DeLong vs Boldrin on Fiscal Stimulus

The following links are from Greg Mankiw's blog. The first is a statement by Brad DeLong, explaining why the large fiscal stimulus package can be expected to work; see here.

Any good scientist will try to support his or her views by pointing to the evidence. What is the evidence that large fiscal stimulus packages have worked in the past? DeLong gives us three examples:

[1] The 2003-2005 housing boom, facilitated by loose monetary policy;
[2] The 1996-1998 internet boom;
[3] The post 1982 boom following the easing of monetary policy, the Reagan tax-cuts, and increase in military expenditure.

He goes on to write:

These are just three examples of a general principle: each major business-cycle expansion we have seen has been driven by a leading wave of spending—by some group that became enthusiastic about their prospects and decided to greatly increase its spending. And that pulled employment and production up.

I view this as evidence that DeLong should have his degree in economics revoked.

This is the best he can do? The first two examples have nothing to do with fiscal policy. The suggestion that the 1980s boom would not have occurred absent the Reagan tax cuts and increased military spending is dubious at best. Moreover, he neglects to point to the several cases we know of demonstrating the converse (with Japan being the most notable recent example).

His thesis appears to be that a significant increase in "confidence" is followed by an increase in spending and an increase in production. This much is no doubt true. Whether this "starry eyed" optimism begins in the private sector or the public sector is, in his view, irrelevant. This is almost surely not true. Confidence in the private sector is ultimately based on information that signals the expected productivity of capital investment (these expectations can turn out to be wrong ex post, of course). In short, private sector confidence is a by-product of changing fundamentals; that is, confidence is symptomatic and not causal. Confidence cannot be manufactured out of wishful thinking; which is the approach that fiscal policy appears to based on.

For more sober appraisal, I refer you to Michele Boldrin's take on this; see here.

Our "Deregulated" Financial System?

I used to love watching "60 Minutes" as a kid. Unlike "60 Minutes," however, I eventually grew up (although, not everyone around me agrees). Perhaps you have seen their recent report that places the blame for the current financial market turmoil squarely on those that "deregulated" the U.S. financial market; see here.

Is the U.S. financial system really an example of laissez-faire capitalism run amok? This certainly appears to be the bill of goods being marketed by the religious left and other clear-thinking people. It is unfortunate, as far as this view is concerned, that it contradicts reality so violently. The truth of the matter is that the financial market is by far the most heavily regulated sector in any “well-developed” economy.

If you already knew this, there is no need to read further. But for those of you who may be surprised by this, let me document just some of the federal agencies that play a major role in the U.S. financial market. Of course, I don't expect anyone to read what follows carefully: it is far too long to keep anyone's attention for any length of time. But I suppose that this is precisely the point that I am trying to make. Take a deep breath now...

The U.S. Department of the Treasury

Naturally, I begin with the U.S. Treasury. Here is their mission statement:

Serve the American people and strengthen national security by managing the U.S. Government’s finances effectively, promoting economic growth and stability, and ensuring safety, soundness, and security of the U.S. and international financial systems.

Again, in their own words,

The Department of the Treasury's mission highlights its role as the steward of U.S. economic and financial systems, and as an influential participant in the global economy.

If we are to take this seriously, I suppose it implies that the U.S. Treasury takes responsibility for the current global financial crisis.

The Treasury currently consists of 12 bureaus. I highlight the 5 here that have a direct bearing on the financial system. See: http://www.treas.gov/bureaus/

[1] Bureau of the Public Debt

These are the guys responsible for selling and redeeming U.S. government bonds. They are also useful bean counters. If you visit their website, you’ll see that they keep a precise measure of the outstanding dollar value of the U.S. federal debt (to the penny). As of this writing, this debt amounts to $10,877,144,501,237.52. This is almost 11 trillion dollars; or roughly $36,000 per American.

Who is backing this debt? The American taxpayer of course. And of course, not all Americans pay taxes. Children do not pay taxes. Drug dealers and the unemployed do not pay taxes. According to the IRS, almost 33% of tax filers in 2004 did not pay taxes. You get the picture. It is probably not unreasonable to guess that each American taxpayer is on the hook for $100,000. And this does not include “off balance sheet” items, like social security.
Fortunately, the Bureau of Public Debt has a mechanism in place to help deal with this burden. On one of their webpages, they answer the question: “How do you make a contribution to reduce the debt?” Here is the answer:

Make your check payable to the Bureau of the Public Debt, and in the memo section, notate that it is a Gift to reduce the Debt Held by the Public. Mail your check to: Attn Dept GBureau of the Public DebtP. O. Box 2188Parkersburg, WV 26106-2188

[2] Community Development Financial Institutions Fund

Here is their mission statement:

Through monetary awards and the allocation of tax credits, the CDFI Fund helps promote access to capital and local economic growth in urban and rural low-income communities across the nation.

Through its various programs, the CDFI Fund enables locally based organizations to further goals such as: economic development (job creation, business development, and commercial real estate development); affordable housing (housing development and homeownership); and community development financial services (provision of basic banking services to underserved communities and financial literacy training).

In short, this federal department extends credit to low-income high-risk individuals. Where have we heard this before? This department is also responsible for implementing President Obama’s American Recovery and Reinvestment Act of 2009 (Recovery Act). According to their website:

It is an unprecedented effort to jumpstart our economy, create or save millions of jobs, and put a down payment on addressing long-neglected challenges so our country can thrive in the 21st century. The Act is an extraordinary response to a crisis unlike any since the Great Depression, and includes measures to modernize our nation’s infrastructure, enhance energy independence, expand educational opportunities, preserve and improve affordable health care, provide tax relief, and protect those in greatest need.

[3] The Inspector General

Conducts independent audits, investigations and reviews to help the Treasury Department accomplish its mission; improve its programs and operations; promote economy, efficiency and effectiveness; and prevent and detect fraud and abuse.

In short, this department does nothing.

[4] Office of the Comptroller of the Currency (OCC)

The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises all national banks. It also supervises the federal branches and agencies of foreign banks. Headquartered in Washington, D.C., the OCC has four district offices plus an office in London to supervise the international activities of national banks.

The OCC was established in 1863 as a bureau of the U.S. Department of the Treasury. The OCC is headed by the Comptroller , who is appointed by the President, with the advice and consent of the Senate, for a five-year term. The Comptroller also serves as a director of the Federal Deposit Insurance Corporation (FDIC) and a director of the Neighborhood Reinvestment Corporation.

The OCC's nationwide staff of examiners conducts on-site reviews of national banks and provides sustained supervision of bank operations. The agency issues rules, legal interpretations, and corporate decisions concerning banking, bank investments, bank community development activities, and other aspects of bank operations.

National bank examiners supervise domestic and international activities of national banks and perform corporate analyses. Examiners analyze a bank's loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk, and compliance with consumer banking laws, including the Community Reinvestment Act. They review the bank's internal controls, internal and external audit, and compliance with law. They also evaluate bank management's ability to identify and control risk.

In regulating national banks, the OCC has the power to:

Examine the banks.
Approve or deny applications for new charters, branches, capital, or other changes in corporate or banking structure.
Take supervisory actions against banks that do not comply with laws and regulations or that otherwise engage in unsound banking practices. The agency can remove officers and directors, negotiate agreements to change banking practices, and issue cease and desist orders as well as civil money penalties.
Issue rules and regulations governing bank investments, lending, and other practices.

The OCC's Objectives

The OCC's activities are predicated on four objectives that support the OCC's mission to ensure a stable and competitive national banking system. The four objectives are:

To ensure the safety and soundness of the national banking system.
To foster competition by allowing banks to offer new products and services.
To improve the efficiency and effectiveness of OCC supervision, including reducing regulatory burden.
To ensure fair and equal access to financial services for all Americans.

So you see, how could we expect to see anything to wrong with such extensive government oversight?

[5] Office of Thrift Administration (OTS)

The OTS supervises a national thrift industry that is built on the bedrock of the American dream of homeownership—supplying affordable home financing for Americans from all walks of life.

The industry has a long history dating back to 1831 with the establishment of the first savings association, the Oxford Provident Building Association, which made home loans and offered savings accounts. Today, the charter is a vibrant, sophisticated model for running a retail financial services business.

Home mortgages remain a staple of the thrift industry. However, the array of financial products and services offered by many institutions and their holding companies paint a modern-day portrait of great diversification within the industry based on size, complexity, and business strategy.

Three unique advantages of the federal thrift charter foster this diversification:

Preemption – The federal thrift charter operates under a comprehensive framework of federal regulations that supersede state and local laws on lending and deposit taking activities. This provides a uniform national standard for lending and deposit taking, thereby reducing regulatory burden and increasing the efficiency of operations at thrift institution. This authority supports the delivery of low-cost credit and other services to the public, while maintaining consumer protections and promoting the safety and soundness of federal thrifts and the nation’s financial industry.

Branching – Federal thrifts enjoy the distinctive ability to establish branches nationwide, seamlessly and without restriction, under a single charter and a single regulator.

Single Supervisor – Savings and loan holding companies, and their thrift subsidiaries and affiliates, operate under the consolidated supervision of a single federal regulator, the OTS.
The thrift charter is employed by some of the largest financial enterprises in the world, as well as small, one-office savings associations. Financial institutions from across the nation and a number of international financial firms have found that the thrift charter and the experienced, responsive workforce of the OTS provide an ideal framework for conducting retail banking operations and related financial services activities. The charter enables these institutions to meet the needs of their customers and to innovate effectively, compete, and prosper in today’s fast-paced financial marketplace.

Today’s “fast-paced” financial marketplace indeed!

Other Government Regulatory Agencies

http://www.treasurydirect.gov/instit/statreg/statreg_links.htm

[1] U.S. Commodity Futures Trading Commission (CFTC)

Congress created the Commodity Futures Trading Commission (CFTC) in 1974 as an independent agency with the mandate to regulate commodity futures and option markets in the United States. The agency's mandate has been renewed and expanded several times since then, most recently by the Commodity Futures Modernization Act of 2000.

[2] Federal Deposit Insurance Corporation (FDIC)

The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.

[3] National Credit Union Association

The National Credit Union Administration (NCUA) is the independent federal agency that charters and supervises federal credit unions. NCUA, backed of the full faith and credit of the U.S. government, operates the NCUSIF insuring the savings of 80 million account holders in all federal credit unions and many state-chartered credit unions.

[4] Federal Reserve Board

Here you go: another fine example of laissez-faire capitalism (a government legislated monopoly on the paper money supply and sweeping regulatory powers). For details, see: http://www.federalreserve.gov/pf/pf.htm

"Shock and Awe" Needed to Combat Recession

See the full article here.

A selected excerpt:

Government leaders will need to take a "shock-and-awe" approach towards the economy as indicators show a worsening recession, Mohamed El-Erian, co-CEO of the Pimco bond fund, said Friday. Asked what he would do if he stood in Treasury Secretary Timothy Geithner's shoes, El-Erian said the government needs to take drastic, immediate and comprehensive action to combat the threats posed by the crumbling economy.

Do people like El-Erian actually think before speaking? Do they think at all? Perhaps not thinking is a luxury that only the very rich can afford?

A leading bond fund manager is asked for his views on how U.S. government policy might be designed to combat what appears to be a worsening recession. How will he answer? One might hope that the experienced sage will draw on the lessons learned from past interventions in the U.S. and elsewhere. Nope. Perhaps he will draw on a few philosophical principles concerning the role of government in the economy. Nope. Perhaps he will frame his views in the context of a coherent economic theory. Yeah, right.

Nosiree...forget all that BS. Instead, for inspiration and as a model of successful intervention, our high-paid fund manager draws on one of the greatest U.S. policy failures of all time -- the "shock and awe" bombing campaign that preceeded the U.S. invasion of Iraq. How's that as an example of "drastic, immediate, and comprehensive" action? And oh boy, that sure turned out well, didn't it?

Gosh Darnit, Mr. Immelt

Another slow day. But trust General Electric's Chief Executive, Jeff Immelt, to provide us with some entertainment value (as opposed his real job of generating shareholder value). Check out the story here. Here is a quote:

The U.S. economy is in its worst shape since the deep recession of 1974 and 1975, and if it deteriorates further the most meaningful comparisons will be to the Great Depression. We're at least to 1974-75. Once you break through '74-'75, you don't stop 'til you get to 1929. Unlike the other downturns that I've been a part of, this one is faced with limited liquidity. If liquidity exists, it's not coming back readily. That's why the government's role in this cycle is so gosh-darned important.

Jeepers...I had no idea. But gosh-doodly, I suppose this is why he is paid the big bucks.

We're at least to 1974-75? What is he talking about? U.S. real per capita GDP 35 years ago was approximately 50% lower than it is today; see first figure here.

Oh, wait a second...I think he was referring to GE's stock price.

But you see, this is not Immelt's fault. Nosiree. Jack Welch (legendary former CEO of GE 1981-2001) never experienced anything like this. Things are "different" this time around. In particular, there appears to be a shortage of "liquidity;" or a "credit crunch." Nope...I can't recall people ever talking about a phenomenon like this before during an economic downturn. This is why the government's role in this cycle is so gosh-darned important.

And just what, pray tell, might that role be? Well...you know...the government should do something...and it should do it right away...anything really big...anything, I presume, to legitimize the view that things are really different this time around; and that poor share price performance really has nothing to do with poor executive decisions.

On Krugman, Barro, Boneheads, and Keynes

How can one not love or hate Paul Krugman? (There appears to be no middle ground with this guy). He must have been an imp as a child; no doubt a terror to his parents and his petrified teachers. One cannot help but admire his academic contributions (primarily in international trade, for which he recently won a Nobel prize). He is courageous and opinionated; he is fun to read.

His impishness appears to have persisted well beyond middle age. On his personal webpage, he writes "With any luck, you will find many of these pieces extremely annoying." I think that he underestimates his own abilities in this regard; I am sure that luck has nothing to do with it at all.

Speaking of imps, I found it amusing to see that Robert Barro is a recent addition Krugman's Bonehead List. I am not in a position to evaluate Barro's government multiplier analysis or Krugman's critique of it. But I would like to comment on Krugman's update concerning Barro's interpretation of Keynes' economics. The quote from Barro is this:

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.

In reply to this, Krugman writes:

Is it too much to ask that someone criticizing Keynes actually, you know, read Keynes—at least enough to know that he devoted a whole chapter to explaining why a fall in wages would not expand employment?

I can hardly believe what I am about to say here, but...Krugman is absolutely correct; and Barro is being a bonehead on this matter. In support of Krugman, let me cite a relevant passage from Keynes' General Theory.

In this summary, we shall assume that the money-wage and other factor costs are constant per unit of labour employed. But this simplification, which we shall dispense later, is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money wages are liable to change. (Chapter 3, Part II)

Indeed, Keynes goes on to suggest in a later chapter that sticky wages were likely a good thing; and that flexible wages would serve to reinforce his general theory. The basic idea (as far as I understand it) is that falling wages would serve primarily to lower "effective demand;" leading to a further contraction in output and employment. It seems clear enough that Keynes had in mind some notion of "coordination failure;" i.e.,

Indeed it (the economy) seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. (Chapter 8, Part III).

Contrary to what some may believe, this type of outcome can be shown to be a theoretical possibility in suitably modified (and non-crazy) versions of otherwise standard neoclassical macro models (with fully flexible wages).

And so, Barro did indeed make a boneheaded remark. But to what might we attribute his error to? There is little doubt that this common boo-boo is the product of Hicks' interpretation of Keynes' theory; which relied heavily on the simplification of sticky wages alluded to above. Generations of economists were subsequently trained to believe that sticky wages were essential to Keynes' theory. The legacy of this "bastard Keynesianism" (Joan Robinson's colorful adjective) lives on today in the form of "New Keynesian" economics.

To see how this misperception lives on today, consider the following quotes from a graduate level macro course taught not too long ago at one of the world's best economics departments.

To make the transition (from neoclassical to Keynesian theory) we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline...

Finally, sticky prices play a crucial role in converting this into a theory of real economic fluctuations; while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory.

The lecture notes in question are available here. Who was the bonehead who made these remarks? Hint: His initials are not RB.

A New Look at the New Deal

In my previous post, I made note of Paul Krugman's statement that "Everyone's looking back to the 1930s for policy guidance-and that's a good thing."

I think what he likely meant by this is that it is a good thing that everyone appears to acknowledge the self-evident fact of how FDR's New Deal policies lifted an unwilling American private sector out of what would otherwise have been a state of permanent stagnation; and how current policy should be designed with the knowledge of this experience firmly engrained in our minds.

It is certainly true that many people are looking back to the 1930s for current-day parallels. But obviously, not everyone shares Krugman's religion on this matter. Consider, for example, this recent piece by Professor Hal Cole (University of Pennsylvania) and Lee Ohanian (UCLA) in the Wall Street Journal:

How Government Prolonged the Depression

Pop quiz: Which U.S. president made a speech in which he acknowledged that the American economy had become a "concealed cartel system like Europe"? Hint: the speech was made in 1938.

A Stimulating Lesson from Japan?

Here we go again. Economic growth is slowing. Stock markets have plunged. Banks are failing. Perennial doomsayers are basking in a glow of perverted pleasure. A plethora of pundits are earnestly explaining the dire need for "stimulative" government spending measures to reverse the course of what will otherwise be a prolonged depression. In short, par for the course.

Well, perhaps not quite par. This time around, many governments appear to be taking seriously the notion that a massive government "electric shock therapy" is needed. Things certainly do seem gloomy out there. Is there any merit in the view that a massive government fiscal action can rescue the day? Apparently, there must be. Why would all these learned people be advocating a policy prescription that is not solidly backed by economic theory and the historical evidence?

To learn more about this view and what underlies it, I decided to visit the arch-liberal Professor Krugman. He begins a recent article by stating that

Everyone’s looking back to the 1930s for policy guidance—and that’s a good thing. But we don’t have to go back that far to see how fiscal policy works in a liquidity trap; Japan was there only a little while ago.

Japan? Well, this sounds promising. What does he have in mind exactly? Evidently, it is the evidence provided in Adam Posen's new book, Chapter 2, entitled Fiscal Policy Works When it is Tried.

Posen argues that, contrary to common perception, Japanese fiscal policy during the 1990s was not really expansionary. On pg. 49 he highlights an exception to this case; a brief period in September 1995. He interprets the corresponding increase in GDP in late 1995 and early 1996 as being attributable to the September stimulus package. This is his evidence that fiscal policy works when it is tried.

Well, maybe he's right. Or maybe not. Quite frankly, I doubt that anyone really knows. In any case, I thought it would be interesting to see how this hypothesis might square up with another look at the data. For this purpose, I chose to consult the Penn World Tables; an international data set frequently used to make international comparisons.

In what follows, I compare Japan to the US. Annual data is available for the time period 1950-2004. I take a look first at levels of real per capita income (GDP) across these two countries. The data look a lot like what one would expect. Relatively stable growth in the U.S., interrupted by the occasional recession. The post-war Japanese growth "miracle," interupted briefly in the 1970s, the late 1980s boom followed by the "lost decade" of economic stagnation.

Next, let's take a look at the available measure of government spending (government purchases; which excludes that sizable chunk of government spending in the form of entitlements). The data reveal a general upward trend, as one would expect in growing economies. Significant bumps in US government spending occur during the Korean war, the peak of the Vietnam war, and in the late 1980s. The growth in government spending in Japan appears more stable and rapid. Note that the 1995 stimulus bill (and subsequent contraction) highlighted by Posen shows up as a relatively minor blip on this chart. Moreover, the pattern appears to have been sharply reversed in the late 1990s and into the 2000s.

A better measure of the "size" of government is to compare it to the "size" of an economy; say, as measured by its GDP. The next figure plots the ratio of government purchases to GDP. By this measure, the relative size of the U.S. government has been in secular decline since the Korean war. There is an even sharper secular decline in the relative size of the Japanese government in the early part of the sample. This latter trend appears to have ended by 1970; and has shown signs of accelerating upward since 1990. On the basis of this data, I think that one might be forgiven for adopting the "mistaken" impression that Japanese fiscal policy has been largely expansionary since 1990.

The last figure I present considers the relative magnitudes of GDP across Japan and the U.S.; as well as the relative magnitudes of the government spending (purchases) share (GPS) across these two economies.

The blue line plots relative income (real per capita GDP). That is, in 1950, real per capita income in Japan was roughly 20% of that of the U.S. By 1970, it was roughly 70%; and by 1991, it was roughly 85%. By any measure, this constitutes a remarkable economic achievement. And this must especially be the case when one considers the devastated state of the Japanese economy at the end of WW2.

The question I want to ask here relates to the behavior of the relative size of government spending over this episode; this is plotted by the red line in the figure. The downward plunge in the early part of the sample reveals that Japanese government spending (as a fraction of GDP) declined rapidly relative to its U.S. counterpart. The upward rise during the latter part of the sample reveals that Japanese government spending (as a fraction of GDP) increased rapidly relative to its U.S. counterpart. The most interesting thing to note is that the blue and red lines are virtual mirror images of each other.

Of course, there are several ways in which the patterns displayed in this data might be explained or interpreted. I am especially eager to learn how this evidence might be construed as supporting the notion that fiscal policy "works" and how this lesson from Japan might be fruitfully employed to cure the current economic crisis.