Tag Archives: Stimulus

Differences on Fiscal Matters

Mark Thoma writes:

Additional fiscal policy measures could make a difference to the unemployed, but instead the administration is proposing policies that might sell well, but only address a tiny fraction of the long-run deficit problem.

I think that in many instances this statement can summarize the differences between those who favor and those who don’t favor fiscal stimulus. Those who favor the stimulus read this statement and think that things just need to be done better. However, myself and others who oppose stimulus recognize that policies that “sell well” are the rule, not the exception when it comes to real world policy design and that this is part of the drawback.

Can We Please Raise the Level of the Debate?

In all of our self-importance, economists and political pundits have seen the current recession as a time to argue about whether markets clear. Inevitably, the discussion on financial news networks always devolves into a debate about whether markets are efficient, etc.* (Incidentally, can I call cross-talk and yelling a discussion? I am talking to you CNBC.) A prime example of this type of discourse is found in a recent article by John Tamny and a subsequent post by Ezra Klein.

Tamny’s article essentially extols the virtues of free markets. He points out that recessions often lead to falling asset prices, which allow others to purchase these assets and use them more wisely. Tamny is correct that an important part of any recession is the reallocation of assets and capital. However, when making a larger point about the macroeconomy and the policy, it often doesn’t serve ones case to provide anecdotal examples of how markets clear.

Ezra Klein rightfully scoffs at using such examples to sell markets as well as articulating the left-of-center response that although markets might clear, the process can be painful. Unfortunately, Klein continues:

What would a “humble federal government” do, exactly? Shut down the stimulus projects so a couple million more people end up unemployed and a couple million other people can buy their possessions at fire sale prices? Shut down the system of financial supports which are currently sustaining a weakened lending market? Should they have held back from Detroit’s collapse so that the assets of the various companies were simply liquidated, along with what was left of the Rust Belt’s economy? Should they cut off economic aid to the states so infrastructure literally crumbles?

A course these are all loaded questions. For example, even if the stimulus were to save “a couple million” jobs, this would come at the expense of either current or future consumption due to the increase in future tax liabilities that was created thereby causing job losses where this money is no longer spent. (We have been through the literature on this before.) It is similarly questionable why the automakers would have to liquidate upon entering bankruptcy without government assistance.


At the end of the day, it will be a resuscitation of household spending and business expansion that restarts our economic growth. But for now, both have fallen through the floor, with terrible consequences for both individuals and businesses. What little demand exists is being substantially kept afloat by the massive intervention of the federal government.

Define “little”. I would describe several trillion as substantial. Furthermore, there must be a very large multiplier, especially considering much of the fiscal stimulus hasn’t even been spent.


…the idea that the economy will heal itself if the government only steps out of the way is exactly the thinking that led to the deep recession of 1937. What a pity those lessons haven’t been better learned.

I am struggling to understand how the year that FDR decided to raise taxes and the Federal Reserve decided to increase reserve requirements thereby leading to another monetary contraction strikes one as government getting out of the way. It is indeed a pity that those lessons haven’t been learned.

I don’t mean to pick on Klein or Tamny, but rather highlight the fact that this debate is rather silly. We did not live in a world of laissez faire prior to the financial crisis — nor prior to the Great Depression — and thus it seems more than a bit self-important to sit around and debate whether markets clear as though we are living through the quintessential moment in which this argument will be won. It is also important to realize that the fact that markets fail does not imply that government can perform any better.

* I find this entire debate to be quite a bit tiresome as well considering that banks are one of the most heavily regulated industries in the country (by this I mean the actual regulation that is supposed to be enforced, not what actually is enforced) as well as the fact that the Federal Reserve, whose power is derived from the government, plays such a central role in this entire fiasco.

Keynesian Versus New Keynesian Multipliers

A new paper from Cogan, Cwik, Taylor and Wieland suggests that the estimated multipliers are inflated:

Renewed interest in fiscal policy has increased the use of quantitative models to evaluate policy. Because of modelling uncertainty, it is essential that policy evaluations be robust to alternative assumptions. We find that models currently being used in practice to evaluate fiscal policy stimulus proposals are not robust. Government spending multipliers in an alternative empirically-estimated and widely-cited new Keynesian model are much smaller than in these old Keynesian models; the estimated stimulus is extremely small with GDP and employment effects only one-sixth as large and with private sector employment impacts likely to be even smaller.

Here is the non-gated link.

Estimating the Multiplier

As many of you know, I have expressed skepticism that the stimulus package will work. At the heart of the debate is whether the multiplier associated with government spending is greater than one. Some recent literature should allow us to do some back-of-the-envelope calculations of the multiplier.

A recent paper by Matthew Shapiro and Joel Slemrod (non-gated link) uses survey data to determine the effects of the 2008 stimulus package in which individuals received tax rebates. They find that 20% of those interviewed suggested that they would “mostly spend” the rebate. 32% would mostly save the check and the remaining 48% would mostly pay down their debt. At first glance, this would seem to suggest that the fraction of the population likely to increase their consumption is 20%. The authors, however, note that there is a difference between “save” and “mostly save”. Thus, they estimate the marginal propensity to consume (MPC) to be roughly .3.

In Mankiw-Campbell land, this roughly translates to the idea that the fraction of consumers that are rule-of-thumb consumers (those that live paycheck-to-paycheck) is about .3. We can then use this measure of the number of rule-of-thumb consumers to estimate the multiplier based on a recent study by Jordi Gali, et. al (HT: Ambrosini).

The paper by Gali, et. al provides two ways to estimate the multiplier based on the fraction of rule-of-thumb consumers. First, with competitive labor markets, the fraction of rule-of-thumb consumers would have to be roughly .65 to generate a multiplier of 1. Clearly, this is well above the estimate provided above. Second, with non-competitive labor markets, the fraction of rule-of-thumb consumers would have to be .25 to generate a multiplier of 1. Further, a rule-of-thumb fraction of .3 implies a multiplier greater than 1, but less than the administration’s estimate of 1.5.

Naturally, this raises the question as to whether the labor market in the United States is competitive. Gali et. al define a non-competitive labor market as that in which unions set the wage and employment is determined by the labor demand curve. The idea that the wage is determined by labor demand is certainly a reasonable assumption, especially given the current circumstances (Thanks Will). Thus, based on the work presented, the multiplier may be slightly above 1.

(A BRIEF NOTE: The paper by Shapiro and Slemrod examines the impact of a temporary government stimulus. The current stimulus package contains both temporary and permanent aspects. Nevertheless, I think that their estimates provide a meaningful guide. The current stimulus provides permanent tax cuts through the “making work pay” rebate. It also includes temporary spending provisions such as infrastructure spending etc. In addition, some of the spending side is likely to be permanent. Thus, the increase in consumption is likely to be greater than that estimated by Shapiro and Slemrod because the tax cut is permanent. However, this effect might be offset by the permanent increases in government spending in the package, which will crowd out private investment. Also, the package has been sold as a temporary stimulus to the American people and thus treating the entire thing as temporary when evaluating the behavior of consumers is likely a good first-approximation. Finally, these are merely back-of-the-envelope calculations and should be taken with a grain of salt.)

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 Stimulus Debate and the Stimulus Package

Will Wilkinson has been ridiculing macroeconomics for the last few weeks for the apparent inability of theory to provide a consensus view on the stimulus package. While I admit that there is a great deal of debate among economists about the desirability of the stimulus package, one must understand both macroeconomic theory and the nature of the debate to actually make sense of the bantering. The simple “macroeconomics sucks” mantra, while provocative, is not a legitimate criticism.

The stimulus debate is largely centered around two questions:

1. Can we create a stimulus package that will boost real GDP in the short run?

2. Can a stimulus package get us out of the recession?

The problem with the debate is that those in favor of the stimulus package answer question 2 in the affirmative while actually providing evidence for question 1. On the other hand, those who oppose the stimulus package do not believe that the it will get us out of the recession, but argue on the grounds that it cannot even boost real GDP.

I have already discussed what macroeconomic theory has to say about a potential stimulus package and so I will not belabor the point. Suffice it to say that, if designed correctly, a stimulus package could provide a temporary boost to real GDP. It will not, however, get us out of the recession.

Of course, this brings us to the actual stimulus package. The problem that we are dealing with is that what is being proposed is not based on any type of economic theory, but is rather a grab-bag of goodies to be handed out under the guise of being of the public interest. This is, of course, something that is implicitly assumed by many stimulus skeptics and ignored by many of the stimulus advocates. Nevertheless, the stimulus in its current form likely renders this debate to have been for naught.

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?

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.

The Consumption Myth

Stimulus. Every politician and every pundit has a plan to “stimulate” the economy. Yet very few seem to understand that consumption is not the driver of economic growth. Rather this notion is a relic of old Keynesian thinking and a misinterpretation of GDP calculations.

The natural beginning of this discussion should begin with Say’s Law. According to Say’s Law, supply creates demand. In other words, there cannot be demand without supply. The division of labor allows individuals to work hard to produce goods in a field in which they specialize in order to earn income which in turn will facilitate the purchase of goods from someone else with another specialization. The natural conclusion of Say’s Law is that there can never be a recession due to a lack of demand.

One of the major insights of John Maynard Keynes was to claim that Say’s Law did not hold in the short run. According to Keynes, Say’s Law does not hold up in the short run. According to Keynes, shortfalls in aggregate demand were the main cause of involuntary unemployment and other frictions in the macroeconomy. His solution was to facilitate an increase in aggregate demand through government spending. Since the time of Keynes, this type of prescription has taken many forms (i.e. temporary government employment programs and tax rebates).

The remnants of Keynesian thinking are still alive and well today (as evident from the proposed stimulus package). All in all, the assumption is that consumption is what can alleviate economic downturns. However, this is largely based on a misconception about what causes monetary disequilibria.

When Swedish economist Knut Wicksell wrote Interest and Prices, he introduced the idea of a natural rate of interest. The natural rate was “the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods.” (p. 102) Thus when the market rate of interest is equal to the natural rate, the economy is in a state of monetary equilibrium. However, if the market rate should deviate from the natural rate, monetary disequilibrium would occur and lead to economic discoordination and a change in the overall price level.

It seems important to note that when Keynes originally wrote A Treatise on Money, a great deal of his insights were centered on Wicksellian foundations. However, Keynes’ General Theory left out these insights (perhaps because they could not be explained away).

Others, however, such as Hayek and many others in the Austrian school as well as monetarists such as Clark Warburton, Leland Yeager, and others have critiqued and advanced the Wicksellian theory to more aptly describe monetary disequilibrium and the discoordination that results. The Austrian school largely emphasizes the role of capital, changes in relative prices and the eventual boom and bust due to monetary disequilibrium are caused by monetary expansion (a rate of interest below the natural rate). In contrast, the monetarists largely contend that the excess demand for money (a rate of interest above the natural rate) causes discoordination due to the differing effects on prices resulting from varying degrees of price stickiness that in turn lead to the introduction of noise in price signals and therefore reductions in output.

The important point is that Keynesian solutions to the idea of inadequate demand are somewhat lacking. The lack of an explanation of intertemporal coordination (as was shown through Wicksellian foundations) creates a false sense of belief that actively managed monetary and fiscal policy can facilitate appropriate changes in unemployment without producing macroeconomic discoordination. Of course, the unfortunate and painful lessons of the Phillips Curve management have largely proven otherwise.

Even beyond the pure academic Keynesian thinking (although one could argue it finds its roots there) is a further misrepresentation of the explanations for economic growth by pundits. When tuning in to financial news, one cannot help but to be bombarded with the ridiculous notions that the consumer is what drives the economy. Again, this is a misrepresentation that is facilitated by remnants of Keynesian thought as well as a misunderstanding of the concept of GDP shares.

First, in order to consume, one must earn an income that allows for consumption (even borrowing is based upon one’s income and credit standing). If one is not producing, one cannot consume. As we have previously detailed, this is the major insight of Say’s Law. Without getting into a discussion of which comes first, demand or supply, it should seem quite obvious that if Keynes is true and Say’s Law does not hold up in the short run and that government intervention could facilitate the lack of demand, it would only be admissible to follow such a policy if the benefits exceed the costs. However, a Wicksell-based understanding of intertemporal coordination suggests that the cost could be substantial given the potential subsequent macroeconomic discoordination. Thus, it is doubtful that the benefits of temporary stimulus could exceed the costs of future discoordination.

Second, financial news pundits love to highlight the fact that over 60% of GDP is consumption. Thus, it must follow that consumption is what drives economic growth, right? Wrong. GDP accounting is merely, as the name would suggest, an accounting device. Given the fact that GDP is the total of new final goods and services produced in a given year, it is hardly a surprise that a majority of those final goods would be consumed by a developed country. Discussing the share of GDP as though it were a predictor of relative importance is incorrect. The large consumption share of GDP is not a signal of begin the driver of economic growth, but rather a reflection of the prosperity in the United States. Economic growth is caused by technological innovation and productivity. The result of economic growth.

So while it may be politically popular to promote stimulus packages, these ideas are largely based on misconceptions of the role of consumption that have been rampant since the emergence of Keynes. In reality, actively managing the economy can have serious adverse effects on the economy. For that reason, I’d prefer not to be stimulated.

Bipartisanship and Stimulus

Clive Crook:

The country may be ready for a woman or a black man as president–but can it deal with something more radical? I mean cooperation between Republicans and Democrats. The reception of last week’s fiscal stimulus agreement between the Bush administration and the House leadership makes you wonder whether America is ready for bipartisanship. Everybody says they want it. Finally we get some, and everybody hates it.

Certainly, economists hate it — and rightfully so.