Size Matters–But Quality Does, Too
February 13th, 2009 . by economistmomToday Bruce Bartlett explains (in Forbes) that Republicans just don’t get it when it comes to fiscal stimulus–that when it comes to effective countercyclical policy, bigger deficits are better:
One reason why Republicans strenuously oppose the Obama administration’s fiscal stimulus plan is because it repeats the errors of Franklin D. Roosevelt. To them, the New Deal was mainly about vastly expanding government spending and deficits, which Republicans believe made the Great Depression worse rather than better. Therefore, doing so again in the present downturn will also lead to failure…
But in terms of fiscal policy, Roosevelt’s error wasn’t that he spent too much, but that he didn’t spend nearly enough…
The critics [of the New Deal] were also totally opposed to deficit spending. As with Republicans today, they said that federal borrowing would simply draw funds out of productive uses in the private sector to be squandered on make-work government jobs, pork barrel projects of dubious value and welfare programs that would sap the dynamism of the American economy.
Apparently, it didn’t occur to these critics that the existence of vast unemployment, closed factories, abandoned farms and extremely low interest rates meant that much of the private sector’s resources were simply idle. Borrowing them by running deficits didn’t reduce private output because there were no alternative uses available.
Furthermore, an expansive fiscal policy was essential to recovery because without it monetary policy was impotent and deflationary conditions continued…
Bruce then looks back at the historical data on GDP during the New Deal era and calculates what the “appropriate deficits” would have been, in contrast to what the actual deficits were; as he explains (my emphasis added):
In the table below, I have done a very simple calculation showing what fiscal policy should have been during the New Deal. I assume that the economy’s real productive capacity was at least equal to what it was in 1929 throughout the 1930s. The difference between the actual gross domestic product and what it was in 1929 I assume to be the output gap–a measure of idle resources.
Then I show the federal budget surplus or deficit and a calculation of how much the deficit should have been to compensate for lost gross domestic product. This required making an assumption about the multiplier effect–the number of times federal spending turns over as workers hired by government programs spend their earnings, thereby creating income and employment for other workers and so on…
Bruce’s table shows that deficits should have been maybe ten times larger than they were in the early 1930s, to close up that GDP gap. My question is whether that’s really the “appropriately sized” deficit, and “appropriate” for what purpose? For that fully compensates for lost GDP during the downturn (is full compensation, or a complete “filling up” of the economic hole, necessary or even desirable?), and it won’t necessarily even increase GDP in the longer term, once the adverse effect of higher debt (lower national saving) is accounted for. (The Congressional Budget Office warns of the recovery package’s potential net adverse effect on GDP by as soon as five years from now.)
And Bruce explains why it took World War II to bring us out of the depression:
Ironically, Republicans implicitly acknowledge the truth of this when they argue that “the only thing that brought us out of the depression was World War II,” as Sen. John Ensign explained on Feb. 7.
Yet Republicans conveniently overlook the fact that it was massively larger budget deficits–which averaged close to 20% of GDP from 1941 to 1945–that were the principal contribution of the war to economic recovery.
But I have to wonder, without the convenient spending demands of a major world war (and this is not a reason to wish for war), can we come up with enough quality deficit-financed government spending to both effectively fill a lot of our current economic hole (reducing the output gap) in the short term and be “worth it” in terms of providing a net positive for our society (whether measured in GDP or broader notions of social welfare) over the longer term?
I still think that when we ask whether a massive amount of deficit spending makes us better off or not, it’s also the quality, not just the quantity, of the deficit spending that matters. It’s still a question of whether the benefits are worth the costs.
Diane is correct that the composition of deficit spending is as important as the amount. Unfortunately, we have to contend with both the constraints of the political process and the constraints of what can actually be done in the short run.
In the end, I decided that doing something was better than doing nothing. But that doesn’t mean I am happy with the result. I think the stimulus package could have been both more stimulative and imposed less of a long-term burden on the economy. But that was not to be.
Some observations that hope to be rationally skeptical about the stimulus – a bit less Paleo than both Republican and Democratic politicians, who argue positions driven by politics.
#1) This continues the endless mantra of “Worst Since the Great Depression”, when in reality there is no comparison to the Great Depression.
The recent CBO “letter to Gregg” projects that without any stimulus unemployment will top at 9%, with an output gap of 7.4%. Those are 20% below the levels of 1982 (unemployment 10.8% and output gap at 8.9%). And 1982 was no Great Depression.
E.g.: Any argument that deficit spending won’t draw resources from productive private uses at an output gap of 7.4% currently, any more than they would have in the 1930s with an output gap of >40% , when…
… is based on a specious comparison.
I understand that “Worst Since the Depression!” is very effective at selling advertising for the press and scaring up votes in politics. But if the media and Obama were being scrupulously honest, wouldn’t they be repeating “Worst Since 1982” or “Worst In 25 Years” instead? As less scary as that is.
The CBO projection indicates a recession in the worse end of the normal range, postwar. Regarding which, at least since I took my econ courses way back in the ‘80s, the textbooks have all generally dismissed government spending as anti-recession policy as “very inefficient”. Have they all been so wrong?
2) “This required making an assumption about the multiplier effect”. It certainly does. The multiplier of 4 suggested by DeLong, cited in the article, may be very conservative as to the amount of needed spending it implies, but it is extremely aggressive as to the benefit/tax cost ratio.
At the other end of the spectrum we have Barrow telling us…
Multipliers for [non-defense] forms of government spending are imprecisely determined but are not significantly different from zero … You want me to ignore good economic theory and empirical analysis and pretend that a voodoo multiplier above one should be respected as a “consensus?”
… and if he’s right the benefit/tax cost ratio today is going to be really expensive.
3) As to WWII ending the Depression via huge deficit spending, that’s become such a common belief it’s practically a cliché, but it has been seriously challenged in several quarters. E.g., Cole and Ohanian argue the Depression would have ended circa 1935 but for the NIRA policies of price rigging, price supports, cartelization, etc., that increased wages and prices in major industries to 25% above market clearing levels, and which continued in full force de facto into the 1940s under the political influence of the New Dealers, even after being overturned de jure by the courts in the 1930s. They say the major effect of WWII on ending the Depression was the introduction of wage and price controls that knocked these prices back down to market levels, the return of anti-trust enforcement, etc. Higgs has done a lot on how the “command economy” economic numbers of WWII are seriously misleading about how it presumably worked to end the Depression, etc.
4) I still think that when we ask whether a massive amount of deficit spending makes us better off or not, it’s also the quality, not just the quantity, of the deficit spending that matters.
Absolutely. As one of countless examples in this bill, what does the effective repeal of welfare reform have to do with stimulating growth of the economy during the next two years?
If everyone was talking about the “Worst Recession Since 1982!”, things like that might have gotten a lot more scrutiny. Which is one reason why the politicians aren’t talking about that.
If Barro is right about the multiplier, this is going to be costly indeed.
Ironically, Republicans implicitly acknowledge the truth of this when they argue that “the only thing that brought us out of the depression was World War II,” as Sen. John Ensign explained on Feb. 7.
But I have to wonder, without the convenient spending demands of a major world war (and this is not a reason to wish for war), can we come up with enough quality deficit-financed government spending to both effectively fill a lot of our current economic hole (reducing the output gap) in the short term and be “worth it” in terms of providing a net positive for our society (whether measured in GDP or broader notions of social welfare) over the longer term?
I agree, of course, that the convenient spending demands of a major war is not a reason to wish for one. I’ve long thought that the idea that World War II brought us out of the depression is incomplete if not outright flawed. Major wars have a cost beyond the death and destruction that they incur. For example, economist Frederick C. Thayer long made the argument given at this link that surpluses cause recessions. Upon looking closely at the six examples before World War II that he lists, however, I noticed that five of them were merely a partial paydown of a larger increase in the debt. And each of these increases in debt was due to a major war. Hence, once could reasonable maintain that the large debt that results from major wars often leads to economic problems, including recessions.
One other problem that they can lead to is inflation. The graph at this link shows the relationship between the consumer price index and the M2 money supply since the 1800s. As can be expected, there is some correlation. Also noticeable, however, is that inflation spiked 5 times since 1800. Those spikes occurred shortly after the War of 1812, the Civil War, World War I, and World War II. The last spike around 1980 may well have aided by the costs of the Vietnam War.
The near-term output gap (shortfall of actual relative to potential GDP) resembles that which prevailed in the early 1980s, widely regarded to be our worst downturn in modern times. However, unlike those previous large gaps, we got to our currently low gap without having exceeded potential GDP during the 2001-2007 recovery. Accordingly, the economy is not cultivating any inflationary pressures at the moment. Indeed, the major downside risk we’re now facing is deflation–a vicious downward spiral in the general price level is expected to fall, raising both the burden of existing debt and the expected real cost of new borrowing. That dangerous spectre of deflation looming over the economic outlook has not been seen in the United States since the 1930s. So, in that sense, the current economic outlook is the worst it’s been since the Great Depression.
For policy (monetary and fiscal policy) to mitigate the risks of deflation it must stay ahead of the game. While measures of underlying inflation (such as the change in the core CPI or PCE deflator) have not turned negative (yet) they hover perilously near zero. The Fed must create credible expectations of inflationary pressure over the near term, and fiscal policy must support that as well. Stimulus (quantity and timing matters more than quality at the moment), banking recapitalization (which should raise the credit multipliers once we near recovery making the stimulus all the more potent), and foreclosure mitigation are all anti-deflationary measures that should be well in place in advance of a deflationary downswing. With any luck at all, deflation will have been the dark counterfactual we staved off.