Economist's View

Fiscal Policy: "The Right and the Obvious Thing To Do"

Two things seem relatively clear. First, given the projected baseline for the economy, the previous stimulus package was too small. It was big enough to help, but it won't give anything near the boost the economy needs. Second, the original baseline was far too optimistic.

So I agree:

Fiscal Policy: The Obama Administration Is Not Making Much Sense These Days, by Brad DeLong: ...Last December the Obama administration to be decided on a fiscal stimulus package which they believed would have minor effects on the economy in the first two quarters of 2009 and major effects--would push unemployment down below what it would other wise have been by more than half a percentage point--starting in the third quarter of 2009. They believed that the economy was not that weak, and that with the fiscal stimulus package taking effect unemployment would be peaking now at a rate of 7.9%.

Instead, unemployment is now probably in the 9.5-9.7% range--and without the stimulus package it would right now have turned out to be above 10%:

The financial crisis of last fall hit the economy's levels of production, spending, and employment much harder than people thought at the time. If we had known then what we know now, it would have been prudent then to propose twice as large a fiscal stimulus program as the Obama administration in fact did propose. ...

All in all, it looks like the unemployment rate in 2009 is going to average 1.2 percentage points above where the administration last December thought we would be. ...

It is interesting and important to note that the excess unemployment now forecast over 2009 relative to last December's forecast is of the ... magnitude ... of ... a $170 billion shortfall.

If I were running the government, I would be trying to make up that GDP shortfall right now: I would be rushing a clean $170 billion--$500 per citizen--aid-to-states-that-maintain-effort package through the congress this week. It would seem the right and the obvious thing to do.

At least that much, and the sooner the better.

Paul Krugman: The Stimulus Trap

Everybody makes mistakes. But not everyone can admit their mistakes, and then take the steps needed to overcome them:

The Stimulus Trap, by Paul Krugman, Commentary, NY Times: As soon as the Obama administration-in-waiting announced its stimulus plan — this was before Inauguration Day — some of us worried that the plan would prove inadequate. ...

The bad employment report for June made it clear that the stimulus was, indeed, too small. But it also damaged the credibility of the administration’s economic stewardship. There’s now a real risk that President Obama will find himself caught in a political-economic trap.

I’ll talk about that trap, and how he can escape it, in a moment. First, however, let me ... ask how concerned citizens should be reacting to the disappointing economic news. Should we be patient, and give the Obama plan time to work? Should we call for bigger, bolder actions? Or should we declare the plan a failure and demand that the administration call the whole thing off? ...

When there’s an ordinary, garden-variety recession, the job of fighting that recession is assigned to the Federal Reserve. ... Reducing rates a bit at a time, it keeps cutting until the economy turns around. At times it pauses to assess the effects of its work; if the economy is still weak, the cutting resumes. ...

Normally, then, we expect policy makers to respond to bad job numbers with a combination of patience and resolve. They should give existing policies time to work, but they should also consider making those policies stronger.

And that’s what the Obama administration should be doing..., stay calm in the face of disappointing early results,... the plan will take time to deliver its full benefit. But ... be prepared to add to the stimulus now that it’s clear that the first round wasn’t big enough.

Unfortunately, the politics of fiscal policy are very different from the politics of monetary policy. For the past 30 years, we’ve been told that government spending is bad, and conservative opposition to fiscal stimulus (which might make people think better of government) has been bitter and unrelenting even in the face of the worst slump since the Great Depression. Predictably, then, Republicans — and some Democrats — have treated any bad news as evidence of failure, rather than as a reason to make the policy stronger.

Hence the danger that the Obama administration will find itself caught in a political-economic trap, in which the very weakness of the economy undermines the administration’s ability to respond effectively. ... The question is what the president and his economic team should do now.

It’s perfectly O.K. for the administration to defend what it’s done so far. ... It’s also reasonable for administration economists to call for patience...

But there’s a difference between defending what you’ve done so far and being defensive. It was disturbing when President Obama walked back Mr. Biden’s admission that the administration “misread” the economy, declaring that “there’s nothing we would have done differently.” There was a whiff of the Bush infallibility complex in that remark, a hint that the current administration might share some of its predecessor’s inability to admit mistakes. And that’s an attitude neither Mr. Obama nor the country can afford.

What Mr. Obama needs to do is level with the American people. He needs to admit that he may not have done enough on the first try. He needs to remind the country that he’s trying to steer the country through a severe economic storm, and that some course adjustments — including, quite possibly, another round of stimulus — may be necessary.

What he needs, in short, is to do for economic policy what he’s already done for race relations and foreign policy — talk to Americans like adults.

"Will Europe’s Economies Regain Their Footing?"

Kenneth Rogoff on the prospects for recovery in Europe:

Will Europe’s Economies Regain Their Footing?, by Kenneth Rogoff, Commentary, Project Syndicate: What will Europe's growth trajectory look like after the financial crisis? ...

True, things are pretty ugly right now. ... Yet, ugly or not, the downturn will eventually end. Yes, there is still a real risk of hitting an iceberg, beginning perhaps with a default in the Baltics, with panic first spreading to Austria and some Nordic countries. But, for now, a complete meltdown seems distinctly less likely than gradual stabilization followed by a tepid recovery, with soaring debt levels and lingering high unemployment.

It is not a pretty picture. Some commentators have savaged Europe's policymakers for not orchestrating as aggressive a fiscal and monetary policy as their U.S. counterparts have. ...

But these critics seem to presume that Europe will come out of the crisis in far worse shape than the U.S., and it is too early to make that judgment. An epic, financial-crisis-driven recession, such as the one we are still experiencing, is not a one-year event. So policymakers' responses cannot be evaluated by short-term measures... It is just as important to ask what happens over the next five years as over the next six months, and the jury is still very much out on that.

America's hyper-aggressive fiscal response means a faster rise in government debt, while its hyper-expansive monetary policy means that an exit strategy to mop up all the excess liquidity will be difficult to execute. ... Europe's more tempered approach, while magnifying short-term risks, could pay off in the long run, especially if global interest rates rise, making it far more painful to carry oversized debt loads.

The real question is not whether Europe is using sufficiently aggressive Keynesian stimulus, but whether Europe will resume its economic reform efforts as the crisis abates. If Europe continues to make its labor markets more flexible, its financial market regulation more genuinely pan-European, and remains open to trade, trend growth can pick up again in the wake of the crisis. If European countries look inward, however, with Germany pushing its consumers to buy German cars, the French government forcing car companies to keep unproductive factories open, etc., one can expect a decade of stagnation.

Admittedly, the past year has not been a proud one for policy reform in Europe. Recessions have never proven an easy time for ... reforms. ...

The recent recession has presented challenges, but European leaders were right to avoid becoming intoxicated with short-term Keynesian policies, especially where these are inimical to addressing Europe's long-term challenges.

If reform resumes, there is no reason why Europe should not enjoy a decade of per capita income growth at least as high as that of the U.S. Moreover, with growing concerns about the sustainability of U.S. fiscal policy, the euro has a huge opportunity to play a significantly larger role as a reserve currency.

One shudders to think what will happen if Europe does not pull out of its current funk. ...

European leaders argued they didn't need to be as aggressive as the U.S. at putting new fiscal policy in place because they had much larger social safety nets that would kick in automatically as the crisis deepened. In addition, Europeans noted, they already had much higher levels of government spending as a share of output than the U.S., so it was much harder for them to increase this share further. Another way to say this is that Europeans do not believe they have an inferior short-run response, especially when it comes to labor and providing jobs.

Thus, the very thing that Rogoff believes is Europe's biggest long-run challenge - the extensive social safety net, including provisions affecting adjustment in labor markets - is the reason why Europe was able and willing to choose a different strategy relative to the U.S. to attenuate the effects of the recession. If the U.S. had European levels of debt and, more importantly, the same degree of social protections for people affected by recession, then the U.S. would not have needed or been able (politically) to increase deficit spending as much as it did. I am among those who believe Europe could have reacted more vigorously, and should have, but I don't think it's correct to say they avoided Keynesian type policy (and see this post concerning France's stimulus package).

If, in the long-run, we look back and see that Europe's more extensive protections did, in fact, smooth the adjustment to the crisis, the motivation for long run change of the type Rogoff hopes for will diminish. If having European style social protections does lower growth - and that is a debatable assertion - that may be an insurance premium people are willing to pay to avoid more severe downturns. If the opposite happens, if the social safety net does not do its job (and that cannot be measured through unemployment rates alone), then the motivation for change could become stronger. But the crisis is far from over and the jury is still out.

France is "Remarkably Effective at Deploying Funds Quickly"

The "cheese-eating surrender monkeys" say that when it comes to stimulus programs, “The country that is behind is the U.S., not France.”:

France, Unlike U.S., Is Deep Into Stimulus Projects, by Nelson D. Schwartz, NY Times: French workers normally take off much of the summer, but this month,... throngs of tourists will be jostling alongside stonemasons, restoration experts and other artisans paid by the French government’s $37 billion economic stimulus program.

Their job? Maintain in pristine condition the 800-year-old palace of more than 1,500 rooms where Napoleon bid adieu before being exiled to Elba and where Marie Antoinette enjoyed a gilded boudoir.

Besides Fontainebleau, about 50 French chateaus are to receive a facelift, including the palace of Versailles. Also receiving funds are some 75 cathedrals like Notre Dame in Paris. A museum devoted to Lalique glass is being created in Strasbourg, while Marseilles is to be the home of a new 10 million euro center for Mediterranean culture.

All told, Paris has set aside 100 million euros in stimulus funds earmarked for what the French like to call their cultural patrimony. It is a French twist on how to overcome the global downturn, spending borrowed money avidly to beautify the nation even as it also races ahead of the United States in more classic Keynesian ways: fixing potholes, upgrading railroads and pursuing other “shovel ready” projects.

“America is six months behind; it has wasted a lot of time,” said Patrick Devedjian, the minister in charge of the French relance, or stimulus. By the time Washington gets around to doling out most of its money, Mr. Devedjian sniffed, “the crisis could be over.” ...

As it turns out, France’s more centralized, state-directed economy ... is proving remarkably effective at deploying funds quickly and efficiently in bad times. ...

It is easier to find money for castles and cathedrals, of course, in a country that believes “art is equal to other investments, not secondary,” as Mr. Devedjian puts it. But the largess is driven as well by President Sarkozy’s support for more spending to combat the recession, even if it means borrowing more and running up big deficits.

That contrasts sharply with the commitment by the German chancellor, Angela Merkel, to hold down stimulus spending and move as quickly as possible to curb her government’s budget deficit.

So what about the criticism that Europe is not being as aggressive as the United States in combating the global slowdown, with only tepid stimulus packages? That’s not the way the French see it.

“You lost time with changing a president and no decisions were made in the last three months of 2008,” Mr. Devedjian jibed. “Nothing happened in January 2009, and in February, there was just a speech.”

“The country that is behind is the U.S.,” he said, “not France.”

While the scale, $37 billion versus close to $800 billion, is a bit different and probably ought to be accounted for in the comparison, there does seem to be a difference not just in the speed of deployment, but also in the focus of the policy. It will be interesting to see how that difference, which seems to place somewhat more emphasis on boosting employment and aggregate demand immediately than on long-run growth in France as compared to the U.S., translates into a differential response to the fiscal policy boosts in the two countries.

Another Boost for the Economy?

Paul Krugman wonders what the vice president is thinking:

What didn’t the vice president know?, by Paul Krugman: And when did he not know it?

Seriously, the economy isn’t doing all that much worse than a number of people warned was probable. And the whole political economy thing was, sadly, predictable:

This really does look like a plan that falls well short of what advocates of strong stimulus were hoping for — and it seems as if that was done in order to win Republican votes. Yet even if the plan gets the hoped-for 80 votes in the Senate, which seems doubtful, responsibility for the plan’s perceived failure, if it’s spun that way, will be placed on Democrats.

I see the following scenario: a weak stimulus plan, perhaps even weaker than what we’re talking about now, is crafted to win those extra GOP votes. The plan limits the rise in unemployment, but things are still pretty bad, with the rate peaking at something like 9 percent and coming down only slowly. And then Mitch McConnell says “See, government spending doesn’t work.”

Let’s hope I’ve got this wrong.

Apparently I didn’t.

But never mind the hoocoodanodes and ayatollahyaseaux. What’s important now is that we don’t compound the understimulus mistake by adopting what Biden seems to be proposing — namely, a wait and see approach. Fiscal stimulus takes time. If we wait to see whether round one did the trick, round two won’t have much chance of doing a lot of good before late 2010 or beyond.

Brad DeLong:

Joe Biden Misses the Point..., by Brad DeLong: If the Obama fiscal boost program has its anticipated impact on the economy as its main effects take hold over the next year, it is still half the size of the program it now looks like we need. Only if it magically turns out to be twice as strong as we think--only with simple Keynesian multipliers of 3 rather than 1.5--is it the right size.

And, of course, if the situation deteriorates further we will need an even bigger stimulus, while if the situation improves having too-big a stimulus is not a problem because we can soak up the demand through monetary policy.

So Vice President Joe Biden completely misses the point when he says:

I think it's premature to make that judgment [that we need a larger stimulus]. This was set up to spend out over 18 months. There are going to be major programs that are going to take effect in September, $7.5 billion for broadband, new money for high-speed rail, the implementation of the grid -- the new electric grid. And so this is just starting, the pace of the ball is now going to increase.

Of course, he is paid to miss the point. Which is one reason why being Vice President is a really lousy job.

Sam Stein reports:

Biden Ignores Warnings Of Krugman, Stiglitz, Roubini And Others: During his interview with ABC's This Week on Sunday, Vice President Joe Biden made what will be a much-discussed admission in the week ahead. The Obama administration, he said, had "misread" the extent of the economic catastrophe it inherited. "The truth is, we and everyone else misread the economy," declared Biden. "The figures we worked off of in January were the consensus figures and most of the blue chip indexes out there. We misread how bad the economy was, but we are now only about 120 days into the recovery package," the vice president said later in the interview. "The truth of the matter was, no one anticipated, no one expected that that recovery package would in fact be in a position at this point of having to distribute the bulk of money."

Certainly, the Obama administration's acknowledgment that it misjudged the crisis it inherited is rife with possibilities for its political opponents. ...

But equally problematic is Biden's assertion that "everyone" - not just the White House - was off in their prognostications. This is simply untrue. Host George Stephanopoulos pointed out that "a lot of people were saying that you needed to do something bigger and bolder" when it came to the stimulus package. He named New York Times columnist Paul Krugman as one example. There are many others. The prize-winning Columbia University economist Joseph Stiglitz not only warned that the stimulus was too small during its construction, the day after Obama signed it into law he predicted how its shortcomings would make themselves apparent. ... Stiglitz was joined by a whole host of liberal economists -- from the University of Texas' James Galbraith to Dean Baker of the Center for Economic and Policy Research -- who warned that the stimulus package inexplicably underestimated the size of the crisis.

Several weeks after the stimulus passed, economist Nouriel Roubini, known affectionately as Dr. Doom, made the case that the administration's approach to stabilizing the economy lacked an effective international component. ...

The day that June's job numbers came out, meanwhile, Nassim Taleb, principal of Universa Investments and author of 'The Black Swan,' offered a far more grim interpretation of what was transpiring, though one relatively consistent with what he had said in the past. "We're in the middle of a crash," said Taleb during an appearance on CNBC. "So if I'm going to forecast something, it is that it's going to get worse, not better." ...

To be fair, the process of economic forecasting is, as Taleb noted in his CNBC segment, an inherently tricky proposition. In October 2008, for instance, Roubini was arguing that the government needed a $400 billion stimulus package, which ended up being just more than half of what the Obama White House settled on.

But among those who were sounding the loudest alarms about the potential inadequacies of the economic recovery plan, the consensus seems to be emerging that more now needs to be done. Later in his ABC segment, Biden - who is responsible for overseeing the stimulus - was asked if a second package was in the offing. No, he replied, without dismissing the possibility outright. "I think it's premature to make that judgment. This was set up to spend out over 18 months. There are going to be major programs that are going to take effect in September, $7.5 billion for broadband, new money for high-speed rail, the implementation of the grid -- the new electric grid. And so this is just starting, the pace of the ball is now going to increase."

That pretty much covers it, so I will just add that all of this also applies to Bruce Bartlett's commentary today in the Financial Times:

We do not need a second stimulus plan, by Bruce Bartlett, Commentary, Financial Times: As the US unemployment rate has risen to 9.5 per cent from 8.1 per cent since the $787bn fiscal stimulus package was enacted in February, many Democrats have become very nervous. They say that another large stimulus may be needed to keep unemployment from rising well beyond the 10 per cent rate that President Barack Obama has predicted will be reached this year.

Another stimulus would be a grave mistake. The first one was justified by extraordinary circumstances. But it must be given time to work. People should not allow their impatience to lead to the adoption of policies that will not only fail to reduce unemployment this year, but could stoke inflation in the not-too-distant future.

The problem is that the Obama administration was much too optimistic about how quickly stimulus spending would affect the economy. Christina Romer, chair of the Council of Economic Advisers, and Jared Bernstein, chief economist to vice president Joe Biden, forecast in January that the stimulus would reduce unemployment almost immediately. ...

As for inflation fears, see here for one of the many arguments that have appeared here explaining why those fears are overblown. And, on the claim about the administration's forecast, back to Brad DeLong:

The quotes from the Hon. Christina D. Romer are:

• We do not want to repeat the mistake Japan made in the 1990s, when the moment things started to improve they tightened policy...

• [Stimulus spending is] going to ramp up strongly through the summer and the fall. We always knew we were not going to get all that much fiscal impact during the first five to six months. The big impact starts to hit from about now onwards...

• [Stimulus spending] should make a material contribution to growth in the third quarter...

• I am more optimistic that we are getting close to the bottom...

• I still hold out hope it will be a V-shaped recovery. It might not be the most likely scenario, but it is not as unlikely as many people think. We are going to get some serious oomph from the stimulus, there is the inventory cycle, and I believe there is some pent-up demand by consumers...

As Krugman says above, and as I stressed in a recent interview, if we "wait to see whether round one did the trick, round two won’t have much chance of doing a lot of good." Here's what I said in April in response to talk of green shoots:

...I don’t think we’ve reached the beginning of the end, and caution is in order, particularly for policymakers. It is not at all unusual for the economy to tick upward temporarily during a slowdown, only to have it return to its previous, stagnating state. So policymakers must consider the possibility that this is nothing more than a temporary blip in the data, and continue to plan and set the stage for further action, if necessary.

Did they start setting the stage? Not as far as I can tell.

Update: Paul Krugman:

Bruce Bartlett misstates the problem, by Paul Krugman: He says:

The problem is that the Obama administration was much too optimistic about how quickly stimulus spending would affect the economy. Christina Romer, chair of the Council of Economic Advisers, and Jared Bernstein, chief economist to vice president Joe Biden, forecast in January that the stimulus would reduce unemployment almost immediately.

Um, that’s totally false. Did Bartlett even look at the Bernstein-Romer paper? Here’s the key graph [link to graph]... We’re now at the very beginning of 2009Q3; they predicted that the unemployment rate right now would be only a fraction of a percent lower now than it would otherwise be. The impact wasn’t supposed to be really noticeable until late this year, and wasn’t supposed to peak until late 2010.

The problem, in other words, is not that the stimulus is working more slowly than expected; it was never expected to do very much this soon. The problem, instead, is that the hole the stimulus needs to fill is much bigger than predicted. That — coupled with the fact that yes, stimulus takes time to work — is the reason for a second round, ASAP.

Bruce Bartlett, in comments:

The chart clearly shows the unemployment lines diverging in the second quarter, suggesting that the stimulus was expected to impact on the economy within two months of enactment. That's a pretty damn fast effect. And needless to say, we haven't seen any impact of the stimulus on unemployment yet. So I don't understand what Paul is disagreeing with me about when I say that the administration was too optimistic. It seems self-evident that it was.

Paul Krugman: That ’30s Show

The economy needs more help:

That ’30s Show, by Paul Krugman, Commentary, NY Times: O.K., Thursday’s jobs report settles it. We’re going to need a bigger stimulus. But does the president know that?...

Since the recession began, the U.S. economy has lost 6 ½ million jobs — and as that grim employment report confirmed, it’s continuing to lose jobs at a rapid pace. Once you take into account the 100,000-plus new jobs that we need each month just to keep up with a growing population, we’re about 8 ½ million jobs in the hole.

And the ... job figures weren’t the only bad news in Thursday’s report, which also showed wages stalling and possibly on the verge of outright decline. That’s a recipe for a descent into Japanese-style deflation, which is very difficult to reverse. Lost decade, anyone?

Wait — there’s more bad news: the fiscal crisis of the states. Unlike the federal government, states are required to run balanced budgets. And faced with a sharp drop in revenue, most states are preparing savage budget cuts, many of them at the expense of the most vulnerable. Aside from directly creating a great deal of misery, these cuts will depress the economy even further.

So what do we have to counter this scary prospect? We have the Obama stimulus plan, which aims to create 3 ½ million jobs by late next year. That’s ... not remotely enough. And there doesn’t seem to be much else going on. Do you remember the administration’s plan to sharply reduce the rate of foreclosures, or its plan to get the banks lending again by taking toxic assets off their balance sheets? Neither do I.

All of this is depressingly familiar to anyone who has studied economic policy in the 1930s. ... President Obama and his officials need to ramp up their efforts, starting with a plan to make the stimulus bigger. Just to be clear, I’m well aware of how difficult it will be to get such a plan enacted.

There won’t be any cooperation from Republican leaders... Indeed, these leaders responded to the latest job numbers by proclaiming the failure of the Obama economic plan. That’s ludicrous, of course. The administration warned from the beginning that it would be several quarters before the plan had any major positive effects. ...

It’s also not clear whether the administration will get much help from Senate “centrists,” who partially eviscerated the original stimulus plan...

And as an economist, I’d add that many members of my profession are playing a distinctly unhelpful role.

It has been a rude shock to see so many economists with good reputations recycling old fallacies — like the claim that any rise in government spending automatically displaces an equal amount of private spending, even when there is mass unemployment — and ... grossly exaggerated claims about the evils of short-run budget deficits. ...

Also, as in the 1930s, the opponents of action are peddling scare stories about inflation even as deflation looms.

So getting another round of stimulus will be difficult. But it’s essential.

Obama administration economists understand the stakes. Indeed, just a few weeks ago, Christina Romer, the chairwoman of the Council of Economic Advisers, published an article on the “lessons of 1937” — the year that F.D.R. gave in to the deficit and inflation hawks, with disastrous consequences...

What I don’t know is whether the administration has faced up to the inadequacy of what it has done so far.

So here’s my message to the president: You need to get both your economic team and your political people working on additional stimulus, now. Because if you don’t, you’ll soon be facing your own personal 1937.

"Old Speeches, New Policies"

Greg Mankiw responds to this post, "Deficits are Worrisome, but Not as Worrisome as an Economy that is ... Rapidly Shedding Jobs" (or maybe it was this):

Old Speeches, New Policies, by Greg Mankiw: For academics, it always a delight when some old, obscure thing we've written suddenly gets noticed. So I was pleased when econoblogger Mark Thoma decided to draw attention yesterday to a speech I gave six years ago (pdf version) to the National Association of Business Economists. I had not looked at that speech in years, but looking back at it today, I think that it holds up pretty well. So, please, feel free to follow the link and read the whole thing.

The part of the speech that Mark highlights on his blog is the defense of running budget deficits during a recession. I am a bit puzzled about why Mark picked up that piece, however. Mark seems to be suggesting that my speech can somehow be construed as a defense of Obama fiscal policy. Yet I don't think that aspect of current economic policy is controversial. As I wrote in the NY Times in March of this year, "Few economists would blame either the Bush administration or the Obama administration for running budget deficits during an economic downturn." ...

The controversial part of current fiscal policy are, first, the relative reliance on spending hikes versus tax cuts as short-run stimulus and, second, the long-term picture. ...

This speech was given in September 2003, just under two years after the end of the 2001 recession, but job growth remained sluggish. From the speech:

Growth had resumed after the end of the recession in November 2001, but the pace of growth was far from satisfactory. And of course the labor market remained, and still remains, lagging behind.

So what did they propose? As a follow-up to the "Administration’s tax cut in 2001 and the stimulus package of 2002," they proposed another stimulus package, and never mind the deficit:

Because further policy action was clearly needed, the President pushed hard for the passage of his Jobs and Growth initiative. The purpose of this initiative was not only to help push the economy back toward its potential but also to raise this potential by improving supply-side incentives for work and investment.

I'm sure the Obama administration will be pleased to know that, should this recovery be similarly jobless, or W-shpaed - if the recovery is listless or non-existent for any reason - that, rather than harping on the deficit and the potential problems it might cause, they can count on Greg Mankiw's support for another round of fiscal stimulus to try to turn things around. (And if a lot of the spending is on infrastructure, as it was this time, he should also be pleased with the long-run supply-side effects of these policies.)

"Hire the Unemployed"

The stimulus package had two components, new spending and tax cuts. Everybody knew that the spending component would take time to put into place, six months or more for a lot of the infrastructure projects, and that meant that we needed something to increase demand and provide a bridge until the new spending comes online.

Enter the tax cuts that the GOP insisted upon, tax cuts that were a larger part of the stimulus package than I thought justified. These cuts were to come online immediately and stimulate demand until the spending could begin taking up some of the slack later in the year. I would have preferred targeted, non-infrastructure spending that could have been put in place almost as fast as the tax cuts (particularly those that simply require making existing programs more generous), but that type of spending was considered wasteful because it didn't add to our long-run capacity for growth and hence had little chance of being part of the stimulus package.

The problem was partly bad luck. A crisis hit and we had the bad luck of having an administration that opposed active intervention and though there was a bit of a stimulus attempt through a one time tax rebate, a strategy theory predicts won't do much to help, the real action in terms of stimulating the economy was left to the new administration. So nothing was done, nothing could have been done until the new administration took over, and given the insistence that any new spending be on infrastructure projects with clear benefits, tax cuts were the main hope for an immediate effect.

So if the policy has failed at this point, it is not the spending component since, fully consistent with predictions when it was enacted, it was going to be months before it could be of any help. What failed is the GOP's insistence that tax cuts be used to provide an immediate boost to the economy. Increasing food stamps, unemployment compensation, payments to help states with declining revenues and increasing demands for social services, payments to help unemployed workers maintain health care, digging (needed) holes, there were many, many other ways to provide more immediate relief and stimulate the economy at the same time, but no, it had to be tax cuts or nothing.

Finally, I want to note that what we maximize matters. For example, we can maximize GDP growth over the next ten or twenty years, or we can maximize employment over the next few months. Which we choose to maximize has a big effect on the policies we put in place. If we use the stimulus money to maximize GDP and growth - which is essentially what we did - that will have a much slower effect on employment than if we maximize employment directly. The efficiency argument always leads you to maximize output, and efficiency prevailed in the structure of the current package, but I think an argument can also be made that maximizing employment provides social benefits that are just as large, or larger.

Just noticed this, which makes a surprisingly similar point:

A Message to President Obama: Stop Priming the Pump, Hire the Unemployed, by Pavlina R. Tcherneva: Many have called President Obama’s stimulus plan a return to Keynesian policy. Some of us who like reading Keynes professionally or for leisure have already been scratching our heads. I have wondered in particular whether the plan isn’t set up to work in a manner completely backwards from what Keynes himself had in mind when he advocated economic stabilization by government.

There are two things to remember about Keynes’s fiscal policy proposals: 1) government spending was always linked to the goal of full employment... and 2) to achieve macro-stability and full employment, the government had to employ the unemployed directly into public works.

By contrast, most modern economists believe that 1) there is some natural level of unemployment that includes the structurally unemployed, which governments cannot generally tackle, and that 2) public employment is an inefficient use of public resources.

So, when the government is called to action, the economic profession has replaced Keynes’s “fiscal policy via public works” with a “leaky bucket pump-priming mechanism.”

How is the latter policy supposed to work? Instead of employing the unemployed directly, the idea is to generate large enough government expenditures to produce a level of economic growth that would, in turn, gradually reduce unemployment. For example, the government could spend money on various private sector contracts, stimulate different private industries, offer investment subsidies and tax cuts, and increase unemployment insurance payments, in hope that it will boost GDP sufficiently to reduce unemployment to desired levels. This is essentially the underlying logic behind President Obama’s stimulus package. But it is also a bit of a gamble.

Not all of these injections will be effective because the fiscal stimulus enters the economy through “a leaky bucket”. Some of the money will be lost in transit (because of administrative costs, for example) and much of it will have no direct job creation effects (e.g. the tax cut component of the recovery act). Nevertheless, despite this leaky bucket, the theory goes, sooner or later, large enough government expenditures will produce the kind of growth that would reduce unemployment. ...

All of this is ... why Keynes never had any “leaky bucket” or “pump priming” idea in mind. For him “the real problem fundamental yet essentially simple…[is] to provide employment for everyone” (Keynes 1980, 267) and the most bang for the buck from fiscal policy would be achieved via direct job creation. This he called “on the spot” employment via public works.

As I have argued elsewhere, it is useful to think of Keynesian fiscal policy, not as aggregate demand management, but as labor demand management. ...

Commentators often call this a policy of “make work” but Keynes didn’t advocate digging holes, burying jars with money and digging them out, or any other similarly worthless projects. The key was to marry the two goals: to employ the unemployed directly and to make sure that they do useful things. Once they are put to work on a particular project, Keynes argued, “there can be only one object in the economy, namely to substitute some other, better, and wiser piece of expenditure for it” (Keynes 1982, 146). We might as well ask a very basic question: is there really a shortage of useful things to do?

If we insist on calling ourselves Keynesians again, and more importantly, if President Obama’s plan for economic stabilization should generate rapid reduction in unemployment, it would help to set fiscal policy straight. Instead of relying on “leaky fiscal buckets” we could return to “labor demand management” a la Keynes that provides immediate employment opportunities to the unemployed via bold and creative public works projects, which generate useful output and services for all.

"Deficits are Worrisome, but Not as Worrisome as an Economy that is Not Growing and is Rapidly Shedding Jobs"

What do you think of this administration's arguments for deficit spending to spur the economy?:

Remarks of the Chair of the Council of Economic Advisers: ...I very much appreciate the opportunity to speak with you today. I will take this time to discuss recent developments in the economy, and some of the challenges the nation faces going forward. I ... also ... want to discuss some larger issues about how fiscal policy should be evaluated...

I view the economy as experiencing something similar to a tug of war. ... On the contraction end of the rope are the shocks that the U.S. economy has experienced... Pulling hard on the other end of the rope are the expansionary forces of monetary and fiscal policy—the Federal Reserve’s series of interest rate cuts and the Administration’s ... stimulus package...

Monetary and fiscal policy – the two main levers of macroeconomic stabilization policy – are both actively engaged..., both leaning hard against the headwinds...I will not say much today about monetary policy. This is not to diminish in any way the crucial role of the Federal Reserve in helping to counter the adverse forces in this recession. But fiscal policy is my beat as CEA chair, so that will be the focus of my comments. ...

[A]nalysis done within the Administration has shown ... that ... the ... job market is not what we would like it to be right now, but it would have been worse without the Administration’s actions.

One can view the short-run effects [of our policies]... from a classic Keynesian perspective. ... This ... helps maintain the aggregate demand for goods and services. There is nothing novel about this. It is very conventional short-run stabilization policy: You can find it in all of the leading textbooks. ...

The qualitative effects ... on the short-run output gap ... are not controversial. There is less agreement on quantifying these effects—how many jobs are created, how much growth is increased, and so on. To answer these questions, one would normally turn to a macroeconomic model such as those maintained by private forecasting firms, the Federal Reserve, and other institutions. I view such models as being very useful at relatively short time horizons such as one or two years. ...

Of course, the expansionary effects ... will be offset to some degree by the effects of the budget deficits that arise... Deficits can raise interest rates and crowd out of investment, although I should note that the magnitude of this effect is much debated in the economics literature. The main problem now facing the U.S. economy is not high interest rates...

The Administration would prefer not to have deficits, but deficit reduction is only one of many goals. ... Deficits are worrisome, but not as worrisome as an economy that is not growing and is rapidly shedding jobs. ...

The most important fiscal challenge facing the United States is not the current short-term deficits,... but instead the looming long-term deficits associated with the rise in entitlement spending ...

We do not yet have all the answers to the problems posed by entitlement costs, but we are hard at work. ... These longer-term issues, however, should not blind us to the immediate needs of the economy. The President came into office inheriting an economy ...[in] a recession. He has responded vigorously to the challenges and, as a result, the current outlook for the U.S. economy is bright...

That was Greg Mankiw, on September 15, 2003 in a speech to the NABE. [Note: verb tense changed from past to present in a few places, 'chairman' was changed to 'chair,' and he is, of course, mainly promoting tax cuts, not government spending.]

What's behind Recent Changes in Long-Term Interst Rates?

Martin Feldstein says we need to cut social programs so that we don't "weaken demand in the near term and hurt economic incentives in the long run":

The Fed must reassure markets on inflation, by Martin Feldstein, Commentary, Financial Times: The interest rate on 10-year US Treasury bonds almost doubled in six months, rising from 2.26 per cent last December to 3.98 per cent in mid-June, before decreasing slightly in recent days. This sharp rise happened despite the Federal Reserve’s ... policy aimed at lowering long-term rates by buying $300bn of Treasuries and promising to buy more than $1,000bn of mortgage securities. ...

There is no single reason for the sharp rise in rates... The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. ... The prospective decline of the dollar is also a potential source of inflation. ...

But such an explanation is deceptively easy. ... Those scared by Lehman Brothers’ collapse wanted the safety and liquidity of ordinary Treasury bonds, causing their yields to fall sharply...

Treasury yields rose this month to their level a year earlier because improving market conditions meant investors were no longer willing to pay for the extreme liquidity of Treasuries. Inflation was thus not the only, and perhaps not even the main, reason for the rise in rates.

Why did the Fed’s massive buying of long-term Treasury bonds not hold down the bond rate? The answer is that bond markets are less impressed by the $300bn of Fed purchases than by the official projection of $10,000bn of government borrowing over the next decade... The resulting crowding out of private investment will require higher future interest rates, and that is reflected in current long-term rates.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors’ concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. ...

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

Here's (my interpretation of) Paul Krugman's argument about the source of recent movements in long-term interest rates:

There are two reasons long-term rates might rise, first more worries about the debt and inflation in the future would drive rates up, and second the prospect of better economic conditions in the future would have the same effect, rates would go up.

Suppose we receive bad news about the current state of the economy. That should cause expectations of lower output growth in the future, and hence lower tax revenues and higher spending on social programs than would exist with a stronger economy. So the bad news should cause an expectation of a larger deficit and more inflation worries, and that would drive long-term interest rates up (these worries would also make foreign central banks less likely to fund US borrowing which would reinforce the increase in long-term interest rates).

But if it is future economic conditions that are driving the changes in long-term interest rates, bad news about the economy should drive rates down.

Last week, we received bad news about the economy. If the debt/inflation/foreign lending story is correct, long-term rates should have gone up. If the state of the economy story is driving rates, rates should have fallen. What did long-term rates actually do? They fell.

FRBSF: Fighting Downturns with Fiscal Policy

Sylvain Leduc of the San Francisco Fed reviews several studies on the effectiveness of fiscal policy and concludes:

The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output. Nevertheless, the uncertainty regarding those estimates remains high. ...

This brings up a point about tax cuts I've been meaning to make (again). The effectiveness of tax cuts depends, in part, on how hard the recession hits household balance sheets. In a recession where balance sheets are relatively unaffected, a tax cut may very well translate into spending, and do so fairly quickly.

But when balance sheets are hit hard, the result is different. In this case tax cuts may be used largely to rebuild balance sheets - to recover what was lost - rather than for new spending. Thus, in this recession the stimulative effects of tax cuts may not have as large of an immediate effect as in the past (there are also reasons to suspect the government spending multipliers shown in the table below are underestimated due to the fact that this recession is not like those in the data used to produce the estimates, e.g. for one, the historical data may overestimate the crowding out effect, but for now I want to focus on taxes).

The fact that in this recession tax cuts may not have as large of an immediate impact as in the past should not necessarily lead us to conclude that the tax cuts were a waste. That is, households will not turn back to consumption until they have saved enough to make up for what has been lost, at least in part, so how long it takes for the recession to end depends upon how quickly household balance sheets are refilled (once this is over, I expect saving rates to be higher than in the past, but I also expect that saving will fall some from where they are now once balance sheets are in better shape). The faster they are refilled, the sooner people begin to spend more, and the sooner this thing ends.

So in that sense, the tax cuts were not a waste at all. Unfortunately, however, during the time when the balance sheets are being refilled it will look like the stimulus package is not having any effect - all you see is higher savings rate - but again, the higher saving rate brings the end of the recession nearer in time, and that is important in and of itself. That's a hard effect to estimate, even if you are looking for it after the fact, but again, it shouldn't be dismissed as inconsequential.

Finally, because tax cuts are likely to be saved more than in the past, and hence have a smaller impact than tax multipliers from historical data suggest, and because there is reason to think that government spending multipliers rise as recessions get more severe (e.g. even if interest rates go up, investment is likely to be insensitive when conditions are bad), the logic of using both tax cuts and spending to stimulate the economy is sound.

Here's more:

Fighting Downturns with Fiscal Policy, by Sylvain Leduc, FRBSF Economic Letter: Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals. The main argument is that monetary policy can act quickly when output falls below an economy's potential or when inflation varies from its optimal rate, and that these actions can be reversed quickly as conditions change. By contrast, modifications to the fiscal code take a long time to enact and implement and can be very difficult to undo.

However, the current recession is clearly not a typical downturn. In particular, unlike other post-World War II U.S. recessions, monetary policy has run out of its usual ammunition to boost economic activity. The federal funds rate, the principal tool that the Federal Reserve uses to stabilize the economy, is now hovering near zero. Because interest rates cannot be negative in nominal terms, monetary policymakers are unable to lower the federal funds rate further. In this situation, the Federal Reserve has turned to unconventional tools to get around this barrier, commonly called the zero lower bound.

Because of the severity of the recession and the uncertain effects of unconventional monetary policy tools, Congress and the Obama Administration have also enacted a fiscal stimulus package. The $787 billion program approved by Congress in February includes a mix of tax and spending measures aimed at creating jobs and boosting output. Yet, economists and political leaders heatedly debate whether tax cuts or increased spending are more effective, a dispute that's hard to resolve because of the difficulty of determining the precise magnitude of fiscal policy's impact on real GDP. This Economic Letter examines some recent empirical studies analyzing data on the relative effects of higher spending and lower taxes on output.

Mishkin: How to Get the Fed Out of Its 'Box'

Frederic Mishkin is worried about the long-run budget and how it constrains what the Fed can do:

How to Get The Fed Out Of Its 'Box', by Frederic Mishkin, Commentary, WSJ: When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma.

Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around ... 0.70%,... the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates ... has the potential to choke off economic recovery and lead to further deterioration in the housing market. ... Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?

To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause ... is the more positive economic news..., particularly in financial markets. The bad news is ... the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. ...

Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, ... be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.

The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy... The fiscal situation argues against this policy action, because it would weaken the Fed's inflation-fighting credibility.

How can the Fed get out of the box and pursue the expansionary monetary policy that is needed...? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions..., fiscal stimulus to promote economic recovery ... in a severe recession is a sensible prescription.

However, the failure to take steps to get future budgets under control is a recipe for disaster. Not only does it make it difficult for the Fed..., but it may even make the fiscal stimulus package less effective. After all, if you know that the government is issuing a lot of debt ... you can expect to pay much higher taxes in the future. With the prospect of higher taxes, you will be less likely to spend today.

How can the Obama administration and Congress help the Fed do its job and help the fiscal stimulus package work? It needs to address exploding spending on entitlements -- Social Security and particularly Medicare -- which are causing future deficit projections to be so bleak.

One possibility is to establish a nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s. ... Another is taxing health-care benefits as part of any package to reform health care. Taxing health-care benefits would ... generate large amounts of revenue. It would also increase the incentive for people to lower the costs of their health care. There are surely many other ways to promote more fiscal responsibility.

The Fed can assist this process. It could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past. In the current extremely difficult economic environment, we surely need such a deal now.

As has been pointed out here many times, the inflation and interest rate concerns are likely overblown, as is the worry that consumption will suffer significantly due to the expectation of taxes in the future, and hence the motivation to attack entitlements is not as strong as suggested. Also, there is also at least some question about the Fed's ability to control long-term interest rates.

But beyond that the projected increase in health care costs is the biggest problem with the long-run budget by far, and the Obama administration is trying to reform the health care system. So the administration is attempting to "address exploding spending on entitlements," at least the one that is actually exploding - there's no sense in which the projected increase in the deficit due to Social Security can be described as "exploding" - and if the Fed, Mishkin, or anyone else wants to assist with that effort with deals or op-eds that promote the necessary reform, I'm sure the administration would welcome their help.

Don't "Nullify" Fiscal Policy

My entry at the Romer Roundtable:

Don't "Nullify" Fiscal Policy, by Mark Thoma: When deciding between two alternatives such as whether the government should intervene in the economy with a fiscal stimulus or not, the choice of the null and alternative hypotheses influences the type of errors we are likely to make.

A standard example to illustrate this is the problem of deciding guilt and innocence. If we make guilt the null hypothesis, and only reject the null when there is overwhelming evidence to the contrary, then we are going to find people guilty unless there is enough evidence presented to convince jurors the person did not act as charged. The biggest risk here is that innocent people will be sent to jail since innocence must be established through overwhelming evidence, but guilt is presumed. It's possible that a guilty person will be found innocent, but the more evidence that we require to find someone innocent—e.g. a strict standard like beyond a reasonable doubt—the smaller the chance that the guilty will be set free.

If we make innocence the null hypothesis, then things are reversed. In this case we will only send someone to jail if the evidence overwhelmingly points to guilt, so the biggest risk under this null is that guilty people will be found innocent. Again, it's possible that an innocent person will be found guilty, but the system requires a high burden of proof so as to minimise the possibility of this happening.

In the US, we think sending innocent people to jail is a bigger mistake than setting guilty people free, so we make innocence the null hypothesis in court cases rather than guilt, and we require a high level of "proof" before rejecting the null. (When money rather than freedom is at stake as in civil cases, the standard for conviction is often lower. This causes more innocent people to have to pay fines, but fewer guilty people escape them).

What does this have to do with deficit spending and recessions? Our tendency is to assume that the economy is doing fine and doesn't need help from fiscal authorities unless there is clear evidence the economy is crashing. Only then does the government intervene with deficit spending.

Thus, our null hypothesis is that the economy does not need any help, and we require a fairly high burden of proof to overcome that presumption. Because of this, the error we are most likely to make is to do nothing when action is called for, and that includes ending help too soon, particularly given the information lags we face in assessing the state of the economy. It's possible that we could get fooled by the data into acting when it isn't necessary, but since we require clear signals that the economy is in trouble before we act, and because data are slow to arrive, acting when it isn’t needed is less likely than doing nothing when, in fact, active intervention is called for.

Unlike in court cases, however, where a null of innocence allows us to minimise the costly error of jailing the innocent, the null that the economy is "innocent", i.e. that intervention from authorities is not required, leads us to minimise the wrong outcome.

Which is the bigger error, to deficit spend when it's not needed, or to fail to do so when it is? I think the bigger risk is doing nothing when it's needed, particularly when the economy has the type of difficulties we are seeing now. The risk of doing nothing is a severe depression, while the risk of overreacting is inflation or, perhaps, slightly slower growth for a period of time in the future. I don't see those risks as balanced at all, allowing a depression is—to me—the more severe error, the equivalent of sending the innocent to jail.

We saw the problem with having the wrong null hypothesis when the economy was slipping into the recession. The stimulus package should have been in place long before it was actually implemented in order to be maximally effective, but policymakers were reluctant to act until there could be no doubt that action was called for.

And we are seeing this again now. We may very well need another stimulus package, and we ought to be doing the work to get it ready, but there just isn’t enough evidence to convince policymakers that's the case. They will have to see clear evidence of continuing troubles and also believe there's no chance that recovery is just around the corner before they will act, and that’s a high standard to meet. And worse, as we’ve seen recently, as soon as the evidence that we are still in a recession becomes a bit foggy—at the first sign of green shoots—many people will be ready to end the intervention even though that may not be the right course of action.

I can understand the tendency to resist intervention at the first inkling of troubles. So on the front side of a recession, I can understand a null hypothesis that no action is needed, but it ought to be one that can be overturned with a fairly low burden of proof. We shouldn't have a "beyond a reasonable doubt" standard, it's not criminal to mistakenly intervene, it should be more like the "clear and convincing" standard sometimes used in civil procedures, or, even better, the weaker "preponderance of the evidence" standard used in civil cases.

But once we are in a recession, as now, I cannot understand why the null does not change to being one where the economy is presumed to need help until there is—beyond any reasonable doubt—evidence that the economy is on the path to recovery. Look at the 1937 experience on the graph in Mrs Romer's article again and see how costly it is to pull back too soon, then compare that to what the cost would have been to continue the policies for a year, or several years, even though they weren't needed. It seems pretty clear to me that the cost of pulling back too soon was the much bigger worry. We are facing the same choice now, or will soon. Do we pull back at the very first signs of green shoots, as we seem to want to do, or do we wait until we are much, much more certain that things have, in fact, improved to the point where recovery is all but certain before withdrawing stimulus measures?

As Brad DeLong notes, if it is the long-run budget you are worried about, ending the stimulus package, say, six months or a year earlier makes little difference to the long-term budget outlook. That being the case, and given the dangers of not doing enough and the dangers of ending the help too soon, why are we in such a hurry to end the stimulus package, and we are we so reluctant to consider doing more?

Other entries from:

• The Lessons of 1937 - Christina Romer (Lead Essay)

• Allan Meltzer: Think, plan, and tell us the plan
• Brad DeLong: Worse than we planned for
• Harold James: Develop an exit strategy
• Tyler Cowen: An unprecedented experiment
• Michael Bordo: Avoid monetary tightening
• Barry Eichengreen: Inflation signs are misleading
• Ray Stone: An imperfect parallel

Update: See also:

• Brad DeLong on Allan Meltzer

Update: More:

• Allan Meltzer: A Reply to Brad DeLong
• Carmen M. Reinhart: Debt will Keep Growing

Paul Krugman: Stay the Course

It's too soon to ease up on monetary and fiscal policy:

Stay the Course, by Paul Krugman, Commentary, NY Times: The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts.

For those who know their history,... this is the third time ... that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts ... have reached their limit. ...

The first example of policy in a liquidity trap comes from the 1930s. The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while F.D.R. tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

The second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery... Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.

And here we go again.

On one side, the inflation worriers are harassing the Fed. The latest example: Arthur Laffer... Meanwhile, there are demands from several directions that President Obama’s fiscal stimulus plan be canceled. Some ... argue ... the economy is already turning around. Others claim that government borrowing is driving up interest rates, and that this will derail recovery.

And Republicans, providing a bit of comic relief, are saying that the stimulus has failed, because the enabling legislation was passed four months ago — wow, four whole months! — yet unemployment is still rising. This suggests an interesting comparison with ... Ronald Reagan, whose 1981 tax cut was followed by no less than 16 months of rising unemployment.

O.K., time for some reality checks.

First of all,... unemployment is very high and still rising. That is, we’re not even experiencing the kind of growth that led to the big mistakes of 1937 and 1997. It’s way too soon to declare victory.

What about the claim that the Fed is risking inflation? It isn’t. Mr. Laffer seems panicked by a rapid rise in the monetary base... But a rising monetary base isn’t inflationary when you’re in a liquidity trap. America’s monetary base doubled between 1929 and 1939; prices fell 19 percent. Japan’s monetary base rose 85 percent between 1997 and 2003; deflation continued apace.

Well then, what about all that government borrowing? All it’s doing is offsetting a plunge in private borrowing — total borrowing is down, not up. Indeed, if the government weren’t running a big deficit right now, the economy would probably be well on its way to a full-fledged depression.

Oh, and investors’ growing confidence that we’ll manage to avoid a full-fledged depression — not the pressure of government borrowing — explains the recent rise in long-term interest rates. These rates, by the way, are still low by historical standards.

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

Those demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss.

The Return of the Great Debt Scare

Robert Reich is worried that the "Great Debt Scare" will lead to a repeat of the Clinton administration's abandonment of its investment agenda due to concerns over the deficit:

The Great Debt Scare: Why Has It Returned?, by Robert Reich: It’s the kind of thing I expect to hear from deficit hawks and chicken littles -- from the self-described "fiscally responsible" right, from the scolds Ross Perot and Pete Peterson, from my former cabinet colleague Bob Rubin. But yesterday I was shown slides developed by the putatively liberal Center for American Progress intended to make the point. And today’s front page story in the New York Times, by the eminent David Leonhardt, entitled "Sea of Red Ink: How It Spread From A Puddle," puts the issue right before our progressive noses, so to speak.

The Great Debt Scare is back.

Odd that it would return right now, when the economy is still mired in the worst depression since the Great one. ...

Odder still that the Debt Scare returns at the precise moment that bills are emerging from Congress on universal health care, which, by almost everyone’s reckoning, will not increase the long-term debt one bit because universal health care has to be paid for in the budget. In fact, universal health care will reduce the deficit and cumulative debt -- especially if it includes a public option capable of negotiating lower costs from drug makers, doctors, and insurers, and thereby reducing the future costs of Medicare and Medicaid.

Even odder that the Debt Scare rears its frightening head just as the President’s stimulus is moving into high gear with more spending on infrastructure. Every expert who has looked closely at the nation’s crumbling infrastructure knows how badly it suffers from decades of deferred maintenance... These public investments are as important to the nation’s future as are private investments.

First, some background: Deficit and debt numbers ... take on meaning only in relation to ... the size of the national economy..., in particular, to the debt/GDP ratio. True, that ratio is heading in the wrong direction right now. It may reach 70 percent by the end of 2010. That’s high, but it’s not high compared to the 120 percent it was in 1946, after the ravages of Depression and war.

Over time, the basic way America has reduced the debt/GDP ratio is by growing the U.S. economy. GDP growth makes even large debts manageable. When the economy is cooking, more people have jobs and better wages. So they pay more taxes. And they require less unemployment assistance and other social insurance. That’s why it’s so important now, in the depths of depression, that government, as purchaser of last resort, steps in and runs large deficits. Without large deficits this year and next, and perhaps the year after, the economy doesn’t have a prayer of getting back on a growth path, and the debt/GDP ratio could really get ugly. ...

In this respect, national budgets are like family budgets. It’s dumb for an indebted family to borrow more money to take a world cruise. But it’s smart even for an indebted family to borrow money to send their kids to college. So too with the Obama budget. Public investments, just like family investments, build future wealth. They allow faster growth. They make the debt/GDP ratio even lower and more manageable over time.

Don't get me wrong. I'm not saying there's nothing to worry about when it comes to long-term deficit and debt projections. I'm just saying now's not the time to worry, and we ought to temper our worries by understanding the larger context.

Not every expert agrees that a deficit-driven stimulus is the best and fastest way to get the economy back on a growth track, or that public investments can speed growth. Conservative economists, Republicans, and many Wall Streeters are skeptical because they don’t think government can do anything well. But look at the record of the last seventy-five years -- look at how the nation got out of the Great Depression, and consider the critical role public investments have played since then in speeding the nation’s growth, investments such as the interstate highway system -- and you have ample evidence that the deficit hawks are wrong. They were wrong when they convinced Bill Clinton to chuck a large part of his investment agenda (the nation is now paying the price) and they're wrong now.

So, back to the mystery. Why are the ostensibly liberal Center for American Progress and New York Times participating in the Debt Scare right now? Is it possible that among the President’s top economic advisors and top ranking members of the Fed are people who agree ... with conservative Republicans...? Is it conceivable that they are quietly encouraging the Debt Scare even in traditionally liberal precincts, in order to reduce support in the Democratic base for what Obama wants to accomplish? Hmmm.

Not so sure about that, but the larger point is certainly valid. The economy needs short-term demand stimulus, and that stimulus can be from spending on infrastructure, or it could be on something with little long-run benefit such as large firework shows held throughout the nation - big extravagant events that spend millions and millions of dollars in the most depressed economic areas. In the short-run the goal is to kick start the economy, and a firework show is just as good at that task as infrastructure spending if the spending is approximately the same.

Where they differ is in the long-run. The firework show leaves only memories - and sometimes that's enough to justify an expenditure - but let's assume that for the most past the shows were nothing more than an excuse to spend money to get the local economies moving (not that there's anything wrong with that; also, perhaps a series of shows would be better so that the impulse is spread out over time and sustains the economy through the downturn, but the idea is the same). However, as Robert Reich explains above in his example of borrowing to go on a cruise versus borrowing to go to college, infrastructure spending does have long-run benefits and can help the economy grow faster.

So, to the extent that we can, we should do both - deficit spend to get the economy moving in the short-run, and spend the money on infrastructure so the spending has long-run benefits. But the main thing is to get the economy moving again through deficit spending, it doesn't have to be on infrastructure (and there are plenty of things to spend the money on in the short-run that don't necessarily help with long-run growth but are nevertheless justified, there are choices other than firework shows and cruises, but the politics work against this).

So deficit spend in the short-run and target infrastructure as much as possible - until further spending on infrastructure begins to threaten short-run goals because, for example, it can't be done fast enough - then switch to other types of spending to give aggregate demand the kick it needs.

It may seem like I disagree with Robert Reich in that he is insisting that the spending be to rebuild our physical and social infrastructure, where I am saying it doesn't matter, but that's because we need to separate two reasons for deficit spending. What I have just described is deficit spending to offset cyclical swings in the economy, so called countercyclical policy. What Robert Reich describes in his example with the family is spending that is an investment in the future. You borrow money now in the hopes of a higher return in the future (in terms of economic growth), a return that is high enough to justify the costs. Note that this type of spending is entirely justified independently of spending to offset recessionary conditions. However, because of the politics involved, and because it can be efficient in any case, combing the two types of spending - i.e. using infrastructure spending to stimulate the economy - has benefits.

But although right now deficit spending is justified by countercyclical policy and by the need for social and physical infrastructure, we also need a plan for the long-run that credibly manages the resulting debt. Not immediately, but slowly over a long period of time. Importantly, however, that plan should not threaten or compromise our ability to do what's needed to offset the effects of this recession. I wouldn't mind having the conversation about managing the long-run debt now if it didn't do exactly that, i.e. cause policymakers to be wary of deficit spending and do less than is needed to combat the recession. But it does, and as Robert Reich notes, that is likely the point of the conversation.

I want both monetary and fiscal policy to have the best possible chance for success in dealing with our present difficulties, and that requires a large sustained shock to the system both in term of Fed actions and deficit spending. But success also requires managing the long-run appropriately. When things improve we have to pay for the stimulus to the economy (i.e. pay for all of the countercyclical part plus our share of the investment in infrastructure) and take the steps necessary to bring the budget into long-run alignment. If we don't do that, the conclusion will be that we can deficit spend when times are bad without any problem, and sure, that is helpful, but we simply do not have the discipline to pay for what we borrowed when times are better. Our inability to implement countercyclical policy effectively could then mean that future generations would not have countercyclical fiscal policy at their disposal when they need it.

But for now the main thing to realize is that "This thing ain’t over yet," and we need to continue to support aggressive policy action. We do have work to do to get the long-run budget fixed, and working on health care is a large step in that direction, but for now short-run policy goals must come first.

"The Problem with Bailouts"

Ed Glaeser doesn't like the auto bailout:

The problem with bailouts, by Edward L. Glaeser, Commentary, Boston Globe: Recessions can ... reveal weakness in seemingly invulnerable businesses, like Citibank and Toyota. But diagnosing the nature of corporate ill health may be difficult. Some firms suffer from a fatal disease; others have a temporary virus. ...

The distinction between permanent and transitory troubles appears across industries, companies, and cities. The metropolitan areas of San Jose and Detroit are both suffering from double-digit unemployment rates... Despite California's political mismanagement, San Jose has a superb base of tech-savvy entrepreneurs and a terrific climate. Silicon Valley will rise again, but the prognosis for Detroit is less rosy. Overdependence on one not very competitive industry, a shortage of college graduates, and a cold climate have led the city of Detroit to lose more than 50 percent of its population since 1950. ...

When investment is private, professional investors determine which companies are doomed and which are salvageable. In the current situation, however, the government has decided that a large number of firms are too big to fail and so our elected leaders are deciding which firms to save and which to let go.

The right answer is not "save everybody." Human and physical capital should move out of declining industries and into more productive areas, unless America wants to be a permanent, industrial underperformer. But public-sector intervention usually errs on the side of the status quo. Politicians respond to the workers in an existing firm who are ... rallying to keep their jobs. The customers and employees of the new firms that will rise from a collapse have no seat at the table.

Since the collapse of Lehman Brothers, the public sector has spent billions saving the banks. While these decisions are certainly debatable, they are understandable. The US financial industry misbehaved badly,... but it is still a sector with a future. ... After all, every other sector in the economy depends on banks for their financing.

But what about cars? ... Does anyone, other than GM's management, believe that this company can come back? The current treatment, cash infusion and a reduction in corporate liabilities, provides a solution for a company that is broke, not for one that is broken.

The great cost of saving GM as a single company is that ... America's car industry ... might be better served with a number of smaller, nimbler firms. Across metropolitan areas and across sectors within areas, there is a strong link between small firms and economic success. Detroit was, a century ago, among the most entrepreneurial places on the planet, and it achieved automotive miracles, the scale of which ultimately turned the city into a model of big-firm stagnation.

If General Motors becomes a permanent employee-owned, state-sanctioned enterprise, the firm will lose its chance to split up and become entrepreneurial once more. This could be the great price, even greater than the tax costs, of treating a permanently plagued company like one with a temporary cash shortfall. As flawed as the free market may be, it is hard to be enthusiastic when politicians start playing financier with our tax dollars.

I don't think anyone is planning on "a permanent employee-owned, state-sanctioned enterprise." I don't disagree that the auto industry needs to change. However, there is a maximum rate at which the economy can transform itself, a maximum rate at which the economy can create new industry and absorb displaced and unemployed labor, and presently there's not much more the economy can do. Putting people out of work only to have to spend money in other ways to support those very same people through social insurance programs, losing tax revenues because of their lost income, and so on, is not wise. The transition needs to happen, and a break-up into smaller firms might very well be part of it, but it needs to happen at an acceptable rate.

When the bathtub is already draining as fast as it possibly can, dumping more water into it does not make the tub empty any faster, it only raises the water level. Similarly, right now the pool of unemployed is draining as fast as it can, and dumping more people into it will simply make the problem worse, the transformation of the economy won't happen any faster. Yes the car companies need to change, and yes, the government support needs to end as fast as possible. But the change can only happen so fast, and trying to push it faster doesn't do any good.

There will come a time once recovery is under way to make changes such as those discussed above. I know I don't want a permanent state-run or state-backed enterprise, and there will come a time when the companies must stand or fall on their own. But I also don't want to put people out of work during a recession based upon the notion that the industry must transform itself through private sector initiative when there's very little chance of that happening until things improve.

"The Bond War"

 What is the bond market telling us?:

The Bond War, by Daniel Gross, Slate: It's fair to say that 10-year and 30-year Treasury bonds are not subjects that enthrall the American public... In the last six months, however, the state of those bonds has become the subject of feverish argument in the economic elite. The interest rate of the 10-year Treasury bond has spiked from 2.07 percent in December 2008, when the world was falling apart, to a recent high of 3.715 percent on June 1... Now factions led by economist Paul Krugman and historian Niall Ferguson are feuding bitterly about the import of these charts. In late April, Krugman and Ferguson squared off at a New York Review of Books/PEN panel, and they've continued with an op-ed war in the Financial Times and New York Times (Ferguson here and Krugman here).

In a nutshell, Ferguson and his allies believe that the rising bond yields prove that markets are worried about the inflation that will inevitably result from the fiscal policies of the Obama administration and the Fed. ... Ferguson's fears have been echoed by the planet's leading inflation-phobe German Chancellor Angela Merkel and by influential Stanford economist John Taylor. Turn on CNBC, and you're likely to hear talk about bond-market vigilantes, the mass of traders who sell bonds and push interest rates up in order to warn governments not to spend freely.

Krugman and his fellow travelers couldn't disagree more. Far from being a sign of failure and impending disaster, they say, the rising bond yields actually signal success and impending improvement. ... Clear-headed as always, Martin Wolf of the Financial Times notes: "The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets." This line of argument makes sense...

In ... this instance, the Fergusonians lack credibility. H.L. Mencken tagged the Puritans as people possessed of the "haunting fear that someone, somewhere, may be happy." Ferguson represents a strain of intellectual Toryism bedeviled by the haunting fear that someone, somewhere may be getting social insurance. ... Their solution to the problem of large deficits always seems to be to cut entitlements and never to raise taxes.

As for the bond vigilantes, have you noticed that they seem to surface only when a Democrat is in the White House? Stanford's John Taylor didn't write many articles about the inflationary aspects of rapidly expanding deficits when the Bush administration and Congress were turning surpluses into huge deficits, massively increasing government spending, and creating a new Medicare prescription drug entitlement. He was working in the Bush Treasury Department. ...

Federal Reserve Chairman Ben Bernanke, seemed to split the difference yesterday. "However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen," he told Congress. "These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings."

"An Umbrella that Melts in the Rain"

Medical problems contribute to a large proportion of bankruptcies. I wonder how much a health care plan that protects people from losing everything when serious illness hits would have helped to soften the economic crisis:

Illness, medical bills linked to nearly two-thirds of bankruptcies, EurekAlert: Medical problems contributed to nearly two-thirds (62.1 percent) of all bankruptcies in 2007, according to a study in the August issue of the American Journal of Medicine that will be published online Thursday. The data were collected prior to the current economic downturn and hence likely understate the current burden of financial suffering. Between 2001 and 2007, the proportion of all bankruptcies attributable to medical problems rose by 49.6 percent. The authors' previous 2001 findings have been widely cited by policy leaders, including President Obama.

Surprisingly, most of those bankrupted by medical problems had health insurance. More than three-quarters (77.9 percent) were insured at the start of the bankrupting illness, including 60.3 percent who had private coverage. Most of the medically bankrupt were solidly middle class before financial disaster hit. Two-thirds were homeowners and three-fifths had gone to college. In many cases, high medical bills coincided with a loss of income as illness forced breadwinners to lose time from work. Often illness led to job loss, and with it the loss of health insurance.

Even apparently well-insured families often faced high out-of-pocket medical costs for co-payments, deductibles and uncovered services. Medically bankrupt families with private insurance reported medical bills that averaged $17,749 vs. $26,971 for the uninsured. High costs – averaging $22,568 – were incurred by those who initially had private coverage but lost it in the course of their illness.

Individuals with diabetes and those with neurological disorders such as multiple sclerosis had the highest costs, an average of $26,971 and $34,167 respectively. Hospital bills were the largest single expense for about half of all medically bankrupt families; prescription drugs were the largest expense for 18.6 percent.

The research, carried out jointly by researchers at Harvard Law School, Harvard Medical School and Ohio University, is the first nationwide study on medical causes of bankruptcy. ...

Subsequent to the 2001 study, Congress made it harder to file for bankruptcy, causing a sharp drop in filings. However, personal bankruptcy filings have soared as the economy has soured and are now back to the 2001 level of about 1.5 million annually.

Dr. David Himmelstein, the lead author of the study and an associate professor of medicine at Harvard, commented: "Our findings are frightening. Unless you're Warren Buffett, your family is just one serious illness away from bankruptcy. For middle-class Americans, health insurance offers little protection. Most of us have policies with so many loopholes, co-payments and deductibles that illness can put you in the poorhouse. And even the best job-based health insurance often vanishes when prolonged illness causes job loss – precisely when families need it most. Private health insurance is a defective product, akin to an umbrella that melts in the rain." ...

According to study co-author Dr. Steffie Woolhandler, an associate professor of medicine at Harvard and primary care physician in Cambridge, Mass.: "We need to rethink health reform. Covering the uninsured isn't enough. ... Only single-payer national health insurance can make universal, comprehensive coverage affordable... Unfortunately, Washington politicians seem ready to cave in to insurance firms and keep them and their counterfeit coverage at the core of our system. Reforms that expand phony insurance – stripped-down plans riddled with co-payments, deductibles and exclusions – won't stem the rising tide of medical bankruptcy."

Dr. Deborah Thorne, associate professor of sociology at Ohio University and study co-author, stated: "...Families who file medical bankruptcies are overwhelmingly hard-working, middle-class families who have played by the rules of our economic system, and they deserve nothing less than affordable health care." [A copy of the study is available at here.]

Since we're on the topic:

May Bankruptcy Filings Climb to Over 6,000 Per Day, by Bob Lawless: According to data from Automated Access to Court Electronic Records ("AACER"), there were over 120,000 U.S. bankruptcy filings in May 2009 or 6,020 for each of the 20 business days in May. That is the first time daily bankruptcy filings have topped the 6,000 mark since the 2005 bankruptcy law was adopted. ...

It is important not to make too much out of the month-to-month changes in the bankruptcy filing rate. It is the long-term trend that matters, and the graph ... shows how the long-term trend is heading us back toward the daily filing rate before the 2005 law was enacted. ...

It is important not to make too much out of the month-to-month changes in the bankruptcy filing rate. It is the long-term trend that matters, and the graph ... shows how the long-term trend is heading us back toward the daily filing rate before the 2005 law was enacted. ...

Will the Debt be Monetized?

David Altig doesn't think the recent concern that the debt will be monetized is fully justified:

Debt and money, macroblog: If you are hunkered down on inflation watch, yesterday's news offered some soothing words. From Reuters:

Chinese officials have expressed concern that heavy deficit spending and an ultra-loose monetary policy could spark inflation, eroding the value of China's U.S. bond holdings.

But [U.S. Treasury Secretary Timothy] Geithner said: "We have a strong, independent Fed and I am completely confident they have the ability to do their job under the law, which is to keep inflation stable and low over time..."

And from Bloomberg:

He said that there was 'no risk' of the U.S. monetizing its debt...

Concerns about such monetization arose in the wake of the FOMC's decision at its March meeting to purchase up to $300 billion of longer-term Treasury securities and that decision's coincidence with the very large fiscal deficits contemplated in President Obama's budget proposals. Those concerns have accelerated as longer-term Treasury yields have moved higher since. ...

I will offer just a little perspective in the form of the chart below, which shows the recent and (near-term) prospective shares of federal debt held by the Federal Reserve. The red line represents the share of debt that will be held by the Fed at the end of fiscal year 2009 if the $300 billion Treasury purchase program is completed and the federal deficit emerges as currently predicted by the Congressional Budget Office.

Bernanke: Current Economic and Financial Conditions and the Federal Budget

[A simulated interview based upon the speech Current economic and financial conditions and the federal budget, by Ben Bernanke, Chair, FRB (lightly edited - deletions only).]

Thanks for agreeing to this, I didn't think you would. Before turning to financial market conditions and the effects of the federal budget, the main topic today, let's start by getting your assessment and overview of the economy:

The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market--the number of new and continuing claims for unemployment insurance through late May--suggests that sizable job losses and further increases in unemployment are likely over the next few months.

What about the "green shoots" you talked about not too long ago? Are they withering or growing?

Recent data suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households' spending power will be boosted by the fiscal stimulus program.

So does that mean household consumption is likely to improve soon?

A number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions.

What about housing, how do you see things there?

Starve the Beast (Recession Edition)

John Taylor plays Starve the Beast. First, he calls for permanent tax cuts - and only permanent tax cuts - to stimulate the economy, tax cuts that will make the long-run budget picture worse. (Paul Krugman: "You’ve got John Taylor arguing for permanent tax cuts as a response to temporary shocks, apparently oblivious to the logical problems.") Then, he tells a "scary" inflation story and argues that deficits are a bigger threat than the financial crisis and must be reduced through reductions in the size of government:

Exploding debt threatens America, by John Taylor, Commentary, Financial Times: ...Under President Barack Obama’s budget plan, the federal debt is ... is rising – and will continue to rise – much faster than ... America’s ability to service it. ...

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers..., a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. ... A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. ...

The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. ... And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. ... This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating. ...

The time for ... excuses is over. ... Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis. The problem is that policy is getting worse not better. ...[G]overnment is now the most serious source of systemic risk. ...

"Will the Stimulus Stifle Recovery?"

More people tired of hearing criticisms of the economic stimulus package that are wrong due to the "Great Forgetting":

Will stimulus spending stifle recovery?, by James W Dean and Richard G Lipsey, Economists Forum: The enormous stimulus packages hastily put together by governments in most large economies encounter two sorts of criticisms from many conservative economists. Both criticisms are wrong.

The first is that spending will either be hurried and wasteful, or that it won’t come on stream until employment has recovered, and will therefore be inflationary.

The second is that deficit-financed government spending merely replaces spending by consumers and firms dollar for dollar; so-called 100 per cent ‘crowding out’. Critics often fail to point out that these two arguments cannot both be true. If government spending merely replaces private spending dollar for dollar, it does not affect total demand. As a result, it cannot be inflationary. ...[...continue reading...]

On the first point, they conclude that:

To be sure, stimulus programmes should target projects with productive potential. Economies from the US to China are in dire need of new physical and social infrastructure. But even “unproductive” projects are better than none at all if the alternative is to leave labour and capital unemployed.

And if stimulus spending for infrastructure comes into effect after the end of recession, when real resources and financial markets are re-employed, there are adequate monetary tools to contain such pressures. In other words, long-term plans for infrastructure planning can stand on their own merit.

And on the second:

...arguments that deficit-financed stimuli will be crowded out are far-fetched in the extreme...

"Stay the Course"

Having made the same points about not pulling back on monetary and fiscal policy too soon, I can hardly disagree with this call to "avoid a replay of the policy disasters of 1936-37":

It’s No Time to Stop This Train, by Alan Blinder, Commentary, NY Times: Contrary to what you may have heard from some doomsayers, 2009 is not 1930 redux. ... But even if another depression is next to impossible, there is still the danger that next year, or the year after, might turn into 1936. Let me explain.

From its bottom in 1933 to 1936, the G.D.P. climbed spectacularly (albeit from a very low base), averaging gains of almost 11 percent a year. But then, both the Fed and the administration of Franklin D. Roosevelt reversed course.

In the summer of 1936, the Fed looked at the large volume of excess reserves piled up in the banking system, concluded that this mountain of liquidity could be fodder for future inflation, and began to withdraw it. This tightening of monetary policy continued into 1937, in a weak economy that was ill-prepared for it.

About the same time, President Roosevelt looked at what seemed to be enormous federal budget deficits, concluded that it was time to put the nation’s fiscal house in order and started raising taxes and reducing spending. This tightening of fiscal policy transformed the federal budget... — a swing of four percentage points in a single year. (Today, a swing that large would be almost $600 billion.)

Thus, both monetary and fiscal policies did an abrupt about-face in 1936 and 1937, and the consequences were as predictable as they were tragic. The United States economy, which had been rapidly climbing out of the cellar from 1933 to 1936, was kicked rudely down the stairs again... The moral of the story should be clear: Prematurely changing fiscal and monetary policies ... can be hazardous to the economy’s health.

Wow, we’ve learned a lot since the ’30s, right? Well, maybe not. For the echoes of 1936 are being heard right now, even before the current recession hits bottom. If you’ve been paying attention, you know that a number of critics of the Fed are sounding alarms over the huge stockpile of excess reserves it has created... The clear inference is that some of it should be withdrawn before it’s too late.

On the fiscal side, many of President Obama’s critics are complaining vociferously about the huge federal budget deficits. Try to ignore, if you can, the sheer hypocrisy of many Congressional Republicans... But whatever the motives, the worries of today’s deficit hawks sound eerily reminiscent of Roosevelt in 1936 and 1937.

Fortunately, Mr. Bernanke is a keen student of the Great Depression who will not allow the Fed to repeat the errors of 1936-37. But his critics, both inside and outside the Fed, are already branding his policies as dangerously inflationary, and no Fed chairman wants to be called an inflationist.

Similarly, I hope and believe that President Obama will not transform himself from the spendthrift Roosevelt of 1933 to the deficit-hawk Roosevelt of 1936 — at least not until the economy is back on solid ground. That said, a growing flock of budget hawks are already showing their talons. They will have their day — but please, not yet. To avoid a replay of the policy disasters of 1936-37, both the Fed and our elected officials must stay the course. ...

We'll see. I'm not as sure as he is that the desire to get health care reform passed this fall won't dominate the need to maintain stimulative policies. One of the big objections to health care reform is how we will pay for it (a preliminary CBO estimate suggests it will cost a little over 1 trillion). Suppose the economy continues to stay recessed and the choice becomes health care reform verus another stimulus package. What will be chosen? What should be chosen? (The answer is that one shouldn't be traded against the other, we should do both since they deal with different problems. One problem is to stabilize the economy in the short-run. The other is to provide health care universally and at the same time rein in health care costs to bring the budget into balance in the longer run. While each stands on its own merits, the politics would be unlikely to allow us to do both, and I'm guessing health care reform will be the administration's first priority.)

The "Apparent Abdication of Responsibility"

Tyler Cowen says congress is letting others take the responsibility - and the potential blame - for decisions it ought to be making:

There’s Work to Be Done, but Congress Opts Out, by Tyler Cowen, Economic View, NY Times: The longer the financial crisis runs, the more policy makers at the Treasury, the White House and the Federal Reserve are working around Congress rather than with it. It’s not that anyone is behaving illegally or unconstitutionally, but rather that Congress seems to want to be circumvented and to delegate more power to the executive branch as well as to the Fed, at least temporarily.

While Congressional leaders are consulted on the major policies, Congress is keeping its distance, perhaps to minimize voter outrage. This way, Congress can claim credit if a recovery comes, but deny responsibility if the price tag ends up higher than advertised or if banks seem to be receiving unfair benefits from the government.

Trillions of dollars of financial commitments have been made without explicit Congressional approval. ... The traditional division of labor among policy makers was that the Fed determined the quantity of money in the economy — it set monetary policy — and Congress decided precise government expenditures — it handled fiscal policy. These new programs blur that distinction and, in essence, the Fed is running some fiscal policy. ... A full description of important financial policies handled outside of Congress would more than fill this column and would add up to trillions of dollars in potential commitments and guarantees.

Many economists are happy to see technocrats play such a big role in the current emergency in the belief that the Obama administration and the Fed have more economic expertise — and more incentives to care about policy at the national level — than Congress does. But if that is true, we should be nervous about the future. A Congress that won’t accept much responsibility for the financial bailouts, for example, is unlikely to rise to the occasion when the time comes to make tough decisions on the budget. ...

Both Democrats and Republicans are at fault for this apparent abdication of responsibility. The Republicans are focused on blaming the Democrats for bailouts, since they know the policies can go through without their support. The Democrats want to enjoy the benefits of making commitments and guarantees without accepting accountability or responsibility for them.

It's a common theme in American history that crises expand the power of the executive branch of government, and that is part of what is happening here. Even the Federal Reserve, which ... is supposed to be quasi-independent, has ceded much of its power to the Treasury. ... Just as the Bush administration brought a growth of executive power in foreign policy and surveillance, so executive power has grown when it comes to economic policy; that development spans the administrations of both Mr. Obama and George W. Bush.

On any single policy, the abdication of Congressional responsibility may not be a problem. Sometimes it is good to let the technocrats have their way. In the longer run, though, the United States requires a Congress courageous enough to accept responsibility for potentially unpopular policies. We are moving further away from that every day.

Paul Krugman: Falling Wage Syndrome

Are we doing enough to reduce the risk that we’ll face a sustained period of deflation and stagnation?:

Falling Wage Syndrome, by Paul Krugman, Commentary, NY Times: Wages are falling all across America. Some of the wage cuts, like the givebacks by Chrysler workers, are the price of federal aid. Others, like the tentative agreement on a salary cut here at The Times, are the result of discussions between employers and their union employees. Still others reflect the brute fact of a weak labor market: workers don’t dare protest when their wages are cut, because they don’t think they can find other jobs.

Whatever the specifics, however, falling wages are a symptom of a sick economy. And they’re a symptom that can make the economy even sicker.

First things first: anecdotes about falling wages are proliferating, but how broad is the phenomenon? The answer is, very.

It’s true that many workers are still getting pay increases. But there are enough pay cuts out there that, according to the Bureau of Labor Statistics, the average cost of employing workers ... rose only two-tenths of a percent in the first quarter of this year — the lowest increase on record. Since the job market is still getting worse, it wouldn’t be at all surprising if overall wages started falling later this year.

But why is that a bad thing? After all, many workers are accepting pay cuts in order to save jobs. What’s wrong with that?

The answer lies in one of those paradoxes...: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment. ... So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more ... but as wages fall, they’re chasing a moving target. ... Things get even worse if businesses and consumers expect wages to fall further in the future. ...

Concern about falling wages isn’t just theory. Japan ... is an object lesson in how wage deflation can contribute to economic stagnation.

So what should we conclude from the growing evidence of sagging wages in America? Mainly that stabilizing the economy isn’t enough: we need a real recovery.

There has been a lot of talk lately about green shoots and all that, and there are indeed indications that the economic plunge that began last fall may be leveling off. The National Bureau of Economic Research might even declare the recession over later this year.

But the unemployment rate is almost certainly still rising. And all signs point to a terrible job market for many months if not years to come — which is a recipe for continuing wage cuts, which will in turn keep the economy weak.

To break that vicious circle, we basically need more: more stimulus, more decisive action on the banks, more job creation.

Credit where credit is due: President Obama and his economic advisers seem to have steered the economy away from the abyss. But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising.

Here's a graph of the Phillips curve over the last two and a half years (2006:Q3 - 2008Q4) as measured by the year over year percentage change in the employment cost index (total compensation) versus the civilian unemployment rate:

Artificially restraining wages from falling is not the correct response, the key is to drive the unemployment rate down so that the labor market tightens and wages rise in response. That is why it's essential that stimulus programs provide a boost to employment, and I've wondered from the start if the stimulus programs we enacted have focused enough on providing employment opportunities. Building new infrastructure does provide long-term benefits, and that gives political cover to the large government expenditure and tax cuts that were enacted, but infrastructure projects alone do not give the maximum possible boost to employment. Providing jobs - some of which may not directly boost long-run productivity - is an essential component of short-run stabilization policy, and there is more that we could do to give unemployed workers opportunities for employment until jobs begin to reappear in the private sector.

Paul Krugman: Erin Go Broke

Paul Krugman hopes we don't turn Irish:

Erin Go Broke, by Paul Krugman, Commentary, NY Times: “What,” asked my interlocutor, “is the worst-case outlook for the world economy?” It wasn’t until the next day that I came up with the right answer: America could turn Irish.

What’s so bad about that? Well, the Irish government now predicts that this year G.D.P. will fall more than 10 percent from its peak, crossing the line ... sometimes used to distinguish between a recession and a depression.

But there’s more to it than that: to satisfy nervous lenders, Ireland is being forced to raise taxes and slash government spending in the face of an economic slump — policies that will further deepen the slump. And it’s that closing off of policy options that I’m afraid might happen to ... us. ...

How did Ireland get into its current bind? By being just like us, only more so. ...Ireland jumped with both feet into the brave new world of unsupervised global markets. Last year the Heritage Foundation declared Ireland the third freest economy..., behind only Hong Kong and Singapore.

One part of the Irish economy that became especially free was the banking sector, which used its freedom to finance a monstrous housing bubble. ... Then the bubble burst. The collapse ... sent the economy into a tailspin... The result, as in the United States, has been a rising tide of defaults and heavy losses for the banks.

And the troubles of the banks are largely responsible for putting the Irish government in a policy straitjacket.

On the eve of the crisis Ireland seemed to be in good shape, fiscally speaking... But the government’s revenue — ...strongly dependent on the housing boom — collapsed along with the bubble.

Even more important, the Irish government found itself having to take responsibility for the mistakes of private bankers ... putting taxpayers on the hook for potential losses of more than twice the country’s GDP, equivalent to $30 trillion for the United States.

The combination of deficits and exposure to bank losses raised doubts about Ireland’s long-run solvency, reflected in a rising risk premium on Irish debt and warnings about possible downgrades from ratings agencies.

Hence the harsh new policies. ... As far as responding to the recession..., Ireland appears to be really, truly without options, other than to hope for an export-led recovery if and when the rest of the world bounces back.

So what does all this say about those of us who aren’t Irish?

For now, the United States isn’t confined by an Irish-type fiscal straitjacket:... financial markets still consider U.S. government debt safer than anything else.

But we can’t assume that this will always be true. Unfortunately, we didn’t save for a rainy day: thanks to tax cuts and the war in Iraq, America came out of the “Bush boom” with a higher ratio of government debt to GDP than it had going in. And if we push that ratio another 30 or 40 points higher — not out of the question if economic policy is mishandled over the next few years — we might start facing our own problems with the bond market.

Not to put too fine a point on it, that’s one reason I’m so concerned about the Obama administration’s bank plan. If, as some of us fear, taxpayer funds end up providing windfalls to financial operators instead of fixing what needs to be fixed, we might not have the money to go back and do it right.

And the lesson of Ireland is that you really, really don’t want to put yourself in a position where you have to punish your economy in order to save your banks.

Feldstein: Inflation is Looming

Martin Feldstein is worried about inflation

Inflation is looming on America’s horizon, by Martin Feldstein, Commentary, Financial Times: ...The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation. According to the Congressional Budget Office, the president’s budget implies a fiscal deficit of 13 per cent of gross domestic product in 2009 and nearly 10 per cent in 2010. Even with a strong economic recovery, the ratio of government debt to GDP would double to 80 per cent in the next 10 years.

There is ample historic evidence of the link between fiscal profligacy and subsequent inflation. But historic evidence and economic analysis also show that the inflationary effects can be avoided if the fiscal deficits are not accompanied by a sustained increase in the money supply and, more generally, by an easing of monetary conditions. ...

A fiscal deficit raises demand when the government increases its purchase of goods and services or, by lowering taxes, induces households to increase their spending. ... If the fiscal deficit is not accompanied by an increase in the money supply, the fiscal stimulus will raise short-term interest rates, blocking the increase in demand and preventing a sustained rise in inflation.

So the potential inflationary danger is that the large US fiscal deficit will lead to an increase in the supply of money. This inevitably happens in developing countries that do not have the ability to issue interest-bearing debt and must therefore finance their deficits by printing money. ...

[T]he large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth. ...

The link between fiscal deficits and money growth is about to be exacerbated by “quantitative easing”, in which the Fed will buy long-dated government bonds. While this may look like just a modified form of the Fed’s traditional open market operations, it cannot be distinguished from a policy of directly monetising some of the government’s newly created debt. Fortunately, the amount of debt being purchased in this way is still small relative to the total government borrowing.

The Fed is also creating a massive increase in liquidity by its policy of supplying credit directly to private borrowers. Although these credit transactions do not add to the measured fiscal deficit, the unprecedented Fed purchases of more than $1,000bn of private securities have led to the enormous $700bn increase in the excess reserves of the commercial banks. The banks now hold these as interest-bearing deposits at the Fed. But when the economy begins to recover, these reserves can be converted into new loans and faster money growth.

The deep recession means that there is no immediate risk of inflation. ... But when the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit.

This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding and the Fed lacks enough Treasury bonds with which to conduct ordinary open market operations. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.

The government budget constraint is:

(Government spending including interest on the debt) - (Taxes) =
      (Change in the Money supply) + (Change in the Bond supply)

Or, more simply:

G - T = ΔM + ΔB

The left-hand side, government spending (G) - taxes (T), is the government deficit (surplus if the value is negative). The right-hand side shows the two ways of paying for the deficit, printing new money, ΔM, (the change in the money supply can raise prices) and borrowing from the public by issuing new bonds, ΔB (the change in debt can raise interest rates and lower growth).

Let's start with Feldstein's comments about developing countries. Suppose you are a developing country and you want to improve your country's growth rate, and you think the key is infrastructure spending. You run a deficit to accomplish this, fully intending to pay it back out of higher future growth (which may not actually happen).

But how will you pay for that spending on new infrastructure? You, as the dictator, could raise taxes but you are a poor country and the wealth and income base just isn't there to support a higher tax level. You could borrow the money, but once again the wealth level in your own country isn't high enough to allow that, so if you borrow, it will have to be from foreigners. But, unfortunately, there are some defaults in your country's recent past and the international community won't lend to you without restrictions that you just aren't willing to take on.

So once international credit dries up, becomes prohibitively expensive, or comes with too many restrictions, and if taxes cannot be raised enough, there is but one choice to pay for the infrastructure spending and the deficit it causes, print the money, and it's a choice developing countries often find themselves making. The result of these persistent deficits, then, is persistent growth in the money supply - month after month more money has to be printed to cover government operations - and the result is inflation.

Feldstein's point about quantitative easing monetizing debt can also be explained in terms of this equation. Under quantitative easing, the Fed prints new money, and uses it to purchase long-term government bonds. Thus, the right-hand side of the equation above is unchanged overall, but the money component gets larger while the bond component gets smaller as the Fed purchases government debt. (Note that the money supply also goes up if the Fed purchases private sector bonds rather than government bonds since new money has to be printed to pay for them, another one of Feldstein's points.)

Once we begin to recover, there are three ways to reduce the inflationary pressures from the growing money supply. First, we could simply reduce the money supply. How do you do that? By selling bonds to the public. Feldstein's worry is that the Fed has bought so many private sector bonds (and traded for government bonds in the process) that it won't have enough government bonds to reduce the money supply by as much as needed, and nobody will want to purchase the private sector bonds unless the price is very low, or, saying the same thing, the interest rate is [excessively] high. But high interest rates are undesirable so reducing the money supply may be difficult.

The second choice is to raise taxes. It might happen, but my inclination is to say good luck with that. But I hope I'm wrong, and maybe we can make some headway here. Third, we could reduce government spending. I don't know what the administration's goals are as to the size of government over the long-term, so I can't say for sure how much of the stimulus spending is considered to be temporary, and how much is intended to be permanent, e.g. for health care reform. But much of it was sold to the public as temporary, and I expect the administration to make good on that commitment (though "good luck with that" comes to mind again, but I'm still hopeful). If it doesn't, other goals such as health care reform could be compromised.

And speaking of health care reform, that's where the focus needs to be. The budget worries twenty years from now have little to do with the temporary stimulus measures we are taking today, going forward health care costs are the most important issue by far in terms of the budget, and everything else revolves around solving that problem.

So am I worried about inflation? Somewhat, particularly when I hear that the Fed's independence is likely to come under review by congress. Whatever doubts you have about the Fed's commitment and ability to keep inflation low in the future, I have little doubt that congress would choose to monetize the debt when faced with tough choices about how to solve a deficit problem (would congress have done what Volcker did?). I still have faith in the Fed, but as you can see from the government budget constraint above, what the Fed can do is dependent upon the actions of congress. If deficits persist, it could come down to a choice by the Fed to monetize the deficit - and risk inflation - or allow government debt to pile up and risk high interest rates. Volcker chose low inflation over high interest rates when confronted with a similar choice, but it's not completely clear to me at this point what this Fed will do in the same situation, and how much cooperation they can expect from congress in terms of reducing the deficit.

Tax Cuts, Household Balance Sheets, and the Duration of Recessions

Greg Mankiw:

It May Be Time for the Fed to Go Negative, by N. Gregory Mankiw, Commentary, NY Times: ...What is the best way for an economy to escape a recession? Until recently, most economists relied on monetary policy. ... The problem today ... is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools...

So why ... not lower the target interest rate to, say, negative 3 percent? ... The problem with negative interest rates ... is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive. ... At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. ... Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal..., such an incentive isn’t a flaw — it’s a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. ...

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt...

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In ... the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. ...

This reminds of the the gift card idea to make sure people spend their tax cuts. Under these proposals, instead of giving people tax cuts, which they are likely to save instead of spend, the government gives them cards worth a given amount, say $1,000, and has the cards expire after, say, three months (you could stagger the issue of the cards over a three month time period so that purchases don't bunch up at the beginning and the end). The connection to the above is, of course, that the expiring gift card is just like the "expiring" money drawn through the serial number lottery (except, of course, that in one case it was a "gift" from the government, while in the other it is your savings). In both cases you are inducing people to spend rather than save through the threat that their saving will become worthless in the future (hyper-inflation does this too).

The reason for gift cards is to prevent the tax cuts from being saved. Initially, I opposed tax cuts that would mostly be saved rather than spent because it wouldn't stimulate aggregate demand, and that's what the economy needed. But I've changed my mind about that, and I think tax cuts can be an important part of the solution in a recession like this one.

Here's why. This recession has wiped out a lot of balance sheets in the financial sector, and it has also done severe damage to the balance sheets of individuals, especially those with a large proportion of their savings in financial assets or real estate (equity in their homes). Those households are not going to spend until those savings for retirement and other purposes are replenished, so how soon the end of the recession comes depends, in part, on how fast those balance sheets are repaired. Tax cuts help to do this, some types better than others. The effect of these balance sheet repairing tax cuts may not be immediately obvious since they are going toward saving, but it helps the recession end earlier than otherwise. Big ticket items, in particular, are less likely to be purchased so long as balance sheets still have big, missing pieces.

So tax cuts should be part of a recovery package, and they can be used in two ways. Some tax cuts can be used to stimulate the economy immediately by helping families who are having trouble and cannot save even if they want to, they have no choice but to consume it all, and part can be targeted at speeding up the recovery by helping households make up for losses. We have to understand, though, that this component of the package will not stimulate aggregate demand immediately, the main effect is to bring an end to the recession sooner, and other measures - increase government spending or additional tax cuts targeted at people who will spend it all - must be increased to compensate.

Recessions can be characterized by their depth and their duration, and my initial opposition to tax cuts underplayed, I think, the role they can play in reducing the duration. I still think the best and most certain way to stimulate aggregate demand is through government spending, and that government spending can itself help to end a recession sooner, but there's a role for tax cuts too. Not in every recession, at least not to the same extent, it's not always the case that a recession wipes out household balance sheets like this one did. But when that happens, household balance sheets are one of the things that must be repaired before we can fully recover.

"Depression Lurks Unless There’s More Stimulus"

Robert Shiller says we need to continue with the monetary and fiscal policies we are pursuing, but both efforts need to be larger:

Depression Lurks Unless There’s More Stimulus, by Robert Shiller, Commentary, Bloomberg: In the Great Depression ... the U.S. government had a great deal of trouble maintaining its commitment to economic stimulus. “Pump- priming” was talked about and tried, but not consistently. The Depression could have been mostly prevented, but wasn’t. ...

In the face of a similar Depression-era psychology today, we are in need of massive pump-priming again. We appear to be in a much better situation due to the stronger efforts to date. Still, there is a danger that, because of a combination of faulty economic theory and inadequate appreciation of human psychology, as well as deep public anger, we will not continue with such stimulus on a high enough level. ...

In our analysis of the current economic crisis, we conclude that the government should have two targets. One would be a joint fiscal-monetary policy target. The same kind of expansionary policies embodied in the government expenditure stimulus and tax cuts that are already being tried have to be done on a big enough scale and for a long enough time in the future. ...

The government should also have a credit target. Once again, we are calling for more of the same kinds of existing policies... Achieving this requires new approaches, like those announced by the Bernanke Fed and the Obama administration, but on a continuing and even larger scale. ...

In this crisis, acceptance of these measures is being replaced with outrage. It is increasing the blood pressure of the public, and that can’t continue without damage to our system. ... It is time to face up to what needs to be done. The sticker shock involved will be large, but the costs in terms of lost output of not meeting either the credit target or the aggregate demand target will be yet larger.

It would be a shame if we are so overwhelmed by anger at the unfairness of it all that we do not take the positive measures needed to restore us to full employment. That would not just be unfair to the U.S. taxpayer. That would be unfair to those who are living in Hoovervilles...; it would be unfair to those who are being evicted from their homes, and can’t find new ones because they can’t find jobs. That would be unfair to those who have to drop out of school because they, or their parents, can’t find jobs.

It is now time to keep our eye on the ball and set clear targets to fix a system that broke when our animal spirits got out of bounds.

"The Case for Waste"

Is the government too worried about preventing waste in the spending associated with the stimulus package, so worried that it is causing harmful delays in putting the spending in place?:

The Case for Waste , by Alec MacGillis, Commentary, Washington Post: As the $787 billion stimulus package starts to flow, the message from on high is clear: No one dare waste a dime of it. "This plan cannot and will not be an excuse for waste and abuse," President Obama declared last month... Sen. Susan Collins (R-Maine) has warned ... that "we must ensure that haste does not make waste" and that even minimal amounts of misspent money would be simply "unacceptable." And California Gov. Arnold Schwarzenegger has appointed an inspector general to oversee "every single dollar" of the $50 billion flowing into his state.

Missing amid all these high-minded calls to protect taxpayer dollars is an awkward question: When the whole point of a major government spending program is to stimulate the faltering economy as quickly as possible, what exactly counts as "wasted" money? After all, if some stimulus cash is misspent -- say an errant official or contractor buys himself a Cadillac or a Harley Davidson, only to suffer the full force of law -- might not such fraud boost the economy more than if the cash languished in a law-abiding state account? All that monitoring, however well-intentioned, may undercut recovery by compelling officials to spend more slowly to avoid hearings, prosecution, or embarrassment in the media. ...

Underlying this contradiction is a broader tension... Obama sold the package as a "down payment" on his goals for energy, education and health care and has expressed the hope that it will also renew confidence in government. From that perspective, it's crucial that the money have the desired policy impact and be spent in an above-board manner. Members of Congress calling for close oversight cite notorious examples of waste in Iraq war contracts and the Hurricane Katrina recovery.

But the stimulus package's main stated goal was to jumpstart the economy by getting billions of dollars into circulation fast, and that requires a different mindset. ... It was John Maynard Keynes who famously said that paying unemployed men simply to dig up bottles filled with cash and buried in abandoned coal mines would be "better than nothing" as economic stimulus.

Instead of catching a break because of the time pressures, the stimulus is receiving far greater scrutiny than regular government spending. ... Rob Nabors,... the White House's point man for the stimulus,... said that the increased oversight is justified because the legislation's policy aims are as much a part of it as the stimulus.

"Yes, from an economic perspective, the money is spent when the money is spent, but we are planning for this money to leave a lasting legacy," he said. "We expect to show not just X numbers of jobs created but X number of homes weatherized. We're looking to improve our parks system, modernize our infrastructure. Any dollar distracted from those purposes really is a wasted dollar." He added: "...and if that means we have to take an extra day to make sure the reporting is in line and we're doing things right, we tend to push the agencies to . . . slow down a little." ...

For all the political benefit of promising to protect taxpayer dollars, the rhetoric around accountability may also unintentionally raise the stakes when the eventual spending scandals do surface. ... "There may be a naive impression that, given the amount of transparency and accountability called for by this Act, little or no fraud or waste will occur... Some level of waste or fraud is, regrettably, inevitable."

It is politically harder to argue for spending that does not produce a tangible asset you can point to, a bridge or something like that (it can even be named after the stimulus package to maximize the political benefit). But even so, I think they have over-emphasized long-term investments that are really about the supply-side of the economy, and under-emphasized policies that can boost demand in the short-run quickly and effectively, but do not have the kinds of long-run impacts that provide "a lasting legacy."

Public Goods and Stimulus Packages

Two from Richard Green. First:

Adam Smith on Roads, by Richard Green: From Chapter 11 of the Wealth of Nations:

Good roads, canals, and navigable rivers, by diminishing the expense of carriage, put the remote parts of the country more nearly upon a level with those in the neighbourhood of the town. They are upon that account the greatest of all improvements. They encourage the cultivation of the remote, which must always be the most extensive circle of the country. They are advantageous to the town, by breaking down the monopoly of the country in its neighbourhood. They are advantageous even to that part of the country. Though they introduce some rival commodities into the old market, they open many new markets to its produce. Monopoly, besides, is a great enemy to good management, which can never be universally established but in consequence of that free and universal competition which forces everybody to have recourse to it for the sake of self-defence. It is not more than fifty years ago that some of the counties in the neighbourhood of London petitioned the Parliament against the extension of the turnpike roads into the remoter counties. Those remoter counties, they pretended, from the cheapness of labour, would be able to sell their grass and corn cheaper in the London market than themselves, and would thereby reduce their rents, and ruin their cultivation. Their rents, however, have risen, and their cultivation has been improved since that time.

Second, in response to Robert Lucas:

Two Questions about Macroeconomics, by Richard Green: I am not a macroeconomist. One of the reasons for this, I suppose, is that I was taught a lot of rational expectations overlapping generations stuff in graduate school and while I found it elegant, I did not believe it. The reason I didn't believe it is because the models are rejected by data: for instance, when households get short term changes in income, they seem to change their consumption behavior somewhat.

Nevertheless, there are ... macro issues that puzzle me. ...Ricardian equivalence types seem to have an underlying assumption that government can't invest in positive NPV opportunities. For instance, Robert Lucas argues that if the government borrows $100 million to build a bridge, household will know they have a future tax liability of $100 million, reduce their spending accordingly, and therefore offset the stimulative impact of the bridge.

But what if the cost to borrow for the bridge is 3 percent and the bridge's IRR is 5%? Then doesn't the bridge stimulate spending for the simple reason that it is a good investment? The federal government has made, it seems to me, some very good investments. Hoover Dam is one. Rural electrification is another. The interstate highway system. The Golden Gate Bridge. The New York City subway system. I could continue...

I do worry about bridges to nowhere. But many macroeconomists seem to believe in the hearts that public goods don't exist, and that there is nothing government can do better than the private sector. I think it is here that macro takes its cues more from religion than science.

[See also: Tax Cuts, Government Spending, Public Goods, and the Stimulus Package and Lucas: Monetary Policy Can Still be Effective.]

"President Obama Must Squarely Face the Bad Asset Problem"

Lessons from Japan from Keiichiro Kobyashi. The key to recovery, he says, is to get non-performing assets off of bank balance sheets: "The greatest lesson from Japan's experience is not that bank recapitalization should take place quickly, but that market confidence can be restored only when progress is made on the painstaking process of disposing of nonperforming assets":

The G20's Blind Spot: President Obama must squarely face the bad asset problem, by Keiichiro Kobayashi, voxeu.org: In proceeding with financial reform in response to the financial crisis, the US has been injecting public funds into banks and struggling companies with little success, sometimes forced to do so repeatedly. It appears that even President Barack Obama, a leader upon whom the expectations of the world await, has been unable to cut the Gordian knot.

Lessons from the New Deal

The Senate committee for Banking, Housing, and Urban Affairs held a hearing today on "Lessons from the New Deal":

Panel 1

• Honorable Christina Romer
  Chair, Council of Economic Advisors

Panel 2

• Dr. James K. Galbraith
  Lloyd M. Bentsen Chair
  Lyndon B. Johnson School of Public Affairs, University of Texas at Austin
• Dr. J. Bradford DeLong
  Professor of Economics
  University of California Berkeley
• Dr. Allan M. Winkler
  Professor of History
  Miami (Ohio) University
• Dr. Lee E. Ohanian
  Professor
  University of California, Los Angeles

Here's the video:

View archive webcast (starts at the 29:00 minute mark)

DeLong: Kick-Starting Employment

Brad DeLong:

Kick-Starting Employment, by J. Bradford DeLong, Commentary, Project Syndicate: Unemployment is currently rising like a rocket... In response, central banks should purchase government bonds for cash in as large a quantity as needed to push their prices up as high as possible. Expensive government bonds will shift demand to mortgage or corporate bonds, pushing up their prices.

Even after central banks have pushed government bond prices as high as they can go, they should keep buying government bonds for cash, in the hope that people whose pockets are full of cash will spend more of it...

In addition, governments need to run extra-large deficits. Spending ... boosts employment and reduces unemployment. And government spending is as good as anybody else's.

Finally, governments should undertake additional measures to boost financial asset prices, and so make it easier for those firms that ought to be expanding and hiring to obtain finance on terms that allow them to expand and hire.

It is this point that brings us to US Treasury Secretary Timothy Geithner's plan to take about $465 billion of government money, combine it with $35 billion of private-sector money, and use it to buy up risky financial assets. The US Treasury is asking the private sector to put $35 billion into this $500 billion fund so that the fund managers all have some "skin in the game," and thus do not take excessive risks with the taxpayers' money.

Private-sector investors ought to be more than willing to kick in that $35 billion, for they stand to make a fortune when financial asset prices close some of the gap between their current and normal values. ... Time alone will tell whether the financiers who invest in and run this program make a fortune. But if they do, they will make the US government an even bigger fortune. ...

The fact that the Geithner Plan is likely to be profitable for the US government is, however, a sideshow. The aim is to reduce unemployment. The appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets that other private investors will have to hold. ... When assets are seen as less risky, their prices rise. And when there are fewer assets to be held, their prices rise, too. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms.

The problem is that the Geithner Plan appears to me to be too small - between one-eight and one-half of what it needs to be. Even though the US government is doing other things as well -fiscal stimulus, quantitative easing, and other uses of bailout funds - it is not doing everything it should.

My guess is that the reason that the US government is not doing all it should can be stated in three words: Senator George Voinovich, who is the 60th vote in the Senate - the vote needed to close off debate and enact a bill. To do anything that requires legislative action, the Obama administration needs Voinovich and the 59 other senators who are more inclined to support it. The administration's tacticians appear to think that they are not on board - especially after the recent AIG bonus scandal - whereas the Geithner Plan relies on authority that the administration already has. Doing more would require a legislative coalition that is not there yet.

We're losing, roughly, 600,000 jobs per month, which is about 20,000 per day. There are many costs associated with job loss, but I wonder how many foreclosures per day are generated from the loss of 20,000 jobs? And that's in addition to the foreclosures we'd have anyway.

The administration has an obligation to protect people from cyclical fluctuations in the economy, to help them avoid losing their jobs, their houses, and other sources of security. For example, if bank nationalization is the safer path to pursue ex-ante to stabilize the banking system, then that means convincing the 60th vote in the Senate, one way or the other, to support the action. If more fiscal stimulus, or a larger version of the Geithner plan is needed, then there should be no rest until the votes are there. If the "tacticians appear to think that they are not on board," or someone takes the time - as I hope they did - to ask them and finds out that, in fact, they aren't aboard, then do whatever it takes to change that.

Maybe the effort was there prior to the Geithner plan, and maybe the effort is there now to try to enhance the Geithner plan through legislative authority, to set the stage for a second stimulus in case it's needed, and to change the public perception of what has been done to date. Perhaps a lot of it is behind the scenes, and all that can be done, is being done. Maybe the administration is saving political capital for other things. But prior to the announcement of the Geithner plan, I had the impression that many of the minds within the administration that counted the most were already made up, or if not fully made up that they had a preference for clever market-based solutions (that the public had no hope of understanding, which makes obtaining the public's support much more difficult), and that stood in the way of a true full court press toward nationalization. As for now, I also wonder if concerns within the administration about the deficit are causing hesitation to pursue more aggressive policies. So I'm not so sure that Voinovich was and is (or will be) the only thing standing in the way.

It's a Zoo Out There. Or Maybe Not.

[via Discover]

Fed Watch: Fed-Treasury Accord

Tim Duy on the Fed's efforts to maintain its independence:

Fed Treasury Accord, by Tim Duy: The Fed and Treasury released a joint statement yesterday afternoon that was lost amid the official release of the Geithner Plan (hat tip Across the Curve).  Clearly, it reveals the concerns of the Federal Reserve that its expansive role in the crisis will eventually threaten monetary independence, and thus wants that right/privilege reasserted:

The Federal Reserve's independence with regard to monetary policy is critical for ensuring that monetary policy decisions are made with regard only to the long-term economic welfare of the nation.

The need for such a statement was heightened by last week's FOMC decision to expand the balance sheet via outright purchases of Treasury securities (in addition to mortgage backed securities).  Considering the massive amount of red ink fiscal authorities are expected to spill for the foreseeable future, the Fed's action could be interpreted as the first salvo in a campaign to monetize deficit spending. I do not believe that this is the interpretation the Fed intends.   Indeed, I believe this is one reason the Fed has shied away from the term "quantitative easing."  Note Bernanke & Co. always place the expansion of the balance sheet in terms of the improving the functioning of private capital markets. See Federal Reserve Chairman Ben Bernanke's speech last Friday:

These purchases are intended to improve conditions in private credit markets. In particular, they are helping to reduce the interest rates that the GSEs require on the mortgages that they purchase or securitize, thereby lowering the rate at which lenders, including community banks, can fund new mortgages.

The stated intent is not supporting fiscal stimulus, creating inflationary expectations, nor even fighting deflation.  The Fed expects they will withdraw their extraordinary liquidity operations when financial conditions stabilize (see Monday's Wall Street Journal).  They expect they will have the political freedom to do so; but the deeper they delve into financial markets, the more politicized their activities become. 

The broad points, with my comments:

"Ricardian Equivalence in Practice"

This discussion at Brad DeLong's makes the point that Ricardian equivalence fails for deficit financed temporary changes in government spending. But what's not clear from the discussion is that there's no reason to expect Ricardian equivalence to hold in any case in practice, even for deficit financed tax cuts where it can be true in theory.

This is from the third edition of Brad's colleague David Romer's Advanced Macroeconomics text where he explains why "there is little reason to expect Ricardian equivalence to provide a good first approximation in practice":

11.3 Ricardian Equivalence in Practice

An enormous amount of research has been devoted to trying to determine how much truth there is to Ricardian equivalence. There are, of course, many reasons that Ricardian equivalence does not hold exactly. The important question, however, is whether there are large departures from it.

Short-Run and Long-Run Deficits

Robert Frank says its important to separate the cyclical component of the budget from its long-run trajectory, and that when evaluating deficits, how the money is spent matters:

When ‘Deficit’ Isn’t a Dirty Word, by Robert H. Frank, Commentary, NY Times: ...Because important policy decisions hinge on whether deficits matter, this is an opportune moment to take stock of what we know. The good news is that there is little disagreement among economists who have studied the issue. The consensus is that short-run deficits help end recessions, and that whether long-run deficits matter depends entirely on how government spends the borrowed money. If failure to borrow meant forgoing productive investments, bigger long-run deficits would actually be better than smaller ones. ...

Galbraith: No Return to Normal

Update: Speaking of Jamie Galbraith, he says to watch this Paul O'Neill video:

---

This is by Jamie Galbraith. There's much, much more in the actual article:

No Return to Normal, by James K. Galbraith, Commentary, Washington Monthly: ...CBO’s model is based on the postwar experience,... if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system. ... Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt’s ambition exceeded anything yet seen in this crisis:

[Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. ... If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.

It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. ... But the relaunching of private finance took twenty years, and the war besides.

A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

That being so, what must now be done?

"Transatlantic Divergence in Tackling the Crisis"

Here's a follow-up to Krugman's column A Continent Adrift:

Transatlantic divergence in tackling the crisis, by Charles Wyplosz, Vox EU: While the US calls for a coordinated macroeconomic policy reaction to the ongoing recession, France and Germany are calling for microeconomic measures to prevent the next crisis. While the US is concerned about mounting unemployment and the associated distress of millions of households, France and Germany worry about their public debts. The G20 will not be able to paper over these differences, which reflect deep divergences in the way economic policies are prepared and understood.

Denial in Europe

It all looks like France and Germany, among other European countries, failed to realise the depth of the recession and the historical hardship that it is gradually creating. Alternatively, it looks like the US authorities are needlessly panicking, sowing the seeds of an outburst of inflation and massive public debt. History will eventually tell who is right. A good bet is that the Europeans are in denial or, worse that they cynically count on the US budget deficit to pull the world out of the recession. After all, the US is where the crisis was created.

For a while, many political leaders in Europe and elsewhere, including in Asia, were soothed by the decoupling theory, according to which the crisis would not come their way. Even now that the decoupling theory is in shambles, many in high positions seem to believe that it will never be as bad in continental Europe as it is in the US. Besides believing that banks here are in better shape, they like to argue that Europe’s famed welfare systems have larger automatic stabilisers and should reassure consumers. This is not really supported by most empirical estimates, but we know that precision is not the hallmark of this corner of economic knowledge.

In fact, our poor understanding of fiscal policy effects is spilling into widespread scepticism that most measures taken by the US will not do much of a difference. Coupled with concerns about public indebtedness, this view has swayed many political leaders into doing as little as possible, essentially dishing out transfers to sensitive industries, a thinly-veiled codeword for “friends”. When influential US economists such as Robert Barro support the view that fiscal policy is basically inefficient, no argument and no evidence will ever convince the sceptics.

It is true that piling up public debt is a guaranteed implication of fiscal policy expansion, while no one really knows how much bang we will get from the bucks. It is also true that many countries had finally started to come to grip with endemic financial indiscipline when the crisis got under way. What is missing in this line of argument is the simple fact that a recession will worsen budget deficits. Containing the recession, therefore, is one way to limit the deficits. This is a lesson that, I thought, we had learnt from the Great Depression. But the debate about the New Deal is raging again. Arguments that it was ineffective are not new, and economic historians have not sorted it out. So, once again, we are in a situation where economists, as a profession, cannot come out with firm answers while individuals relish the possibility of making a clever argument. The problem is that, if clever arguments can get you a publication in a good journal, they may also confuse the laymen, including policymakers.

Why the divide? Europe’s lack of expertise in high office

Why, then, the growing divide between the US and Europe on how to respond to the recession? The size of public debts is one answer. Another answer is that the hallways of power in Washington (both in the Fed and the Treasury) are peopled with first-rate economists who happen to be of the saltwater variety who believe that fiscal policy works and have developed a clear view of what they want to see done. Several of them are also economic historians who have studied the Great Depression in great detail and concluded that, maybe, policy actions did not do as much good as is sometimes asserted, but that inaction under the Hoover administration transformed the financial crash into a full-blown recession.

Now look at the hallways of power in continental Europe, and you will not find many economists, even fewer first-rate economists, and certainly no one who can claim any in-depth knowledge of the Great Depression. Confused policymakers cannot develop a macroeconomic strategy on their own. On the other hand, microeconomic policies are more reassuring, because they do not seem to involve general equilibrium reasoning. Policymakers like partial equilibrium reasoning – because it is easier but mainly because they can believe that they understand what they do. Of course, we know that partial equilibrium is dead wrong and that you never get what you expect.

What can we expect from the G20 summit next month?

Sadly, not much, as most agree. The Franco-German idea of focusing on the next crisis by rethinking financial regulation is disastrous. For one, there is no reason to choose between macroeconomic policies and financial regulation. Both are badly needed, although fiscal action is a matter of acute urgency while financial regulation is going to be a long drawn-out process that will take years to deliver its results. In addition, financial regulation is extraordinarily complicated, as it calls for sophisticated general equilibrium reasoning. Summit meetings are ideally unsuited to the task. It is one thing to ban tax havens, which played no role in the crisis; it is another thing to design incentives that will prevent financial firms from taking risks that yield vast private returns and even larger public losses.

The US, with some support from the UK, Japan and, surprisingly, China, are highly unlikely to extract more than token fiscal policy commitments from the Europeans. Maybe this is not all that disastrous. These four countries account for about a hefty share of world GDP, so they can do a lot of good to themselves and to the rest of the world. Indeed, it is very likely that a significant portion of their fiscal expansion will feed imports from the other countries thus spreading relief internationally, especially if their currencies appreciate, but who knows? The problem is that free-riding by some countries may elicit protectionism from those that carry the burden. And that would be disastrous.

"Grading Obama on the Economy"

I was asked about the grade of "F" the WSJ gave to the economic policies of Obama and Geithner:

Grading Obama on the economy, by Mark Thoma, Comment is Free, UK Guardian: Obama hasn't received high marks for his handling of the financial crisis. Does he deserve a failing grade?

The Obama administration's economic policies received a low average rating from 54 economists participating in a recent poll appearing in the Wall Street Journal, low enough to allow the paper to award an "F" grade to the president and US Treasury secretary Timothy Geithner. (Ben Bernanke fared a bit better.)

However, there was considerable variation across the 54 responses, perhaps because the question was too broad. In particular, when assessing the administration's policy successes or failures to date, it's important to separate the stimulus package from the bailout package, and to separate the economics from the politics.

Though they are often confused, the stimulus package is intended to jump-start the economy and is largely independent of Geithner and the Treasury, while the bailout policies are directed at repairing the financial sector and are, to a large extent, a direct product of the Treasury's efforts.

The economic policies underlying the stimulus package do not, in my opinion, deserve a failing grade, or anything close to that. The policies the administration would have liked to have implemented were based upon solid principles. But I was disappointed with the actual legislation.

The problem was the politics, not the economics. The administration did not get out in front and dominate the political message. Instead, the framing was left to the opposition, and that forced compromises in the stimulus legislation that limited its potential effectiveness, perhaps to the point of falling below the critical threshold needed to get the economy moving.

For example, the bill that actually emerged slanted too much toward tax cuts that are likely to be saved rather than spent, thus reducing the impact on aggregate demand. There was not enough help for state and local governments, and there was not enough help for struggling households who have taken big balance sheet and employment hits as the crisis has unfolded. So while I would give the policy design decent marks, the actual implementation has fallen short, largely due to a tendency to compromise instead of taking control of the political battlefield.

The financial bailout suffers from a similar problem, but here the economics have been problematic as well. The plan has been slow to develop, and does not seem to recognise the nature of the problem. However, this may be due to fear of the politics associated with nationalisation rather than a lack of understanding of the problem and then potential solutions to it. Or it could be from a genuine belief that nationalisation ought to be a last resort.

But all of the false steps, the hesitation, the lack of a firm commitment to a particular course of action look to me like they have been driven by a desire to find some way, any way, of avoiding the political consequences of doing what they know needs to be done in their heart of hearts: take temporary control of the banks, separate the good assets from the bad, recapitalise the banks as necessary, then sell the reconstituted banks back to the private sector.

But instead of leading the political argument, they have allowed the opposition to dominate the political landscape and that has forced the administration's hand in terms of the policies they are able to pursue. In the case of the financial sector, it's time to stop hoping that muddling along until the economy recovers will somehow solve the problem, and to get out in front and lead. As for the stimulus package, the message is the same. Given that the first package may not be enough due to the lack of a proper political foundation, and therefore that a second round may be needed, it would be helpful to begin paving the political path forward here as well.

Clarida and DeLong on Fiscal Policy

Two views on fiscal policy from Brad DeLong and Richard Clarida. First, Clarida who has doubts about fiscal policy (and he isn't so sure about monetary policy either), then DeLong who, like me, is more supportive of fiscal policy efforts.

Richard Clarida:

A lot of bucks, but how much bang?, by Richard Clarida, Vox EU: “We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand” - John Maynard Keynes, “The Great Slump of 1930”, published December 1930.

I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts to discuss the state of global markets, geopolitics, and the many and varied ways that Russia factors into these complex domains. The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me, from the two-and-half-hour session that included probing questions from a number of the audience members assembled for the event.

That theme suggests the title I’ve chosen for this column; there are, at last, a ‘lot of bucks’ now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much ‘bang’ we can expect from these bucks.

Paul Krugman: A Continent Adrift

Was European integration and the creation of a common currency a mistake?:

A Continent Adrift, by Paul Krugman, Commentary, NY Times: I’m concerned about Europe. Actually, I’m concerned about the whole world... But the situation in Europe worries me even more than the situation in America.

Just to be clear, I’m not about to rehash the standard American complaint that Europe’s taxes are too high and its benefits too generous. Big welfare states aren’t the cause of Europe’s current crisis. In fact,... they’re actually a mitigating factor.

The clear and present danger to Europe right now comes from ... the continent’s failure to respond effectively to the financial crisis.

Europe has fallen short in terms of both fiscal and monetary policy... On the fiscal side, the comparison with the United States is striking. Many economists ... have argued that the Obama administration’s stimulus plan is too small... But America’s actions dwarf anything the Europeans are doing.

The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates..., and it has shied away from any strong measures to unfreeze credit markets.

The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.

This is no small matter. Guaranteed health insurance and generous unemployment benefits ensure that, at least so far, there isn’t as much sheer human suffering in Europe as there is in America. And these programs will also help sustain spending in the slump.

But such “automatic stabilizers” are no substitute for positive action.Why is Europe falling short? Poor leadership is part of the story. European banking officials ... still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany’s finance minister you have to listen to, well, Republicans.

But there’s a deeper problem: Europe’s economic and monetary integration has run too far ahead of its political institutions. The economies of Europe’s many nations are almost as tightly linked as the economies of America’s many states... But unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.

This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to ... finance a stimulus that will convey many if not most of its benefits to voters in other countries.

You might expect monetary policy to be more forceful. After all, while there isn’t a European government, there is a European Central Bank. But the E.C.B. isn’t like the Fed, which can afford to be adventurous because it’s backed by a unitary national government — a government that has already moved to share the risks of the Fed’s boldness, and will surely cover the Fed’s losses if its efforts to unfreeze financial markets go bad. The E.C.B., which must answer to 16 often-quarreling governments, can’t count on the same level of support.

Europe, in other words, is turning out to be structurally weak in a time of crisis. ... Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe.

But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?

Summers at Brookings

Economic Recovery
[Transcript of Entire Speech]


Fiscal Solvency


Education


Secretary Tim Geithner
 

Using the Crisis as an Excuse

Andrew Leonard had a post entitled The silliest Republican economic proposal yet. He may want to reconsider that call:

Republicans Propose 'No Cost' Stimulus, Fox News: SEAN HANNITY, HOST: And in "Your America" tonight, another economic plan is also emerging tonight. The Republicans have proposed an alternative to the president's $787 billion stimulus package, and it costs a little bit less. Zero dollars. And it also promises to create two million new jobs without any of your money.

Joining us Congressman John Shadegg and Senator David Vitter. They're here to explain.

All right. Now we keep hearing from the Democrats well, the Republicans, they need to — they need an alternative proposal. You have an alternative proposal.

Congressman Shadegg, we'll start with you.

JOHN SHADEGG (R), ARIZONA CONGRESSMAN: We do have an alternative proposal. It looks at the fact that we spent billions of dollars on this stimulus package taxing the American people and burdening future generations with little to show for it. And many of us believe it will not produce Americans jobs.

With unemployment rates going up how can we produce American jobs? And the answer is we have had a non-energy policy in this country for a very long time. The reality is we are giving jobs to oil fieldworkers and natural gas fieldworkers in Russia and Saudi Arabia and Venezuela, when we should be putting those people to work here in the United States.

HANNITY: Right.

SHADEGG: Now Senator Vitter and I have drafted a bill that says let's put Americans to work, let's pursue the fight we had last summer of an all of the above energy strategy, let's clear the bureaucracy out of the way, and let's move forward with American jobs, producing American energy. ...

So opening ANWR and easing restrictions on offshore drilling is (a) free (never mind the potential environmental costs, those don't count if you're a Republican), and (b) will create 2 million jobs by taking them from other countries (the jobs will come from commies and terrorists, foreigners in any case, so no problem there, no need to count the costs to those workers).

This is, of course, silly and simply a way to use the crisis to push a favorite Republican proposal, something they do routinely (a terrorist threat? looks like we need another tax cut...). But I'm curious why the standard Republican objection to attempted job creation through changes in taxes or spending - that the jobs will simply be taken from other industries - doesn't apply here (if the jobs do come from other industries, it's not "costless" as claimed). Or are there, as Democrats claim, idle resources sitting around just waiting to be put back to work? [Note: Comments point out - correctly - that talking about short-run tradeoffs for this policy is silly since most estimates don't anticipate much job creation from relaxing these restrictions, and the jobs that would be created don't appear for several years. That is, this does nothing to stimulate the economy to use idel resources in the short-run.]

Mr. Freeze

David Brooks:

The Democratic response to the economic crisis has its problems, but let’s face it, the current Republican response is totally misguided. The House minority leader, John Boehner, has called for a federal spending freeze for the rest of the year. In other words, after a decade of profligacy, the Republicans have decided to demand a rigid fiscal straitjacket at the one moment in the past 70 years when it is completely inappropriate.

The real goal, I think, is to protect the Bush tax cuts. The tax cuts are scheduled to expire soon due to budget games the Republicans played to get the tax cuts in place, but they never intended to actually let the tax cuts be reversed. Now that they are out of power, something they didn't expect would happen, there is a possibility that the increase in taxes Bush scheduled to game the budget figures will be allowed to happen after all. However, if the political winds move against more spending - something Boehner is trying to facilitate - and the economy remains weak, the case for allowing the scheduled Bush tax hikes to occur is harder to make.

Update: Paul Krugman:

Can America be saved?: So I read this:

Boehner said Americans want government to practice the same financial restraint they have been forced to exercise: “It’s time for government to tighten their belts and show the American people that we ‘get’ it.”

and I wonder if this country can handle the crisis we’re in. Remember, John Boehner is, in effect, the second-most influential member of the GDP...

What’s insane about Boehner’s remark? He’s talking about the current economic crisis as if it were a harvest failure — as if we faced a shortage of goods, so that the more you consume the less is left for me. In reality — even most conservatives understand this, when they think about it — we’re in a world desperately short of demand. If you consume more, that’s GOOD for me, because it helps create jobs and raise incomes. It’s in my personal disinterest to have you tighten your belt — and that’s just as true if you’re “the government” as if you’re my neighbor.

Plus, who is “the government”? It’s basically us, you know — the government spends money providing services to the public. Demanding that the government tighten its belt means demanding that we, the taxpayers, get less of those services. Why is this a good thing, even aside from the state of the economy?

Again, this is what the leaders of a powerful, if minority, party think. Can this country be saved?

Paul Krugman: Behind the Curve

[Behind the Curve, by Paul Krugman, Commentary, NY Times]

I've heard people say the debate over the size of the stimulus package was misrepresented in the media, that the media rarely presented the view that the plan was too small.

President Obama’s plan to stimulate the economy was “massive,” “giant,” “enormous.” So the American people were told... Watching the news, you might have thought that the only question was whether the plan was too big, too ambitious.

Yet many economists, myself included, actually argued that the plan was too small and too cautious. The latest data confirm those worries — and suggest that the Obama administration’s economic policies are already falling behind the curve.

Why do you say that? Won't his plan create millions of jobs?

Mr. Obama’s promise that his plan will create or save 3.5 million jobs by the end of 2010 looks underwhelming, to say the least. It’s a credible promise... But 3.5 million jobs almost two years from now isn’t enough in the face of an economy that has already lost 4.4 million jobs, and is losing 600,000 more each month.

Ah, I see. Even though it's likely to create 3.5 million jobs as promised, it's still millions short of what is needed. So how do we improve the plan?

There are now three big questions about economic policy. First, does the administration realize that it isn’t doing enough? Second, is it prepared to do more? Third, will Congress go along with stronger policies?

What are the answers?

On the first two questions, I found Mr. Obama’s latest interview with The Times anything but reassuring.

“Our belief and expectation is that we will get all the pillars in place for recovery this year,” the president declared — a belief and expectation that isn’t backed by any data or model I’m aware of. ... And there was no hint in the interview of readiness to do more.

Do you mean he doesn't seem ready to do more in terms of fiscal policy, or that he's not ready to do more of anything, in particular, more to help the banking system recover?

A real fix for the troubles of the banking system might help make up for the inadequate size of the stimulus plan... But he went on to dismiss calls for decisive action... As I read it, this dismissal — together with the continuing failure to announce any broad plans for bank restructuring — means that the White House has decided to muddle through on the financial front, relying on economic recovery to rescue the banks rather than the other way around. And with the stimulus plan too small to deliver an economic recovery ... well, you get the picture.

Yep. It's like one of those bad dreams where your feet won't move fast enough to get away from the impending doom closing in on you. Will the administration wake up and get moving?

Sooner or later the administration will realize that more must be done. But when it comes back for more money, will Congress go along?

One side won't, that's pretty clear, and I'm not so sure about the Democratic side of the aisle either.

Republicans are now firmly committed to the view that we should do nothing to respond to the economic crisis, except cut taxes — which they always want to do... If Mr. Obama comes back for a second round of stimulus, they’ll respond not by being helpful, but by claiming that his policies have failed.

And if there are any small successes to point to Republicans will, of course, insist it was because of the tax cuts in the first round of stimulus. Where does the public stand at this point?

The broader public ... favors strong action. ... But will that support still be there, say, six months from now?

I wouldn't count on it.

Also, an overwhelming majority believes that the government is spending too much to help large financial institutions. This suggests that the administration’s money-for-nothing financial policy will eventually deplete its political capital.

I don't suppose we can borrow political capital from China?

So here’s the picture that scares me: It’s September 2009, the unemployment rate has passed 9 percent, and despite the early round of stimulus spending it’s still headed up. Mr. Obama finally concedes that a bigger stimulus is needed.

And at that point, he begins pushing a new plan?

But he can’t get his new plan through Congress because approval for his economic policies has plummeted, partly because his policies are seen to have failed, partly because job-creation policies are conflated in the public mind with deeply unpopular bank bailouts. And as a result, the recession rages on, unchecked.

Would you bet some of your Nobel money on that prediction?

O.K., that’s a warning, not a prediction. But economic policy is falling behind the curve, and there’s a real, growing danger that it will never catch up.

Rogoff: Countries Risk Drowning in Red Ink

Ken Rogoff with lots of gloom and doom:

Countries are so deep in debt, they risk drowning in red ink, by Kenneth Rogoff, Project Syndicate: No one yet has any real idea about when the global financial crisis will end, but one thing is certain: Government budget deficits are headed into the stratosphere. ...

Although governments may try to cram public debt down the throats of local savers (by using, for example, rising influence over banks to force them to hold a disproportionate quantity of government paper), they eventually will find themselves having to pay much higher interest rates as well. Within a couple of years, interest rates on long-term U.S. Treasury notes could easily rise 3 per cent to 4 per cent, with interest rates on other governments' paper rising as much, or more. ...

With the credit crisis still making it difficult for many small-and medium-sized businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. A real possibility exists that global growth will register its first contraction since the Second World War. ...

Worse, unless financial systems spring back, growth could disappoint for years to come, especially in “ground zero” countries such as the United States, Britain, Ireland and Spain. U.S. long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution.

Countries with European-style growth rates could handle debt obligations of 60 per cent of GDP when interest rates were low. But with debts in many countries rising to 80 per cent or 90 per cent of GDP, and with today's low interest rates clearly a temporary phenomenon, trouble is brewing. ...

Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium-term growth prospects, raising real questions of solvency and sustainability. Italy, for example... Other countries, such as Ireland, Britain and the U.S., started with a much stronger fiscal position but may not be much better off when the smoke clears.

Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the U.S. printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road – if the euro is still around, that is.

As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combination of all three. Unfortunately, the endgame to the great recession of the early 2000s will not be a pretty picture.

That's why I wrote this. As I noted, there are plenty of people who are anxious to pin our economic problems on the deficit, and going one step further, the welfare state (e.g. the "growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution" statement above). But government intervention is not going to make things worse for, say, the typical unemployed worker, it will make things better by improving job prospects and providing an enhanced level of support while unemployed (health care, unemployment insurance, food stamps, and similar programs). The stimulus package won't prolong the recovery period, it will shorten it by jump starting the economy in important areas and keeping it going until the private sector can take over (think of the government spending and tax cuts as a bridge over troubled assets).

So I want to emphasize one more time that stabilization policy does not have to change the size of government in the long-run (and see pgl for a debunking of some of the claims about the size of government. i.e. he notess that "Federal spending as a share of GDP was about as high in 1985 as it is projected to be for 2019").  Fiscal policy can increase the size of government, but it can also shrink the size of government (lower taxes in the downturn, then cut spending when things are better to eliminate the deficit and government will shrink). So the criticism is not about the use of stabilization policy to help people during the downturn and to give the economy a boost, instead it's a claim about the long-term political aims of the administration with respect to the size of government. However, according to pgl's calculations, the projections are that the size won't exceed what we had under that well known socialist sympathizer Ronald Reagan.

Will Fiscal Policy Pass the Test?

This won't be the last downturn in the history of the world, I'm pretty sure of that, and how monetary and fiscal policymakers react and the difference it makes - if any - will be studied carefully and used to guide our response the next time something like this happens.

So we need to do this right. With respect to monetary policy, I think we have learned that monetary policy loses its punch as interest rates get stuck at or near zero. Not everyone agrees - some people argue that unconventional monetary policy can still be used effectively - but even if that's true, I don't think that monetary policy alone can stop the downturn and turn things around.

That leaves fiscal policy. I believe that fiscal policy can help people during downturns like we are in now. I could be wrong about that, the evidence just isn't there to say for sure. But of the two errors, not helping people when help would have mattered, and trying to help but failing to do any good, I'd rather make the second mistake.

But as we try to help, there are two ways in which we could make fiscal policy less attractive as a stabilization tool in the future.

First, the political process could render fiscal policy too weak to be effective. If tax cuts and government spending are directed mostly toward political goals, that could water the policy down so much that it does little good.

In the stimulus package just enacted, politicians did direct tax cuts and spending towards political ends, and they had enough success to make the policy far less effective than it might have been. But let's hope there's enough useful policy measures left to make a difference, and I think there are, and that the evidence is clear enough so that we are able to learn what works and what doesn't. That way, the lesson going forward will be about how to do fiscal policy better next time - which mix of policies works best - rather than that politicians can't be trusted to do it at all.

Second, we could fail to reduce the budget deficit once the economy turns around. Done correctly, stabilization policy does not add to the long-term budget problems of an economy. During the bad times, the troughs of the business cycle are filled by running deficits (either tax cuts or increased government spending), and during the good times the peaks of the cycle are shaved as these policies are reversed. By filling the troughs during the bad times with the shaved peaks from the good times, the economy is more stable since we are moving resources from times when the economy is overheated to times when it is running cold. And since the peak to trough transfers are one-to-one, there is no net change overall in the size of the government debt (the size of government could go up or down in the process, or it could stay the same, that depends upon the particular mix of tax and government spending changes that politicians choose, it has nothing to do with stabilization).

We're pretty good at giving away the goodies when things get bad, and I'm glad we are generous enough to do that, but we haven't been as good at paying the bills when times get better. If we are going to try fiscal policy, and as I said above I don't think we have any choice but to run a budget deficit right now, we have to find a way to pay the deficit off once things improve (but not before). If we don't, if this ends up adding substantially to our long-run debt, then the lesson will be that changes in taxes or government spending are too sticky to be used effectively as a stabilization tool. Taxes can be cut easily, but raising them again later is a lot harder, and  the same goes for spending - it's easier to add to spending than to cut it back. If the lesson is that we cannot overcome this resistance to paying for stabilization policy, and there are plenty of people who cannot wait to make that point - in many cases the same people who are all too ready to argue that the increased debt necessitates cuts in key social programs - then fiscal policy will not look very attractive the next time the economy goes into a recession so deep that monetary policy alone is not enough to save the day.

In the short-run, the first problem is the worry, i.e. that the bill that was enacted is too watered down to be effective (and that another round won't be possible if things don't turn around), but over the longer run it's the second problem that is of concern. If it was up to me - and many of you will be happy it isn't - I'd put parts of fiscal policy in the hands of an independent Fed like structure and charge it with stabilizing fluctuations in the economy over the business cycle while retaining a long-run balanced budget (perhaps even implementing Andrew Samwick's idea of having a predetermined list of infrastructure projects on the shelf and ready to go if a recession hits). But that's not going to happen, so it's up to the political process to make fiscal policy work as a stabilization tool and, while there have been some good signs from the administration along these lines, I can't say I'm overly confident that politicians are up to the task.

Stiglitz: How to Fail to Recover

Yet another voice saying the stimulus package was too small, and that the bank bailout plan is inadequate:

How to Fail to Recover, by Joseph E. Stiglitz, Project Syndicate: Some people thought that Barack Obama's election would turn everything around... Because it has not, even after the passage of a huge stimulus bill,... a new program to deal with the underlying housing problem, and several plans to stabilize the financial system, some are even beginning to blame Obama and his team.

Obama, however, inherited an economy in freefall, and could not possibly have turned things around in the short time since his inauguration. President Bush seemed like a deer caught in the headlights - paralyzed, unable to do almost anything - for months before he left office. It is a relief that the US finally has a president who can act, and what he has been doing will make a big difference.

Unfortunately, what he is doing is not enough. The stimulus package appears big ... but one-third of it goes to tax cuts. And ... Americans ... are likely to save much of the tax cut. Almost half of the stimulus simply offsets the contractionary effect of cutbacks at the state level. ...

In short, the stimulus will strengthen America's economy, but it is probably not enough to restore robust growth. ...

The real failings in the Obama recovery program, however, lie not in the stimulus package but in its efforts to revive financial markets. America's failures provide important lessons...: