Stimulus debate mired in fuzzy thinking
Posted in Uncategorized by demandside on December 11th, 2008 Susan Woodward and Robert Hall have produced a piece “Options for Stimulating the Economy,” which has some interesting elements, but which reproduces many of the old errors. Barack Obama’s current plan is on a trajectory far superior to this.
In times of great uncertainty, however, everybody will want to save, and tax cuts will tend to be saved by all as much as possible. The consumption function is lower. The consumption function being the proportion of new income that is consumed.
Woodward and Hall begin
In 2009, GDP in the U.S. is expected to be about $900 billion below its normal growth path. The ideal stimulus would have most of its effect in 2009 and would close a reasonable fraction of that gap. We see five general strategies for stimulus:
- Further expansion by the Fed
- Income tax cuts with rebates, as earlier this year
- Tax cuts that reduce the prices of consumer goods temporarily
- Tax cuts that reduce the cost of labor to businesses
- Increase in purchases of goods and services by state and local governments
Further expansion by the Fed is — here it comes — like buying a larger belt in hopes of getting fat. The authors agree in a more elaborate way, but conclude: “there is no scope for further expansion in this way.”
Income tax cuts with rebates, as earlier this year, did not work, as we’ve pointed out here.
Woodward and Hall suggest:
Which means the money gets out there quickly, but it is the consumer who delays its effect.
The piece reproduces a chart from John B. Taylor.
http://s.wsj.net/public/resources/images/ED-AI600B_taylo_NS_20081124210819.gif
Taylor uses the information to promote the absurd notion of permanent tax cuts as temporary stimulus, but his chart demonstrates that just as we at Demand Side predicted at the time, the stimulus in the fall had its influence from the moment it was announced, as consumers accessed the stimulus by credit card. The chart does suggest that a flattening of personal income expenditures that began in 4th quarter of 2007 was temporarily reversed through July. One can speculate that this was due to the stimulus, but it equally likely that the exploding energy prices extracted unwilling spending through the peak of the oil bubble. Tax Cuts that reduce the cost of consumer goods may be useful to ameliorate the pain of the recession, but are not good stimulus.
Woodward and Hall disagree, saying:
But they also identify the fatal flaws, the mechanism would be through reductions of sales taxes, which are in the United States, state taxes, and would involve a complicated interconnection and variable impact depending on the state, while at the same time, as the authors point out:
The plan needs to take effect soon after it is announced. The announcement will cause consumers to defer purchases until the tax cut takes effect. Similarly, toward the end, they will accelerate purchases and then buy less after the sales tax resumes. Phasing in the resumption might be a good idea.
The consumer will not be the engine of this recovery, however, for reasons we have identified before, including losses in housing and investment wealth, lost jobs and incomes, uncertainty or fear about the future generating more savings, and the financial markets freezing availability of credit. And the production of jobs will not occur through a reeling retail sector.
Tax cuts to reduce the price of labor, identified here as through the payroll tax, suffer from similar criticisms. Direct production of jobs is preferable to indirect and uncertain inducement, particularly diluted through the subsidy to business, of payroll tax cuts.
Increase in construction spending by state and local governments
Woodward and Hall have a dim view of infrastructure spending, such as proposed by Obama, citing the old critiques of time lags, but another, equally spurious idea that
they will end up generating employment for highly specialized businesses and workers, rather than stimulating economic activity more broadly.” They add that “The consensus of macroeconomists across the spectrum is that a spending stimulus raises total spending by between 1.0 and 1.5 times the amount of the direct increase in spending. The follow-on or multiplier effects are between zero and half the direct increase in spending. Thus a program that funnels money to construction firms and their workers mainly raises their incomes and employment levels and has relatively little effect elsewhere.”
I have not heard the problem of highly specialized business and workers before. We would suggest that the construction industry is not so highly specialized in its labor function, and that engineers and workers might move from commercial and residential construction to roads, bridges, HVDC transmission lines, building retrofitting without so much difficulty. But more than this, there is arguably a need for these specialized workers now and into the future. Why not develop them.
But more to the point, the demand profile of a job is much deeper and broader than one for tax cuts to promote consumer spending. Housing, the range of services, everything that goes with an independent life is stimulated with a job. Spending on consumer discretionaries is much less broad and much less effective as measured by a multiplier. We disagree with the suggestion that everything in the Obama plan will be construction firms and their workers, but we also disagree that these actors are concentrated in any meaningful way. They are geographically and demographically quite broad.
Our is a view not shared by Woodward and Hall:
It’s hard to imagine that a significant fraction of the large stimulus under consideration for 2009 will take the form of state and local construction and other infrastructure spending. We are hoping that discussion of stimulus will not become sidetracked over this part of the program and neglect the opportunities to stimulate consumer spending broadly without complicated, detailed, and time-consuming decisions.
Again, the consumer was 70 percent of the economy, but trying to reproduce that proportion in current times is a fool’s errand. Across the world, the consumer is often far less, fifty or fifty-five percent in some places, prosperous places, where health care, transportation and public goods are more prominently a part of the society.
The consumer is not going to lead us out of this economic situation, it will have to be the public sector.
Japan is often mentioned as a cautionary tale, where public spending did not produce the hoped-for rebound in economic fortunes and instead was simply another chapter in the decade of economic stagnation. This is a red herring. First, it should be noted, Japan is the only other industrial power where taxes are a smaller percentage of income than in the U.S. So the first lesson from Japan should be that low taxes is not driving any kind of recovery. Second, the absence of a strong social safety net in Japan produces high savings rates from the motive of hoarding against old age and want.
Producing confidence and security in the American consumer is absolutely essential. The free market promises have now been exposed, the personal wealth in housing and stocks has disappeared, and now jobs are being lost. National health care, social security, an engaged government, all are necessary to rebuild that confidence.
Which brings us to our conclusion. Obama has a program that will work in place. He should carry through on it, with the tax cuts, the infrastructure spending, the health care push, the green jobs, help to states and localities, and yes, even the national service corps. These are not only very effective recovery program, but it restates and emphasizes the vision of the man who is now the leader. Very good for confidence.
The clincher, however, is that we need this infrastructure to survive. We need energy-smart, environmentally correct ways of doing things or we are going to cook the planet. It is foolish to follow a weak and disproven policy of tax cuts and money expansion to recreate a consumer who will, if allowed to continue on her previous path, create a huge new problem that will need massive government mitigation anyway.
And we are happy to report that all indications from the Obama camp are that this confluence of economic sobriety, political reality, social concern and environmental necessity will be followed.
We also notice other economists have qualms about Woodward and Hall’s analysis. Paul Krugman ended a recent blog post referencing Woodward and Hall audibly banging his head on the table.
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