Seven Myths. Nay: Seven Follies (III)4603
We need a larger fiscal stimulus.
3. The fiscal stimulus is going to do wonders
The greatest fiscal stimulus of all times has just been approved. Various people (including a large number of economists) have tried to explain why, on the one hand, the stimulus, as conceived, would have not been able to solve the problems we are facing and, on the other hand, it could worsen the situation if it contained the kind of measures the actual stimulus package ended up containing. Because I have written so much recently on this topic, I just summarize here things published elsewhere. They may not be intellectually original - in fact, they certainly are not original at this point of the debate - but these are the facts.
First: it is a fantasy that the economic profession at large finds the "stimulus" and the "bank bailout" plans sensible and adequate. Most economists I know oppose them: fiscal stimuli either do not work or work too slowly, and bailing out bad managers is never a good idea. These two, plain and simple as they sound, are the basic reasons why most economists, and not only "fresh-water" economists, oppose both measures. These measures are instead supported by most politicians, advisors to politicians, professional pundits, and all kinds of businessmen from failing industries. I am not surprised. Supporters of the plans are a minority among academic economists outside the administration: both plans contradict four decades of research and are designed to please special interest groups. But then, monetary policy and banking regulation have also shared these defects for the last two decades, so I am not surprised to see the bailout approved and hailed as the solution to our problems.Second, a very large fiscal stimulus plan is potentially damaging because it raises the outstanding amount of debt, and we are already deeply in debt: being deeply in debt has brought us to this crisis, nothing else. Am I repeating myself? Yes, I am but then: has someone argued HOW on Earth you get out of "being deeply in debt you could not afford" by taking on even more debt? Further, the Japanese experience of 1992-2003 shows that even gigantic public spending plans are of no help when the banking system is paralyzed and kept alive artificially. Japan's public debt grew from about 60% of GNP in 1993 to 155% in 2004 and then to 194% in 2008, but it really made no difference: growth started again only after 2003/04, when the banking system was "cleansed" through a number of failures, mergers and plain "digestion". Is THAT the plan?
Third: not every fiscal measure is wrong, just most. For example, the extension of unemployment benefits is not controversial; in fact we may even need more of that. The tax cuts are deficient because they do not reduce tax rates. Research recommends cutting the Social Security and income tax rates for low earners. Most of the projects are either "make work" or the money won't be spent in time to have much impact on the crisis; this is true of half of the expenditure. While the actual amount devoted to true pork may not exceed a quarter of the total, some large expenditures on broadband and "green" projects are pork-like in that they do not really increase productivity. When you add it up, about two-thirds of the expenditure is not really useful, while the tax cuts should be redesigned. In other words, even conditional on pretending that "spending per-se is good for growth" (which it is not), the design and composition of THIS specific spending is bad and should be rejected.
Fourth: tax cuts are a better way to stimulate the economy, particularly this time. Research shows that supply-side miracles are voodoo economics, hence I do not expect miracolous jumps in GNP following the tax cuts. Simply, I claim they are the most useful fiscal policy tool in this moment. Income tax cuts would have the double positive effect of leaving money in the pocket of workers whose wages are being reduced and lowering the cost of hiring for new firms, which is exactly what we need to speed up the labor reallocation process. It is argued that tax cuts are saved rather than spent. Tax cuts targeted on lower income workers will enable them to "save" by paying off credit card debt and meeting mortgage terms. That will help relieve stress in the financial sector and housing markets. The one thing that 'stimulus supporters' do not understand is that a massive labor-reallocation process is taking place in the economy and that it is the consumption (demand for consumption) of those losing their jobs and searching for a new one that needs to be sustained ("smoothed-out"). You do not sustain the consumption demand (or the credit card's bill payments) of recently fired Circuit City employees by spending hundreds of millions of dollars in making rural Nebraska wireless! You sustain the consumption demand of those Circuit City former workers by giving them a tax break on their previous salary and on the new one, plus effective unemployment benefits in the meanwhile. So, if supporting demand is really what one needs (not obvious) the pseudo green projects are good for nothing. Cuts in tax rates of the working people are.
Fifth: Is there a case for public borrowing now to finance a stimulus package? People are worried about the future and are sensibly reducing their spending. Does this imply the government should step in and do the spending for them? Put that way, the idea seems like a non-starter. If we are poorer, so is our government. It will collect fewer, not more, taxes. On the other hand, government borrowing is cheap right now, and labor costs relatively low. If we accept this logic, then we reach an interesting conclusion - the additional spending now should be offset by less spending in the future. Sadly the approved plan does not say anything of the sort. And therein is the problem: in spite of President Obama promises of cutting deficit in a half by 2013, there is no commitment to cut spending in the future. Hence, he must plan to raise taxes.
Sixth: The money being spent to aid state budgets will prevent cutbacks in existing services. This should have some positive effects. Still, it encourages the states to continue to be irresponsible in their budgeting, which is why they are in so much trouble. It should have been accompanied by stringent requirements imposed on the states to get their budgets in order, but it wasn't. The greatest problem with the bailouts has been the lack of willingness to make those responsible be responsible. CEOs who bankrupted their firms get to keep their jobs; state governments that spent irresponsibly get bailed out with no strings attached. Larry Summers has repeated for years that "moral hazard" is a problem only in abstract models and not in reality: the facts prove him wrong. I admit this is not an original remark but it is, nevertheless, a fact.
Hence, what economic sense does the mega stimulus make (everyone understands the political one, i.e. pleasing people that are asking for taxpayers' money)? Waiting for next week when Brad De Long will finally explain me why I am so wrong and confused, I have looked around in various places. They all say the same thing: there is unused capacity to be employed. The capacity is unused because "demand dropped". Why "demand dropped" no one asks, or answers.
Dean Baker writes, perfectly summarizing the logic shared by every "super stimulus supporter" (Dean being one of the most active):
With consumption, housing, non-residential construction, and investment all collapsing, the economy is in a free fall. The federal government is the only entity that has the power to stop the decline.
In other words: everything is a matter of demand. Because demand, for no good reason, suddenly dried up, we are in troubles. People have suddenly, and irrationally, decided not to spend anymore. Hence, the government must spend even if it does not have the means for it. OK, let's proceed.
The Obama stimulus can begin this process. It will immediately make hundreds of billions of dollars available to state and local governments through various channels. This will allow them to maintain vital programs like unemployment insurance and Medicaid and allow them to put off the mass layoffs they are currently planning. The funds for infrastructure and energy conservation should also be an important source of employment growth in the economy in the next two years.
Let's not argue over the statement that the planned expenditure will produce "growth ... in the next two years". Let's just pretend it is useful and it is not the waste that, in my evaluation, at least 1/3 of the expenditure actually is. To spend now, the Federal Government will have to borrow resources from somewhere, correct? I mean; even assuming (which is an incorrect assumption) that ALL the workers employed by the stimulus are currently un-employed or will be un-employed in the near future, it is still true that in order to pay their salaries upfront we need to borrow resources from somewhere else. Because the private sector is contracting, certainly the additional resources needed to finance the extra public sector expenditures must come from somewhere other than taxes on the private sector. Question, where will they come from? They must come from someone's savings, right? Whose savings? The Chinese's? China is contracting as rapidly as the USA, or more: I doubt we will see a surge in their purchases of US T-bills. So, from where? From where will it come? It must come from the private sector in the USA and the EU countries, right? Good, so it amounts to crowding out saving that would, otherwise, have flown to investments in the private sector, or to consumption. It is a matter of budget constraints, nothing else.
In other words, we are changing the composition of aggregate demand, scarcely its level. Obviously, we may claim we KNOW that the new composition is better, more productive, more growth-inducing than the one that would have realized without the expenditure portion of the stimulus. Do we have any proof that this is the case? Not that I know. Anything we know suggests the opposite. Hence, even assuming that the additional public expenditure generates demand for productive capacity that would otherwise remain unused or idle, it does so by reducing demand for other productive capacity that will become idle. Where, in this process, the "multiplier" appears, beats me.
The biggest problem with the stimulus is that it is nowhere near large enough. The combined loss of demand due to the collapse of bubbles in both residential and non-residential real estate and the loss of consumption following the loss of $15 trillion in household wealth is close to an additional $2.6 trillion over the next two years. President Obama originally proposed to counter this with an $800 billion package, which the compromise version effectively cut to $700 billion (the $70 billion annual adjustment to the Alternative Minimum Tax is not stimulus).
Indeed, we need another trillion after this ... keep digging: we may find oil, eventually. Now THAT would be a stimulus, wouldn't it?!
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