McArdle, Stimulus, and the Literature

Megan McArdle writes:

The real question, I think, is how close the permanent income hypothesis is to being true.

Well, there is some recent literature by John Seater (and co-authors) that suggests it is true (see here, here, and here).

She continues:

The basic idea is that people are forward looking, and they try to smooth their consumption over time. So if you give them a “temporary tax cut”, they save most of it, knowing that eventually they will have to give the money back.

But of course, this should also be true of “temporary government spending”–if people think the money won’t be there next year, they’ll salt as much of the money away as possible. This is a topic very underexplored in the various estimates of the stimulus multiplier, even though consumers are massively overleveraged and will presumably save as much of their new income as they can.

She is correct regarding the temporary tax cut, however, her claim regarding government spending is simply incorrect. Under the permanent income hypothesis, individuals base their consumption decisions on the their permanent lifetime income. A permanent increase in government spending is equivalent to an increase in the present value of taxes paid by the household. However, the present value of a temporary increase in government spending is zero (0). The difference between the two is that in the first instance individuals will reduce consumption due to the increase of the present value of taxation, whereas under the latter scenario there is no such expectation.

I am also not sure that this is “underexplored”. Anyone care to defend that claim?

Modern Macro

I echoed Will Ambrosini’s call for critics of modern macro to survey the literature. Here are a couple papers (non-gated) that provide an overview:

• Convergence in Macroeconomics: Elements of the New Synthesis by Michael Woodford
• The Econometrics of DSGE Models by Jesús Fernández-Villaverde

I would actually recommend the debut issue of the American Economic Journal: Macroeconomics (which features the Woodford piece above) for a brief look at the goings on in modern macro as well.

A Note to Critics

The belief that macroeconomic theory is garbage and that it has nothing to say about the current crisis (and policy) is pure myth. This is one of the points that I tried to make in writing my piece on the stimulus package.

Will Ambrosini (who has been added to the blogroll) suggests that critics actually survey the literature before leveling their charges.

Krugman on the Bad Bank

Krugman revives an old joke:

As the Obama administration apparently prepares to launch Hankie Pankie II — buying troubled assets from banks at prices higher than they will fetch on the open market — it occurred to me that an updated version of an old Communist-era joke may be appropriate: under Bush, financial policy consisted of Wall Street types cutting sweet deals, at taxpayer expense, for Wall Street types. Under Obama, it’s precisely the reverse.

More on Stimulus

1. James Hamilton presents his stimulus package.

2. Will Ambrosini discusses a paper by Jordi Gali that measures the multiplier relative to the fraction of non-savers.

3. Of course, the actual stimulus bill doesn’t appear to be able to generate all that much stimulus — or to even be aimed at doing so.

4. Cato is running an advertisement that includes the signatures of economists who oppose the stimulus package.

Thoughts on Stimulus, UPDATED

The debate over stimulus is growing quite divergent. First, there is understandable disagreement about the nature of stimulus policies in and of themselves. Second, the is a growing debate as to whether or not the Obama stimulus plan itself will be successful. (I have previously offered my thoughts on stimulus here.)

The first debate is laid out explicitly by Robert Barro, who in today’s WSJ discusses the multiplier associated with government spending:

Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called “multiplier” effect of government spending on economic output is greater than one — Team Obama is reportedly using a number around 1.5.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy’s total output expands by enough to create the airplane or bridge without requiring a cut in anyone’s consumption or investment.

The explanation for this magic is that idle resources — unemployed labor and capital — are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

Barro then uses World War II spending to estimate the multiplier effect of government spending. What he finds is that the multiplier for this period is about 0.8. What this means is that for every $1 that the government spent, GDP increased by $0.80. For times of peace, he finds that the multiplier is statistically insignificantly different from zero (we cannot reject the hypothesis of a complete crowding out of private expenditure, for non-econ nerds). Indeed, this is consistent with Hayek’s critique of Keynesian policies. Hayek pointed out that while Keynes criticized classical economists for assuming full employment, Keynes was implicitly assuming unemployment of resources.

Barro’s peacetime finds warrant further investigation as he does not state whether this measurement is for all periods or times of less than full employment as well as whether he is referring to temporary or permanent government purchases. However, it is clear that his findings regarding World War II fail to satisfy the ceteris paribus assumption needed for such analysis. As Paul Krugman explains:

Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort. Oh, and the economy was at full employment — and then some. Rosie the Riveter, anyone? I can’t quite imagine the mindset that leads someone to forget all this, and think that you can use World War II to estimate the multiplier that might prevail in an underemployed, rationing-free economy.

Nonetheless, the debate about the multiplier is perhaps the important question regarding the stimulus package and despite the possible flaw in using World War II data, I think that Barro’s conclusion regarding the multiplier being below 1 is likely correct. After all, I don’t think that we can make the claim that there is no crowd out effect or that the multiplier overwhelms any crowding out.

On this point, Casey Mulligan has offered some interesting thoughts. His main conclusion is as follows:

Government spending will reduce private spending virtually anywhere it may be targeted. The case for government spending should thus be made on its intrinsic, not stimulation, value.

I think that this is perhaps the best way of thinking about stimulus. I agree with Barro and Mulligan in that the multiplier is likely between 0 and 1. I do not buy the argument that it is zero in the current environment. Thus, if it is close to one, there is an argument that can be made for spending based on its intrinsic value. For example, the modernization of government facilities and the rebuilding of infrastructure represent these types of ideas. Ultimately, the multiplier is dependent upon the spending itself. For example, if spending is temporary (as is implied in the examples just given) the multiplier is likely to be larger than if spending is permanent. In the latter case, there is substantial reason to believe that the multiplier is quite small and perhaps near zero.

This brings us to the question as to the likelihood of success of the Obama stimulus package. Mulligan warns of the particular aims of the stimulus:

Despite the recent increase in unemployment rates, I see little reason why the multiplier situation is realistic. For example, President Obama’s economists have explained that about half of the jobs they plan to create (both directly and indirectly) are for women. But the large majority of this recession’s employment reduction has been among men. Thus, the Obama spending plan is not intended to primarily draw on the pool of people unemployed in this recession.

President Obama has a vision to spend more on health care, largely for its intrinsic value. Its stimulation value is minimal because unemployment is low in that sector; health sector employment has actually increased every single month during this recession.

I am not optimistic about stimulus in terms of lifting us out of the recession and, in particular, I am not optimistic about many aspects of the Obama stimulus plan. Further, the assumption of a multiplier of 1.5 is incredibly unlikely. I would much rather see meaningful tax reductions (e.g. lower marginal rates, lower corporate tax rates).

UPDATE: There has been a great deal of discussion in the blogosphere surrounding the nature of the rhetoric, especially with regards to Krugman’s comment that Barro’s analysis was “boneheaded.” In this respect, I think that Tyler Cowen’s comments sufficiently summarize my view:

Either way you cut it, there aren’t any boneheads in the room.

Indeed. After all, Robert Barro essentially wrote the book on government from a macro perspective. The tone of the debate is trending down and I think that we would all do well raise the level of discourse to a respectful tone.

Again, my view (free of name-calling) is that:

1. Stimulus will not get us out of the Depression.

2. The multiplier for government spending is likely between 0 and 1, which means that $1 spent by the government results in less than a $1 increase in real GDP.

3. Given (2), the proponents of the stimulus package must make their proposals based on intrinsic value rather than on promises that are impossible to keep. On this point, Barro is right on, “Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called ‘multiplier’ effect of government spending on economic output is greater than one — Team Obama is reportedly using a number around 1.5.”

Questions For Tim Geithner

The NYT is running a piece in which economists (and others) propose questions for Tim Geitner. My favorite questions come from Anna Schwartz:

1. Ordinary taxpayers would like an answer to this question: Why have they been billed more than $45 billion to rescue Citigroup from failure when, as president of the Federal Reserve Bank of New York, you were its primary supervisor? Three major problems led to Citigroup’s downfall: bad investment policy; overexpansion, which overwhelmed Citigroup’s management; and an inadequate capital base. Why was Citigroup’s supervision inadequate to deal with these problems?

2. The Treasury and Federal Reserve have been selecting which companies in American industry and finance will get taxpayer money. What criteria do you use to decide?

3. During the banking crisis of the late 1980s, assets of failed savings and loans were acquired by the government’s Resolution Trust Corporation. The trust corporation then sold off the assets in an orderly fashion. Would you consider requesting Congress to revive the Resolution Trust Corporation, so you would not have to decide which companies to save and which not to save? Would you consider re-establishing the trust corporation now for commercial banks that are likely to fail?

— ANNA JACOBSON SCHWARTZ, an economist at the National Bureau of Economic Research and the author, with Milton Friedman, of “A Monetary History of the United States, 1867 to 1960”

Zero Inflation?

Was 2008 really the year of zero inflation? Perhaps not. From the WSJ’s Real Time Economics:

Measured on a December to December – or calendar year – basis, the consumer price index only grew 0.1% in 2008, according to Labor Department figures, the smallest gain in over 50 years and well below the 4.1% gain in 2007.

But when the annual average of the CPI for all of 2008 is compared to the average for 2007, the increase was much higher, 3.8%. That was actually up from 2007’s rate.

“It’s unusual for there to be this big of a difference,” said Labor Department analyst Stephen Reed. The two series sometimes line up exactly, and usually when there’s a gap it’s only a few tenths of a percentage point.

I actually prefer the calendar year measure, but an anomaly nonetheless.

The Great Depression Debate

Our friend David Beckworth explains the Great Depression debate with one picture.

Taylor on the Crisis

If I could only recommend one economist to read on the current financial crisis, I would choose John Taylor. His latest paper details the causes of the financial crisis as well as the subsequent policy responses (and failures). Here are some highlights:

• He presents evidence that the Federal Reserve significantly deviated from its historical behavior (the Taylor Rule), which created the boom-bust scenario in housing.
• He presents counter-factual evidence through the use of simulation that suggests the housing boom would have been avoided had the federal funds rate not deviated from the Taylor rule.
• He rejects the global savings glut hypothesis.
• The behavior of other central banks similarly deviated from the Taylor rule and those with the largest deviations also had the largest housing booms.
• There is a connection between excessive monetary policy and risk-taking.
• The subprime mortgage market exacerbated the problem.
• The financial crisis was (is) not a liquidity problem, but rather a counter-party risk problem.
• There is a strong correlation between the sharp cuts in the federal funds rate and the price of oil.
• Credit spreads increased in the aftermath of the announcement of the TARP. (Taylor blames this on the uncertainty surrounding the vague discretionary power of the Fed/Treasury in implementing the plan.)
• From his conclusion:
  

  “In this paper I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.”

I am teaching Money and Banking again this semester and this paper will undoubtedly be required reading.

Here is a non-gated link to the paper.