Let me begin by saying that I’m with the new Keynesians on the central issue here. I believe real world markets break down. A stunning point for me is the juxtaposition between the fact that much of modern macro began by trying to incorporate micro foundations into their models, but in the end, many of the proponents of the extreme version of fresh-water economics have ignored 30 years of micro that is pretty specific on all sorts of ways that markets can fail to clear.
That said, one can argue about the role of government on many levels. I take a variety of positions on these issues. I’m a deficit hawk, but a big believer in well-timed intervention. I’m in sympathy with the comment from our treasury secretary that we need to pay serious attention to the deficit, just not this year. I sure as heck hope he means the second part, though. The long chain of budget deficits forecast by the CBO scares the heck out of me.
Today, however, I want to make two reflections on the right form of stimulus.
The first is an easy one. In talking about the purported wastefulness of direct stimulus spending, I think it is well worth noting that very few people would argue that this country has been spending too much on infrastructure. Clearing up a lot of deferred maintenance seems like a fine idea to me, and getting our transportation system back up to something approaching the quality viewed as normal in much of the developed (and developing) world a pretty good idea too. For much the same reason, I get less worked up than many about “pork-barrel” spending; sure, it would be nice to have a more transparent process, and maybe doing a little better on allocating scarce resources on the margin, but we seem so far from a sensible amount of public goods in this country that I’m doubtful that much of the spending is truly a waste.
Now to my second, and maybe less trivial point about stimulus spending. One theme that has recurred in left-of-center blog land of late is that if only we could have another round of “real” stimulus, we wouldn’t need to be doing back door stuff like cash for clunkers and the tax subsidy for home purchasers. I disagree! If one wants to stimulate economic activity at reasonable cost, this seems like a good way to go. Why? Because it is pulling exactly the right lever if you think hard about why spending has fallen in the first place.
One reason, of course, is because some people have less money. Extending unemployment insurance benefits seems a good idea in this context. State governments, many of which have mandatory budget balance mechanisms, are also in the class of entities to which a direct cash transfer is likely to stimulate spending.
But, the bulk of the reduction in spending, by both firms and consumers, is not “we have no money to spend, or nothing worth spending it on”. Rather, they are properly exercising option value in a setting of wildly increased uncertainty. In the months after the financial meltdown, a new TV suddenly needs to meet a much higher hurdle: the question is not “do I think the flow of services from the TV over the next 8 years is more than worth the cost”, but “do I expect to derive enough value from owning this TV now instead of 3 months from now that I wouldn’t rather wait a bit, and see how the situation develops.” If things look less apocalyptic in three months, one can always buy the TV then, having foregone only a few months of HDTV heaven. On the flip side, if in three months the situation has shifted for the worse, then one has avoided being saddled with a TV/car/house/factory that does not make sense in the new environment.
If I’m waiting to buy a new house because I’m waiting to see if I get tenure, this delay is economically efficient. But, if the uncertainty is aggregate and extreme, so the we all want to exercise the option value of delay, and if one believes that markets don’t always clear, then if we all start delaying economic activity because we want to see if the future is bad, the future has a decent chance of being just that.
In such a context, a tax cut, or a check from the government, is likely to have very little effect. I’m a little more flush than I was (although I’m also guessing that my future tax liability is going to be higher), but heck, I had money to spend before anyway. If the issue is uncertainty, then the right thing to do with extra money that appears is to simply stick it in the bank.
On the other hand, if the choice is “new car today at huge discount” vs. car in 3 months at normal prices, then I may well pull the trigger even if I face a moderate degree of uncertainty. Note then, though, that cash for clunkers and the housing subsidy are particularly effective precisely to the extent that people think they will end. If I am pretty sure the program will be renewed, then the original calculation is back in effect, and waiting is probably the right thing to do.
This brings us to one of the most important points made by Lucas, Phelps, and company: economic policy based on consistently fooling people is unlikely to be a great idea. Here, the problem is to avoid the temptation to go back and re-new each program as it nears expiration. If people grow to expect this, they lose their oomph.
This has been illustrated in a paper by Megan Busse, Duncan Simester, and Florian Zettelmeyer. In the wake of 9/11, GM ran “The best deal you’ll ever get.” Precisely because it had a well-defined end date, and one that seemed credible given the extraordinary circumstances, the program was extremely effective in raising sales for GM despite the uncertainty rampant that fall. But, when GM renewed it, the effect was much smaller, probably because people no longer saw the cost of delay as being large.
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6 comments
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November 11, 2009 at 2:07 pm
Noah Yetter
“…but we seem so far from a sensible amount of public goods in this country that I’m doubtful that much of the spending is truly a waste.”
How is this statement in any way defensible? We spend orders of magnitude more on “public goods” than we should, mainly because much of what our government believes to be public goods, are not (education, health care, the arts, etc.).
November 12, 2009 at 8:19 am
William
You are assuming the very appealing story that an exogenous increase in uncertainty drives a fall in economic activity on impact – the band of inactivity increases in size. This should then lead to a recovery later on (people are going to buy the nice TV eventually – purchases are delayed, not put off forever). This is clearly true in theory in some models (in particular, in partial equilibrium in the simplest Ss models), but there is some dispute about whether it is true in practice. Bloom (Econometrica, 2009) argues for this but Bachmann and Sims have a very new paper (not yet online) disputing Bloom’s conclusions – they find that what they call increases in uncertainty look more like plain bad news shocks (and simply lead to a fall in economic activity, with no later recovery to above-normal levels).
That is, what is an increase in uncertainty? What is an example of a rise in second moments in reality that doesn’t come bundled with some kind of bad news about first moments? (The banking crisis caused an increase in the variance of forecasts for future GDP, sure, but what if its primary effect was simply a decrease in the expected value of future GDP?)
November 12, 2009 at 11:02 am
jeroenswinkels
Yup, all good points. I agree that most increases in variance also come with bad news about the mean (although, if one thinks about things like the fall of the Iron curtain, I think you have a nice example where the mean has improved, but a smart firm may well wait to make an immediate expansion into, say, Hungary, until they see some of the variance die down).
This particular recession, though struck me as having more to do with the second moment than usual. We all knew we were in for a pretty sizeable recession. But, many of us, I think, were taking precautionary actions based on a small but real probability of something much, much, worse.
December 8, 2009 at 10:44 am
RJ Dragon
Good article overall. I agree that targeted spending on stimulus is the proper route if you are going to do it at all. Not because it will cure the recession, it won’t. Rather it diverts some money into things worth saving, such as the auto industry, the state of Michigan, housing values and schools. In other words, you reallocate spending to weak sectors, but in the process drain stronger ones. Hence non-auto consumer spending was depressed during the cash for clunkers campaign.
The blank check stimuluses used in this recession (the Bush stimulus and the Obama stimulus) have been total wastes of money. Like drinking a Coca Cola, they provide a temporary sugar and caffeine buzz that a sick patient should not confuse with real medicine. Moreover, cash to consumers will not provide much stimulus, as consumers need to deleverage their personal balance sheets, and money that is spent on consumer goods is more likely to stimulate the Chinese economy than the US economy. A better approach than checks to consumers would have been to spend less money on a targeted investment tax credit for business.
In the end, the real medicine that could heal the economy is being administered by the Federal Reserve. A flood of liquidity combined with time and the yield curve is what will heal the banking sector and end the recession.
December 11, 2009 at 10:33 am
DSB
This was clearly written by a professor who like most academics, has no real understanding of the real world. Every dollar spent by the government is a dollar taxed from the the private sector that if invested by the private sector, would actually create economic activity. Rather than this ineffective government “so-called” stimulus which is really income redistribution, the government should lower taxes, streamline government, and allow companies to make money, hire people, and increase economic activity. Most of the infrastructure spending is wasteful as it has to be done at prevailing union wages, minorities are given preference (at a greater cost), and many of the projects are just a waste. A $500m loan given to Al Gore electric car company (never produced a car) is really not a great use of stimulus…as is hundreds of billions for a U.S. auto industry that makes crappy cars with over-priced unionzed labor. Why should we ever give money to people to buy cars…take tax dollars from one group and give it to people who really don’t need new cars. DB
December 14, 2009 at 11:04 am
RJ Dragon
As a follow-on to Noah’s and DSB’s comments, consider the following:
“The number of federal workers earning six-figure salaries has exploded during the recession, according to a USA Today analysis of federal salary data.
“Federal employees making salaries of $100,000 or more jumped from 14% to 19% of civil servants during the recession’s first 18 months — and that’s before overtime pay and bonuses are counted.
“Federal workers are enjoying an extraordinary boom time — in pay and hiring — during a recession that has cost 7.3 million jobs in the private sector.
“The highest-paid federal employees are doing best of all on salary increases. Defense Department civilian employees earning $150,000 or more increased from 1,868 in December 2007 to 10,100 in June 2009, the most recent figure available.
“When the recession started, the Transportation Department had only one person earning a salary of $170,000 or more. Eighteen months later, 1,690 employees had salaries above $170,000.”
http://www.usatoday.com/news/washington/2009-12-10-federal-pay-salaries_N.htm?csp=34&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+usatoday-NewsTopStories+(News+-+Top+Stories )
What is good for General Motors is good for the American government. Time to restructure the government, cut bureaucrats salaries down to the level of average Americans, replace fat pensions with 401Ks and lay off at least 1/3 of the workforce. Cut costs down to the level of revenues and quit running a deficit.
Where is the Federal pay czar? Government employees earnings on average are double those of the private sector.
These people look less like public servants and more like a public aristocracy. A restructuring is definitely in order.
If the government was restructured so that most spending was cut to the levels of the Clinton administration’s “good times” and federal employees were paid lower market salaries, it would be possible to lower tax rates and get some real economic growth instead of phony stimulus.
The Federal government needs a bankrupcty-style restructuring to get its costs in line with its revenues.