Obama's Stimulus Theory: Will it Work?

[_Kevin Graham]

And I mean to ask, will it work in the long run?

I'd like to start a debate about the efficacy of Obama's deficit spending. In one corner I suspect we'll have Droopy, bcspace and a few others argue that "Keynesian" theory has been proven to be untenable over and over again. On the other hand I keep reading articles by people like Krugman who suggest deficit spending is actually a good thing during recessions in order to prevent the country from falling into a depression. Lessons from the Great Depression support that case. Thus, Obama was a genius for preventing our nation from plummeting into a depression, although he could have acted faster. I suspect Analytics, Gadianton and JSM will take this position.

From what I can tell, the argument from deficit spending is that the economy needs a sudden "jolt" to keep it alive during a recession and only by pouring money into the system in the form of stiumulus, will that end be met quickly. Flooding the economy with more money is seen as a solution the same way a defibrillator is used to restart a failed a heart after a heart attack. The question I want to explore is whether this is true. What does history prove? Krugman says that the reason the Great Depression worsened was because the President tried to tend to the deficit instead of focusing on job creation. I can't help but wonder what the Republicans would do for an alternative. If Mitt or Reagan were in charge, what would they do differently? If they had every supply-side "fix" implemented, would it be enough to act as a economic defibrillator?

So, let the games begin... I'm hoping for some good debating and plenty of informative commentary from some of our economy gurus.


PS: I hope the mods don't move this thread. I want as much exposure as possible and I know most people frequent this forum.

[_Scottie]

So, Kevin, you subscribe to the theory that without Obama's trillion+ dollar stimulus that the country would have fallen into a 30% unemployment rate?

I haven't seen much evidence to support that any of that stimulus went to save jobs. From what I can tell it made a lot of very rich men a lot richer.

[_dblagent007]

This blog contains some very good responses to Krugman. http://www.themoneyillusion.com/

It sounds like you want to debate monetary policy versus Keynesianism. For the most part, I still believe that monetary policy is the better tool to control economic shocks. Also, I think poor monetary policy was the cause of the depression and better monetary policy got us out of it, not increased government spending.

Japan has been trying the stimulus route now for 20 years and it hasn't really gotten anywhere. Japan is an interesting study in whether government stimulus makes things better. I think temporary government stimulus helped a little, but in the long run didn't do anything.

In the U.S., I think public sentiment is negatively affected by huge deficit spending. Most people think the future is bleak when the government is spending gargantuan amounts of money. I think this slows a real recovery.

I don't have any problem with the government creating money in recessionary times because that is exactly what it should be doing. However, I would like to see that money allocated by individuals who make decisions in their own best interest rather than by an inefficient government bureaucracy.

[_Kevin Graham]

Keep in mind that the fiscal year for 2009 actually began October 2008, four months before Obama took office. Thus, the budget for 2009 was already determined by Bush's policies. Bush is directly responsible for no less than $1.2 trillion of the $1.4 trillion deficit.

Also, unemployment was gradually rising monthly before Obama took office. In fact it was on a roll, increasing for twenty months straight, only to come to a halt in November 2009 and then dropped for the first time in two years, to 9.7%. Injecting $300 billion into the economy in the last two quarters of 2009 is directly responsible for this. Here is a fairly balanced take on the subject: http://correspondents.theatlantic.com/r ... eficit.php

If you don't think the stimulus has had an effect on jobs, then all I can say is you should stop reading strictly Right Wing literature.

[_dblagent007]

Scott Sumner wrote a response to the Keynesians on his blog (I linked to it above). I think this goes a long way to answering Kevin's question. http://s84684.gridserver.com/?p=4172#more-4172

Here it is in full (he's also got some great posts about the cause of the depression):

The New York Times (and former President Bush) need to read Krugman
In my comment section, I keep getting Keynesian commenters claiming that fiscal stimulus is the only way to boost AD in a recession. Here is a similar example from the New York Times:

WHAT CAN BE DONE NOW? Here is an unpopular but undeniable fact of life: When private sector demand is weak, the federal government must serve as the spender of last resort. Otherwise, collapsing demand sets in motion a negative, self-reinforcing spiral in which lack of demand — for goods, services and new employees — leads to ever deepening economic weakness.

That is why when the banks and the economy began to crumble in 2008, President Bush responded with a $700 billion bank bailout and a $168 billion stimulus package.

Now I suppose you could argue that they meant it is necessary when interest rates are at zero. But of course rates were at 2% when Bush implemented this stimulus. So that argument won’t work. As we will see, it doesn’t even work when interest rates are at zero. But first I want to quote from Paul Krugman, as my Keynesian readers won’t trust anything I have to say:

I notice that commenters keep citing this paper by Alesina and Ardagna as if it were a definitive rejection of Keynesian economics. So I guess I should explain why I’m not convinced.

First, the whole stimulus debate is supposed to be about what happens when interest rates are up against the zero bound. Everything is different if the central bank is busy adjusting rates in response to conditions, and may well raise rates to offset the effects of any fiscal expansion. Yet the Alesina-Ardagna analysis doesn’t make that distinction; Japan in the 90s, which was up against the zero bound, is treated the same as a batch of countries in the 70s and 80s, when interest rates were quite high.

Krugman and I believe that if the central bank is targeting some sort of nominal aggregate like the price level or NGDP, level targeting, it is pretty hard for fiscal stimulus to have much effect. Any anticipated effect would be mostly offset by monetary policy, indeed completely offset if monetary policy is efficient. Where we diverge is what happens when rates hit zero. I assume that at zero rates the central bank can still engage in inflation targeting. Krugman assumes that . . . well it isn’t always easy to figure out what Krugman assumnes. Here are some options:

1. Monetary stimulus is ineffective at the zero bound

2. Monetary policy is potentially effective if central banks are credible, but they often are not.

3. Monetary policy is effective but central banks simply refuse to do what is necessary, such as unconventional QE and/or inflation targeting.

Lately he has emphasized the 3rd option, which is the most defensible. No one can seriously claim that the BOJ has been powerless in recent years. They could always depreciate the yen. A few decades ago people used to argue that yen depreciation wasn’t an option because the US would object. But that view is totally indefensible today, for three reasons.

a. The focus is mostly on China, not Japan.

b. The yen recently rose from 120 to the dollar to 90. So even holding it steady would have been far more expansionary, and obviously there weren’t many complaints from the US when the yen was at 120. Even if you don’t believe that, surely they could have limited the appreciation to a level closer to 110 than 90.

c. Most importantly, the Japanese government is actually pushing for more expansion, and the BOJ stubbornly resists. Recall that any US pressure is directed at the Japanese government, not the BOJ directly.

There can no longer be any doubt that the BOJ prefers stable prices or mild deflation over the alternative of mild inflation. This explains why the Japanese fiscal stimulus failed. Even if, as Krugman implies, the 1995 stimulus worked, all it did was postpone the problem for a year. As soon as the stimulus stopped the economy slipped back. You can’t run big deficits forever, so if stimulus is to work the central bank must be accommodative. The BOJ was not accommodative, hence the stimulus didn’t work. If the BOJ had been accommodative I suppose you could claim it would have worked. But of course if the BOJ had been accommodative then fiscal stimulus would not have been needed in the first place. It is a fifth wheel.

Part 2. People also got moody when they saw the Titanic was sinking

I recently argued:

I’m not convinced mood swings are as obvious as they might seem. I’ve argued that the stock market crash of 1929 was a rational response to the sudden awareness that we were rushing headlong into Depression. I wonder if that stock market crash was one of those examples where Bryan thinks it’s “obvious” there was a mood swing. Even if Bryan doesn’t believe that, I’d estimate about 99.9% of historians do look at the crash that way.

Bryan Caplan responded:

I’m not going to argue the Depression with an expert like Scott. But I saw the 2008 crash and subsequent downturn with my own eyes, and I’m convinced that mood played a key role. The world freaked out, big time. It was the economic analog of a riot.

But hasn’t Sumner shown that the fundamental problem was falling nominal GDP? I’m sympathetic, but he never really explains why money velocity suddenly plunged. (Yes, the Fed started paying interest on reserves, but that’s far from the whole story). After the 2008 crash, people clearly became much more reluctant to spend, holding their income constant.

I argued that people were responding to expectations of a fall in NGDP. The following year NGDP did fall at the fastest rate since 1938. Bryan is arguing that the public panicked and saw a ghost. Or more specifically that got very worried about the economy. Then the economy got much worse precisely because people had become worried. Self-fulfilling expectations. by the way, it is rational to be reluctant to spend if your current income is stable, but you expect it to fall very soon.

There are two things wrong with the argument. First it relies too much on common sense. When people respond correctly to fundamentals that are hard to discern, it can look like panic. And the fundamentals are often hard to discern, because if they were easy to spot then people would have seen the problems coming even earlier. Imagine the point where the smartest person in the world sees a problem. The market will see it even earlier. Stocks crashed in early October, not September 2008. So even in September it clearly was not yet obvious that the economy was about to fall through the floor. (by the way, don’t say person X saw it before the market. That’s cheating. You have to pick the smartest person before the event, not after. Buffett lost billions in the crash.)

The more significant problem is that Bryan unintentionally ignores the fact that fundamentals drive NGDP in the long run. And the important fundamental in this case is monetary policy. The great flaw in Keynes’ General Theory is that it takes the current level of NGDP as a historical datum. It has no explanation for why current US NGDP is $14 trillion rather than $14 billion or $14 quadrillion. Instead, the model merely tries to explain changes, starting from a level that is assumed given. But of course the factor that explains why NGDP is currently $14 billion also will determine what NGDP is three years from now. And only monetary policy can do that.

So any panic about future levels of NGDP going several years out cannot be a purely self-fulfilling prophecy. Even if monetary policy operates with a lag (and I think lags are exaggerated) the Fed can always try to steer NGDP back on course at a later date. But if people expect them to do that, then current NGDP would change much less. It was pretty obvious that if we had had a NGDP futures market in late 2008, you would have seen NGDP contracts for 1, 2, 3, 4, and 5 years out plunging sharply. The public wasn’t just losing confidence in current monetary policy, they were also saying, “we don’t expect the Fed to correct its mistake.” And they would have been completely right.

Bryan also makes an error when he focuses on velocity. The Fed doesn’t target the base, nor should it. Under interest rate targeting the base is endogenous, and under the NGDP futures targeting that I favor the base is also endogenous. The question is not what caused velocity to fall, we know that was an endogenous response to two factors; interest on reserves and expectations for falling NGDP (I won’t argue the relative importance here.) The question is what caused NGDP expectations to fall. And that was a failure of monetary policy, as it is their job to keep NGDP expectations on course. Falling velocity, falling commodity prices, falling stocks, a falling dollar price of euros, falling prices of houses in non-subprime areas, falling commercial real estate prices, were just some of the many symptoms of sharply falling 2010 NGDP expectations in late 2008.

How did the market read the Fed’s intentions back in October 2008? Why ask me? The market figured this out way before I did, because they are much smarter than me. Don’t confuse me with my many commenters who are smarter than the market. You should ask them how the market correctly saw the Fed would let NGDP stay depressed, and wouldn’t try to bring it back up with the sort of rapid NGDP growth we had in the 1983-84 recovery. I stand in awe of the market’s wisdom. If I was that smart (here comes the cliché) . . . I’d be rich.

[_Jason Bourne]

I am posting from my phone so I only have a quick comment. Obama is doing targeted stimulus. I would prefer a stimulus that is a direct across the board tax cut. Lower everyone's rates as well as corporate rates by 10% points and then let the market take over.

[_Kevin Graham]

The thing is, cuts have already been made to our taxes and the corporate tax rate is about as high as it was during Reagan, and there is little reason to believe that by cutting their taxes more, that we'd see a jump in jobs. Corporations are evil in my view. If they create any jbs, they're likely to be overseas. They have no sense of loyalty to America or Americans. They're the ones who got us into this mess, I say let them pay for the brunt of it. Why should the little guy pay more when he is already bailing them out? Who bails out the little guy?

Where is the evidence that the conservative economic strategy would create more jobs, increase GDP and reduce the deficit? The only time in history that compares to today is the great depression, which is why the Keynesians think they have a leg up on the rest. All the other proposals are just theoretical solutions.

[Guest]

Here is another excellent series of points made by Sumner:
http://s84684.gridserver.com/?p=4104

I have bolded the especially salient points below.

DeLong and the Republicans are both wrong
Tyler Cowen and Greg Mankiw linked to a Keith Hennessey graph that has been getting a lot of attention. It shows the ratio of spending to GDP over the next 10 years as estimated in Obama’s proposed 2010 budget (last year), as well as the spending/GDP ratios expected in his current budget.

It’s easy to look at the graph and assume spending is out of control, and that Obama hasn’t kept his promise to reduce spending in the out years. But that is slightly misleading, as DeLong argues here:

Left out of Hennessey’s “analysis” is the reason that an 8.3% of GDP deficit is warranted: that the economy is very weak.

Left out of Hennessey’s “analysis” is the reason that President Obama projects bigger deficits this year than he did last year–that the economy is extremely weak, and is much weaker than we expected it to be, and when the economy is weak the deficit goes up as revenues fall and social-insurance spending rises: a year ago the administration expected the unemployment rate now to be 7.7%, but it’s 10.0%; a year ago the administration expected the unemployment rate at the start of fiscal 2011 to be 7.0%, but now it expects it to be 9.8%; a year ago the administration expected the unemployment rate at the start of fiscal 2012 to be 6.4%, but now it expects it to be 8.9%.

All very good points, but in the end they lead to a dead end. If Hennessey is wrong, then DeLong is just as wrong, albeit for two different reasons.

DeLong says we need more fiscal stimulus because the recession is far worse than predicted. Let’s stop right there. Last January Obama knew exactly the sort of financial crisis we faced. He proposed a major stimulus, which he claimed would spur the economy. New Keynesian models say that the expansionary effect of stimulus begins occurring when it is announced. New Keynesian theory suggests that current AD is strongly influenced by changes in future expected AD. So here is my question; what was the impact of the first stimulus package? Yes, we know it wasn’t as big as DeLong would like, but what was its impact?

To answer that question, it would seem logical to look at how NGDP grew, and compare that growth to the trajectory expected in the absence of the stimulus. Trust me, if you are a Keynesian you don’t want to do that. Instead, a Keynesian would argue that things quickly deteriorated after the first projections were made, but the stimulus somehow prevented the deterioration from being even worse. Possibly, but there are two problems with that explanation. It still leaves us without a shred of evidence that the stimulus worked, it merely indicates there might be an excuse for it seeming not to work. Even worse, that near-term deterioration is not supposed to happen in forward-looking New Keynesian models where the stimulus is expected to boost output later. So the Keynesians don’t have any good explanation for the horrible performance of NGDP in 2009 relative to the expectations back in January. Banking problems? We already knew about that, they occurred in 2008. Mysterious drop in consumer confidence? Animal spirits? Those are terms people throw around when they haven’t a clue as to what’s going on.

To summarize, the Keynesian complaint is “the economy deteriorated far more severely than we expected when we proposed our massive $800 billion dollar stimulus, consumer confidence has been shattered by all those scary stories on FoxNews about a government near bankruptcy, so we need to run even bigger deficits.”

I admit all this is highly debatable, but here is my real complaint with DeLong’s post, (or the Republican view for that matter.) Everyone wants to set the debate up as follows:

1. Do you favor massive deficits or are you content to have the economy self-correct, risking high unemployment for several years?

I want to scream when I see the debate structured that way. That is not the issue. Rather there are two distinct issues:

1. Is more AD desirable, or should we let the recovery take its natural course?

2. If we need more AD, is monetary expansion preferable to massive budget deficits?

Let’s review a few simple ideas. Fiscal stimulus does not boost AS, it boosts AD. (OK, MTR cuts can boost AS, but Obama’s opposed to those. And some public investment like education might have a long-term payoff. But let’s get serious. We are talking about high unemployment over the next 5 years. A more educated workforce won’t have much short term impact.) So if fiscal stimulus is to help the recovery, it does so by exactly the same method as monetary stimulus—boosting AD.

I happen to favor more stimulus, although I understand that some thoughtful economists disagree with me. I happen to think monetary stimulus is preferable to fiscal stimulus, and in this case there aren’t any thoughtful economists who disagree with me. Not one. If there was going to be one, it would be Paul Krugman. But even he admitted late last year that monetary stimulus is the first choice, and you only move on to fiscal stimulus if the Fed won’t play ball.

So here is the debate: Do we need more monetary stimulus, or should we let the economy recover naturally. But DeLong wants to say the debate is between fiscal stimulus and stagnation. How can he do that? Buy simply assuming away monetary stimulus. Presumably he would say that Obama doesn’t control monetary policy, so he can hardly be blamed for relying on fiscal stimulus. Has Obama made a single public statement calling on the Fed to promote higher NGDP growth, or higher inflation, or higher whatever? And then there is the little problem that Obama just re-appointed Ben Bernanke last month. Bernanke’s now his guy at the Fed.

I am actually not trying to blame Obama personally. As with all other politicians I assume he does not understand that low interest rates don’t mean easy money. Most economists don’t even seem to understand that. Rather as with any President, the term ‘Obama’ is really shorthand for the entire policy-making apparatus.

Don’t get me wrong, I’m not that naïve. I understand it would be very hard getting the Fed to change its ways at this point. But can we at least have a debate? I was about to ask if we’ve reached the level of passivity of the Japanese, but then I recalled that they are engaged in a fierce debate right now, and Finance Minister Kan is putting strong pressure on the BOJ for more stimulus. So compared to us, the new Japanese administration is almost Rooseveltian.

If Obama doesn’t want to have that debate, that’s fine. But then don’t tell us fiscal stimulus is the only answer to high unemployment. And don’t tell us that Obama doesn’t understand monetary policy. I thought the whole point of replacing Bush with Obama was to get an intellectual in the White House. Someone who understood the issues. If we have “grown-up” intellectuals in the White House, then let’s have that debate. Let’s see some discussion of unconventional monetary stimulus. Can’t Congress at least pass a law repealing the interest on reserves program?

by the way, I’m just as frustrated at the right-wingers at the Fed. We are running up trillions of dollars in debt precisely because the elected leaders of our country think we need more AD, and the Fed doesn’t. I understand the need for the Fed to be independent, but how about some honesty at least. If these inflation hawks really believe what they are saying, show some guts and come out and say “We are not doing more monetary stimulus because we feel a need to offset what we regard as excessive fiscal stimulus, and prevent it from raising the expected inflation rate.” If they really have the courage of their convictions, then why not admit what they are doing?

In February I said fiscal stimulus wouldn’t work, as the Fed had some sort of nominal aggregate target in mind, and was going to simply offset the fiscal stimulus. And that is what happened. In March when things looked scary, like a Depression was possible, the Fed announced its big program of buying Treasuries and MBSs. Later in the year when things picked up a bit, and we were clearly going to avoid a depression, the Fed started furiously back-peddling. They started talking about ending the bond buying program and “exit strategies.” Ask yourself this; what does that back and forth behavior tell you? It tells me the Fed has some sort of implicit nominal target, and if the economy seems to fall short they’ll pull out all the stops and flood the economy with liquidity. That’s why the $800 billion dollar fiscal stimulus was a complete waste of money; the Fed wasn’t going to allow NGDP to fall much further than the actual 2.5% it fell. Shame on us for not figuring that out, and shame on the Fed for not explaining that to us.

Oh, and shame on the Fed for not having a more aggressive policy even with the stimulus.

And shame on me for writing this post just one day after I resolved to be less opinionated.

[_The Dude]

Who bails out the little guy?

When he gets pissed on it's called "trickle down" and viewed as a good thing.

[_Analytics]

Who bails out the little guy?

When he gets pissed on it's called "trickle down" and viewed as a good thing.

LOL.

In response to the OP, it’s obvious from a microeconomic perspective that borrowing too much is bad. From an accounting perspective, the fact is that for every dollar one person borrows, somebody else saves a dollar. This leads to the paradox that if too much borrowing is bad, then too much savings is also bad. When there is too much borrowing and savings, the borrowers eventually reach the point of effectively being the indentured servants of the savers.

If I may wax religious here, Jesus said don't lay up treasures for yourself upon the earth, and go on to say, take therefore no thought for the morrow: for the morrow shall take thought for the things of itself. If people didn't save too much, we wouldn't be in the current situation.

I don’t believe Kensian-flavored responses are the panacea to all economic problems, but it is clear that in the current situation, the private sector isn’t coming to an arrangement where production equals consumption plus investment. Investment is really just a form of borrowing. The savers in the economy have trillions to loan, and there just aren’t enough people who are willing and able to borrow it.

If the people with money want to loan it to the government and the government can figure out how to use the money to enhance to productive capacity of the society, then I’m all in favor of the government making the investment.