Category: Economics

Here's Brad Setser:

Implicitly, Geithner and his colleagues seem to have concluded that the
“great unwind” has limited the private sector’s ability to absorb the
banks troubled assets. Key players no longer can borrow the funds
needed to make large bets on troubled mortgage-backed securities. By
providing credit to those willing to buy bad assets, the US government
hopes to push up their market price up, and in the process induce the
banks now holding these assets to sell. The US government in effect is
providing the financial system with leverage to facilitate – one hopes
– a transition to a less leveraged financial system. The amount that
private investors have to put down – relative to the amount they are
spending – is a key detail.

The post is interesting throughout.

Clive Crook asks that question about the fiscal stimulus (by the way, Paul Krugman responds to the part of the column about him).  I do think there is more of a consensus than the current debates in the media, and the blogosphere, might imply.  I take the general consensus of macroeconomics to be not too far from the position articulated by Alice Rivlin.  That means accelerate the truly stimulative parts of the proposal and ponder the rest at greater length, plus emphasize aid to state and local governments.  I'm not suggesting that you have to bow down and yield to that view, only that the view makes sense to a large number of macroeconomists.

In part the appearance of so much disagreement is driven by the fact that both MSM and the blogosphere select for opinions which deviate from the mainstream.  Many segments of MSM are willing to represent the mainstream opinion, but there is then a sense that some new point of view must be offered, if only to hold the interest of the reader or viewer.  And some parts of MSM are openly partisan and thus they skew toward extreme points of view.  In the blogosphere libertarians are overrepresented, relative to their numbers in the profession.  On the Democratic side, Paul Krugman is the most influential figure, and I would place him to the left of most Democratic economists.  Progressives, like libertarians, are overrepresented on the web, relative to their numbers in the economics profession or elsewhere.

It is good that so many different points of view are being reflected, but we need to keep the biases of our filters in mind.  Repeating a moderate view, again and again and again, isn't always the best way to attract or keep an audience.

Hamilton hits the nail on the head:

But rushing through new government spending plans, just for the sake of spending? Count me off of that bandwagon.

Matt Yglesias offers a clear, non-technical explanation.  I would add a few points:

1. If wages are relatively flexible in the downwards direction, it is easier to avoid the downward spiral from falling aggregate demand.  There is an odd tension (though not contradiction) between the view that a stimulus is necessary and the Progressive view that workers don't have much bargaining power and that bargaining power really matters.

2. Savings are especially likely to fail to translate into investment when the banking system is messed up. That applies today, but Keynes was not sufficiently aware of the importance of this condition.

3. Prior to the collapse, savings out of income in this country were approximately zero.  So the notion of "people ending up saving less" has to mean a rising ratio of debt to gdp.  That's OK for the argument, but now it gets complicated.

For instance, instead of "saving more" the core action under consideration might be to pay down some debt instead of spending money on consumption.  But what does the creditor do with those funds?  Are dollars sent to creditors "low velocity dollars" rather than "high velocity dollars"?  Maybe, but of course they don't have to be.  If the citizenry is paying back to creditors who engage in active lending (or for that matter rapid consumption), and make new loans rapidly, things can be OK.  If the citizenry is paying money back to zombie banks, maybe those banks just sit on the cash.  (How much of the money is going to zombie banks?)

A lot of claims about the paradox of thrift depend on having a good handle on which micro-sectors of the economy breed high vs. low velocities of money.  We don't always have such information.  The whole notion of how money can get trapped in "low velocity circuit," beyond simple observations about first-round effects (the poor spend a higher percentage of their incomes than the rich), is receiving insufficient attention.

The "Treasury view" that you can treat monetary velocity as constant is wrong.  But there's a lot about monetary velocity which we don't understand, or at least which we have not yet applied to the current problems at hand.

It seems he favored the idea.  Mario Rizzo directs me to his letter to James Meade, circa 1942:

I
am converted to your proposal…for varying rates of contributions in
good and bad times. (June 16, 1942). Keynes, Collected Writings, vol.
27, p. 208. 

…[Y]ou
are able to show fluctuations in income of an order of magnitude which
is significant in the context… So far as employees are concerned,
reductions in contributions are more likely to lead to increased
expenditure as compared with saving than a reduction in income tax
would, and are free from the objection to a reduction in income tax
that the wealthier classes would benefit disproportionately. At the
same time, the reduction to employers, operating as a mitigation of the
costs of production, will come in particularly helpfully in bad times.  (July 1, 1942). Keynes, Collected Writings, vol. 27, p. 218.

Will today's Keynesians follow suit?

Read the whole post, for Greg's full set of prescriptions, but this idea I had not previously considered:

And here is Greg on the broken window fallacy, worth a read.

Not every country is opting for fiscal stimulus:

Speaking to the Irish parliament, Prime Minister Brian Cowen said
the bulk of this year's cuts — some €1.4 billion — would come in the
form of increased pension levies on public-sector employees. That is
effectively a pay cut for those workers. Mr. Cowen also pressed forward
with tax increases for higher-income workers and second-home owners.

I'll let you know how it goes.  A few things are worth noting.  First, a small open economy has a harder time making fiscal stimulus work.  Second, a small open economy often has to worry more about its credit rating.  Third, a small open economy offers a tougher testing ground for macroeconomic "field experiments" because there are more confounding external factors.

I'm not sure I understand the proposal, but here is what the NYT says:

Like Arnold Kling, I wish to shift the economy out of housing, not into it again. I also believe that the supply of homes is relatively elastic right now.  The tax credit will subsidize the new buyers without propping up the price of homes.  Demand will go up, supply will go up, price will stay more or less on the same trajectory, and banks won't be any healthier.  The subsidy goes to new home buyers and why should we be helping them above all others?  Aren't they relatively wealthy on average?  (Not that there's anything wrong with that.)  Aren't some of them the dreaded "flippers" and speculators for that matter?  (Can we really enforce the primary residence requirement?)  Do we really want to push people into being less diversified and less geographically mobile in the labor market?  And here's Alex's post from earlier today.

There's a whole other debate you could have on whether we should be encouraging people to buy outputs which are already produced.

So far I say boo to the Republicans.  It could be I don't understand the proposal; if that is so please correct me in the comments.  Here are further discussions of what is going on.

Ed Olsen, one of the nation's foremost housing experts, points out that it's much harder to stimulate housing than many people think because you have to take into account the rental market.

The primary effect of many proposals directed at the housing market would be to decrease the demand for rental units by about the same amount as they would increase the demand for owner-occupied units. This would be the effect of the proposed tax credits or loans at below-market interest rates to new homebuyers.

 …The impact of preventing foreclosures on housing prices is overstated for the same reason. The overwhelming majority of families who default on their mortgages move to another unit that they do not share with others. Therefore, preventing foreclosures would have little effect on the total demand for dwelling units and hence little overall effect on market prices.

 …Subprime mortgages did induce some people to buy houses beyond their means, and foreclosures would decrease the demand for the types of houses bought by these people. This would decrease the prices of similar houses. However, when they default on their mortgages, the families involved move to more modest houses or apartments, thereby increasing the demand for other types of units in other locations and the prices of units of these types. Preventing foreclosures would lead to higher prices for some properties and lower prices for others.

Read the whole thing (doc).

I'm not sure further progress will be made on what to me seems like
a largely semantic debate.  Krugman is making perfectly sensible economic arguments but then making a
semantic leap to claim he has proven something about permanent vs.
temporary.  He hasn't, as I'll consider in a moment.  But don't worry, the more important substantive
issue is government spending vs. tax cuts and on that I agree with
Krugman that very often tax cuts don't get you much stimulus.

Now let's turn to the details of the exchange.

Krugman argues, correctly, that fiscal policy can create a "bonds are net wealth effect" and also a "new bridge is built effect," and his post stresses the latter.  But playing up the "bridge effect" does not shift the evaluative balance between permanent vs. temporary fiscal policy, as both can be used to build useful things and indeed that is one element of the analysis which I have been explicitly holding constant across the two alternatives.  (I've not been denying the potential productivity of bridges or how gdp is calculated.)

Krugman also calls forth a "size of expenditure" effect (which is not in my view a true permanent vs. temporary comparison, but still let's go ahead and say it is).  He writes:

The question then is how much of that direct increase in government demand is offset by a fall in private consumption because people expect their future taxes to be higher; obviously that offset is smaller if they think the bridge is a one-time expense than if they think there will be a bridge built every year. That’s why temporary government spending has a bigger effect.

Even there I am not convinced, and that is because of the very last sentence of the paragraph.  If the government builds more bridges rather than fewer bridges, yes private consumption goes down more in the former case.  But if each bridge is valuable, the net stimulus (which is what matters) doesn't have to go down.  In this setting, with varying expenditure across the two cases, the permanent fiscal policy easily can have both more crowding out and more net stimulus.  Krugman is citing the higher crowding out but there is no demonstration (or even argument) of a smaller net stimulus from the permanent fiscal policy.  It still can go either way and no, figuring out the net effect isn't simple. 

Oddly, my position in this debate is that, within a Keynesian framework, "doing more over time" can in the theoretical sense work out in favor of stimulus.  It is thus instructive to see MR and Krugman commentators attacking my "right wing" position or Krugman's "left wing" position; it's a sign they don't understand what is being debated.  Krugman himself already mentioned that he was arguing under the rubric of Milton Friedman so I'll claim Keynes.  Keynes himself was a bigger fan of permanent than temporary fiscal policy and he thought it could provide ongoing stimulus by providing ongoing value for the dollar.  In this sense I am arguing for the theoretical coherence of the truly Keynesian view, even though when it comes to practice I am skeptical on public choice and Hayekian grounds. 

Addendum: Here is Megan McArdle's response.

From Chris Blattman.  By my calculations (here and here) road traffic accidents account for about 1.68% of deaths in the United States so there is certainly room for improvement in low-income countries although it would be important to know whether it is the driving, the roads, or the health care most amenable to such improvement.

Let's say government can spend $100 billion today or spend the present expected value of $100 billion, stretched out over time so it is a commitment in perpetuity.  Both spending programs are financed by bonds.  So that's the same net present value of spending and the same method of finance.

The Keynesian boost to aggregate demand arises because people consider the resulting bonds to be "net wealth" even when they are not, in the sense outlined by Robert Barro (1974).  People are tricked by the government's fiscal policy, but of course the extent, timing, and nature of the trickery is hard to predict.

Is it easier to trick people "a lot all at once" or "a little bit by bit over time"?  It depends.  If you try to trick them slowly over time, temporal learning and adaptive expectations may work against the policymaker.  But if you try to trick people a lot all at once, the trick may rise over their threshold of attention, perhaps because of media coverage.  We don't know which "trick" to aggregate demand will be greater, the temporary boost to spending or the permanent boost.

One way to get a clear answer — in favor of Krugman's hypothesis that the temporary spending is more potent — is to assume that bonds as net wealth fails for a policy rule but not for a single period policy surprise (the temporary boost in spending).  In contrast, the traditional Keynesian view is to think that bonds are also net wealth in the medium run and perhaps the long run too and then we are back to not knowing whether the permanent or temporary spending boost does more for aggregate demand.  Or you might think, as I have suggested, that whether bonds are viewed as net wealth in the short run will depend on the size of the spending boost.  Many different assumptions are possible and thus many different results are possible.

Alternatively, you might compare $100 billion today (and no more) to $100 billion each year, every year.  You could call that "temporary" vs. "permanent" although I suspect the dominant effects will fall out of "small" vs. "large."

The latter, permanent boost to spending will give a bigger boost to aggregate demand overall (unless again you neuter it by applying Ricardian Equivalence to the rule but not the single period policy).  It also will lead to more crowding out.  Do note that in the early periods of this policy taxes need not rise by $100 billion for each year but rather the early installments can be paid off over time.

It is less clear whether the permanent spending boost leads to a bigger AD shift only for today.  It will if you apply the same degree of bonds as net wealth to the rule and single period policy, and if you think that the later periods of government spending will add net value, thus creating positive feedback through the long-run wealth effect.

It is also unclear if the larger, permanent spending boost creates more "stimulus per dollar" (as opposed to more stimulus in the aggregate or more stimulus for the single period).  That will depend on whether we are in the range where the stimulus has increasing returns to scale (maybe a certain critical mass is needed, as I believe Mark Thoma has suggested), constant returns to scale, or diminishing or even negative returns to scale, because of eventual crowding out. 

Overall the Keynesian effects can mean either the permanent or the temporary spending boost has a bigger effect and there are also a number of ways of defining what a "bigger effect" might mean.  This analysis has more variations than does the Poisoned Pawn Sicilian.

Perhaps Krugman is drawing from Barro's 1981 JPE paper on government purchases, which does indeed derive the stated result, but that is no longer the dominant approach. Circa 1990, Aiyagari, Christiano, and Eichenbaum note:

On pp.4-5 they explain why Barro is incomplete. 

Overall I find these debates confusing.  I wonder for instance if Krugman's blog example is actually comparing tax finance to debt finance, rather than temporary vs. permanent spending shocks.  (Note also that Krugman is making a claim about demand or effective "stimulus" rather than output and employment, although I am taking the latter as what matter.)

Those of you with lots of time on your hands can ponder whether the "permanent vs. temporary" debates compare "$100 billion this year vs. $100 billion for each year to come" and/or "$100 billion this year vs. the present value of $100 billion spread out over time, in perpetuity," and whether all cited articles and blog posts are making exactly the same comparisons.

Results in this area usually can be modified by further assumptions.  I think of this as the central paper, published in the JME 1999.  Admittedly it is for a small open economy but the key result is:

Moreover, permanent increases in government expenditures have larger
positive labor supply and output effects than temporary fiscal policies.

Again, I don't have faith in these models and I believe agnosticism is the correct stance.  The point is not about who is wrong and who is right but rather how treacherous these analytical waters can be.  Beware! 

In any case there is hardly an overwhelming brief in favor of the stimulative powers of the temporary spending increase.  The best case for the temporary boost is I think the public choice argument that it is better to get it over with more quickly, so as to limit corruption of the government.

Addendum: Megan McArdle adds comments on her contribution to the debate.

Second addendum: You'll find a response from Paul Krugman here.  I'll note it is he that introduced the framework of Milton Friedman and the permanent income hypothesis, not I.  If you look at the literature as a whole, it can go either way whether the permanent or temporary increase in government spending is more potent.  Krugman's own example doesn't demonstrate his point that the temporary increase is stronger, as it compared debt-based to tax-based finance rather than permanent vs. temporary.