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What a massive fiscal boost can and cannot accomplish
I feel like I am repeating myself, but since the topic is so much in the news, let's give it another go. A massive fiscal policy could:
1. Generate some investments which are worthwhile on their own terms. LaGuardia really does need another runway.
2. If the broader monetary aggregates are falling, because of either a credit crunch or a liquidity trap, a fiscal boost can keep aggregate demand from deteriorating. Note that this is distinct from bringing about a recovery; it is limiting further downside.
3. A fiscal boost can provide a beneficial "sunspot" in a multiple equilibrium model, thereby moving everyone to the higher output equilibrium.
4. If spending needs to fall, a fiscal boost can postpone this fall. Postponing this fall may be a good idea to prevent immediate economic destruction. But then the fiscal policy is not really bringing about recovery. In fact the fiscal policy is (optimally, perhaps) hindering the pace of adjustment and recovery. Fiscal policy makes the downturn less severe but it also prolongs the adjustment process.
You'll note that only under #3 does a massive fiscal boost in fact bring about an economic recovery. But I do not believe that #3 is better for anything than a few good days in the stock market nor do most people rely on #3 in making the case for fiscal policy.
You might also try #5:
5. The economy needs a boost to aggregate demand and since monetary policy isn't working any more, fiscal policy has to step in. This is usually followed by drawing a graph with two or three curves on it.
This makes sense if it is reworded to be more precise and to be some combination of #2 and #4. But still, a huge fiscal boost will not bring recovery because a big chunk of the problem requires real economic adjustments (the simple graph obscures this). The economy needs to adjust out of housing, out of so much consumption, and out of various classes of associated risky assets. Those are some pretty massive adjustments and along the way lots of major banks become zombie banks. A massive fiscal boost won't get us over those problems.
Just to recap: Because of #1 and #2, you might think that a massive fiscal boost is a good idea, compared to the alternatives. But you should not argue that a massive fiscal boost will bring about or drive an economic recovery. It is tempting to cite #5 to justify the fiscal boost but the bottom line is some mix of #2 and #4.
Posted by Tyler Cowen on November 24, 2008 at 05:31 AM in Economics | Permalink
Comments
Regarding Keynsian stimulus of the kind Tyler seems somewhat enamored,
I posted the following at Cafe Hayek:
Keynsian stimuli are orthogonal to microeconomic stimuli (i.e., seeing resources allocated to their highest valuing users. The reason is that the aggregated government variables in the macro models G, T, etc. make no distinctions between different types of, for example, G and T. Following Osama's attack on the United States, the defense portion of G grew. Much of this was socially productive, but lots of other aspects of G grew that allocated resources AWAY from highest valuing users (e.g., various and sundry Congressional pork unvetoed by President George Dry-pen Bush).
The proposal of Obama to "lower taxes for 95% of the American people" would have to be considered by a Keynesian as a reduction in T. But any self-respecting micro economic would have to rhetorically ask, for starters, whether introducing further progression into the tax system would be lead resources to be allocated toward or away from highest valuing users.
G and T in the Keynesian model are blunt instruments; using them on the economy is like doing brain surgery solely using a pliers and a chain saw. It ain't pretty Sherlock!
Posted by: indiana jim at Nov 24, 2008 9:03:11 AM
Tyler, are you sure you don't subscribe to the Austrian theory of the business cycle? What's your problem, again? You don't like German accents?
Posted by: Bob Murphy at Nov 24, 2008 9:12:49 AM
Oh, I didn't realize it was up when I posted the above, but the reason I draw a connection between Tyler's post and ABCT is that it sounds very similar to my open letter to Gary Becker.
Posted by: Bob Murphy at Nov 24, 2008 9:31:59 AM
Could one take the view that employment needs time to adjust to changes in the economy and thus in a time like this it is best to avoid most new changes? For example no changes in tax rates no new regulations especially in finance.
Posted by: floccina at Nov 24, 2008 9:43:51 AM
How about an expansion of #2?:
a. In a serious economic downturn, a lot of fundamentally sound, good businesses will close down, just because their customers are broke/need their assets to cover the ill-considered credit protection they wrote/are scared to invest in anything not immediately necessary for their business.
b. If those businesses close down entirely, their continuity of operations will be lost, their assets will be sold off, and restarting them later will be much harder and more expensive.
c. In normal times, those businesses might raise money by selling stock or borrow money from someone who could see that they were a solid business riding out some hard times. But in these times, a lot fewer people are willing to invest or lend money--they need that liquidity themeselves, they've already got too much risk, whatever.
d. In this situation, maybe government spending can keep some of those fundamentally good businesses going, which will decrease the depth of the hole we have to climb out of in a few years.
Now, I have no reason at all to expect that government spending will accomplish this, rather than, say, be used to prop up big, visible, politically important industries that aren't really viable long-term. But it seems like a plausible argument for, say, using government money to have a lot of construction done during this time when lots of construction companies are going hungry.
Posted by: albatross at Nov 24, 2008 9:50:48 AM
Speaking as a non-economist, I looked at Tyler's argument: "Fiscal policy makes the downturn less severe but it also prolongs the adjustment process," and thought: just so! fair enough!
If you offer most Americans -- those not notably poor, but not rich enough to have their own personal investment banker -- the choice between:
(a) a short but severe catastrophic downturn with mass unemployment, drastic decreases in economic activity, soup kitchens, and possible social and political unrest including the formation of radical right-wing or left-wing movements to overthrow or seize the government,
OR
(b) a less severe downturn, cushioned by public works employment, infrastructure improvements, major government spending (which goes, in part, to underserving corporate dinosaurs or well-lobbied special interest constituencies), new murals on building walls across the country paid for by Federal sponsorship -- all of which leaves a major government deficit that will be paid for after the crunch by years of higher tax rates, less generous public benefits, and slower economic growth...
then, most of us would choose (b). (I realize that (a) makes 'worst-case' assumptions, and (b) relies on either best-case or at least mid-case assumptions, but that's the point.)
Thus, if your argument is that we'd really be better of with a short sharp crisis rather than a longer, more gentle one, then I think you are misjudging the rational economic and socio-economic choices that a lot of consumers -- as opposed to economists -- might make. And as a believer in 'free markets' and individuals making economic choices in their own interest, perhaps you should accept the economic rationality of choosing (b).
I'm not expecting the 2009 stimulus plan to bring about some utopian 'recovery' and return to the status quo: I see it as an effort exactly to prevent a crisis so severe that it could destabilize our entire political economy, and I accept that we face the risk of a longer, more lasting slowdown as the price of that gamble. One way or another, we face real net decreases in the standard of living, but we still have some choices about both the time frame (short, brutal, disruptive vs. long, dreary, hard to climb out of), the distribution (large-scale impoverishment of parts of the middle-class for a shorter time, or longer-term restrictions on the wealth of the upper-middle class and wealthy), and specific elements (short-term immiseration followed by entrepreneurial recovery vs. state-supported safety nets such universal health care funded by slower long-term growth) that are involved.
Posted by: PQuincy at Nov 24, 2008 10:51:21 AM
i think a combination of #1 and PQuincy's post is the best case for the stimulus. we should be spending hundreds of billions of dollars on badly needed investment anyway, in energy, green infrastructure, etc. it also seems desirable not to have the government overthrown by nazis and/or communists (see: 1932).
Posted by: raft at Nov 24, 2008 11:12:18 AM
I would like to know Bob Murphy's (and other ABCTer's) response to the idea that there is a "safer" pace and a "less safe" pace for the economic adjustments of a serious recession. In this understanding government policy can be useful as a "brake" to ensure that people don't get so economically dislocated or freaked out that they start hibernating (putting a psychological freeze on the economy), or joining revolutionary parties, or what have you.
Posted by: mk at Nov 24, 2008 12:24:00 PM
I guess the really aggressive interpretation of ABCT might be that occasional bouts of revolutionary fervor and economic drop-out-ism are a legitimate part of the "search procedure" of a society! After all, let's not second-guess the ability of individuals to determine their own destiny. Maybe we should start redirecting our investments of attention and dreams into revolutionary socialism. If the market deems it desirable, the market is right!
(Obviously I'm being snarky. But I guess I'm wondering what the moral dividing line is. And doesn't it make sense to consider social dislocation a threat to the very economic freedom ABCTer's want?)
Posted by: mk at Nov 24, 2008 12:33:21 PM
(Last post, I swear). I'm also curious why we can't just dump $700 billion in money on taxpayers (a "tax cut" or helicopter drop).
Is the argument that people might save instead of spend, which won't jumpstart anything? Wouldn't a savings glut at least have the effect of massively lowering the price of investment? If so, then even if it won't increase consumption, is it worthwhile to helicopter drop money to stimulate investment, rather than having the government choose what to invest in?
My mind is reeling trying to remember all the old econ models from college intro classes, and what they have to say about this. Maybe they're wrong anyway.
Posted by: mk at Nov 24, 2008 12:51:09 PM
mk,
Bob Murphy has provided a link to a really interesting powerpoint that is MUCH better than the old C+I+G model you might be trying to remember (that has you mind "reeling"):
http://www.auburn.edu/~garriro/ppsus.htm
Thanks Bob Murphy for the above posts and insights!
Posted by: indiana jim at Nov 24, 2008 1:13:50 PM
For an economy where we think of the central bank setting a rate of interest (and this assumption is a fortiori correct when it hits the lower bound), and if prices adjust slowly to excess demand, then any standard macro model WILL have two long-run equilibria. In the first (bad) equilibrium, deflation (and expected deflation) will accelerate over time, until the economy disappears down a hole. In the second (good) equilibrium, a temporary fiscal boost stops deflation, stops expected deflation, and so lowers the real rate of interest, and allows the central bank to raise nominal interest rates above zero (and thereafter adjust nominal interest rates to keep inflation on target).
Posted by: Nick Rowe at Nov 24, 2008 1:32:03 PM
Re #2, it seems to me that the distinction drawn between "bringing about a recovery" versus "limiting further downside" is a false one. Let me suggest the following, perhaps naive model of the business cycle. The natural tendency of the economy is to grow. We have a recession when certain contractionary forces take over; this time it's declining asset values and contracting credit. Once these contractionary forces have exhausted themselves, the natural tendency towards growth reasserts itself; at that point no artificial stimulus is needed. But the further you fall, the further you have to climb. During the Great Depression, nothing was done to arrest those contractionary forces, the bottom was much further down than anyone expected. So limiting downside really is hastening recovery.
3
Posted by: Phil P at Nov 24, 2008 1:56:06 PM
#s 2 and 4 suggest that fiscal stimulus could put a rather spongy platform under the economy. Difficult to spring out of. I'll stipulate to that.
But can you rationally suggest that it is better to have no platform at all, or a firm platform sitting at the bottom Death Valley?
IOW, what pquincy said.
Posted by: Steve Roth at Nov 24, 2008 2:10:23 PM
Exactly how fast could massive public works projects like "wind farms" get off the ground? Here in California, it typically takes 5 to 15 years of environmental hearings and the like before any dirt is turned. This sounds more like a full employment plan for environmental impact consultants and land use lawyers than something that will have any short major short term impact.
Posted by: Steve Sailer at Nov 24, 2008 3:09:27 PM
Another point: because we are already deep in debt, deficit spending will not generate the same multiplier effect expected in the traditional Keynesian model (I don't think it would anyway but whatever). In the last few years it took $5 in new debt to create $1 in GDP. The $700 billion Obama stimulus is a drop in the bucket.
So, the "massive" stimulus is not as massive as it seems and the cushion to the drop in GDP will be limited.
It seems to me that the further we go down this road the harder it will be for any fiscal stimulus to be effective. If we raise the debt load with this stimulus, won't the next one have to be even bigger just to get the same effect?
When one finds oneself in a hole, stop digging.
Posted by: Joe Calhoun at Nov 24, 2008 7:11:44 PM
Jim says: "But any self-respecting micro economic would have to rhetorically ask, for starters, whether introducing further progression into the tax system would be lead resources to be allocated toward or away from highest valuing users."
First, following your argument, allocating these resources to those who value it most rather than least, the decreasing marginal utility of money argues that that would be the lower income scales.
Second, Obama's plan would only be restoring the progression that Bush took out back to the Reagan levels.
Lastly, the progressive tax structure doesn't exist in a vacuum but rather with an income distribution which skews strongly in favor of the wealthy, the top 1-2%. Yes, they pay more but they make a lot more.
Posted by: Chris at Nov 24, 2008 8:42:24 PM
As an adherent to the ABCT, from a purely economic standpoint I think as long as a social commitment to free-markets and private property is somehow unshaken in a deep downturn, dynamic liquidation and hyper-entrepreneurial repurposing of capital produces the best overall chance of markets recovering their fullest ability to increase the standard of living in the long run.
However, This Austrian realizes that the "Economic Man" is a fantasy and the more likely result of massive dislocation and uncertainty is psychological regression making totalitarianism a far more likely result. This is the paradox purist Austrians have to grapple with--a frustration in the belief that these kinds of crises would never occur in a truly free economy (ex. free banking, private money, minimal interventionism, priced-in moral hazard, minimal taxation and subsidies), while having to face the fact that we don't have the prerequisite political economy to make the Austrian "soultion" workable.
It seems because statism has been so thoroughly ingrained, only statist solutions can solve statist crises, while an attempted free-market solution will backfire to result in even more statism. Arghh! Of course the endgame is either total state usurpation of the means of production and/or a currency crises both of which result in the inevitable bankrupcy of the State. What then, social moderates, what then??
Posted by: Jordan Stone at Nov 24, 2008 8:44:56 PM
I've looked at stimuli packages as something to prevent destruction while the market corrects itself. But okay, how do we move out of a consumption economy, what do we actually make that people want to buy? Unless we develop some new nanites, green energy stuff (and we are so far behind the rest of the world) or practical fusion reactors what will we be selling?
Posted by: MNPundit at Nov 24, 2008 11:51:40 PM
[Note that this is distinct from bringing about a recovery; it is limiting further downside]
That's a really silly rhetorical point and the "distinction" is one that doesn't make a difference. It just means "output is higher because of fiscal policy, consumption has less downward volatility because of fiscal policy, everything is in general better because of fiscal policy but nonetheless I'm going to say that this doesn't count as 'bringing about a recovery'".
Furthermore, a quick numerical example shows how bass-ackwards this way of thinking is and how much is given away by "optimally, perhaps" below:
[ In fact the fiscal policy is (optimally, perhaps) hindering the pace of adjustment and recovery]
Economy 1: GDP goes 100 - 95 - 91 - 93 - 96. Growth would be (-5%, -4%, 2%, 3%)
Economy 2, with fiscal policy: GDP goes 100 - 98 - 97 - 96 - 98. Growth would be (-2%, -1%, -1%, 2%)
Oh noes! Fiscal policy has slowed down the recovery by one year, and the growth rate is a percentage point lower! The much needed adjustment to the cycle has not happened and the malinvestment has not come out of the economy! Damn you Keynesians!
But none the less, the citizens of economy 2 have $98 for every $96 that the citizens of economy 1 have. If you make large percentage losses, you need *much larger* percentage gains later to make up for them.
Posted by: dsquared at Nov 25, 2008 3:02:52 AM
albatrosss,
"...a lot of fundamentally sound, good businesses will close down..."
Isn't that the same as saying that there is a "fundamentally sound" price and that any deviation from it is a consequence of the business cycle? I thought the price of things was determined by what someone is prepared to pay for them, not some intrinsic value to be divined by "the experts". "Fundamentally sound, good businesses" do not close down; the fact they are closing down is proof that they were not sound.
Posted by: Frederick Davies at Nov 25, 2008 9:48:08 AM
Chris wrote: "First, following your argument, allocating these resources to those who value it most rather than least, the decreasing marginal utility of money argues that that would be the lower income scales."
NO: 1) you are assuming that interpersonal utility comparisons are valid; 2) you are assuming that people as clones with the marginal utility of money being the same function for each.
Beyond this if the marginal utility of wealth is uniformly diminishing there is no explaining via the expected utility hypothesis the fact that people BOTH gamble and insure; Nobelist Harry Markowitz hypothesizes a utilty of wealth function that is thrice inflected (the marginal utility of wealth decreasing for the wealth level range immediately below one's wealth endowment (and increasing for wealth levels significantly below the endowment), and increasing in a wealth range above the endowment and finally decreasing for wealth levels significantly above the endowment. Additional complexity (beyond uniformly dimninishing marginal utility of wealth) has to be introduced if expected utility is to explain the observation of people who pay actuarially unfair prices BOTH to assume and insure against risk. (Alternatively one can relax the assumption of expected utility that probabilities are linear weights.)
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