perhaps that work has given me more appreciation for their contribution, as well as for the defects in the Keynesian worldview.

Here is DeLong on Fama, and on Cochrane.