I think they made a big mistake by not bailing out Lehman Brothers, I think they recognized that two days later

From Marginal Revolution:

"Interview with Robert Barro, on the New Deal and Great Depression

From The Browser, here is one bit:

It’s clear that a lot of the policies that were put into place were negative, but as to sorting out how important they were, that’s a much more challenging question. And I think Roosevelt at the time recognized ex-post that some of the things he tried were failures and then his attitude was “OK, it’s a failure I’ll stop doing it.” Which is actually pretty positive. For example, some of the things he did was try to organize labor unions and also businesses essentially promoting monopoly – I don’t think that was a plus. He was trying really hard to keep wages and prices from falling with direct influence and that was a negative. The effect of the expenditure programs is less clear. In the mid-1930s with the New Deal there was an unusual amount of infrastructure-type of expenditures. But it’s not actually big enough to sort out in a statistical sense -- to figure out how much it mattered in terms of the recovery after the trough in 1932-33. I don’t think we know that that was a mistake, but it’s not clear that it was all that important.

Barro also offers a reading list on the topic.

Posted by Tyler Cowen"

Me:

Three good points:

"1)The New Deal is part of my research, and it’s bigger than the other non-defense expenditure in terms of stimulus, but it’s not enough to really sort it out.

So I don’t think you can reliably say what the effect is.

2) Well Bernanke was thinking that way even a year ago. I remember talking to him at the time, in April, just after the Bear Stearns initial intervention. I got a chance to ask him a question about why they were so aggressive at that time when things didn’t look so bad. And his response was that basically he was worrying about a Depression-type scenario – and trying to act early to nip that in the bud.

3) Since the Lehman disaster – I think they made a big mistake by not bailing out Lehman Brothers, I think they recognized that two days later. I think that was Paulson’s individual fault and responsibility from what I can gather."

My main disagreement is that it's not clear what he means by stimulus. I'm assuming that he's for Automatic Stabilizers, so is he simply talking about infrastructure and other spending. As well, I though that he backed what he called 'incentives', like tax cuts. By the way, my choice, a sales tax decrease, is working in the UK with the VAT decrease.

"I think the stimulus package was very stupid; it was awful. It’s just a tremendous waste of money and it’s going to cause some trouble in terms of a bigger public debt, it’s just wasting resources. But the more important thing is the financial system, and somewhat the housing related aspects. So on that, despite a lot of floundering around, mostly I think what they were doing is in the right direction."

I think I agree. It's just that the spending is part of the political floundering around. I don't think that calling it stupid or awful is really called for. Isn't humility an obvious byproduct of this crisis? I do think that a placebo and investment case can be made for infrastructure spending, and Shiller is correct in believing that a massive stimulus would do the trick. However, like Barro, I don't that that we can afford to chance the massive debt.

Posted by: Don the libertarian Democrat | May 03, 2009 at 06:19 PM

I think they made a big mistake by not bailing out Lehman Brothers, I think they recognized that two days later

TO BE NOTED: From The Browser Via Tyler Cowen:

"Robert Barro on Lessons of the Great Depression

Robert Barro is a professor of economics at Harvard, and a commentator for the Wall Street Journal and Business Week. His critique of the Obama stimulus package provoked a sharp attack from Paul Krugman in the New York Times, which brought a spirited response from Barro. Basing his arguments on his empirical work, Barro takes issue with some common assumptions about the Great Depression, and how America got out of it.

The Browser: So if I want to understand what happened during the Great Depression --and even what the Obama administration is trying to do now--do I have to start by reading John Maynard Keynes’ "General Theory of Employment, Interest and Money"?

RB: You’re better off starting of by reading Milton Friedman and Anna Jacobson Schwartz’s "Monetary History of the United States", which I think is a better account. Keynes was more contemporary, so maybe not as much perspective.

B: This is the argument that the Federal Reserve caused the Great Depression, prompting Ben Bernanke’s famous apology to the authors (see sidebar). So why does this book need to be read, in your view?

RB: I think it appropriately looks at the monetary financial situation that is at the core of the Great Depression crisis and also the current situation. So they focus on the role of the monetary authority and the banking panics, and you can fit into that the legislative changes--particularly under Franklin Roosevelt--some of which helped the situation. I think the most important of those was the introduction of deposit insurance in 1934, with the Federal Deposit Insurance Corporation. The FDIC has really worked in preventing banking panics since that time in the US. I think a lot of the solutions these days involve extending that concept beyond the commercial banks that were at the heart of the financial system in the 1930s, but of course the system has been much broadened since then.

B: So we shouldn’t take books with titles like FDR’S Folly, How Roosevelt and his New Deal Prolonged the Great Depression" too seriously?

RB: It’s clear that a lot of the policies that were put into place were negative, but as to sorting out how important they were, that’s a much more challenging question. And I think Roosevelt at the time recognized ex-post that some of the things he tried were failures and then his attitude was “OK, it’s a failure I’ll stop doing it.” Which is actually pretty positive.

For example, some of the things he did was try to organize labor unions and also businesses essentially promoting monopoly – I don’t think that was a plus. He was trying really hard to keep wages and prices from falling with direct influence and that was a negative. The effect of the expenditure programs is less clear. In the mid-1930s with the New Deal there was an unusual amount of infrastructure-type of expenditures. But it’s not actually big enough to sort out in a statistical sense -- to figure out how much it mattered in terms of the recovery after the trough in 1932-33. I don’t think we know that that was a mistake, but it’s not clear that it was all that important.

B: So you’re not saying the New Deal was a mistake, you’re saying basically we don’t know.

RB: You know one of the things I’ve been trying to do in my research is to calculate the effect, particularly on Gross Domestic Product, of government expenditure programs. And I’ve been focusing on the US experience, because that’s where I have the information, although it would be good to go beyond that. But the thing you can really clearly isolate is the effect of wartime expenditure. Particularly World War II - it is so big that in a statistical sense it gives you a lot of power to figure out what is going on.

There’s both the buildup, starting in 1941, and then there’s expenditures coming down after the war, in 1945-6. There’s a lot of evidence there. Sometimes the spending in a year is 20% of GDP, which is absolutely astounding. So in comparison, the New Deal programs, particularly in 1934 and 1936, they’re only 2-3% of GDP of extra spending.

So it’s hard to sort it out. I’ve been trying to do that, but in terms of the stuff that’s not wartime spending--which we’re probably most interested in in the current climate--it’s just hard to know from the history of the data and the time series. The New Deal is part of my research, and it’s bigger than the other non-defense expenditure in terms of stimulus, but it’s not enough to really sort it out.

So I don’t think you can reliably say what the effect is. But conceptually you’d expect the wartime spending to have a bigger effect for various reasons on the GDP than the equivalent amount of expenditure in a non-war situation. And the wartime effect you can estimate pretty precisely and the multiplier is clearly less than 1, even in World War II – in the order of 0.6, 0.7 something like that.

B: So your point is that even in the context of massive expenditures in a wartime situation, the multiplier effect of government spending on the economy is less than 1- i.e. it is not a multiplier at all. In other words, fiscal stimulus does not work. I read your WSJ editorial on this. Is that a good way for the layman to understand your arguments? Also on the “Voodoo Multipliers.”

RB: Yes, those articles refer to this kind of evidence, and I’ve been working more on it, trying to make it more precise. Some economists have argued that in a time of slack the multiple should be bigger, because there’s more capacity to respond to the extra demand. There’s a little bit of evidence that that’s right. A lot of that comes from the buildup in World War II, because in 1941 the unemployment rate is still around 9%, so you can see what is the effect in that environment, in a high unemployment situation, of having a big expenditure increase. (Later in the war, the unemployment rate is close to nothing, so you don’t have that setting.) There’s a little bit of evidence from that that the multiplier is bigger when there’s more slack. But it doesn’t look like the multiplier gets up to 1, even when the unemployment rate is 9%. It’s getting closer to that, but even then it is not 1.

B: And yet neo-Keynesians—which include White House economics adviser Christina Romer--often cite the number as being 1.5, and you say in your article that the Obama administration is using 1.5 as a basis for its fiscal stimulus policies. How do they come up with that then?

RB: Oh they pulled that out of the air. I have the advantage of having at least a little bit of empirical evidence, as I said, it’s based particularly on military purchases. So even though that evidence is not that great, it’s infinitely better than the alternatives, which are no evidence. I think Valerie Ramey’s work is the best in terms of empirically trying to figure what the effect is of expenditure on the macro-variables. She has focused mostly on the post-World War II period, but she’s looked somewhat at the earlier part.

B: So you would put her work among your must-reads?

RB: Since part of the remedy for the current crisis is this fiscal stimulus package--which particularly revolves around this Keynesian multiplier--then Valerie’s work is especially relevant there and is probably the best recent work on that topic that I know of.

B: So what else should I be reading on the Great Depression?

RB: There’s Ben Bernanke’s research in the 1980s, that’s probably his most important contribution in terms of macroeconomics and financial economics.

B: Yes, I saw the Dow Jones Newswires quote on Bernanke’s book, "Essays on the Great Depression", which made me laugh: “With some observers saying that the ongoing financial crisis could be the worst since the Great Depression, the greatest living expert on that period is getting the chance to apply its economic lessons.”

RB: Well Bernanke was thinking that way even a year ago. I remember talking to him at the time, in April, just after the Bear Stearns initial intervention. I got a chance to ask him a question about why they were so aggressive at that time when things didn’t look so bad. And his response was that basically he was worrying about a Depression-type scenario – and trying to act early to nip that in the bud.

B: So what is the thrust of his book and why is it important?

RB: It’s focusing on the Great Depression as a credit explosion, not so much the money supply, which Friedman and Schwartz had emphasized, but a somewhat related phenomenon, which is credit availability. That had been imploding from 1929 through to the trough, early in 1933. So it’s really focusing on the credit aspects and trying to measure that, particularly by looking at patterns in interest rates.

Today, for example, if you look at the spread between lower quality bonds – like B-rated corporate bonds, say – and compare those to treasury yields, that’s a good indicator of the extent of stress in the credit markets. And actually the recent period is going back to the kinds of spreads that you saw in the early 1930’s. Well, perhaps not quite as much, but certainly reminiscent of that. So he’s focused on that as a measure of the extent of the credit stress, and on the other side he focused on how what turned things around was when the credit problems were being eased.

It’s often thought that there was a very prolonged recovery from the Depression, as though the economy was stagnating until World War II, but the data don’t look like that at all. In fact the growth rate of the US economy from 1933 until 1937 is extremely rapid. People often think that the US economy stagnated in the Depression all the way through the 1930s, and didn’t at all get out of that until World War II – and that really is not accurate, it’s not what the data look like.

So from the bottom, which is early in 1933, through 1937, the US economy grows very rapidly. It’s actually the fastest growth period of any peacetime period of that length in the whole history. Maybe it’s not as fast as you would have hoped for or wanted, given how big the contraction was, but it’s very rapid – and then it’s unfortunately interrupted by a pretty big recession, 1937-8, which was probably caused by the Federal Reserve doubling the reserve requirement in 1937. It’s pretty unbelievable that they did that actually.

The Fed was probably the reason, though people have advanced other possibilities. But then it starts again, from 1938-41, there’s also very rapid growth, before the US is into the war and has a lot of expenditures. 1941 is the first year where there is a lot of big federal US expenditure related to the war, there’s not really much of a build up in 1939-40, which is also kind of surprising.

B: So going back to your other bibliographical picks, you recommend some recent papers by Cole and Ohanian. What are they about?

RB: So they focused more on some of these anti-market FDR policies. I think they’re right that these are mistakes, as are some of the tax increases. There was a tax increase under Hoover and then some under Roosevelt, trying to balance the budget, which was clearly a mistake in the context of the very high unemployment rate and the poor economy. But as to how much that mattered is much less clear. Similarly the Smoot-Hawley Tariff in 1930, which every economist agrees is ridiculous, it’s not clear how much that actually mattered in terms of the macro results.

B: I thought that the Great Depression was the ultimate cautionary tale on the dangers of protectionism. That’s not the case?

RB: No I think what is much clearer is the role of the financial system and the credit implosion, both in the 1930s and today. The rest of the stuff may just be a sideshow, it may not be that important. There’s a strong tendency for the economy to recover on its own, as long as it’s not subject to further new shocks, so a likely scenario is that that is what will happen today as well. And then the Obama administration will say that it’s because of our policy that things recovered, and there won’t be any way to prove whether that’s right or wrong.

B: So are you not a fan or what Obama is doing?

RB: I think the stimulus package was very stupid; it was awful. It’s just a tremendous waste of money and it’s going to cause some trouble in terms of a bigger public debt, it’s just wasting resources. But the more important thing is the financial system, and somewhat the housing related aspects. So on that, despite a lot of floundering around, mostly I think what they were doing is in the right direction. Since the Lehman disaster – I think they made a big mistake by not bailing out Lehman Brothers, I think they recognized that two days later. I think that was Paulson’s individual fault and responsibility from what I can gather.

B: But I noticed you did not sign that full page advertisement in the New York Times opposing Obama’s stimulus package. A lot of other economists did, including Edward Prescott, who won the Nobel Prize for economics, so presumably should be taken seriously. Has he done any work on this?

RB: I don’t know what he’s contributed that is particularly relevant on this issue. He has done some brilliant work and deserved the Nobel Prize, but his empirical stuff is not that good frankly. I didn’t sign that advertisement because I don’t really like to sign things in general – I prefer to write my individual thing.

B: But you’re broadly sympathetic to that viewpoint?

RB: For a while there was this ridiculous view that there was this massive consensus in favor of Keynesian stimulus. And Biden even said at some point that “Every economist agrees that we need this stimulus.” Of course that was always nonsense. So in that sense I agreed with the sentiment of what was in that signed letter."

What does all this tell us?

From Free Exchange:

"Barro of bad news

Posted by:

Economist.com | WASHINGTON

Categories:

Business cycles

MACROECONOMIC historians to your data sets, the global downturn has seemed to call. Carmen Reinhart and Kenneth Rogoff have given us a detailed survey of the economic consequences of financial crises—work which revealed that crisis-driven recessions tend to be longer and deeper than other species. Today, in the Wall Street Journal, Robert Barro explains the findings of his examination of stock market behaviour and economic downturns. He also sounds a rather ominous warning:

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war (the Iraq and Afghanistan conflicts are not comparable to World War I or World War II). Thus, we get better information about today's prospects by consulting the history of nonwar events -- for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing. In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes -- 69% for minor depressions and 83% for major ones.

Emphasis mine. Mr Barro defines a minor depression as a fall in real GDP per capita of 10% or more, and a major depression as a fall in real GDP of 25% or more. His study seems to differ from that of Ms Reinhart and Mr Rogoff in that they examine financial crises as precipitators of recession, while Mr Barro examines stock market crashes as barometers of recession. That is, a recession brought on by a collapse in stock prices might or might not be severe, but a recession coincident with a broad and deep market crash suggests dangerous conditions indeed. Markets recovered much of their value following the crash of 1929, for example, but began a sustained decline in 1930 as the extent of the financial damage became clear.

What does all this tell us? Well, that there is a real risk of an economic calamity of historic proportions, such that policymakers must work diligently to avoid disastrous errors—sharply contractionary policy, for instance, or a modern day Smoot-Hawley. Or war. But also that things aren't yet that bad. As Mr Barro notes, a 20% chance of a minor depression implies an 80% chance of avoiding a 10% decline in real GDP per head. Given the situation—massive losses of housing and equity wealth, financial collapse, implosion of global demand, and so on—that's a pretty impressive statisic."

Me:

Don the libertarian Democrat wrote:

March 4, 2009 16:42

There's a huge upside to be seen as calling a market top or bottom, but is there any real downside? It seems that if you correctly call the top or bottom, you are seen as knowing what you're talking about. If you incorrectly call the top or bottom, you're seen as simply missing a few salient points, not that you're clueless. If this is correct, then you will always have people calling tops and bottoms, sometimes in the same paragraph.

Is there any way to weed out buffoons in economics or investment? We already know that it's impossible in banking and the overseeing of it. Here's my prediction:

There will be a bestseller entitled "How To Run A Ponzi Scheme And NOT Get Caught". The fact that it will work and go undetected for a long time will be assumed by the author.

This is not an ordinary recession that differs from other recent episodes simply by being somewhat more severe. It differs in kind.

From Vox:

Axel Leijonhufvud
13 February 2009

This recession is different. Balance sheets of consumers, firms, and banks are under strain. The private sector is bent on reducing debt and this offsets Keynesian stimulus more than standard flow calculations would suggest. Bank deleveraging is by far the most dangerous. Fiscal stimulus will not have much effect as long as the financial system is deleveraging.

This is not an ordinary recession that differs from other recent episodes simply by being somewhat more severe. It differs in kind.

Past recessions and the reallocation of employment

The end of the Cold War brought a decline in military spending and a recession which impinged most heavily on the states, like California, where the military-industrial complex was an important part of the local economy. The nationwide unemployment rate rose from 5.25% in 1989 to 7.5% in 1992. It then fell every year reaching just under 4% in 2000. The “free market” took care of the recession of the early 1990’s. Resources moved from the defence industries, trickling into other uses through innumerable channels. The federal government did not need to take a hand. Beginning in 1993, the federal deficit in fact shrank every year turning into a modest surplus in 1998. That was a very ordinary recession.

If the current situation were at all similar we would expect a recession in residential construction with unemployment among construction workers and mortgage brokers. Naturally, recent boom areas would be hard hit but we would expect resources gradually to trickle into alternative employment. Instead, we are threatened by a veritable disaster.

Balance sheet recessions

What is the difference? It resides in the state of balance sheets. The financial crisis has put much of the banking system on the edge – or beyond -- of insolvency. Large segments of the business sector are saddled with much short-term debt that is difficult or impossible to roll over in the current market. After years of near zero saving, American households are heavily indebted.

The holes that have opened up in the balance sheets of the private sector are very large and still growing. A recent estimate by Jan Hatzius and Andrew Tilton of Goldman Sachs totes up capital losses of $2.1 trillion; Nouriel Roubini thinks the total is likely to be $3 trillion. About half of these losses belong to financial institutions which means that more banks are insolvent – or nearly so – than has been publicly recognised so far.

So the private sector as a whole is bent on reducing debt. Businesses will use depreciation charges and sell off inventories to do so. Households are trying once more to save. Less investment and more saving spell declining incomes. The cash flows supporting the servicing of debts are dwindling. This is a destabilising process but one that works relatively slowly. The efforts by financial firms to deleverage are the more dangerous because they can trigger a rapid avalanche of defaults (Leijonhufvud 2009).

The Japanese example

Richard Koo (2003) coined the term “balance sheet recession” to characterise the endless travail of Japan following the collapse of its real estate and stock market bubbles in 1990. The Japanese government did not act to repair the balance sheets of the private sector following the crash. Instead, it chose a policy of keeping bank rate near zero so as to reduce deposit rates and let the banks earn their way back into solvency. At the same time it supported the real sector by repeated large doses of Keynesian deficit spending. It took a decade and a half for these policies to bring the Japanese economy back to reasonable health.

The Great Depression counterexample

The US Great Depression saw no consistent policy of deficit spending on adequate scale in the 1930’s. War spending not only brought the economy back to full resource utilisation but also crowded out private consumption to a degree (Barro 2009).¹ The deficits run during the war meant that:

1. At war’s end, the federal government’s balance sheet showed a debt of a size never before seen, but also
2. The balance sheets of the private sector were finally back in good shape.

At the time, a majority of forecasts predicted that the economy would slip back into depression once defence expenditures were terminated and the armed forces demobilised. The forecasts were wrong. This famous postwar “forecasting debacle” demonstrated how simple income-expenditure reasoning, ignoring the state of balance sheets, can lead one completely astray.

Lessons from the two cases: Fill the financial sinkholes first

The lesson to be drawn from these two cases is that deficit spending will be absorbed into the financial sinkholes in private sector balance sheets and will not become effective until those holes have been filled. During the years that national income fails to respond, tax receipts will be lower so that the national debt is likely to end up larger than if the banking sector’s losses had been “nationalised” at the outset.

Sweden’s successful policy mix: Don’t forget the mega devaluation

The Swedish policy following the 1992 crisis has been often referred to in recent months. Sweden acted quickly and decisively to close insolvent banks, and to quarantine their bad assets into a special fund.² Eventually, all the assets, good and bad, ended up in the private banking sector again. The stockholders in the failed banks lost all their equity while the loss to taxpayers of the bad assets was minimal in the end. The operation was necessary to the recovery but what actually got the economy out of a very sharp and deep recession was the 25-30% devaluation of the krona which produced a long period of strong export-led growth. Needless to say, the US is in no position to emulate this aspect of the Swedish success story.

Perils, present and future

Strong contractionary forces are at work in the US emanating both from the capital and the income accounts. Stabilisation requires major policy actions on both fronts.

• First, the financial system must be recapitalised so as to remove the relentless pressure to deleverage from the banks.
• Second, a spending stimulus sufficient to reverse the rapidly worsening decline in incomes must be administered.

When the entire private sector is bent on shortening its balance sheet and paying down debt, the public sector’s balance sheet must move in the opposite, offsetting direction. When the entire private sector is striving to save, the government must dis-save. The political obstacles to doing these things on a sufficient scale are formidable.

If banking system losses are of the magnitude estimated by Goldman Sachs or Roubini, the banks need capital injections of at least another $200-300 billion. Even if injections equal to all their losses could be effected, the banks might still want to contract, now that they know how dangerous their leverage of yesteryear was.

US policy: A strangely contrived way out of a political impasse

The American public understands clearly that the present disaster was fashioned on Wall Street (albeit with some stimulus from Fed policy). Outright bail-outs are a “hard sell” therefore. But the American ideological taboo against “nationalisation” also stands in the way of dealing with the matter in the straightforward way that Sweden did. The present administration, like the last, would like to recapitalise the banks at least partly by attracting private capital. That can hardly be accomplished as long as the value of large chunks of the banks’ assets remains anybody’s guess. Government guarantees against (some part of) losses that may be incurred might solve this problem. But it would be a strangely contrived way out of a political impasse.

Fiscal stimulus + financial deleveraging = zero impact

Fiscal stimulus will not have much effect as long as the financial system is deleveraging. Even if that problem were to be more or less solved, the government deficit would have to offset both the decline in industry investment and the rise in household saving – a gap that is rising as the recession deepens. Here, too, the public is sceptical and prone to conclude that a program that only slows or stops the decline but fails to “jump start” the economy must have been a waste of tax payers’ money. The most effective composition of such a program is also a problem.

US states and local governments undoing the federal spending boost

Almost all American states now suffer under self-imposed constitutional balanced budget requirements and are consequently acting as powerful amplifiers of recession with respect to both income and employment. The states will have a spending propensity of one, as will a great many local governments. Income maintenance for unemployed and other low income households will also be effective.³ Tax cuts will have considerably lower spending propensities. However, the political prospects seem to portend a less than ideal program mix.

The danger of deflation, or inflation

If government programs end up not being large enough to turn the recession around, we have to look forward to a deflationary period of indeterminate length. If they do succeed, however, severe inflationary pressures may surface quite quickly.

The US ratio of federal debt to GNP is not particularly high at this time. But it does not take into account the very large off-balance liabilities of entitlement programs. Since the present crisis began, moreover, the Federal Reserve System and other federal agencies have made bail-out, loan and credit guarantee commitments totalling many trillions of dollars with uncertain eventual implications for the consolidated federal balance sheet.

If the US’s foreign creditors balk, inflation will be hard to contain

Much will depend on the willingness of the nation’s foreign creditors to continue to accumulate or at least to hold dollars at low rates of interest. Should this willingness falter, inflation will be hard to contain.

There is much to fear beyond fear itself.

References

Robert Barro, 2009, “Government Spending is no Free Lunch” (Wall Street Journal, January 22).

Leijonhufvud, 2009 “Two Systemic Problems,” CEPR Policy Insight No. 29, January

Richard C. Koo, 2003, Balance Sheet Recession: Japan’s Struggle with Unchartered Economics and its Global Implications, Singapore: Wiley

Footnotes

1 The crowding out at full employment, Barro thinks, “most macroeconomists would regard … as a fair [test case] for seeing whether a large multiplier ever exists” (italics added). Most macroeconomists will presumably agree that World War II was not a free lunch but are not likely to agree to Barro’s test case inference.

2 There were plenty of bad loans but at that time they did not have the non-transparent “toxicity” that “sliced and diced” CDO’s were to generate in the present crisis.

3 Milton Friedman’s negative income tax proposal seems to have become anathema to conservatives by now. It would work in our present situation.

Me:

An Excellent Post

On February 13th, 2009 Don the liberta... says:

An excellent post. I agree that:
1) We should use a version of the Swedish Plan.
2) The stimulus was a poor mix with too much infrastructure and not enough incentives.
3) Social Safety Net spending is essential, including aid to states for essential services. If unemployment gets much higher and people don't feel secure, serious social disruptions and dislocations could occur. This would be very bad news.
4) We cannot overspend because we don't know at what point foreign creditors will balk. ( Buiter )
5) I am for a guaranteed income in any case, but it would certainly be useful here as a Negative Income Tax.
6) The use of WW II for comparison is strange. What can be conspicuous consumption in a recession can be seen as treason during a world war.
I differ in that I believe that we need to use quantitative easing to attack debt-deflation, a la Fisher. I also believe that a massive stimulus could work as Shiller believes, but we do not have the money to try it in these circumstances.

I will have to think about that one...

From Clive Crook:

"Dismal science, revisited

10 Feb 2009 04:52 pm

Paul Krugman and Robert Barro have both responded to my column accusing them of putting politics first. Paul wonders what has happened to me.

Clive used to be a reasonable guy; in his mind he probably still is a reasonable guy. But he has misunderstood what it means to be reasonable. He now apparently believes that it means declaring, in all circumstances, that Democrats and Republicans are equally in the wrong, even if the Democrats are talking Econ 101 and the Republicans are being led by the crazy 36.

And it means hysterical attacks on yours truly for actually taking sides in this debate, with the ostensible basis for the denunciation being a wonkish blog post -- it says so in the title -- in which I acknowledge that there is a potential short-run argument for protectionism, while making it clear that I'm not in favor of acting on that argument. He doesn't actually take on my argument; he just insists that the only reason I might possibly have said anything like this is partisan bias, as opposed to an attempt to be intellectually honest.

Speaking of which, Clive and others have, in my view, a fundamentally flawed view of how to defend free trade. They believe that you should scream "Heresy! Sacrilege!" at anyone who even suggests that the world is more complicated than the simple Ricardian model of comparative advantage. But, you know, the world actually is more complicated than that simple model, and I believe that one's case for free trade should be robust enough to stand up to a bit of free thinking -- not sustained by excommunicating anyone who questions orthodoxy, even hypothetically.

Was that piece really hysterical? I believe it is the first time I have ever been called that. One of Paul's commenters accuses me of being Broderish, which is a criticism that makes more sense to me--but it cannot be possible, can it, to be both hysterical and Broderish? I do try to be reasonable, which I know can be infuriating, but as it happens I don't think that "being reasonable means declaring, in all circumstances, that Democrats and Republicans are equally in the wrong". Each side is usually somewhat wrong, I find, but the proportions do vary according to topic. I am very much in the Democratic camp on the stimulus, for instance. I think it is unreasonable, on the other hand, to regard everything Republicans say as definitionally wicked or stupid or both, which is the organising principle of everything Paul writes in the NYT.

As for defending free trade, I don't recall ever shouting "Heresy! Sacrilege!" at anyone who "even suggests that the world is more complicated than in Econ 101". Well, perhaps I have, but only as a joke, I promise. (Odd by the way that Paul thinks Econ 101 is all you need to talk about the stimulus intelligently, but far too simplistic when it comes to trade.) In fact I agree with Paul about free trade: in the real world, theoretical reservations aside, he is for it and so am I. The problem is that he can't just say that, because most of the progressive Democrats who adore his writings do not want to hear it. He is too good an economist, and too honest a person, to advocate protectionism, so he does the next best thing. He equivocates.

I think Paul is disingenuous (there I go again, more hysterics) when he says that the blog-post in question makes it clear he is not in favour of acting on the short-run argument for protection. You be the judge. In my view, he says it is all very complicated. He kind of supports free trade in an ideal world--that would be an Econ 101 world--but there are circumstances, which happen to be very like today's circumstances, in which protection could make sense. This "needs to be taken seriously", and the case gets stronger if optimal macro co-ordination is not forthcoming (which it won't be). Ask any Democratic congressman what Paul's advice on "Buy American" is. The answer will not be, "Don't do it." It will be, "The most brilliant economist I know of thinks there's a case."

My exchange with Robert Barro was via email. With his permission, here it is:

>>>>>>>>>>

Clive,

I hope that all is well. It seems from your writing that I at least had the beneficial effect of neutralizing Krugman. I am not sure what you mean by "consensus." You don't think it's pretty wild to have a multiplier of 1.5, so that government spending is not only free, it has negative costs? The only informative empirical work I know of (from Valerie Ramey and my own work) finds multipliers associated with defense spending that are positive but less than one. In Valerie's work, this shows up as a negative effect from added government military purchases on private consumer spending. Multipliers for other forms of government spending are imprecisely determined but are not significantly different from zero. Actually, I hope that my current long-term empirical project will shed more light, including macro effects from changes in marginal tax rates.

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?"

-- Robert

>>>>>>>>>>

Hi Robert.

Thank you for writing. It is good of you to take the trouble.

If we are to have Paul doing what he does in the NYT, it might be better to have you writing in a similarly gladiatorial way than not at all. But I do think it would be best of all if you, Paul, and other scholars of such distinction gave a little more thought to the harm that this unscholarly politicised jousting can do.

Rather than asking them to think, Paul gives comfort to the massed ranks of liberal economic illiterates--and you do the same for their conservative equivalents. In the middle, where there are open minds willing to be enlightened, the typical response is to switch off. I think that this is a shame. Needless to say, I am not arguing that you (or Paul) should be untrue to your own views when writing for a wider audience, only that you should not deny or dismiss the professional consensus, such as it is, out of hand, or advance your own views with deliberately exaggerated certainty.

Yes, I do think there is a broad consensus on fiscal policy--one that you, I don't need to say, have helped shape. It is that fiscal policy can deliver a stimulus under certain circumstances, albeit not as powerfully or reliably as was widely believed pre-Barro. The consensus has absorbed your contribution by advocating counter-cyclical fiscal stimulus more cautiously than before, and with much closer attention to the implications for public debt and financing. Of course you would go further--and everybody who cares about this subject will pay close attention to your ongoing research. You may very well push the consensus further yet. But, for the moment, you can press for greater caution in attempting fiscal stimulus, or even argue against it altogether, without saying that advocates of stimulus under present circumstances--including economists like Paul or Larry or Christina Romer, whom I know you respect--are dealing in voodoo economics.

By the way, is it helpful to say that a multiplier of 1 implies that government spending is free? The implication would be that even a multiplier of 0.5 (which you seem willing to contemplate) would buy you real resources at half-price. Obviously public spending eventually has to be paid for, in full, one way or another--which is true regardless of the multiplier. It is quite another thing to say that a multiplier of more than zero commits you to the view that we can have a free lunch. That is a debating point, something to please one's allies and annoy one's opponents--not an aid to understanding.

Perhaps all I am saying is that economists of the stature of you and Paul and Larry and so on should address each other in your pop writings with something like the same courtesy and intellectual seriousness you would use in an academic setting, rather than pushing custard pies into each other's faces. That just looks bad--and I find it hard to believe that you or Paul value the approbation of the idiots on either side who are delighted by it.

-- Clive

>>>>>>>>>>

Clive,

Sorry, but I do not believe you are getting the economic substance right. A multiplier of 1 means that, from a social perspective, the added government purchases really are free--they are provided by the utilization of idle resources. This point holds even if the spending is deficit financed so that the public debt rises, although there can be deadweight losses in the future from financing the larger debt. In the same sense, if the multiplier is greater than 1, say 1.5, the free public goods really do come with the bonus of free private consumption or investment. I think this view is the one actually held by Summers, C. Romer, etc., and I really do think it's voodoo macroeconomics. I think you do not regard it as voodoo because you find it familiar and comfortable.

If, as you say, the multiplier is positive but less than 1--say 0.5--the public goods cost only 50 cents on the dollar. This is correct, but I think, in practice, the only evidence for positive multipliers comes from responses to (temporary) military outlays during wars (such as in the U.S., where the wars have not involved a lot of physical destruction or loss of life). In these cases, the added outlay did require a lot of added work beyond reduced unemployment, notably by women, so this extra effort has to be included in the social cost. For non-defense outlays, the best empirical estimate I have at this point is a multiplier of 0 (though not precisely determined). This is the standard cost-benefit case where the benefit of an extra unit of public spending has to justify the added cost one-to-one. This multiplier of 0 should not be regarded as a pole, but rather as a central point. In the medium run, the multiplier is likely to be negative, reflecting the adverse effect of larger government on economic growth.

By the way, although WWII raised U.S. real GDP a lot, this response is not typical for the OECD. If fact, WWII is the biggest economic disaster of the 20th century, out-stripping the Great Depression. This is, of course, because many countries suffered greatly from physical destruction and loss of life (the U.K. not nearly as much as many countries on the European continent).

As to Krugman, my response would likely have been more moderate if he had not referred to my ideas as bone-headed. But I promise to behave better in the future.

-- Robert

>>>>>>>>>>

Thanks Robert.

Yes, I take your point, of course. From a social welfare point of view--ignoring distributional issues as they affect taxpayers v bondholders, this generation v later generations, residents v foreigners--then the cost of a fiscal stimulus that puts idle resources to work is confined to the deadweight losses of financing the debt. It feels strange for me to be reminding Robert Barro that those losses and distributional issues might be a big deal, and that one should be cautious on those grounds (among others) about advocating immoderate fiscal activism--but I just did, so there you are.

I would never presume to quarrel with you (or Paul) on the economics. That would be absurd. I am quarrelling with you about your journalism. Your view that counter-cyclical fiscal policy cannot--even in present circumstances--put idle resources to work may for all I know be true. I resolve to keep an open mind about it. But I am sure that for the moment the larger part of the economics profession disagrees with you. And I am sure that in challenging that consensus by calling it voodoo economics you are doing the discipline no favours.

Did Paul call you bone-headed? That was a bone-headed thing for him to say. But you see my point. What are non-economists to make of this exchange of insults and exaggerated certainties? Can you blame them for hearing only the political message they want to hear, and tuning out the rest?

-- Clive

>>>>>>>>>>

Clive,

Oh yes, the bone-headed remark is what started things.

One thing I think you need to be clear on is the distinction between Ricardian equivalence and Keynesian multipliers. The first bears, for example, on how a deficit-finance tax cut affects aggregate demand. The Ricardian view is no effect, and the "standard" view is that the effect is positive but less than one. The multiplier has to do with how a change in aggregate demand affects output. It is possible to have a large multiplier even with Ricardian equivalence, and it is possible to have a small multiplier even without Ricardian equivalence.

-- Robert

Thanks, Robert, especially for that last clarification. I have to admit that I haven't been giving much thought to the scenario in which a deficit-financed stimulus has no effect (under Ricardian equivalence) on aggregate demand and yet still has a big multiplier. I will have to think about that one..."

Me:

"The first bears, for example, on how a deficit-finance tax cut affects aggregate demand. The Ricardian view is no effect, and the "standard" view is that the effect is positive but less than one. "

Has anyone ever studied the question of whether or not Ricardian Equivalence is a tautology, and not an empirical observation? It sounds like a fancy name for "robbing Peter to pay Paul", just as "creative destruction" is a fancy name for the fact that some businesses won't make it.

"The multiplier has to do with how a change in aggregate demand affects output."

I actually doubt that a causal connection about this can be determined. Can someone explain how you rule out all the diverse incentives and disincentives and panic reactions in a crisis? Take spending during wartime. What can look like conspicuous consumption during peace can look like treason during a world war. Surely social pressures help determine spending patterns, or am I being silly?

Posted by: Don the libertarian Democrat | February 11, 2009 11:00 AM

And it's about grasping at straws to try and find something else.

From the Atlantic Business:

"An interview with Robert Barro I spoke with Robert Barro of Harvard yesterday about the stimulus bill, fiscal policy, and related issues in macroeconomics.

I wanted to speak with Professor Barro after reading his piece in the Wall Street Journal about the multiplier on government spending. The piece, which argued that the multiplier has historically been much lower than the Obama administration hopes, produced a tremendous amount of response -- from Paul Krugman, Brad DeLong, Greg Mankiw, Matt Yglesias, and Tyler Cowen (some of them several times). And that response was notable, in part, because it turned into a reflection on the "standards" of the stimulus debate itself. I was interested to hear what Barro thought about his critics this debate.

He was admirably patient with my questions:


Conor Clarke: What I am trying to do is sort of apply a barometer to modern macroeconomics and see where the profession is, because I am sort of confused by a lot of things.

Robert Barro: [laughs] Probably the fault of the profession.

Well, one thing I am confused by is where all of this resurgent interest and fiscal policy came from. That's very broad. But where do you think it came from? When I took macroeconomics in college there was not a lot about fiscal policy.

It came from the crisis and memories of the Great Depression and the fact that monetary policy seems to have done not a tremendous amount, and conventional stuff doesn't look like its going to work anymore. And it's about grasping at straws to try and find something else.

And I take it from the Wall Street Journal piece you wrote last week... well, the piece is just specifically about measuring multipliers, but I take it that you are fairly skeptical in general that fiscal policy will boost aggregate demand.

Right. There's a big difference between tax rate changes and things that look just like throwing money at people. Tax break changes have actual incentive effects. And we have some experience with those actually working.

What would you say is the best empirical evidence there?

Well, you know, it worked to expand GDP for example in '63 and '64 with the Kennedy/Johnson cuts. And then Reagan twice in '81 and '83 and then in '86. And then the Bush 2003 tax-cutting program. Those all worked in the sense of promoting economic growth in a short time frame.

I'm the middle of a study where I am trying to estimate this overall, going back to 1913 -- sort of constructing some measure of the overall effect of the tax rate at the margin, at the moment. I'm just looking at that now, actually...

You're talking about the multiplier on a dollar of...

Well both things, but here I'm talking about the tax rate stuff. Get some measure of the effect of marginal tax rate that comes from the government -- federal, state, local. And then you can see what it looks like going down or going up and how the economy responds. And then, in addition to that, the government might be spending more or less money on either military stuff or not on military stuff. And we can estimate that at the same time. With the government spending stuff, the clearest evidence is in wartime. It's not that it's the most pertinent, but it's the clearest in terms of evidence because it's the dominating evidence at those times, especially during the world wars.

Do you read Paul Krugman's blog?

Just when he writes nasty individual comments that people forward.

Oh, well he wrote a series of posts saying he thought the World War II spending evidence was not good, for a variety of reasons, but I guess...

He said elsewhere that it was good and that it was what got us out of the depression. He just says whatever is convenient for his political argument. He doesn't behave like an economist. And the guy has never done any work in Keynesian macroeconomics, which I actually did. He has never even done any work on that. His work is in trade stuff. He did excellent work, but it has nothing to do with what he's writing about.

I'm not in a position to...

No, of course not.

I'm not in a position to know things like the degree to which Paul Krugman counts as a relevant expert on new Keynesian economics.

He hasn't done any work on that. Greg Mankiw has worked in that area.

And Greg Mankiw is, I guess, skeptical of spending for the same reasons that you are: he says that there's some empirical evidence -- I think he cites the Christina Romer study from 15 years ago -- that a dollar of tax cutting has a larger impact than...

The Romer evidence is very recent actually. It's an ongoing project.

I thought it's from 1993 or something like that. Maybe that's something else.

They have a current thing that's going to be presented at Brookings at the next meeting, where they have some estimates of how the economy responds to tax changes. It's not really looking at tax rates. It's looking at tax revenue, which is not the same thing. That's mostly what Greg was referring to, which is going to be presented in a few months.

I would need to go back and check. But one question, and I think Greg Mankiw raises this question as well, is, Why does this set of evidence depart from what seems like the standard Keynesian theory that a dollar of spending would have a larger multiplier than a dollar of tax cutting?

I don't think it is really confusing at all, because when you cut taxes there are two different effects. One is that you cut tax rates, and therefore give people incentives to do things like work and produce more and pay more -- maybe, depending on what kind of taxes. And then you also maybe give people more income. This income effect is the one that's related to this Keynesian multiplier argument, where it's usually argued that government spending should have a bigger effect. So that's the income effect. But the tax-rate effect, inducing people to do things like work and produce more and invest more, is a whole separate effect, and that could easily be much bigger than the multiplier thing, than the income thing.

This might just be my confusion, but the inducement to work, is separate from the idea of boosting aggregate demand and consumption in the short run.

Oh it's exceptionally different. But the experiment is that the government is doing something by changing the tax system to lower its collections -- by, for example, a tax cut. The response of the economy to that is not going just to isolate this business of giving people money. It's also going to have these incentive effects, more than tax rebates, on economic activity. It's going to be a combination of those two things -- income effects and incentive effects. One piece looks like this sort of multiplier stuff, which is analogous to government spending -- probably because the government spending has a first-round effect where it comes in and directly affects the aggregate demand -- and then in the second round it sort of looks like a tax cut. That's why the government spending thing is bigger in textbooks: because it has this first round in addition to all these subsequent ones.

But all that is just income responses -- people having more or less income, or the government keeping the money and then that shows up as people's income. None of that is about responses in terms of incentives -- incentives changing in response to lower or higher tax rates. And the evidence that Romer and Romer look at is combining the tax rate stuff with the income stuff. I didn't know it was possible to do that but, hey, you get different viewpoints form different people. But the study I am doing now is intended to include all these things together in one framework.

And when does this study come out?

Who knows. I mean, it's a big project, we've been working on it for a while. Part of it is just measuring, back since 1913, the effect of the tax rate that the federal government or the total government is levying on people. Measuring that was a big project. But we've sort of finished that.

I just have two more questions, quickly. One is that you've mentioned that monetary policies sort of seem to be stuck. And I guess there have been a couple of people -- Robert Lucas is one that comes to mind and maybe Greg Mankiw too -- who say there are other kinds of monetary policy that can still be pursued.

Oh I agree with that. There are things that they can still do. The sort of standard stuff. They drove the nominal rates on the usual government paper down to zero, and they drove down the federal funds rate, so they don't have any more leeway on that. But there is plenty of other stuff that they can do and that they are doing.

And what is that?

The Federal Reserve is buying up all kinds of other assets, like long-term government bonds. But they are also buying a lot of private stuff, and that will presumably have a substantial impact. I mean there's a downside to doing all this, but it should certainly have effects. So in that sense they haven't run out of ammunition. I agree with that.

The last thing is just about the stimulus bills as it stands. Two things here. One thing is what do you think about the ratio of spending to tax relief in the bill. And the second is, if you judge it by Larry Summers standard -- that stimulus be temporary, timely and targeted -- does it clear the bar?

This is probably the worst bill that has been put forward since the 1930s. I don't know what to say. I mean it's wasting a tremendous amount of money. It has some simplistic theory that I don't think will work, so I don't think the expenditure stuff is going to have the intended effect. I don't think it will expand the economy. And the tax cutting isn't really geared toward incentives. It's not really geared to lowering tax rates; it's more along the lines of throwing money at people. On both sides I think it's garbage. So in terms of balance between the two it doesn't really matter that much.

Well, presumably Larry Summers is not an idiot.

[laughs] That is another conversation. I have known him for 25 years, and I have opinions about that.

Well, presumably Christina Romer is not an idiot if you're...

They've brought in some reasonable people in terms of economic advisors. I don't know what impact they're having, and I suppose they have different views on Keynesian macroeconomics than I have. But I'm giving you my opinion about it.

I think Geithner is a good appointment. I think he's going to focus on what really matters, which is the financial system and the housing market. That's where they should be putting their efforts. That's where the problems came from.

Fixing the credit market, you mean?

That was the main problem in the Great Depression, too. Though then it was concentrated on commercial banks which were the main credit vehicle. That was the main problem in the depression and fixing that was the main thing that ended the depression.

Well since you brought it up... I have no idea what your views are on financial economics, but it seems like there's going to be another round of TARP-like bailouts. Do you have an opinion on how that should be structured?

That's a hard problem. I mean, they're basically floundering around -- the crew of the previous administration more than the current one. But I admit they're having a good effect by putting more resources into assistance. The exact way to do it is pretty tricky. It's not clear what the best thing to do is. Larry Summers did bring in Jeremy Stein, who is probably one of the best people in the area. I think he's going to have a lot of impact on that design. I hope so. That's another person they hired recently.

From Harvard?

Yeah, he's a Harvard economics department person. He's in the White House. Summers brought him in to advise particularly on the financial and housing issues, the design of the new regulations structure. That was an excellent appointment. That's the stuff that's really going to count. Not this spending thing. I mean democrats were waiting with all these ridiculous projects, and now they've got an excuse to bring it through politically.

Just one last thing. I think Joe Biden and a couple other people have said there's a fairly wide consensus among economists that fiscal stimulus in the form of a large spending bill is the way to go, and...

He said first that every economist thought that.

Well, that's Joe Biden hyperbole. But what is the lay of the land there? Presumably there are economists out there that take this seriously. And then there are economists out there who think there's a one-for-one crowding out with any government spending. And I guess, where does the profession fall on that spectrum?

Most economists haven't really been thinking about this issue, they haven't really focused on it. It's not their specialty. Most economists today, they haven't really been thinking about this kind of multiplier issue. Which goes back to that first question you asked about how come now we're so worried about this. I don't think most economists are focused on this, or that they're familiar with the empirical evidence. I don't think they've really worked on the theory. So I don't know, maybe they have some opinion that they got from graduate school or something.

I think my sense is that the sentiment has been moving against this kind of approach both within the economics profession and more broadly. I think the initial view was that "yeah, this is a terrible situation" -- which I agree with -- "and we've got to do something about this, and maybe this will work." I think there was support in that sense.

Are there any conditions under which you might think spending could have a positive effect on output or is it always going to be the case that as a relative matter that tax cuts are going to be better?

Tax cuts are bound to be better. I think the best evidence for expanding GDP comes from the temporary military spending that usually accompanies wars -- wars that don't destroy a lot of stuff, at least in the US experience. Even there I don't think it's one for one, so if you don't value the war itself it's not a good idea. You know, attacking Iran is a shovel-ready project. But I wouldn't recommend it."


Me:

Don the libertarian Democrat February 5, 2009 6:00 PM

"And the guy has never done any work in Keynesian macroeconomics, which I actually did. He has never even done any work on that. His work is in trade stuff. He did excellent work, but it has nothing to do with what he's writing about.'

I don't see this as a particularly profound point. I mean, after all, he could be doing a lot of work in his field and end up being wrong.

"None of that is about responses in terms of incentives -- incentives changing in response to lower or higher tax rates.'

This is true, but we are constantly presented with incentives and disincentives. For instance, there's a tax incentive to buy a house, and a tax incentive to save in an IRA. Also, since we're human beings, our assessment of these incentives can change.

I tend to agree with Buiter, and also on the lack of specificity Barro gives. Telling us that people often respond to monetary incentives isn't exactly earth shattering news. I like the idea of a cut in Sales Tax to be withdrawn in the future, say $200 Billion, and Tax Cuts for Investment, say $100 Billion. Infrastructure about $100 Billion, and Social Safety Net Spending and aid to states as well. This doesn't seem crazy, and has the merit of moving towards a compromise, in which I prefer Edmund Burke's ideas over Barro's. Perhaps Professor Barro can offer his own plan or tell me if my favorites seem reasonable.

Again, I don't have faith in these models and I believe agnosticism is the correct stance.

From Tyler Cowen:

"Permanent vs. temporary increases in government consumption

Paul Krugman writes:

...he [Brad DeLong] fails to note that it’s not just wrong, it’s 180 degrees wrong: a temporary increase in government spending should have a larger impact on demand than a permanent increase, not a smaller impact.

I intend my comments as the most boring blog post I have written, so it goes beneath the fold...

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:

First, we demonstrate analytically that -- under standard assumptions spelled out in section 2 below -- the employment and output effects of permanent increases in government consumption always exceed those of temporary increases.

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."

And I argue:

Previewing your Comment

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

I would say less useful. The very fact that the model is being improved leads one to believe that the model is useful, but not a complete description, or even causal, of the real world. In our circumstances, it might turn out to be of limited use.

But the same can be said of the multiplier. It seems unreasonable to put so much faith in the precision of any multiplier in this situation, or to simply plug in a consumption figure which needs to be filled.

To me, both approaches seem useful, but not persuasive. The one person I agree with, Shiller, wants us to spend a massive amount of money. I agree that would work, but it could also cause serious inflation, causing us to induce another shock. As well, spending massive amounts of money can influence behavior, but that influence might not all be benign.

And that's my problem with your NY Times post: In order for behavior to be changed in a meaningful way, the influence upon it must be large and long lasting. I think that you underplay the possible social changes that could go with such a shift. They worry me more than this downturn.

Finally, the actual bill. Here was my plan:
1) $100 Billion Infrastructure Investment
2) $200 Billion Sales Tax Cut or Payroll Tax Cut
3) $100 Billion Tax Cut for Investment
4) Social Safety Net and State Aid ( $ ? )

This is different than the bill, but, if I were the Republicans, I would have asked for something similar to my plan and split the difference, for reasons of Political Economy. It would be better that we have an agreed upon plan, precisely because the social changes going forward could be so unpleasant.

Here, I echo Burke:

"All government, indeed every human benefit and enjoyment, every virtue, and every prudent act, is founded on compromise and barter. "

I think that Burke is someone we should keep in mind during a crisis.

Posted by: Don the libertarian Democrat | Feb 01, 2009 at 02:08 PM

I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion.

From Robert Waldmann:

"Background on "fresh water" and "salt water" macroeconomics

by Robert

Will Wilkinson asks what’s with the economics profession.

A bit more on the public relations quandary the economics profession ought to be in, if it isn’t already…

When I see DeLong more or less indiscriminately trashing everyone at Chicago, or Krugman trashing Barro, etc., what doesn’t arise in my mind is a sense that some of these guys really know what they’re talking about while some of them are idiots. What arises in my mind is the strong suspicion that economic theory, as it is practiced and taught at the world’s leading institutions, is so far from consensus on certain fundamental questions that it is basically useless for adjudicating many profoundly important debates about economic policy. One implication of this is that it is wrong to extend to economists who advise policymakers, or become policymakers themselves, the respect we rightly extend to the practitioners of mature sciences. There is a reason extremely smart economists are out there playing reputation games instead of trying to settle the matter by doing better science. The reason is that, on the questions that are provoking intramural trashtalk, there is no science.

Sadly, there is no one better to listen to.

Now before going on I note that Wilkinson does not address the merits of DeLong's criticisms or Krugman's. He uses a words to suggest that they are writing unprofessionally but he doesn't present a counter argument to their claims. I have quoted his full post. Nothing on the merits.

Instead he asks if disagreements between economists are so fundamental that there is no professional consensus useful to non economists. My brief answer is “yes.” A longer answer after the jump.

Update: Over at Kling's blog commenter Bill Woolsey hits the nail on the head.

Perhaps part of the problem we face in macroeconomics today is that a substantial part of the "macro" wing of free market economists really think that new classical macroeconomics is "true" because simple and formalistically complete models fit their notion of what is scientific.

After the jump you can read my verbose effort to say that.

By the way, Kling's willingness to criticize the arguments others present to support policy positions with which he agrees is really admirable.


It is like Ricardian equivalence. Because the model people (person) rationally saves to pay future taxes, we are supposed to assume this has a connection to reality?





Arnold Kling has already attempted to explain things to Wilkinson. He obtained a “department of huh?” from Brad DeLong and, for what it’s worth, two extremely intemporate comments from me (one was blocked as suspected spam because I provided to many links to support my claims which suggests something about the intellectual seriousness of comment threads at at least one blog).

While I claim that Kling’s take on the stimulus debate is absolutely inconsistent with facts in the public record which I found with a few minutes of googling, I share his general view on the divisions in the profession. He notes that there is more than one fundamental gulf which means that there isn’t a consensus among economists which would enable the few non economists who respect us to take our advice. I will mention three more just because I want to consider more economists than those discussed by Wilkensen and Kling and not because I think Kling left out anything relevant to his post

Kling discusses the policy advice of macroeconomists (and Fama). Not all economists are macroeconomists who think that it is there job to offer policy advice. He notes two divisioins left and right and fresh water and salt water.

Left and right correspond fairly closely to libertarian vs egalitarian in the US political spectrum, that is, closely to Democratic vs Republican positions on economics (except that there are leading economists well to the left of the Democratic party and well to right of all but the left fringe of the Republican party). It is a fact that, except for general support for free international trade, the range of views of economists is similar to the range of views of congressmen but somewhat broader. This is a wide enough ideological range that the methods of verification used by economists are absolutely unable to force economists on left and right to admit that economists on right and left have a point.

In the field of macroeconomics there is a much deeper division between macroeconomics as practiced at universities closer to the great lakes than to an Ocean (Fresh water economics) and that practiced at universities closer to Oceans (Salt water economics). The geography has shifted some as Fresh water economics has been exported. I’d consider Professor Robert Barro at Harvard to be brackish (with, he reports, noticed salty contamination in the first 6 months after he moved from U. Rochester) and the economics department at the University of Pompeu Fabra (in Barcelona) seems to be distilled. It is a little difficult to explain the disagreement to non economists. Frankly, I think this is because non-economists have difficulty believing that any sane person would take ffresh water economics seriously.

Roughly Fresh water economists consider general equilibrium models with complete markets and symmetric information to be decent approximations to reality. Unless they are specifically studying bounded rationality they assume rational expectations, that everyone knows and has always known every conceivable conditional probability. I’ve only met one economists who claims to believe that people actually do have rational expectations (and I suspect he was joking). However, the fresh water view is that it usually must be assumed that people have rational expectations.

Over near the Great Lakes there is considerable investigation of models in which the market outcome is Pareto efficient, that is, it is asserted that recessions are optimal and that, if they could be prevented, it would be a mistake to prevent them.

Salt water macroeconomics is basically everything else with huge differences between people who attempt to conduct useful empirical research without using formal economic theory and people who note the fundamental theoretical importance of incomplete markets and of asymmetric information and of imperfect competition (as in everything you think you know about general equilibrium theory is known to be false if markets are incomplete or there is asymmetric information or there is imperfect competition – Market outcomes are generically constrained Pareto inefficient which means that everyone can be made better off by regulations imposed by regulators who don’t know anything not known to market participants who also just restrict economic activity and don’t introduce innovations like, say, unemployment insurance).

Leading fresh water macroeconomists include Robert Lucas, Ed Prescott Thomas Sargent, Lars Hansen, John Cochrane, Larry Jones, Robert Barro (mostly), and Kevin Murphy (usually). Leading salt water economists include Paul Samuelson, Edmund Malinvaud, Jacques Dreze, Joseph Stiglitz, Robert Solow, Paul Krugman, Andrei Shliefer, Olivier Blanchard, George Akerlof, Robert Hall, Ben Bernankle, N. Gregory Mankiw, Christina Romer, David Romer and, and Lawrence Summers. Brad DeLong is also a salt water economist and he is very very smart, but last I knew, he was a little too far out there to be really a member of the economists club. I can’t classify Paul Romer.

Notably all of the above have made important contributions to fields other than macroeconomics.

In the US there is a strong correlation between Fresh and Salt and Right and Left. The correlation is not perfect: I understand that Hansen and Sargent are politically left of center. Hall is far right politically, Mankiw is right of center. and I must admit that I have no clue about Bernanke (who I have never actually, you know, seen in the flesh).

An important discrimminant is opinions of John Maynard Keynes. Fresh water macroeconomists generally seem to think that he was not a competent economist. Salt water macroeconomists claim (often implausibly) to be in some way his intellectual followers. Barro for example clearly doesn’t remember what is written in “The General Theory of Employment Interest and Money.” Mankiw, in contrast, advised the students in his macro class (including me) to read it again and again searching for insights.

Interestingly, the fresh water macroeconomists are certain that salt water macro is discredited along the lines of the Ptolomaic model or the Phlogiston hypothesis. For a while they called their models “Modern Business Cycle Theory” stating that all incompatible models were obsolete. In the current debate many have considered it sufficient to say that arguments for the stimulus are nonsense (e.g. Cochrane). The surprisingly low quality of contributions to the debate from the vicinity of Great Lakes has a lot to do with the fact that Fresh Water macroeconomists haven’t thought about fiscal stimulus in decades and sincerely believe that it is an obviously invalid proposal so obvious arguments against it might be valid.

Even more interesting, Fresh water macroeconomists do not claim that their models have not been refuted by the data. Rather they note that all models are, by definition, false. They do test hypotheses from time to time, but don’t explain what the point is. As far as I can understand, they claim that a model *can* be both false and useful and, therefore, their models *are* useful.

I understand that in the 70s and, maybe, the early 80s there was a heated debate between Fresh Water and Salt water macroecnomists. Now, it seems to me that there is a truce of sorts where each school of thought ignores the other – that macroeconomists have specialized not in the questions that they ask but in the answers.

I think that this is a very bad situation. Anyone can see that, when top macroeconomists are asked for policy advice, some support each of the different proposals which are under consideration.

Frankly, this truce seems to me to be unilateral. Many salt water economists claim (in public) to respect the contribution of fresh water economists. I know of no fresh water economist who has expressed anything but contempt for the contributions of salt water economists to the stimulus debate and I haven’t heard one word of praise of a Salt Water economist from a Fresh water macroeconomist other than Arrow, Samuelson or Solow. I added the phrase “in public” because I clearly remember one of the salt water economists on my list refer to the fresh water economists as “the crazies”.

update: The truce is over. There have been continual cease fire offensives violations, but the shrill blitzkreig is here.

As far as I can tell, fresh water economists have some respect for some thinkers other than fresh water economists. I think they have rather a favorable view of mathematicians and Physicists. I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion. On the other hand, in principle they have great respect for general equilibrium theory, but they don’t listen to general equilibrium theorists at all. Top general equilibrium theorists are all at least left of center politically, the closest David Cass could come to naming an exception is Ed Prescott who, he said, uses general equilibrium theory and studies examples (snort).

Finally I have a view of how people can devote so much effort to working out the implications of assumptions which almost no ordinary people would find other than nonsensical if they understood them. Fresh water economics uses difficult mathematical tools. Students in fresh water graduate programs have to learn a huge amount of math very fast. It is not possible to do so if one doesn't set aside all doubt as to the validity of the approach. Once the huge investment has been made it is psychologically difficult to decide that it was wasted. Hence the school gets new disciples by forcing students to follow extremely difficult courses. Last I hear very few graduate students at U Minnesota came from the USA. Undergrads over there know what the program is like. If my information is not out of date, innocents from abroad are the new blood of fresh water economics."

Me:

Don the libertarian Democrat says:

Today, 2:40:56 PM

“I believe that there is a difference between Economics and Political Economy. Many FW theorists don't seem to agree with this, while SW ones do. My personal favorite is Alan Blinder. Political Economy necessitates that one cannot rely on math or models. They are of limited use. Some of the FW models are of some use, but they do not decribe laws of nature. At best, they are correlative reasoning dressed up with equations. They describe possible movements among different stats or facts. In our situation, there are good arguments for both trying government spending and tax cuts. While a large stimulus would be nice, we are somewhat constrained by debt. I would probably also use more QE. Wilkinson seems to believe that certainty or agreement is necessary for Economics to be useful. He is wrong. It is useful to Political Economy, which, while not leading to certainty, does lend itself to better and worse arguments.Finally, about science. There is often a lot more disagreement on theories than people believe.

"Without training in modern econometrics it is simply impossible to assume something that stupid."

Robert Waldmann with a good post on Angry Bear:

"Barro on Keynes Barro and Grossman

Robert Waldmann

Robert Barro wrote an op-ed in The Wall Street Journal. The substance of the op-ed is to report an estimate of the Fiscal multiplier 0.8 which is less than one. Thus, according to Barro, a stimulus will partially crowd out of investment, consumption or net exports and not just reduced leisure. Paul Krugman took Barro to task for using the huge WWII stimulus in his estimates, since the economy was at full employment during WWII. So have Matthew Yglesias using his Harvard BA in philosophy from Harvard and Kevin Drum using his BA in Communications from The California State University in Long Beach.

I might want to reassess Long Beach State, but I think the reason that Yglesias and Drum immediately make the same argument is Krugman is that Yglesias and Drum don't know about modern econometrics. Barro is using an instrumental variables regression in which wartime military spending is considered to be an exogenous variable which is correlated with government consumption. The implicit assumption is that we can safely assume that the fiscal multiplier today is identical to the fiscal multiplier during World War II, because the economy is basically similar. Without training in modern econometrics it is simply impossible to assume something that stupid. ( A GOOD POINT. I KEEP WONDERING WHAT BARRO'S PHILOSOPHY OF MATH AND THE HUMAN SCIENCES IS. )

There is also a severe gap in economic theory, at least as remembered by Robert Barro. Wouldn't one think that there must be some model( YES ) in which correlations( MATH IS A WAY OF EXPRESSING CORRELATIVE REASONING. HOWEVER, IT IS STILL SIMPLY CORRELATIVE REASONING. THE MATH IS SIMPLY A HEURISTIC TOOL. ) vary depending on the general conditions of the economy -- say like whether at current prices there is excess demand for goods or excess supply of goods.

Of course, no one could expect Barro to know that there is a vaguely Keynesian model, which differs from the neoclassical model only because of rigid nominal wages and prices, in which the economy can be in one of three different regimes, Keynsian (with insufficient aggregate demand), Classical (firms can sell as much as they want but real wages are too high so workers are unemployed) and repressed inflation (excess supply of labor and goods).

I'm mean who's ever heard of the Barro-Grossman model (A General Disequilibrium Model of Income and Employment Barro, Robert J.; Grossman, Herschel I.; American Economic Review, March 1971, v. 61, iss. 1, pp. 82-93 [stable JSTOR link added for those with access])? Certainly not Robert Barro.

The passage quoted by Krugman about what Keynes thought is inconsistent with The General Theory. However, it can be corrected easily. The accurate description of the history of economic thought is "John Maynard Keynes Robert Barro and Herschel Grossman thought that the problem lay with wages and prices ... will mean that wages and prices do not have to fall."

Look I sympathise. Like Barro, when I was young and reckless I did embarrassing things which I have tried to cancel from my memory. I really wish I could do that as well as he has."

The historical context must be considered when addressing the question of why people behaved as they did, even in economic behavior. This is what I call the Existential Context. The context of the 1930s was far different than ours.

Also, there is a difference between economics and political economy. Barro doesn't seem to see a difference. Too bad.

They thought that budget deficits would stimulate growth under all circumstances, not just those of a deflationary depression.

From Mark Thoma:

"Does Stimulus Stimulate?"

Bruce Bartlett:

Does Stimulus Stimulate?, by Bruce Bartlett, Forbes.com: ...The [Great Depression] didn't really end until both monetary and fiscal policy became expansive with the onset of World War II. At that point, no one worried any more about budget deficits, and the Fed pegged interest rates to ensure that they stayed low, increasing the money supply as necessary to achieve this goal.

It was then and only then that the Great Depression truly ended. As a consequence, economists concluded that an expansive monetary and fiscal policy, which had been advocated by economist John Maynard Keynes throughout the 1930s, was the key to getting out of a depression.

Keynes was right, but many of his followers weren't. They thought that budget deficits would stimulate growth under all circumstances, not just those of a deflationary depression( I AGREE WITH BARTLETT HERE, AS I'VE POSTED. BARRO DOESN'T SEEM TO GET THE NATURE OF A CALLING RUN, ALTHOUGH HE SAYS HE DOES. ). When this medicine was applied inappropriately, as it was in the 1960s and 1970s, the result was inflation.( NOT HERE. NOT YET. )

Economists then concluded that it was a mistake to pursue countercyclical fiscal policy, and the idea of "fine-tuning" became a derogatory term. ...

In the 1980s and 1990s, economists came around to the view that only monetary policy could act quickly enough to reverse or moderate a recession. ... [But...] As we have seen, the Fed could not prevent the greatest financial downturn the world has seen since 1929. This has revived the idea that fiscal policy must be the engine that pulls us out.

Somewhat surprisingly, there has been rather heated opposition to the very principle of fiscal stimulus... We have now had several tests of the Keynesian idea--most recently with last year's $300 tax rebate... According to a new paper by University of Michigan economists Matthew Shapiro and Joel Slemrod, only a third of the money was spent, thus providing very little "bang for the buck."( TRUE )

The failure of rebates has shifted the focus to public works and other direct spending measures as a means of stimulating aggregate spending. A study by Obama administration economists Christina Romer and Jared Bernstein predicts that the stimulus plan being debated in Congress will raise the gross domestic product by $1.57 for every $1 spent.

Such a multiplier effect has been heavily criticized by a number of top economists, including John Taylor of Stanford, Gary Becker and Eugene Fama of the University of Chicago and Greg Mankiw and Robert Barro of Harvard.( I LIKE ALL OF THESE PEOPLE ) The gist of their argument is that the government cannot expand the economy through deficit spending because it has to borrow the funds in the first place, thus displacing other economic activities( THIS IS WRONG ). In the end, the government has simply moved around economic activity without increasing it in the aggregate.( WRONG )

Other reputable economists have criticized this position as being no different from the pre-Keynesian view that helped make the Great Depression so long and deep. Paul Krugman of Princeton, Brad DeLong of the University of California at Berkeley and Mark Thoma of the University of Oregon have been outspoken in their belief that theory and experience show that government spending can expand the economy under conditions such as we are experiencing today( I AGREE WITH THEM IN THIS CASE. ).

I think the critics of an activist fiscal policy are forgetting the essential role of monetary policy as it relates to fiscal policy. As Keynes was very clear about, the whole point of fiscal stimulus is to mobilize monetary policy and inject liquidity into the economy. This is necessary when nominal interest rates get very low, as they are now, because Fed policy becomes impotent. Keynes called this a liquidity trap, and I think there is strong evidence that we are in one right now.( ZIRP )

The problem is that fiscal stimulus needs to be injected right now to counter the liquidity trap. If that were the case, I think we might well get a very high multiplier effect this year( I AGREE ). But if much of the stimulus doesn't come online until next year, when we are likely to be past the worst of the slowdown, then crowding out will greatly diminish the effectiveness of the stimulus, just as the critics argue. ... Thus the argument really boils down to a question of timing. ...( I AGREE COMPLETELY )

For this reason, I think there is a better case for stimulating the economy through tax policy than has been made. Congress can change incentives instantly by, for example, saying that new investments in machinery and equipment made after today would qualify for a 10% Investment Tax Credit...( MY IDEA )

Stimulus based on private investment also has the added virtue of establishing a foundation for future growth, whereas consumption spending( OFTEN ) does not. As economist Hal Varian of the University of California at Berkeley recently put it, "Private investment is what makes possible future increases in production and consumption. Investment tax credits or other subsidies for private sector investment are not as politically appealing as tax cuts for consumers or increases in government expenditure. But if private investment doesn't increase, where will the extra consumption come from in the future?"

I don't agree with all of this, e.g. the "government is always the problem" emphasis in the analysis, and casting the debate as a tradeoff between private investment and private consumption rather than between private sector activity (consumption or investment) and public investment overstates the case for private sector solutions. [These arguments from yesterday apply as well.]

I've never objected to tax cuts being part of the package -- I have also argued that the desire for an immediate impact may necessitate some tax cut components in order to maximize the prospects for a faster recovery. And as tax cuts go, there are far worse choices than an investment tax credit( GOOD. THEN JOIN US. ). But just as there's a limit to the number of public sector projects that are shovel ready, there's also a limit to the number of private sector projects that are ready to go (though the planning stage does involve some spending, just not as much as when the public or private sector investment projects are going full throttle)( YES ). There's also a question about how strong the reaction will be to a tax credit when the economic outlook is so gloomy( TRUE. IT MIGHT ONLY MARGINALLY HELP. BUT WE NEED TO TRY. ), a question that doesn't arise when government is making the investments. So, sure, let's get as much out of the private sector as we can, but we shouldn't rely solely upon the private sector response to a tax credit to turn things around( AGREED ). It's very unlikely to be enough on its own, and it may not provide much help at all, Thus, even with tax credits, the public sector response - government spending in particular - still needs to be aggressive."

I agree. Infrastructure investment also sends a positive message. Oh my God. I actually resorted to talking about how people might behave in the real world. A real benefit of the stimulus in Infrastructure ( I said $100 Billion ) would be emotional. I will spend more money if I FEEL LIKE IT. Crowding out, a purely mechanistic explanation, is a fairly useful model, no more, under normal circumstances. Using math to describe correlations between various economic factors doesn't make you a scientist. All that the math does, or any correlative reasoning, is give you some useful guides to understanding how people might react in various circumstances. Crowding out is NOT a law of nature. Adam Smith understood philosophy, politics, economics, history, etc. What education do many of these economists receive? They have a philosophy of math that is hilarious. Of course, so do many mathematicians and philosophers, so let's not go there.

Let me repeat my plan:
1) $100 Billion on infrastructure, to be built only when benefits exceed the costs.
2) Sales tax cut $200 Billion
3) Investment incentives $100 Billion
4) Social safety net spending is not included in my stimulus. It is simply money that needs to be spent as part of the social contract.