Romer on the Stimulus

The success of the stimulus package hinges on the multiplier effect of the increase in government spending. In a talk at the University of Chicago, CEA chair Christina Romer defended her estimate of the multiplier as well as more general criticism of the package.

Whose Moment is This?

It seems to have become somewhat of a contest among pundits, politicians, and economists to name the most relevant economist for the current crisis. Here are the latest:

• Greg Ransom points out that Sears Chairman Eddie Lampert is recommending that shareholders read Hayek.
• A recent Bloomberg article opens, “So long, Milton Friedman. Hello, James Tobin.”

Multimedia

• I highly recommend Tom Keene’s interview with Marvin Goodfriend. Keene, as always, asks the right questions.
• You can see Robert Skidelsky’s speech to the Manhattan Institute on Keynes and Hayek this weekend on C-SPAN’s Book TV. I haven’t yet seen the speech, but Skidelsky is always fun to listen to.

What I’m Reading

1. Mario Rizzo presents a more nuanced version of Keynes with respect to fiscal stimulus.

2. The Money Illusion — an interesting new blog from Scott Sumner. I would note that his posts on the current crisis and the refutation of the Austrian business cycle theory by Friedman and Schwartz are particularly interesting (I happen to disagree with his conclusions, but they are interesting nonetheless).

3. The Theory of Money by Jurg Niehans — a classic.

4. Great Depressions of the Twentieth Century edited by Kehoe and Prescott.

Leijonhufvud on the Financial Crisis

Axel Leijonhufvud has written an excellent policy paper for CEPR. Some highlights after the jump.

Industrial Production

A disturbing graph via Casey Mulligan.

Recommended Reading

1. “Demand for Commodities Is Not Demand for Labor” — Peter Klein

2. “The False Alarm of 2008 Continues” — Casey Mulligan

3. Mario Rizzo asks how we will be able to judge the success of stimulus ex post.

4. Will Ambrosini on technical regress (or, in other words, understanding what negative technology shocks in real business cycles really mean).

Labor Productivity and the Recession

Casey Mulligan’s new working paper is now available through NBER (non-gated version here). Here is the abstract:

A labor market tautology says that any change in labor usage can be decomposed into a movement along a marginal productivity schedule and a shift of the schedule. I calculate this decomposition for the recession of 2008, assuming an aggregate Cobb-Douglas marginal productivity schedule, and find that all of the decline in employment and hours since December 2007 is a movement along the schedule. This finding suggests that a reduction in labor supply and/or an increase in labor market distortions are major factors in the 2008 recession. The decline in aggregate consumption suggests that the reduction in labor supply (if any) is neither a wealth nor an intertemporal substitution effect. “Sticky real wages” or the emergence of significant work disincentives are possible explanations for these findings.

Critics have been quick to reject the idea that the rise in unemployment is largely due to labor supply shift (see here, here, and here). However, each of these criticisms assumes that the change in the labor supply is limited to voluntary choice (i.e. intertemporal substitution effects and/or wealth effects). Mulligan’s paper similarly refutes the idea that the shift in the labor supply can be attributed to these factors as they imply that consumption should be rising when, in fact, it is falling. He therefore argues that the shift in the labor supply can be explained by labor market distortions.

In contrast to the critics above, I actually find this argument somewhat compelling. For example, we are coming out of a period in which we experienced an unprecedented housing boom. Thus, from a macroeconomic perspective, it is likely that we are seeing an increase in the natural rate of unemployment as the economy goes through a significant restructuring. Whether or not this increase is substantial enough to explain the drastic rise in unemployment is questionable, but Mulligan’s paper seems provide some evidence for such a claim.

You Cannot Be Serious!

The debate over stimulus has no progressed to the point at which certain individuals are now claiming that wasteful government spending is stimulus. Case in point, Jonathan Chait:

Normal spending is judged on those terms–whether the goods or services justify their cost. The point of stimulus spending, by contrast, is simply to spend money–on something useful if possible, wasteful if necessary.

I similarly heard an economist — who shall remain nameless — on one of the financial news networks arguing that we could literally boost the economy by paying people to dig holes and fill them back in. This is utter nonsense!

Frederic Bastiat wrote in Economic Sophisms:

But what constitutes the measure of our well-being, that is, of our wealth? Is it the result of the effort? Or is it the effort itself? There is always a ratio between the effort applied and the result obtained. Does progress consist in the relative increase in the first or in the second term of this ratio?

[…]

According to the first thesis, wealth is the result of labor. It increases proportionately to the increase to the ratio of result to effort. Absolute perfection, whose archetype is God, consists in the widest possible distance between the two terms, that is, a situation in which no effort at all yields infinite results.

The second contends that effort itself constitutes and measures wealth.

This is indeed at the core of the debate. Those who argue that wasteful spending will jump-start the economy are either disingenuous or simply do not understand how wealth is created. Wealth is not created by turning on the printing presses and handing individuals checks for a worthless day’s work. On the contrary, that is how wealth is destroyed!

Jonathan Chait further succumbs to another fallacy:

World War II was an effective stimulus that, economically speaking, consisted of 100 percent waste. If war hadn’t broken out, we could have enjoyed the same economic benefit by building all those tanks and planes and dumping them into the ocean.

Those who repeatedly make the claims that the New Deal or World War II got us out of the Great Depression are arguing against solid empirical evidence (from Barrack Obama’s CEA Chair Christina Romer no less). Romer’s influential paper concludes:

Monetary developments were a crucial source of the recovery of the U.S. economy from the Great Depression. Fiscal policy, in contrast, contributed almost nothing to the recovery before 1942.

[…]

That monetary developments were very important, whereas fiscal policy was of little consequence even as late as 1942, suggests an interesting twist on the usual view that World War II caused, or at least accelerated, the recovery from the Great Depression. Since the economy was essentially back to its trend level before the fiscal stimulus started in earnest, it would be difficult to argue that the changes in government spending caused by the war were a major factor in the recovery.

Further, any effects on growth from World War II largely had to do with the effects of financing, not with spending:

. . . Bloomfield’s and Friedman and Schwartz’s analyses suggested that the U.S. money supply rose dramatically after war was declared in Europe because capital flight from countries involved in the conflict swelled the U.S. gold inflow. In this way, the war may have aided the recovery after 1938 by causing the U.S. money supply to grow rapidly. Thus, World War II may indeed have helped to end the Great Depression in the United States, but its expansionary benefits worked initially through monetary developments rather than through fiscal policy. [Emphasis added.]

Critics, such as Krugman, will perhaps note that the spending during the 1930s was not truly stimulus in the sense that it was not financed with deficit spending. However, as I have previously detailed, given that the empirical evidence suggests that Ricardian equivalence is a good approximation of the actual behavior of individuals, it is likely that the effect of financing would be equivalent to the effect of a tax increase.

Ultimately, regardless of one’s stand on the need for stimulus, it is necessarily true that any form of government stimulus must be justified by its intrinsic value. The practice of wasteful spending, on the other hand, destroys wealth.

The Geithner Plan

Pictures are worth a thousand words.