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.

How do we get out of this downward plunge?

From Robert Reich:

"Senate Republicans and the Stimulus:

Playing Politics When the Economy Burns Tomorrow's job report is likely to be awful. January's job losses could easily top half a million. We're deep into the most vicious of economic cycles: Consumers are slashing their spending because they're perilously in debt and worried about keeping their jobs. But as a result, businesses are facing shrinking sales of goods and services, so they're slashing payrolls, which of course makes consumers even more anxious and further reduces their spending power. Meanwhile, businesses are cutting way back on new investments in equipment, which hurts upstream suppliers, who are now slashing their payrolls. And so it goes, downward. The gap between what the economy could produce if it were running near full capacity and what it's now producing continues to widen. The shortfall is projected to be over a trillion dollars this year.

How do we get out of this downward plunge?

Regardless of your ideological stripe, you've got to see that when consumers and businesses stop spending and investing, there's only entity left to step into the breach. It's government. Major increases in government spending are necessary, and the spending must be on a very large scale. In the last several weeks the President has put forward the outlines of a stimulus plan, and has left it to the House and Senate to fill in the details. A tiny portion of the details that made it into the House version should be stripped away because they seem like old-fashioned pork. But most spending in the bill is absolutely appropriate. My worry is there's not nearly enough of spending to fill the shortfall in overall demand.

Yet at this very moment, Senate Republicans are seeking to strip the President's stimulus package of many of its spending provisions and substitute tax cuts. Part of this is pure pander: They know tax cuts are more popular with the public than government spending, even though spending is a far more effective way to stimulate the economy (more on this in a moment). Another part is pure partisan politics: Republicans are emboldened by Obama's willingness to court Republicans (taking three Republicans into his cabinet, bringing Republican leaders into the White House for consultations, putting all those business tax cuts into the stimulus bill in order to gain Republican favor) without getting anything at all back from the GOP. House Republicans snubbed the bill entirely. So, Senate Republicans say to themselves, what's to lose?

Plenty. Millions more jobs and a full-fledged Depression, for example.

Can we get real for a moment? Take a look at this chart, which comes from calculations by Mark Zandy and his colleagues at economy.com. You see that each dollar of spending has much more impact than each dollar of tax cut.

There are three reasons for this. First, most people who receive a tax cut don't spend all of it. They use part of it to pay down their debts or they save it. Most of us did one or the other last spring with that tax rebate. From the standpoint of any particular individual, paying down debts or saving may be smart behavior -- even commendable. But what's intelligent for an individual does not necessarily translate into what's good for the economy as a whole. The only way to get businesses to create or preserve jobs is through additional spending. And unlike tax cuts used to pay down personal debt or add to savings, every dollar of government spending flows directly into the economy and adds to overall demand.

Second, even that portion of a tax cut we might actually spend doesn't necessarily go into the American economy. It goes all over the world. I have nothing against creating or preserving the jobs of Asians who assemble those flat-panel TVs you see at the mall, for example, but right now we're trying to create or preserve jobs here in America. Sure, the retail workers at the mall who sell the flat-panel TV's might benefit, but remember we're talking about how to get the biggest bang for every dollar. When government spends to repair a highway or build a school or help pay for medical services, the money and the jobs stay here in America.

Finally, those who say cutting taxes on businesses is the best way to create or preserve jobs forget about the demand side. Even with a tax cut, businesses won't hire workers unless there are customers to buy what those workers produce. A government stimulus that creates jobs is a necessary precondition.

This isn't a matter of more or less government, however much Republicans and conservatives would like to wedge it in that old ideological box. The issue is how to revive the economy. When consumers and businesses can't or won't spend enough to keep the economy going, government has to be the spender of last resort. Period."

Me:

Don said...

"Second, even that portion of a tax cut we might actually spend doesn't necessarily go into the American economy. It goes all over the world."

This cuts both ways. What if you decide to use infrastructure money to put in a light rail system that comes from, say, Sweden?

"First, most people who receive a tax cut don't spend all of it. They use part of it to pay down their debts or they save it'

Which is why a sales tax cut to be phased out in the future is a good idea.

"Finally, those who say cutting taxes on businesses is the best way to create or preserve jobs forget about the demand side. Even with a tax cut, businesses won't hire workers unless there are customers to buy what those workers produce"

No. The reason to target tax cuts for investment is to help attack the fear and aversion to risk. This is so bad right now that you can't wait for a road to be built even six months from now.

The fact is that a balanced approach is better:

1) $100 Billion Infrastructure
2) $200 Billion Sales Tax Cut
3) $100 Billion Tax Cuts For Investment
4) Social Safety Net Spending And Aid To States To Help With This: Whatever It Takes: Calling It A Stimulus Is Incorrect: We'd Do It No Matter The Multiplier

As for why 1 is so little at first, two projects you know well: Big Dig, Bay Bridge, Case Closed.

Don the libertarian Democrat

Thursday, 05 February, 2009

In a recessionary economy, tax cuts do not necessarily encourage consumers to spend and businesses to hire.

From Salon:

"How to lie about tax cuts

Here's what appears to be the House Republican strategy going forward: lie, misrepresent, and obfuscate. And when you get called on it, just ignore reality and repeat yourself.

A Wednesday afternoon case in point: The Republican leadership is now declaring that their economic recovery plan, which consists primarily of tax cuts, will result in the creation of 6.2 million jobs in two years. As the authority for their claim, they cite none other than Christina Romer, President Obama's Chair of the Council of Economic Advisers.

From a press conference:

...We have an analysis by the president's senior economic adviser who also shows that tax cuts actually provide more immediate relief and more jobs than spending, so you get more -- a bigger bang for the buck.

Well, using the methods and economic models developed by the president's top adviser -- and when those are applied to our Republican plan, it shows the Republican plan could create as many as 6.2 million jobs over the next two years.

Now, let's just be clear about where these estimates come from, the nation's top economic adviser, the president's nominee to chair the Council of Economic Advisors, Dr. Christina Romer, and her peer-reviewed research.

Now, it is true that in their classic paper, "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks," Christina Romer and her husband David Romer found that certain types of tax cuts in certain types of economic situations provided considerable "bang for the buck."

But as has already been endlessly hashed out in the econoblogosphere, their findings primarily applied to tax cuts that were enacted during periods when the economy was healthy. In other words, when the economy's normal job creation engine is plugging along nicely and companies are turning profits and unemployment is relatively low, a tax cut can provide an added stimulus.

But the Romers did not find the same was true when the economy was in recession. Explicitly: "Policymakers' efforts to adjust taxes to offset anticipated changes in private economic activity have been largely unsuccessful."

There is an intuitively obvious explanation for this, which will be familiar to anyone who has been reading How the World Works this week. In a recessionary economy, tax cuts do not necessarily encourage consumers to spend and businesses to hire. When confidence in the economy is low, people are inclined to pay off their bills and boost their savings. Tax cuts might provide a little more cushion for consumers and businesses to wait out the storm, but they are unlikely to incite a wave of euphoric shopping.

Pointing out, again that the House Republicans are misrepresenting the academic research on tax cuts is unlikely to make House Minority Leader John Boehner or Minority Whip Eric Cantor change their tune. But it might help to explain why after two consecutive walloping defeats for Congressional Republicans, the two men have little power to make their obfuscations change policy.

― Andrew Leonard"

And Don:

GOP On Stimulus

I do agree with the administrations attempt to target tax cuts for investment. As well, I liked the idea of a sales tax cut or payroll tax cut that would be phased out in the future. This could give some incentive to spending now. How much either of these proposals would help is hard to gauge, but so is infrastructure spending.

The GOP position is not serious. They are simply looking for a reason to vote no, without appearing to be political. After all, the administration's position is a compromise. Holding out for everything that you say that you want is not serious government.

-- Don the libertarian Democrat

"However, some smart money is short these low-yielding price-inflated bonds denominated in a fragile currency."

From DR. O on Seeking Alpha:

"Discussing the "Stimulus Bill" in the White House. Any legislation without tax cuts for individuals who actually PAY taxes (as opposed to handouts to those who don't), or tax cuts for businesses is doomed to costly failure( I AGREE ).

The US Dollar has been catching a bid relative to other currencies. But I am not optimistic about the value of these multiplying pieces of paper. ( TRUE )

The real preferred currency in this depressing time, the Japanese Yen.( GO FIGURE )

The cost of shipping continues at depressed levels.( TRUE )

Copper pricing remains low, reflecting depressed demand.

The price of oil remains depressed, however, I believe oil at these levels is an attractive investment.( I AGREE )

US Treasuries caught an incredible bid as frightened big money sought a safe haven. However, some smart money is short these low-yielding price-inflated bonds denominated in a fragile currency.( THAT'S WHAT I'D DO )

Gold continues to resist the collapse of other commodities as perhaps the safest of havens. Gold is untied to the value of this currency or that, this country or that, this event or that. It has had intrinsic value for thousands of years. Yet, the chart is erratic and volatile. ( SOME THINK IT CAN, SOME THINK IT CAN'T )

Gold stocks have rallied remarkably from their lows, reflecting both the high price of gold and the decreasing price of oil (lowers cost of production). Would you rather own shares in a gold mine or an insolvent bank? Sadly, multiple resistances lay just overhead on the chart.

Stock volatility remains remarkably high. Not comforting for investors, but fun for traders.

Stocks are currently residing on the oversold side of life.( TRUE )

The S&P 500. I've fallen and I can't get up. Interesting how the "averages" seem to level out as one stock after another, or one sector after another, continues to get obliterated.( A CALLING RUN, DEBT-DEFLATION, FEAR AND AVERSION TO RISK, PROACTIVITY RUN, SAVING SPREE, FLIGHT TO QUALITY . THIS EXPLAINS THE BREADTH.)

My hero Todd Harrison says "As go the piggies (banks) go the poke (the entire stock market)." The piggies continue to implode.

No more stock charts today. Suffice it to say that I am at a loss to find a bank to put my money into that I have confidence is not now or will not soon be bankrupt. Depressing.( I WOULD BUY FINANCIAL ETF'S IN THE NEAR FUTURE. BUT I'M NOT AN INVESTOR. )

Stock position: None."

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.

"Create the incentive for people to take more risk and move their savings from government bonds to risky assets"

Here's the kind of proposal that I agree with for attacking the fear and aversion to risk. From Growthology:

"Stimulate Private Risk Taking

So how do we stimulate the economy without increasing the already large current-account deficit? It's not easy, but here is an idea: Create the incentive for people to take more risk and move their savings from government bonds to risky assets( I AGREE ). There is no better way to encourage this than a temporary elimination of the capital-gains tax for all the investments begun during 2009 and held for at least two years.( FINE )

So say ALBERTO ALESINA and LUIGI ZINGALES. Anyone reading the news knows that the idea of a traditional fiscal stimulus is losing its appeal among those wise enough to know. The CBO announced that most infrastructure spending could not be spent for years -- far too late to matter.

The challenge is whether the new President will focus on what is broken - the financial system - or play the traditional game of big government pork-barreling. The capital gains tax argument will run right into the maw of the liberal trench lines of class warfare. They don't hear "entrepreneur" when you say capital gains, they hear "Wall Street." And I'm afriad they would counter any argument for heart surgery with a counter argument for rebuilding the entire arterial system."

It is a good proposal.

it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending

When I first read about this, I believed that Stiglitz really disagreed with me. Let's take a peek on the FT:

"Do not squander America’s stimulus on tax cuts

By Joseph Stiglitz

Published: January 15 2009 19:48 | Last updated: January 15 2009 19:48

As news of the US economy worsens, worries about whether a stimulus could restart the economy are growing. Making matters more complicated is the fact that our 2009 fiscal deficit will exceed 8 per cent of gross domestic product( TRUE, WHICH IS ONE MORE REASON THE BUSH YEARS HAVE BEEN A NIGHTMARE ), even before the stimulus.

What is clear is that tax cuts will not help much. When Barack Obama, president-elect, last week proposed to use nearly 40 per cent of the stimulus for tax cuts, he was rightly told this would be less effective than, say, spending on infrastructure( HERE, I DON'T AGREE ). It has been surprising, then, to see President George W. Bush’s former economic advisers, including Greg Mankiw, argue that tax cuts are the way forward.

Mr Mankiw cites a recent study by Christina Romer and David Romer, economists at the University of California, Berkeley, who found that each dollar of tax cuts raises GDP by about $3 (€2.30). Such studies, based on past data, may have little to say about the situation the world now faces( CHUCK THEM ). Americans confronted with debt, shrinking retirement accounts, houses worth less than mortgages and a tough credit environment will save more of their money than in the past( TRUE. FOR A WHILE. ). That was the experience with the February 2008 tax cut, where less than half of it has been spent. It matters who gets the break – if it is lower income Americans, the fraction spent will, on average, be greater( TRUE ) than for wealthier Americans.

Tax breaks for business may prove to be a sink-hole as bad as the troubled assets relief programme. Particularly worrisome are rumours that companies will be allowed to set off their losses against profits made in the past five years to get tax rebates( I AGREE ) – a big gift to those who mismanaged risk, including banks such as Citibank. Some suggest that, having exhausted the more transparent bail-out strategy, banks are seeking less transparent help through the tax code. We learnt the lesson from Tarp: we need to link handouts to changes in behaviour( I AGREE ). We should have insisted banks commit to more lending. Now we should insist any tax breaks for business are linked to investment( HE AND I AGREE ).

Similar caution needs to be exercised in evaluating each element of the stimulus package. The Obama team has issued a report projecting its potential for job creation. In estimating the impact of offering relief to the states, it assumed, based on experience, that 30 per cent of the relief would be used to stall tax increases that would otherwise have occurred. (States are facing a shortfall of perhaps $150bn a year.) But with property values plummeting, there is pressure to cut property taxes. And, in any case, state taxes are more regressive than federal taxes – more of the burden of taxation is borne by those with lower incomes. This means that if tax cuts come partly at the expense of state relief, and states are forced to raise taxes, the net effect on the economy is likely to be negative.

There is a more fundamental point that the Bush team missed. Tax cuts have increased our national debt. They encouraged( ONLY THAT ) America to live beyond its means, increasing our liabilities without commensurate increases in assets( WEREN'T HOUSES ASSETS ). Further tax cuts would do the same. Good accounting looks at assets and liabilities. Spending on infrastructure, education and technology create assets; they increase future productivity( IF THEY ARE WELL SPENT. OTHERWISE, THEY CAN DO GREAT HARM. IT'S NOT A PRIORI A GREAT INVESTMENT. ).

Some of the spending in the stimulus serves multiple ends. Increased unemployment benefits ( NOT A STIMULUS )have the largest multiplier effects – cash-strapped families spend every cent given – and meet vital social needs. It is imperative to provide health insurance to the unemployed( NOT A STIMULUS ): without that, a single serious incident can push a family into bankruptcy. Helping the unemployed meet house payments reduces foreclosures, addressing one of the underlying causes of the crisis. There are thus triple benefits.( BUT NOT A STIMULUS. THIS IS SOCIAL SAFETY NET SPENDING. )

We are in uncharted territory in this crisis. But household tax cuts, except for possibly the poorest, should have no place in the stimulus. Nor should business tax breaks, except when closely linked with additional investment( I AGREE ). The one tax cut that should be included is a temporary incremental investment tax credit; it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending( I AGREE ). Increased investments in infrastructure, education and technology, relief to states, and help to the unemployed need pride of place.

This is a stimulus that some Republicans will find less attractive than previous give-aways. But Americans voted for change they could believe in. I trust that that is what we will get.

The writer was awarded the Nobel Prize in economics in 2001. His latest book is The Three Trillion Dollar War, co-authored with Linda Bilmes (2008)"

My only disagreement is about one tax cut, but it's big. I would like a sales tax cut or payroll tax cut which will be phased out in the future, giving people an incentive to spend now instead of waiting. Some people will save money by not spending, but that's fine as well.

"The three-dozen tax provisions also would give businesses incentives to invest in equipment "

Let's remember Don's Stimulus Plan:

1) Social Safety Net spending is not part of a stimulus. This can include aid to states for such services. It will cost what is necessary to truly help people suffering through this crisis. I have no set figure in mind.
2) $100 Billion for Infrastructure.
4) $300 Billion in Tax Cuts.
A. Sales Tax decrease or Payroll Tax decrease.
B. Tax Cuts for Investment.

Let's see what the plan is so far. From Bloomberg:

"House $825 Billion U.S. Stimulus Bill Has $275 Billion Tax Cut

By Ryan J. Donmoyer and Brian Faler

Jan. 15 (Bloomberg) -- An $825 billion economic-stimulus measure drafted by the U.S. House of Representatives would provide $550 billion in new government spending along with $275 billion( I SAID $300 BILLION ) in tax cuts for families and businesses.

A summary of the measure released today said it would provide about $90 billion in infrastructure spending( I SAID $100 BILLION ), $87 billion in aid to states struggling with surging Medicaid costs and $43 billion in unemployment and job training programs.

Other provisions would provide $20 billion for federal nutrition assistance, $15.6 billion to Pell Grants, which help low-income families send their children to college, and $6 billion to expand broadband access in underserved areas.

Individuals and families will get at least $140 billion of the tax cuts, including credits for workers worth up to $1,000 per family or $500 per individual. The bill would also expand tax credits for the working poor, including making more families eligible for a child tax credit.( MY PROPOSALS WERE FOUND NOT WORTHY. )

The tax section contains a provision allowing businesses to convert losses into cash by claiming a refund of taxes paid in previous years( I DIDN'T SUPPORT THIS ). Fannie Mae, Freddie Mac and companies that received aid from the Troubled Asset Relief Program are not eligible for the tax break, according to a summary of the bill.

The three-dozen tax provisions also would give businesses incentives to invest in equipment( THIS WAS MY PROPOSAL ) and remove a requirement that first-time homebuyers repay a special $7,500 tax credit enacted last year to stimulate the housing market.

“This recovery package will provide tremendous tax relief, health care and job training benefits for families struggling to make ends meet while also giving businesses the boost they need to create jobs,” House Ways and Means Committee Chairman Charles Rangel said in a statement.

To contact the reporters on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net; Brian Faler in Washington at bfaler@bloomberg.net

It's not bad, but my plan was substantially better. Oh well.

Obama also has suggested tax incentives for businesses to make capital investments

From the Washington Post:

"Obama Shelves Jobs-Credit Proposal
Democrats Said $3,000 Tax Incentive Could Be Abused by Businesses

By Shailagh Murray
Washington Post Staff Writer
Tuesday, January 13, 2009; A04

Bowing to widespread Democratic skepticism, President-elect Barack Obama will drop his bid to include a business tax break he once touted in the economic stimulus bill now taking shape on Capitol Hill, aides said last night.

Obama suggested the $3,000-per-job credit last week as one of five individual and business tax incentives aimed at winning Republican support. He proposed $300 billion in tax relief( MY NUMBER AS WELL ) in a bill that could reach $775 billion, and he resurrected the jobs-credit proposal from the campaign trail as one of his main provisions.

Republicans reacted favorably to the higher-than-expected ratio of tax breaks to spending for road projects, alternative energy production, health-care technology and unemployment benefits. But they offered mixed reviews of his specific tax proposals and floated their own, including cuts in corporate and capital gains taxes.

Stronger opposition came from Democrats, who dismissed the $3,000 credit to employers for every job created( THIS COULD BE GOOD ) or saved( THIS ONE IS NOT GOOD ) as ripe for abuse and difficult to administer. When no champion for the proposal came forward, the president-elect decided to sideline the incentive.

"We've always said we're open to other ideas. This was never set in stone," said a senior Obama adviser of the decision.

Congressional leaders are aiming to deliver a stimulus bill to Obama's desk in the White House by mid-February, but as the process unfolds, the legislation appears to be growing in size and complexity.

The stimulus and a separate financial rescue package, which is also meeting with objections from lawmakers (story, Page A1), are aimed at preventing the economy from sliding further. But Congress has expressed reluctance to rush through such expensive bills without careful consideration of the details.

Even before assuming office, Obama is taking an unusually direct role in legislative efforts to move both bills forward, personally phoning lawmakers and dispatching senior aides to Capitol Hill on a near-daily basis. Today the president-elect will speak to Senate Democrats at their weekly luncheon, and he will soon appear before House Democrats, although a date has not been set, a senior Obama aide said.

Obama expects to meet with Republicans in both chambers, the aide added, although not until after he is inaugurated next Tuesday.

Former Treasury secretary Lawrence H. Summers, who will serve as Obama's chief White House economic adviser, is scheduled to meet this afternoon with House Ways and Means Committee members, to begin crafting tax provisions for the stimulus bill.

Obama advisers said further adjustments may be made to the president-elect's tax priorities, including to a proposed $500 payroll tax credit for individuals. Many Democrats have criticized Obama's idea of distributing the benefit over 12 months, saying it would amount to about $20 per paycheck for workers who are paid every two weeks. They would prefer to distribute the credit over a shorter period.

Obama also has suggested tax incentives for businesses to make capital investments( THIS IS WHAT I FAVOR, IN ORDER TO HELP EASE THE FEAR AND AVERSION TO RISK. ). Such benefits are popular across party lines and have been successful in recent years. But another Obama proposal, to allow companies to deduct larger portions of recent losses, has raised eyebrows on the Hill, where lawmakers see it as a costly reward for behavior that was possibly irresponsible.( I DON'T LIKE THIS ONE )

Ways and Means Committee Chairman Charles B. Rangel (D-N.Y.) announced last week that he would seek to increase unemployment benefits in the plan. Democrats also are floating generous incentives for domestic energy production and for college tuition relief."

I'm glad to see my main proposal, besides a sales tax cut, being considered. We need to attack the fear and aversion to risk. Not addressing that key issue is a bad mistake.

"The federal government temporarily picks up the tab for state sales taxes (or possibly more)"

Bryan Caplan on EconLog:

"Here's another clever stimulus idea. The source is Andrew Healy, who explained it to me over pizza right the day before Christmas. I'm not sure if he actually advocates it, but here it is:

The federal government temporarily picks up the tab for state sales taxes (or possibly more), as long as the states temporarily stop collecting sales tax. For example, right now California charges an 8.75% sales tax. Under the Healy hypothetical, the feds give California a grant equal to 100% (or possibly more) of .0875 times California's taxable receipts. The state of California then stops collecting sales tax. ( THIS IS THE PLAN I SUPPORT, EVEN THOUGH THE EVIDENCE ON THE VAT CUT IN BRITAIN IS NOT EXACTLY ENCOURAGING. )

At first glance, this looks about the same as a temporary federal income tax cut. But in a world with inflexible prices and wages, intertemporal substitution ramps up the effect of a sales tax cut, but not an income tax cut. What's the difference? When sales taxes are temporarily low, people have an incentive to buy more now( THAT'S IT ). With inflexible prices, this intertemporal substitution diminishes the surplus in the goods market. Income tax cuts, in contrast, encourage people to work more now( TRUE ) - exacerbating the surplus in the labor market( TRUE ).

In the long-run, of course, Healy's proposal encourages higher state sales taxes. Why not have a sales tax of 100% if you know DC is paying? But as a stimulus package, it has a major advantage over an income tax cut. Your thoughts?"

This is the plan that I support.

"now we must make our congress the direct investors of last resort."

From Notes on Credit Spreads:

"Why Infrastructure Spending is Preferential to Tax Cuts

by David Levy

Much concern exists over Obama’s proposal to make tax cuts a major portion of fiscal stimulus. Through a tax cut, we (the government) are increasing the income of those still employed( NOT IF THEY'RE DIRECTED AT INVESTMENT AND CREATING JOBS. ). Hopefully, tax savings will buy goods and services, increasing GDP. In today’s environment, we’re not enacting a stimulus to buy goods, we’re enacting a stimulus to buy jobs.

GDP = government spending + investment + consumption + net exports. The marginal dollars in a tax cut will either be saved or spent.

While savings should be encouraged in the long term, a savings glut currently exists. Fed Funds rate trades near zero, while cash reserves within the Fed have ballooned.

More damaging, marginal spending could be directed at imported goods. From Martin Wolf to Warren Buffet, many shudder at no improvement in our trade balances. Dollars used for imports are either locked up as foreign reserves or exchanged for investments in future US cash flows. Those future cash flows are either US tax receipts or profits distributed as interest or dividends. Those tax receipts could have put new teachers in the class room. Those profits could have built new factories. Those cash flows will never to be re-invested in the US.

By definition then, an increasing current account deficit means the same standard of living - GDP - costs more. If this is not the purest form of inflation( WE WANT INFLATION ), I do not know what is.

Many believe too great a mismatch exists between jobs lost and jobs needed for “shovel ready”. Cokie Roberts on “This Week” opined on finance professionals helping on infrastructure: “Well maybe instead of going to their personal trainers, they can actually get out there and start digging.”

The purchase of infrastructure projects buys jobs across the food chain. Almost every project will go out for private competitive tender. Forget defunct residential home construction (shovel ready employees), companies bidding will require talent to prepare bids, obtain financing, manage payroll, and review costs. Every contract guarantied by the government (state or federal) will give lenders the confidence to finance, spurring new growth.( THAT'S THE POINT OF THE STIMULUS. TO ATTACK THE FEAR AND AVERSION TO RISK. )

The long term benefits (aside from jobs) are then improved transportation, reduced energy costs and reduction of barriers to education( MAYBE YOU COULD LOOK INTO THE BIG DIG AND THE BAY BRIDGE AS RECENT EXAMPLES OF INFRASTRUCTURE. THEY CERTAINLY COST A LOT OF MONEY. ). Thus reduction of risks for future runaway inflation - those risks prevalent in increasing current account deficits. Faith in government is presently difficult yet now we must make our congress the direct investors of last resort( I CALL THEM THE SPENDERS OF LAST RESORT. )."

I agree with the need for a stimulus, and that the government needs to be a SOLR, but I don't understand the problem with tax cuts targeted towards encouraging investment and jobs. What am I missing?

"So if stimulus is partly a game of psychology"

Barbara Kiviat finds someone on my side:

"Obama talks stimulus. He hopes you are listening

Posted by Barbara Kiviat | Comments (6) | Permalink | Trackbacks (0) | Email This

The spate of retailers reporting devastating December sales this morning provided a nice backdrop for President-elect Obama's speech in Virginia about why we need to spend another $775 billion to fix the economy. About 40% of that sum comes in the form of tax cuts, but the bulk of the fiscal stimulus would go to pay for new programs and projects—everything from the greening of federal buildings to the computerization of medical records.

The idea, just to be really basic about it, is that American consumers and companies aren't spending enough, so the government has to. There was a great article in the New York Times yesterday about how pretty much all most economists now agree that it's go-time on this count. Even Marty Feldstein, the champion of conservative economic thought who was a top adviser to President Reagan, has noted that lower interest rates aren't getting the job done because credit markets are screwy and that tax cuts only get you so far, so the "heavy lifting" will have to be done by increased government spending. (Quick historical recap: this hasn't been the consensus in the field of economics since the 1960s.)

But most economists also agree that fiscal stimulus shouldn't be an open-ended thing. This morning I was chatting with Andrew Dilnot, an economist at Oxford University who used to run the U.K's Institute for Fiscal Studies—what he described as a cross between the Congressional Budget Office, the National Bureau of Economic Research and the Brookings Institution. He argued that fiscal stimulus should be geared toward priming the pump—that is, getting private players to start spending again. "The strongest argument for doing these sorts of things is that it's a way of the government demonstrating that they're not going to allow the economy to slide into a depression, that they'll spend the money necessary ( THAT'S MY POSITION. IT'S THE EQUIVALENT OF THE GOVERNMENT GUARANTEES NEEDED TO STOP A CALLING RUN, ONLY THIS IS A PROACTIVITY RUN. HERE, THE GOVERNMENT NEEDS TO BE A SPENDER OF LAST RESORT, AND, ONCE AGAIN, ONLY THE GOVERNMENT HAS THE RESOURCES TO BE BELIEVED AS A SOLR. IT SHOULD ALSO BE CLEAR THAT I BELIEVE THAT HAVING THESE GUARANTEES WILL STOP CALLING AND PROACTIVITY RUNS IN THE FUTURE. THE POINT OF THE GOVERNMENT GUARANTEES SHOULD BE TO KEEP PEOPLE FROM PANICKING, THEREBY KEEPING THE NEED FOR GOVERNMENT ASSISTANCE TO A MINIMUM. )," he said. "If people believe it's going to be okay, then people who are putting off buying a new car or house will instead say, I shan't lose my job, I'll go ahead and do that( THAT'S THE WHOLE POINT. I AGREE. A HUMAN AGENCY EXPLANATION. )."

So if stimulus is partly( COMPLETELY. OTHERWISE, IT'S SIMPLY GOVERNMENT SPENDING AS OPPOSED TO PRIVATE SPENDING. ) a game of psychology, then it would make sense to ease off the extra spending once the economy picks back up( YES ). Get consumers and businesses confident enough to spend again, and then let them take over( YES ). In an interview on Wednesday, Obama nodded at that logic. "I'm not out to increase the size of the government long-term," he said. "My preference would be that the private sector was doing this all on their own( MY POSITION AS WELL. )."

I'm guessing that sounds pretty nice to most folks, especially considering the amount of money we've already spent on fixing the economy. But is it true? Jay Newton-Small has a piece up on Time.com that considers how Obama's stimulus package gives him a running start on a bunch of items on his long-term agenda. If we head down this road and GDP rebounds, do we suddenly cut funding? I know a lot more about economics than I do politics, but I'm guessing most legislation doesn't come with an easy on-off switch( THAT IS A CONCERN ).

Though that's not to say I'm against spending money to increase the energy efficiency of two million homes or to build broadband access to all corners of America so that small businesses, no matter where they're located, can be globally competitive. These are good ideas as far as I'm concerned.( GOOD IDEAS. I AGREE. )

All I'm saying is when we start buying computers for schools and paying people to put up windmills let's be clear about whether we're doing these things to save the economy—or if we'd be trying to do them in the long-term anyway.( FOR THE INFRASTRUCTURE PART OF THE STIMULUS, THIS IS ESSENTIAL. )

Here's one of my favorite parts of Obama's speech:

Instead of politicians doling out money behind a veil of secrecy, decisions about where we invest will be made transparently, and informed by independent experts wherever possible. Every American will be able to hold Washington accountable for these decisions by going online to see how and where their tax dollars are being spent. ( WONDERFUL )

I can't wait.

Barbara!"

My view of the importance and use of a stimulus is exactly the same, which is why I don't believe that we need to do as Paul Krugman says:

"More stimulus notes

Mind the gap

1. The new CBO budget and economic outlook is out. Above is its forecast( BS ) for the GDP gap — the hole stimulus has to fill( WHY DOES IT NEED TO FILL THE HOLE BY ITSELF? ). I’d guess( THAT'S WHAT IT IS ) that the CBO estimate, which has unemployment averaging 8.3 percent in 2009 and 9 percent in 2010, is actually too optimistic (see 3, below), but even so it puts the Obama plan in perspective: a 3% of GDP plan, with a significant share going to ineffective tax cuts( NOT CLEAR AT ALL ), to fill an 8% or more gap.

2. How ineffective? Howard Gleckman of the Tax Policy Center says Lots of Buck, not Much Bang.:

Here's his point:

"Refundable tax credits for hiring new workers promise to be an administrative nightmare and won't create many new jobs. It is tough to see how a company that is seeing its sales slaughtered in today’s recession is going to hire just because it gets a few thousand dollars per new worker from the government. Profitable firms would merely take the credit for bringing on workers they were already planning on hiring. ( IT'S AMAZING HOW PEOPLE CAN INTUITIVELY DIVINE WHETHER OR NOT AN ECONOMIC INCENTIVE WILL WORK. I HAVE NO IDEA WHAT HE'S BASING THIS VIEW ON. IT SEEMS LIKE A POSITIVE MOVE TO ME. )

I can’t begin to imagine how the variation on this idea--credits for not laying someone off--would work( HERE I AGREE ). My head throbs at the concept of the IRS trying to administer a rebate based on intentions. Worse, these breaks would never work unless they are refundable and, to be honest, giving such credits to failing business makes my skin crawl. In reality, it would become yet one more bailout—only this time taxpayers wouldn't even get stock for their trouble."

Back to Krugman:

3. The official BLS numbers won’t be out until Friday, but the ADP jobs estimate, based on private payroll data, is spectacularly grim. "( AND ACCORDING TO THE BIG PICTURE, NOT VERY USEFUL. )

Krugman's view is Mechanistic. The economy is like an engine. It needs a lot of oil. I don't credit this view at all. If there's one view that always wastes money, it's a mechanistic view of human behavior.

I would prefer an incentive for investment, but adding workers isn't a bad alternative. Let me explain something: We're fighting the fear and aversion to risk. One way to attack that is to target incentives to minimally effect this. The alternative is much more than spectacularly grim. There's no proof that any of these measures will be effective, least of all picking an enormous figure based on a graph of useful but inexact numbers. The idea that overspending poses no risk is beyond belief. It is itself a panicked reaction to our crisis. We've had a number of those recently, and, as of now, the record is mixed at best.

"In fact, the investment/net worth ratio is currently at a postwar low."

Bad news for another of my proposals. Namely, targeted tax cuts for investment. From Macroblog:

"Will tax stimulus stimulate investment?

On Monday, the form of potential fiscal stimulus, 2009-style, took a step forward detail-wise. From the Wall Street Journal:

“President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses(ODDLY, THAT'S THE SAME AMOUNT AS MY PROPOSAL FOR THESE TWO TAX CUTS ), a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs( I WANT TO USE IT AS AN INCENTIVE TO ATTACK THE FEAR AND AVERSION TO RISK, WHICH I BELIEVE TO BE THE MAIN PROBLEM NOW.).

“The size of the proposed tax cuts—which would account for about 40% of a stimulus package that could reach $775 billion over two years( MY FIGURE IS $700 Billion )—is greater than many on both sides of the aisle in Congress had anticipated.”

The plan appears to make concessions to both economic theory—which suggests that consumers will save a relatively large fraction of temporary increases in disposable income—and recent experience—which seems to suggest that what works in theory sometimes works in practice. Again, from the Wall Street Journal:

“Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills( ISN'T THAT SPENDING? ) or saved the cash( I HOPE SOME PEOPLE DO. JUST NOT EVERYBODY. ) rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.”( I THINK THAT THE TAX HAS TO BE PHASED OUT TO ENCOURAGE SPENDING SOONER RATHER THAN LATER.)

As for the business tax package:

“… a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

“A second provision would entice firms to plow that money back into new investment( THIS IS WHAT I WOULD FAVOR ). The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.”

A relevant question here is really quite similar to the one we ask when the tax cuts are aimed at households: Will the extra cash be spent? This graph provides some interesting perspective:

Relative to net worth (of nonfarm nonfinancial corporate businesses), private fixed investment has been in consistent decline since the second quarter of 2006. (The level of fixed investment has declined in each quarter, save one.) In fact, the investment/net worth ratio is currently at a postwar low. ( IS HOUSING INCLUDED? )

Why? A couple of hypotheses come to mind. (1) Firms are extremely pessimistic about the outlook and see relatively few worthwhile projects in which to commit funds.( TRUE ) (2) Credit markets are so impaired that the net worth of firms—a critical variable in mainstream models of the so-called “credit channel” of monetary policy—is supporting increasingly smaller levels of lending.( TRUE ) (3) Nonfinancial firms, like financial firms, are deleveraging and hence not expanding( TRUE ). ALL OF THESE ARE PROBABLY TRUE TO SOME EXTENT, BUT WHEN I LOOK AT THE GRAPH, IT SEEMS THAT INVESTMENT STARTED GOING DOWN DURING THE TECH BUBBLE YEARS AND CONTINUED IN THE HOUSING BUBBLE YEARS. I'M WONDERING IF THERE HASN'T BEEN A MASSIVE AMOUNT OF MONEY INVESTED IN STOCKS AND HOUSING AS OPPOSED TO, SAY, MANUFACTURING. SEE BELOW.

Of course, even if one of these hypotheses is true, it need not be the case that marginal dollars sent in the direction of businesses will go uninvested. But it makes you wonder.( I STILL FAVOR MY IDEA. THE GRAPH ISN'T CONCLUSIVE. )

By David Altig, senior vice president and research director at the Atlanta Fed"

Here's Casey Mulligan:

"TESTING THE THEORY WITH DATA FROM 2008

Another application of this logic is to the residential sector: does residential spending increase or decrease nonresidential spending? Here it is easy to see the importance of supply -- see the figure below.

When housing boomed, nonresidential construction spending fell (despite the fact that the housing boom was increasing the prices of construction labor and materials) -- almost dollar for dollar!

When housing crashed, nonresidential construction spending ROSE (despite the fact that the housing crash was reducing the prices of construction labor and materials), about 15 cents on the dollar. Note that, according to the NBER, some of the nonresidential increase occur ed during a recession.

Another fascinating property of this episode is that the shocks to spending are on the order of magnitude (100s of billions of dollars) of the kinds of fiscal stimuli being recommended by some economists.

When interpreting what is above, we need to recognize that a large sector is omitted -- the non-construction sector. For this reason, the calculations above underestimate of the aggegate supply effect of housing spending on nonresidential spending (Take, for example, accountants. A housing boom pulls accountants into work for construction businesses, which leaves fewer accountants to work for non-construction businesses.). But they also underestimate the aggregate demand effect, because the housing construction workers are taking their paychecks and spending some of it on non-construction items. In any case, the supply effect is easy to see -- the housing construction boom did not take place with resources that would have otherwise been unemployed and the housing bust did not release resources entirely into unemployment."

So, I'm wondering if the Tech and Housing Bubbles diverted money away from other types of investment. If so, we might want to rethink subsidizing the purchases of houses ( I'm for a general housing subsidy for low-income people. ) It would seem to me, interpreting Mulligan's points for my own purposes, that now would be an especially felicitous time to encourage investment in sectors that have been recently shunned.

"Economic policy is based on a collection of half-truths."

This has been Buiter's view all along:

"Can the US economy afford a Keynesian stimulus?
January 5, 2009

Economic policy is based on a collection of half-truths. The nature of these half-truths changes occasionally. Economics as a scholarly discipline consists in the periodic rediscovery and refinement of old half-truths. Little progress has been made in the past century or so towards understanding how economic policy, rules, legislation and regulation influence economic fluctuations, financial stability, growth, poverty or inequality. We know that a few extreme approaches that have been tried yield lousy results - central planning, self-regulating financial markets - but we don’t know much that is constructive beyond that.( I AGREE )

The main uses of economics as a scholarly discipline are therefore negative or destructive - pointing out that certain things don’t make sense and won’t deliver the promised results. This blog post falls into that category.

Much bad policy advice derives from a misunderstanding of the short-run and long-run impacts of events and policies. Too often for comfort I hear variations on the following statements: “the long run is just a sequence of short runs, so if we make sure things always make sense in the short run, the long run will take care of itself.” This fallacy, which I shall, unfairly, label the Keynesian fallacy, compounds three errors.

The first error is( 1 ) the leap from the correct assertion that a long interval of time is the sum of successive short intervals of time to the incorrect impact that the long-run impact of a policy or event is in any sense the sum of its short-run impacts. The second error is( 2 ) the failure to recognise that our models (formal or implicit) of how the economy works are inevitably incomplete( TRUE ). Parts of the transmission mechanism - positive or negative feedbacks and other causal links between actions today, future outcomes and anticipations today of future outcomes and future actions - that can safely be ignored when we consider the impact of a policy over a year or two can come back to haunt us with a vengeance over a three-year or longer horizon. The third error is that, ( 3 ) when economic agents, households, firms, portfolio managers and asset market prices are even in part forward-looking, the long run is now. More precisely, the long-run consequences of current policies can, through private sector expectations ( YES )and through forward-looking asset prices influence consumption behaviour, employment and investment decisions and asset prices today( TRUE ).

Matching the Keynesian fallacy is the view that just because a certain set of policies is not sustainable, in the sense that it cannot be maintained indefinitely, such policies should not be implemented even temporarily. I will call this the sustainability fallacy. It rests on the simple error that identifies a sustainable policy rule or programme, with a specific constant policy action. A sustainable, sensible or even optimal contingent policy programme, or contingent sequence of policy actions, will in general involve specific actions that will be undone, reversed or even neutralised by later contingent policy actions in the opposite direction. These specific actions may be eminently sensible, even from a long-run perspective, provided they are not maintained indefinitely and are, and are expected to be, reversed in due course, according to the rule, when the state of the economy has evolved or when a new unexpected contingency arises.

US fiscal policy: the Keynesian fallacy on steroids

How does this apply to the macroeconomic stabilisation policy and the financial stability support policies being pursued in the US today?

First, the fiscal policy actions pursued thus far by the Bush administration, but even more so the policy proposals leaked by Obama’s proto-administration are afflicted by the Keynesian fallacy on steroids. They appear to exist outside time, with neither the long-run consequences of the actions like to be implemented over the next couple of years, nor the history that brought the US to its current predicament, the initial conditions, being given any serious attention.

A nation in fundamental disequilibrium: the disappearance of American ‘alpha’

Even before the crisis erupted, around the middle of 2007, the US economy was in fundamental disequilibrium. The external primary deficit (the external current account deficit plus US net foreign investment income) was running at around five or six percent of GDP. The US was also a net external debtor( SPENDER COUNTRY ), Its net external investment position (at fair value, or the statisticians best guess at it) was somewhere between minus 20 percent and minus 30 percent of annual GDP. The US economy managed to finance this debt and deficit position quite comfortably because it gave foreigners an atrocious rate of return on their investment in the US - a rate of return much lower, when expressed in a common currency, than the rate of return earned by US-resident investors abroad.

Some of this lousy ex-post average return on foreign investment in the US was no doubt unexpected and one-off. If risk premia on foreign investment in the US and on US investment abroad were the same, the appearance of excess returns to US investment abroad relative to foreign investment in the US may simply have been an example of the ‘peso problem’ - a ‘small-sample bias’ in expected returns. Assume expected returns are equal using the true distribution of returns. The true distribution may, however, have fat or long tails, with extreme negative values that occur infrequently (e.g. the collapse of a currency peg). The term ‘peso problem’ came from observations on realised returns on US dollar-denominated securities and Mexican peso-denominated securities during the 1970s. The forward premium on the Mexican peso relative to the US dollar was positive through 22 years of a pegged exchange rate, until August 1976, of eight Mexican pesos to the US dollar. On September 1, 1976, the peso devalued by 45 percent vis-à-vis the US dollar.

The term peso problem was, according to Paul Krugman, invented by a bunch of MIT graduate students of the late Rudi Dornbusch. William S. Krasker published the first paper using the expression (”The ‘peso problem’ in testing the efficiency of forward exchange markets”, Journal of Monetary Economics, Volume 6, Issue 2, April 1980, pages 269-276), long before fat tails, black swans and related regurgitations of the same phenomenon became current. The attribution of the expression ‘peso problem’ to Milton Friedman is almost certainly incorrect.

When the disaster scenario (a collapse of the currency peg) materialises, the roof caves in for peso investments. Before the collapse, statisticians, unlike market participants, don’t know the true distribution but base their calculation of the expected return on a sample during which the extreme event has not (yet) materialised. The result is that statisticians overestimate the expected return on the peso (there has been no depreciation of the peso during my sample, therefore the future expected depreciation rate is zero) and attribute the positive (risk-adjusted) rate of return differential on the peso to ‘alpha’. It is, of course, ‘false alpha, as the September 1, 1976 collapse of the peso (repeated a number of times since then) made clear.

Some of the excess returns on US investment abroad relative to foreign investment in the US, may have been anticipated, and may have reflected a low or even a negative risk-premium on US investment. In that case, if risk-adjusted rates of return to foreign investment in the US and on US investment abroad are the same, we would expect that the so far unrealised risk will in due course materialise and blow a large hole in the US external asset position( YIKES ). Even with a very long enough sample, ex-post realised average rates of return on investing in the US will still be lower than ex-post realised rates of return on investment abroad, but the (ex-post) positive correlation between the return on foreign investment and consumption growth could be stronger for foreign investment in the US than for US investment abroad.

Some of the excess returns on US investment abroad relative to foreign investment in the US may have reflected true alpha, that is, true US alpha - excess risk-adjusted returns on investment in the US, permitting the US to offer lower financial pecuniary risk-adjusted rates of return, because, somehow, the US offered foreign investors unique liquidity, security and safety( YES ). Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run( YES. THAT'S HOW IMPORTANT GUARANTEES ARE. ). This is the ‘dark matter’ explanation proposed by Hausmann and Sturzenegger for the ‘alpha’ earned by the US on its (negative) net foreign investment position ....

Now, from H and S:

"In short, the US is a net provider of knowledge, liquidity and insurance( GOVERMENT GUARANTEES. YOU KNOW HOW IMPORTANT THAT THIS IS IN MY OPINION. ). As the world became more global financially, the increasing asset value of these services underlies the spectacular increase in dark matter over the last two decades."

Back to Buiter:

" If such was the case (a doubtful proposition at best, in my view), that time is definitely gone. The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally ( TRUE ). Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed. Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways( TRUE ). Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations. The problem is not confined to commercial banks, investment banks and universal banks. It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others. ( TRUE )

The legal framework for the regulation of financial markets and institutions is a complete shambles. Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture.( FRAUD, ETC. )

There is no chance that a nation as reputationally scarred and maimed as the US is today, could extract any true ‘alpha’ from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations. I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear. ( HERE I DISAGREE. THE SAVER COUNTRIES ARE TEMPTED, FOR SOCIAL STABILITY REASONS, TO TRY AND KEEP THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS GOING. )

There will, before long (my best guess is between 2 and 5 years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard( IT CAN LEAD TO SOCIAL DISLOCATIONS ). The US dollar and US Treasury Bills and Bonds are still viewed as a safe haven by many( TRUE ). But learning takes place. The notion that the US Federal government will be able to generate the primary surpluses required to service its debt without selling much of it to the Fed on a permanent basis, or that the nation as a whole will be able to generate the primary surpluses to service the negative net foreign investment position without the benefit of ‘dark matter’ or ‘American alpha’ is not credible. ( PROBABLY TRUE )

So two things will have to happen, on average and for the indefinite future, going forward. First, there will have to be some combination of higher taxes as a share of GDP or lower non-interest public spending as a share of GDP( I AGREE ). Second, there will have to be a large increase in national saving relative to domestic capital formation. ( GRADUALLY, YES )

The need for a massive resource transfer towards the public sector

As regards the required massive transfer of resources from the public to the private sector in the US, it has long been recognised by those who look at long-term prospects for taxes and public spending in the US, that a combined permanent increase in the tax share/reduction in the share of public spending in GDP of around ten percentage points would be required to fund existing Medicare and Medicaid commitments (and to a lesser extent Social Security commitments). In the past decade the US has legislated for its citizens (though Medicare, Medicaid and Social Security retirement) a West-European-style welfare state( TRUE ). Obama’s proposals for universal health care will complete this process. The US has done so with a general government public expenditure share in GDP that is about 10 percentage points below the West-European average (in the mid-thirties for the US, in the mid-forties in for Western Europe. Evolving demographics and entitlement will drive US welfare state expenditure towards the West-European levels, in the absence of political decisions in the US to limit coverage and entitlements( TRUE ).

This resource shift from the private to the public sector would only manifest itself gradually however, and no doubt, there will be changes in (whittling down of) these commitments before their full impact is felt. ( I AGREE )

The US Federal government has taken on massive additional contingent liabilities through its bail out/underwriting( GUARANTEES ) of the US financial system (and possibly other bits of the US economic system that are too politically( TRUE ) connected to fail). Together will the foreseeable increase in actual Federal government liabilities because of vastly increased future Federal deficits, this implies the need for a future private to public sector resource transfer that is most unlikely to be politically feasible without recourse to inflation( A BAD CHOICE ). The only alternative is default on the Federal debt( I SAY THAT SAVER COUNTRIES MIGHT GO FOR THIS. ). There is little doubt, in my view, that the Federal authorities will choose the inflation and currency depreciation route over the default route.

If I can figure this out, so can anyone in the US or abroad who follows recent economic developments. The dawning of the realisation( INFLATION ) will lead to the dumping of the assets.( BECAUSE THEY WILL BE WORTH LESS IF HELD. AN INFLATION RUN. )

Even if the US Federal government decides to go the inflation route for ‘paying off’ public debt is would be too politically difficult to service through tax increases or spending cuts, it is unlikely that some, not insignificant, resource transfer from the private to the public sector will have to take place. And there we have the short run-long run conundrum. If the economy were at full employment and a high rate of capacity utilisation today, it would still require a permanent resource transfer from the private sector to the public sector, that is, higher taxes or lower public spending. But for cyclical purposes( OUR CURRENT RECESSION ), lower taxes and higher public spending are indicated - provided the authorities have the credibility to commit themselves to future tax increases and/or spending cuts that would not just take care of the existing obligation, but also of the additional debt that would be incurred as a result of the Keynesian stimulus.( I'M FOR THIS SOLUTION. )

The latest gurgling about the magnitude of the Obama fiscal stimulus are certainly impressive: $775 bn or so (around five percent of GDP) over two years. This on top of a Federal deficit that even absent these stimuli could easily top $750 bn. I now anticipate a Federal deficit of between $1.5 trillion and $2.0 trillion for 2009 and something slightly lower for $ 2010. With both the Fed and the Treasury exposed to trillions of private assets and institutions of doubtful quality and solvency, the stock of US Federal debt could easily increase by many more trillions of US dollars during the next couple of years.

Those familiar with the post World War I and post-World War II public debt levels will not be impressed with even a doubling of the public (Federal) debt held by the public as share of GDP, from its current level of around 40 percent of annual GDP (gross public debt, including debt held by other government agencies, like the Social Security Trust Fund, stands at around 70 percent of GDP). Chart 1 is taken from Wikepedia. Following World War II public debt stood at more than 100 percent of annual GDP.

Chart 1

usdebt.png

A simple (coarse?) indicator of ‘tax tolerance’ - willingness to pay taxes or to make others pay taxes( YES ) - is the highest marginal rate of personal income tax. For the US this is shown in Table 2 below. It is taken from the website of TruthAndPolitics.org.

Chart 2

That, however, was then. The debt was incurred to finance a temporary bulge in public spending motivated by a shared cause: defeating Japan and the Nazis. The current debt is the result of the irresponsibility, profligacy and incompetence of some( FRAUD, ETC. ). Achieving a political consensus to raise taxes or cut spending to restore US government solvency is going to test even the talents of that Great Communicator, Barack Obama.

If you add to the Keynesian fiscal stimulus package Obama’s ambitions for increasing infrastructure investment to stimulate growth, to fund (not quite) universal healthcare and to stimulate alternative energy production and use, the incompatibility of US public spending ambitions and the political capacity to raise the necessary revenues is glaring. So the government would borrow. From whom? Not from the domestic private sector. They are saving rather little and are being discourage from saving what little they are saving by the fiscal stimulus package. So the US government will borrow abroad to finance its infrastructure, health ambitions and green agenda? Some day perhaps. But not during Obama’s presidency.

So will the Keynesian demand stimulus work? For a while ( a couple of years, say) it may. When the consequences for the public debt of both the Keynesian stimulus and the realisation of the losses from the assets and commitments the Fed and the Treasury have taken onto their balance sheets become apparent, the demand stimulus will fade and may be reserved as precautionary( A PROACTIVITY RUN ) behaviour takes over in the private sector. My recommendation is to go easy on the fiscal stimulus( I AGREE ). The US government is ill-placed financially and fiscally, to engage in short-term fiscal heroics. All they can really do is pray for a stronger-than-expected revival of global demand, without any major stimulus from the US.

The need for a massive resource transfer towards the rest of the world

Beggars can’t be choosers. The US has been able to get away with decades of private sector improvidence because of two unique and time-limited factors. The first is a sequence of capital gains on household assets (stocks and real estate) that provided a lovely substitute( TRUE ) for saving to provide for retirement, old age and a rainy day. The second was the excess returns earned by the US on its net foreign investment (its ability to borrow at an unbelievably low rate of interest/rate of return, because of the unique position of the US as the ultimate source of liquidity and security( GUARANTEES ).

Both rational drivers of a low US saving rate are gone. The US housing market and global stock markets have imploded. It will take years, even decades, to restore household financial wealth-income ratios to levels that don’t guarantee retirement in poverty for much of the US population. The rest of the world will also no longer lend to the US at a negative nominal (and real) interest rate, as it has done for years.( AGAIN, I'M NOT SO SURE. )

So the US has to shift aggregate demand from domestic demand to external demand. And it has to shift production from non-tradables to tradables - exportable and import-competing goods and services. By how much? At full employment, probably at least six and more likely by around eight percent of GDP.

As regards shifting production towards tradables, this will not be easy( NO IT WON'T ). And policy is pushing in the wrong direction. The Bushbama administrations have decided to bail out the US car industry( FOR SOCIAL REASONS ). That industry does not produce cars the rest of the world wants. If and when the global economy recovers and oil prices rise to $150 per barrel again, US consumers also won’t want the cars produced by Detroit. Sure they can change. They could have changed in 1973, in 1980 and at any time since then. If they could change, they probably would have by now.

Other US industries are more competitive internationally. But shifting resources towards tradables and away from non-tradables will require re-training and re-education as well as a significant depreciation of the US dollar’s real exchange rate - which amounts to a significant cut in real wages( FOREIGN GOODS WILL BECOME MORE EXPENSIVE ). Chart 3, which shows the US broad real effective exchange rate index, provided by the Fed, shows the behaviour of one measure of the real exchange rate since 1973.

Chart 3

In the past year, the effective real exchange rate of the US dollar has in fact strengthened rather than weakened, thus impeding the necessary external adjustment. With the short risk-free nominal interest rate effectively at the zero floor, conventional expansionary monetary policy cannot be used any longer to weaken the exchange rate. The effect of quantitative easing and qualitative easing on the exchange rate are ambiguous. If they succeed in stimulating spending by credit-constrained businesses and households, it could well strengthen the currency and weaken the trade balance.

In the decades since I first lived in the US, the quality of secondary education and of vocational training appears to have worsened. Despite the excellence of some institutions, including the wide range and variety of community colleges that give a second chance to so many Americans, the educational system of the US increasingly resembles that of the UK: islands of excellence in a sea of mediocrity. This means that, to become competitive, if you cannot compete on quality and innovation, you will have to compete on price. A larger real exchange rate depreciation and cut in real consumer wages will be required to achieve a given shift of resources to the external sector.

With all the talk about investing in the future, improving infrastructure and creating a dynamic competitive economy, I don’t think the Obama administration will want to achieve the necessary shift of resources towards the rest of the world by reducing domestic investment. In fact, in the one area where domestic investment could and should be reduced (residential construction), there is bipartisan support for boosting investment in residential housing( REALLY ? ). That leaves an increase in national saving as the only way to achieve the required primary external surplus. The government is, however, planning to boost its spending and cut taxes. No increase in public saving therefore can be anticipated for many years( A FEW YEARS ) to come.

The private sector in the US is, at last, saving. We have gone from a declining growth rate of private consumption to a declining level of private consumption. But what do the policy authorities do? Rising household saving equals falling household consumption equals declining effective demand equals longer and deeper recession. Can’t have that. Here is a tax cut. If you can no longer borrow from your bank, we may guarantee your mortgage so you can borrow after all( NOT A GOOD IDEA ). Everything that is desirable from a short-run Keynesian aggregate demand perspective (assuming these measures are indeed effective) is a step in the wrong direction from the perspective of restoring external equilibrium and raising the US national saving rate. ( THAT'S TRUE )

One obvious response to this opposition between what is desirable now and what is necessary in the longer run is to say: let’s do now what is desirable now and let’s take care of what is necessary tomorrow. That might be viable if the US private sector and the US policy makers had the necessary credibility to head south when the destination is north, because they can commit themselves to a timely reversal. If the authorities go ahead with the short-run Keynesian stimulus without having convinced the global capital markets and domestic producers and consumers that there will be a timely reversal, the policies will not work. ( TRUE )

This failure of expansionary fiscal policy is not for Ricardian reasons (Mr. Jean-Claude Trichet gets this wrong all the time - the Ricardian model has as one of its key assumptions that the government always satisfies its intertemporal budget constraint, that is, the government when it cuts taxes or raises spending today, is believed to raise taxes or cut spending by the same amount, in present discounted value, in the future; the second key assumption is that postponing taxes, while keeping their present discounted value constant, does not stimulate consumer demand. There either is no redistribution (from the young to the old, from those currently alive to the unborn and from those who are constrained by permanent income to those constrained by current income) or this redistribution does not have aggregate spending effects. Instead the failure of expansionary fiscal policy is because of the fear, uncertainty and higher risk premia ( TRUE )caused by the higher risk of sovereign default caused by expansionary policy.

If the government is believed to be fiscally continent (future taxes will be raised and/or future public spending will be cut by enough to safeguard the solvency of the state) but turns out not be so after all, the Keynesian fiscal policy will be effective in the short run (as long as the public believes in the fiscal virtue of the government) but will become highly contractionary once the truth dawns. ( TRUE )

Conclusion

Given the bad fiscal position of the US Federal government and given the vulnerability of the external position of the US and its growing reliance on foreign funding, the scope for expansionary fiscal policy in the US is much more limited than president-elect Obama’s advisers appear to realise. Underneath the effective demand problem is a deep structural rot, especially in household sector and financial sector balance sheets. Keynesian cyclical policy options that would be open to more structurally sound economies should therefore not be tried on anything like the same scale by the US authorities. "

I believe that the stimulus should not be more than:

Infrastructure: $100 Billion

Social Safety Net: Whatever is needed

Tax cuts: Sales Tax Cut and Targeted Investment Cuts: $300 Billion

Hopefully: $750 Billion

However, under my definition of stimulus, the figure is $400 Billion.

We should also make sure to keep repeating that we will in the future:

1 ) Raise taxes

2) Cut spending

3) Encourage saving

Finally, about the Saver Countries, I simply believe that it is going to be very hard for them to change.