It’s the season for debating the effects of a historic increase in government spending on the economy.
The proposal on the table from Obama, is to increase government spending by about $775 billion over the next two years. About $300 billion of this would come as tax cuts of various kinds, and the rest as handouts to state and local governments and pork-barrel spending.
Why are we doing all this? Well, to make the economy better, of course. But precisely what does it mean to “make the economy better”?
I told you yesterday that, although the global economy and the global financial system face deep, systemic imbalances that have nothing whatsoever to do with the business cycle, the perception by policymakers and ordinary people is very different. The common view is that our biggest problem is an economic recession. And even more specifically, an increase in unemployment that results from reductions in industrial output, or GDP.
As I said, the whole situation is being oversimplified as a need to change two widely-reported statistics. The objective of the largest proposed increase in government spending for decades is not to do anything long-term positive for the the economy. Rather, it’s to increase reported GDP and to reduce reported unemployment.
So in this context, let’s try to understand the claims that are being made by advocates of increased spending. (I’ll leave for another time the issues of increased national indebtedness, misallocated resources, and increased government control over the economy, since the neo-Keynesians have already told us that we should sweep those effects under the carpet for now.)
The basic theory is contained in something called Okun’s Law. This is the empirical relationship between real GDP and the unemployment rate. In plain language, Okun posits that a 1% change in the unemployment rate is correlated with an inverse change of between 2% and 3% in real GDP.
Note that there’s nothing causal or even rigorously theoretical about this relationship. It’s just an observation obtained by regressing historical US data over the last fifty years or so. This hasn’t stopped even Nobel-Prize winning economists from invoking it to justify a massive increase in government spending.
Here are two ways this might work.
First, look at the current rate of economic contraction. We have yet to see any statistics for the fourth quarter of 2008, but it’s plausible that US GDP contracted at an annual rate of anywhere from 3 to 6 percent in Q4. Let’s suppose this rate will continue through 2009. Starting from today’s already-high unemployment rate near 7%, you could use Okun’s Law to project a future unemployment rate of anywhere from 8% to 10%.
The other view is to add fiscal stimulus to the mix. Let’s say the government borrows and spends an additional $400 billion in each of the next two years. There’s a lot of controversy and a lot of fudging over the exact multiplier that should be used to project the effect of this spending on GDP. That matters a lot, so I’ll come back to it in a moment.
Let’s say the multiple is something like 1.25, a number which is as arguably plausible as a range of others. That turns $400 billion in fiscal spending into $500 billion of GDP, an increase of about 3.5%. By Okun’s Law, you’ve automatically reduced unemployment by an amount that could be near to 1.5%.
And then a year from now, you (meaning Obama, Congressional Democrats, and the Keynesian pundits) declare victory over unemployment. If the actual rate turns out to be a number like 9%, you say that it would have been 10.5% without the stimulus, and that you “saved or created” about 2 million jobs.
Keep in mind how this is all working: we’re using the unemployment rate as a fully-regressed proxy for all that is good and well in the body-politic of the United States. If you can say that you kept unemployment lower than it would have been this year, then you’ve done what you had to do. And if you can plausibly say that someone evil (for example, Senate Republican leader Mitch McConnell) prevented you from decreasing the unemployment rate further, that’s a political bonus.
That’s why the advocates of higher government spending are already starting to lower expectations. They’re already saying that the stimulus must be reduced in size, or it won’t be approved by Senate Republicans. But of course, they’ll say that any reduction in the size of the stimulus (or any deviation from the desired mix of spending and tax cuts), will automatically reduce the expected gains in employment.
You’ll be told a year from now, by people who fully expect that they can snow you with economic jargon, that Republicans are to blame for high unemployment.
But there’s a lot wrong with the analysis, besides the inappropriate use of empirical rules-of-thumb by highly-credentialled professional economists who should know better.
We’ve been told by Obama that nearly half of his proposed stimulus will take the form of tax cuts. This gets us back to the multiplier effect of government spending on GDP.
Straight government spending on pork-barrel projects (also known as “critical infrastructure to make America competitive in the 21st Century”) is often assumed to multiply by about 1.5. You get half again as much GDP growth from a given amount of spending. Tax cuts are said to be considerably less efficient at goosing GDP.
This is fine as far as it goes. But I think that the multipliers of either spending (which ultimately functions as a money gift to unionized labor) or tax-cutting are greatly overstated in the current economic environment.
Why? Simply because there has been a sea-change in America’s consumption habits. For at least the foreseeable future, Americans will be much more interested in saving up their money than in consuming it. If you contrive to put money in their pockets, they’ll save more of it in the bank than you probably expect. And those savings will disappear inside the liquidity trap that’s keeping private credit from being formed in the US today.
That means the effect of government stimulus on GDP growth will be muted. And because the stimulus will do far less than expected to increase actual consumer demand, it means the Okun’s Law effect on unemployment will be muted as well.
But none of this will be evident from the reporting that you’ll hear over the next two years. We’ll be told that the stimulus worked, but should have been far bigger than it was. You’ll hear not that the stimulus didn’t actually do what it was supposed to do, but rather that the problem turned out to be far bigger than even our worst-case scenarios anticipated.
And next year, they’ll be back for a whole lot more stimulus.
This isn’t good, people.
As always, thanks
Jack_Savage Wednesday, January 7th at 6:50AM EST (link)I once posited “The Divider Effect” in a grad school econ class when the instructor was being poetic about the wonderful effects of government spending on the economy. My position (which I didn’t think original or brilliant) was that any money spent by government is greatly reduced by administrative costs (by the government as well as the firms who win the contracts) and misallocation, making the actual net amount injected far lower than the accounting would lead us to believe. For example, if
government spending = 500 billion
divider effect is .5
effective net spending = 250 billion x Okun’s Law multiplier of 1.25
= real effect on GDP and unemployment.
The net effect on the economy is far less than if the same amount of money were invested by private actors. This is the flaw in Okun’s Law - because it is simple statistical analysis, it does not discriminate between public and private spending in terms of their net effect on GDP and unemployment. It overemphasizes government spending and underemphasize tax cuts on investment.
The simple fact of the matter is whenever government funds are used to solve a problem - any problem - and the problem is not solved, the answer always seems to be “It’s not the policy that is flawed, we simply didn’t spend as much as we needed to.” You are exactly correct, especially in the last full paragraph of the diary.
“The ultimate result of shielding man from the effects of his folly is to fill the world with fools.”
Herbert Spencer
Government spending directly raises GDP
Francis Cianfrocca Wednesday, January 7th at 8:09AM EST (link)That’s why everyone is so enamored of it in times when GDP growth is below capacity. Everyone wants to manage to a single number.
What the simple GDP number doesn’t capture, and what I think you’re talking about, is that there are qualitative differences between private investment and government spending. Both increase current-period GDP, but there’s a case to be made that private investment can be far more valuable because it creates a better class of capital stock.
Well, sort of
Jack_Savage Wednesday, January 7th at 9:30PM EST (link)“There’s a lot of controversy and a lot of fudging over the exact multiplier that should be used to project the effect of this spending on GDP.”
I argue that government spending has little or no multiplier effect, and may have an effect on GDP which is less than the actual amount spent by the government. Maybe I am off track, but let me give an example:
I give two nephews $100 and tell them to increase GDP by purchasing gumballs. Nephew 1 goes to the store and purchases $100 worth of gumballs at $1.00 each (big gumballs). Nephew 2 lives in New Jersey, and has to pay a toll to get to the store, pay the guy at the door of the store, puts out bids on the gumballs and because he is such a pain in the butt to deal with, his gumballs cost $2.00 each. After all his admin costs he has only has $52 left anyway, so he purchases 26 gumballs.
Nephew 1 (private and unfettered) purchased more of what I wanted than Nephew 2 (government process). I am mad at Nephew 2, because not only did I want to help GDP, I wanted as many gumballs as I could get.
One could argue that the entire $100 of nephew 2 is floating around in the economy, so even thought the capital stock purchased by Nephew 1 is more valuable the overall effect on the economy is the same.
I believe that private investment is allocated and reallocated more and more productively, while most government spending goes dow the rat hole of fees and administrative expense. The Multiplier Effect of one is far more than the other.
Of course, I am no economist and may be confused and silly. However, I was in cash when the storm hit and I did stay at a Holiday Inn Express last night.
“The ultimate result of shielding man from the effects of his folly is to fill the world with fools.”
Herbert Spencer
Can you Address Schiff/other doom mongers?
wennejunk Wednesday, January 7th at 7:13AM EST (link)Perhaps not in this thread, but at some point in the future?
There’s a book by investor/Broker Peter Schiff called ‘Crash Proof - How to Profit from the Coming Economic Collapse’. It was written/published in late ‘06-early ‘07.
This is an article of severe contention (near divorce level) in our household; with the wife (after reading the book) back in early 2007 urging, pleading for me to get out of stocks and into gold and so on. I read the book twice to get an idea of what he predicted, how accurate he was and what he’s advising.
For the most part, it accurately described the collapse of the housing market and sub-prime crises, the substantial devaluation of the dollar, the collapse of the stock market and current recession. He didn’t hang a date on these events, just that they were unavoidable and would likely happen ’soon’.
He went on to predict continued massive devaluation of the dollar due to massive housing re-flation efforts by the Fed and then a refusal by foreign governments to continue to purchase our debt; with these two factors leading to probable hyper-inflation (100%+) combined with an ongoing severe recession lasting years, leading the US to third world status.
His Rx for the reader is to divest of any assets denominated in Dollars and to invest in gold/silver and directly in solid foreign companies of countries who have been buying our debt (China, Japan, etc) and the currencies of those with solid balance sheets.
I’ve noticed many things I disagree with and many things he was not accurate about, but for the most part they are quibbles and he pretty much nailed where we are today.
However, I have a disagreement with his prediction going forward (hyperinflation and continued collapse/depression) and quite frankly, this is tearing my house apart as the significant other feels 100% the other way - that we are headed for root-grubbing in the forest to survive, riots, etc. Not that she would respond to anything written here, but it will help me get a better feel on actions I need to take.
Any input would be appreciated.
There are only two kinds of people in the end: those who say to God, ‘Thy will be done,’ and those to whom God says, in the end, ‘Thy will be done.’ -C. S. Lewis
I'm really not going to get into a domestic debate
Francis Cianfrocca Wednesday, January 7th at 8:18AM EST (link)Nor have I read Peter Schiff, although the general thrust of what you’ve described as his argument has been often-encountered for quite a few years.
What I will say is that if anyone fears a total collapse of the US (and therefore the global) economy and financial system, to the point that we all have to grow our own vegetables, then I’d suggest that holding gold won’t do you any good.
That’s for the simple reason that you can’t eat gold. And if there’s a total economic collapse, there won’t be much that you can buy with it, either.
I don’t accept the case for total systemic collapse. The case for “Great Depression II,” on the other hand, holds that deflation, continued credit crisis, continued housing overvaluation, and financial deleveraging will hold growth well below capacity for several years to come. I find this case more likely than not.
The hyperinflated-dollar hypothesis is very, very real, but also far more complicated than someone who wants to sell you gold will let on. That’s a story for another post, though.
Thanks Dr. Phil!
wennejunk Wednesday, January 7th at 4:47PM EST (link)Actually, I didn’t intend for you to be part of a dispute, only to provide some perspective from your position.
Pretty much everything you’ve said lines up with my thinking.
I foresee a protracted global recession, with continuing deflation for some period of time, followed by substantial inflation once things start moving again.
My arguments to her on gold were almost word for word what you had to say. Thanks for the input
There are only two kinds of people in the end: those who say to God, ‘Thy will be done,’ and those to whom God says, in the end, ‘Thy will be done.’ -C. S. Lewis
Thanks for the post, FC.
CrabCakes Wednesday, January 7th at 7:58AM EST (link)This lib always enjoys your analysis.
A statement that you made has coaxed me out of the semi-lurker status that I’ve occupied over the past few months, and I’m hoping you can confirm or deny the appropriateness of a conclusion I’ve drawn.
You said that: “For at least the foreseeable future, Americans will be much more interested in saving up their money than in consuming it. If you contrive to put money in their pockets, they’ll save more of it in the bank than you probably expect.”
Would I be correct here in drawing the conclusion that this negative effect would more heavily impact a tax cut than straight pork-barrel spending? In other words, if the government just mails people checks and they hoard them in their checking accounts or mattresses, then the multiplier is exactly 1.0 and no actual value is created, just a transfer of wealth, right?
But if the government pays to build a bridge or whatnot, money has to change hands multiple times (contractor hires subcontractor, subcontractor buys concrete from concrete company and pays employees, etc.). Even if everyone down the chain hoards their revenue, like they would have had they received a check in the mail, at least some of the money has to be expended and something has to actually be created, right? In addition, since they’ll be receiving their income from work, which feels a whole lot more stable than a one time check, won’t they be less likely to hoard it?
In other words, if you are right and people are much more likely to hoard any stimulus they get, wouldn’t the wisest course of action (assuming that one is inclined to enact some kind of stimulus package in the first place) to make as much of the stimulus a possible government spending on public works and little to none on tax cuts/checks in the mail?
I’m only an amateur in the field of economics, and I’m probably missing a lot here. Hopefully you’ll be willing to show me where I’ve gone off track.
That's the standard line of argumentation
Francis Cianfrocca Wednesday, January 7th at 8:36AM EST (link)Here’s the problem, though: you’re not really solving any of the systemic problems facing the economy (primarily housing overvaluation and financial de-leveraging).
If you cut people’s taxes, they’ll save their money. Do that over a long enough period of time, and people will soon feel that they have enough of a cushion, and will step up their consumption. GDP will start to grow in response, but the overall economy will be vastly more healthy than it is today, and the growth will be organic and sustainable.
Downside? Low growth and somewhat-elevated unemployment for the several years this process takes to play out.
Alternative: build lots of infrastructure, which as you say, will goose current-year GDP and put some downward pressure on unemployment here. (A great deal of the additional employment will be exported to China, however, muting the benefits here.) And eventually, at the end of the chain, the money will still end up frozen in the bank.
What have you lost? You’ve built a lot of “stuff” of dubious value, you’ve lost a lot of time, and you’ve greatly expanded the national debt.
It’s fashionable to suppose that government spending on infrastructure actually creates capital stock of lasting value (this is generally adduced as a “bonus” to the Keynesian-stimulus argument).
But for that to be true, you have to assume that state and local governments (which will direct most of the spending) will make really good investment decisions, across the board. I don’t accept that case in the slightest, and would be happy to engage that argument with you (although it belongs on another thread).
But to foreshorten the argument, look at Japan: they went from near-creditor status to a national debt of 300% of GDP (far higher than ours, which is now about 70% of GDP), building infrastructure that no needed and no one uses. And they still had 15 years of depression.
Thanks for the reply.
CrabCakes Wednesday, January 7th at 9:05AM EST (link)You state: “If you cut people’s taxes, they’ll save their money. Do that over a long enough period of time, and people will soon feel that they have enough of a cushion, and will step up their consumption. GDP will start to grow in response, but the overall economy will be vastly more healthy than it is today, and the growth will be organic and sustainable.”
I understand this is a long-run argument, but it seems that lots of folks are worried about making it through the short-run (when, according to Keynes at least, we aren’t all necessarily dead). Do you think that the economy has the resilience to weather the period between now and the point when people feel comfortable putting their own money on the line? How bad a clean up period will we be facing? Are we looking at breadlines and soup kitchens or just fewer family dinners at Ruby Tuesday’s?
The multiplier would be 1.0 if contractors & subcontractors hoard it
6eorge Jetson Wednesday, January 7th at 8:41AM EST (link)Would you pay your next-door neighbor’s kid double to cut your grass if he subcontracted the work to the kid from the next block?
The multiplier would come from activities that serve the contractor & subcontractors in ways indirectly related to the project (e.g. the restaurant that opens near the bridge).
There's a very, very important point inside of your remark
Francis Cianfrocca Wednesday, January 7th at 9:01AM EST (link)Let’s say indeed that you pay your neighbor’s kid to cut your grass. The economic multiplier effect doesn’t come from whether or not he subcontracts the work to the kid across the street.
Rather, it comes from combination of two effects: first, that having a mown lawn materially improves your quality of life (or, if spent on a road or bridge, increases the capital stock of your locality).
Second, and more important, the kid puts his money in the bank. And through the magic of fractional-reserve lending, it results in increased economic activity through the intermediation of credit.
Do you see what’s wrong with this picture? There’s no credit intermediation out there to begin with! That’s the atypical nature of this particular recession. The money you pay the kid will just sit there earning him a tiny bit of interest, which they bank will make on the spread between the Fed funds rate and short-term Treasury rates.
That’s why stimulus of any kind is going to have totally disappointing effects on the economy.
5555555 (that's a compliment on this board, right?)
6eorge Jetson Wednesday, January 7th at 9:23AM EST (link)I think I was in the ballpark of the correct framework, but you nailed it.
I was thinking of an "economic activity" multiplier above
6eorge Jetson Wednesday, January 7th at 9:03AM EST (link)In terms of the reported GDP, I think you are right in that it would show an increase on the surface if each contractor subcontractor duplicatively reported the work that they did. But I think my technical mistake actually bolsters the arguments above.
I think the appropriately well-criticized spending multiplier framework
6eorge Jetson Wednesday, January 7th at 8:25AM EST (link)above only covers one side of the transaction.
Once the cash is in the hands of the supplier citizen (goods, services, or their existence in one-directional tax or welfare transfers), the multiplier on what is done with that cash should be (mostly) independent of how it got there.
Likewise, there is a multiplier for what is done with the goods, services, or one-directional tax or welfare transfers that the govt/public consumer receives.
The multiplier on the good received can be high (e.g. a highway that serves to connect two economic areas more efficiently (the enviros will hate that)). But it also can be zero, as in the case of the govt worker who through no fault of his own is employed in near-zero utility generating activities, or through siphoning activities (kickbacks, quid-pro-quos, etc.)
To paraphrase Reagan, at the end of the day, considering ALL multipliers (including the future negative multiplier effects of debt service), who will do a better job maximizing that multiplier? Elected officials, who maximize their utility mostly as a function of future votes curried, or the private sector participants that are seek to maximize their utility mostly as a function of their economic well-being?
The optimal ratio certainly isn’t 0/100 or 100/0. But I believe adding $1 trillion of hurried make work projects (I believe the present annual Federal highway budget is on the order of $50 billion/year) or local projects of such overwhelming utility that the local municipal entities and their citizens aren’t willing to pay for them on their own has got to be suboptimal.
Wow, that Okun's Law sure is insightful...
6eorge Jetson Wednesday, January 7th at 8:31AM EST (link)Unemployment is lower in good times and higher in bad times.
Genius.
And so I will remember Stuart Chase, Blackie
Marcus_Traianus Wednesday, January 7th at 8:45AM EST (link)I am sure you would remember Stuart Chase who supposedly coined the term “New Deal” and said that in a planned society “political democracy can remain if it confines itself to all but economic matter”. Rubbish; and this is a hero of today’s Democrats and those who are pushing to increase government spending in a massive way. This type of spending and the associated control creates, as Hayek said, dictators who steal our freedom. They promote the sophistic idea that somehow handing over this control, this liberty, we somehow gain greater freedom and security in our lives. Nothing and I mean nothing, could be more contra-intellectual, misguided and despicable in our democratic republic.
If greater economic control by the state were a cure or even a method by which an economy could be successfully managed then the Soviet Union and Marxism would be a resounding modern financial miracle. Some might say this analogy is alarmist and ridiculous, but then one making that statement has most likely never fully explored the fundamental objectives of that system. The difference here is just a matter of degrees to which Obama wants the government to take control. Remember that liberty stolen is liberty lost; when has the government ever ceded power back to the people? Does a one time tax rebate or s semantically constructed “tax” gimmick which is actually welfare make up for exponential government growth and control? How about creating a huge amount of government jobs, taking more of your wealth to build roads or creating government control over your healthcare? Does this increase your chances to create a better future life for yourself or enhance your freedom? The answer is a resounding, no.
Obama seeks to steal our liberty right before us as he blames Republican’s and, as Tindale said, the “filthy lucre” to create envy as a distraction. As I noted yesterday, our economic situation is the Trojan horse for his installation of a grand Socialism that will breed generations of dependency and lost liberty. Where are all the theorists and supporters of cutting spending and giving money back to those who are productive? Where is the bill to cut capital gains taxes to, say, zero for two years and then phase back to a lower rate? What about permanent tax breaks for those who actually pay taxes today? Those who actually represent our point of view? Alarmingly gone or silent it appears.
“Both of our political parties, at least the honest portion of them, agree conscientiously in the same object—the public good; but they differ essentially in what they deem the means of promoting that good. One side believes it best done by one composition of the governing powers; the other, by a different one. One fears most the ignorance of the people; the other, the selfishness of rulers independent of them. Which is right, time and experience will prove.”.
Thomas Jefferson
Contributor to The Minority Report
If Unemployment Is 9% (Or More), It Won't Matter What The Dems or The Press Say...
IJB Wednesday, January 7th at 11:57AM EST (link)They’ll be hosed.
Selling the line, “Well, it would be 10.5% if we didn’t do what we did!” will satisfy no one.
Neither will, “Well, it’d be 8.25% if the evil Republicans hadn’t stopped us!”
No one will buy that.
As we’ve seen, been want much simpler answers to (what they perceive to be) simple problems.
If the unemployment rate is 9%, regardless of what Dems and the Press say, the only think people are going to say in response is, “Why didn’t you ‘fix’ this?! We don’t care about your excuses! We elected you to ‘fix’ this, and you haven’t ‘fixed’ it!!”
And, well, you know how that will go…
(If I had a heart, I’d almost feel sorry for Obama and Pelosi and Reid… Good thing I don’t!)
Can you expound on these?
posterposter Wednesday, January 7th at 3:09PM EST (link)“although the global economy and the global financial system face deep, systemic imbalances that have nothing whatsoever to do with the business cycle”