Tuesday, February 3, 2009

A powerful argument against the stimulus bill

Russell Roberts is one of my favorite economists because he is so clear-headed. My first economic mentor, John Rutledge, taught me early on that if you can't explain what is going on in the economy to your grandmother, then you don't really understand it yourself. For me, good economics is all about simple logic and understanding how people respond to changing incentives. I highly recommend reading Roberts' recent article in the Boston Globe titled "Stimulus just digs debt hole deeper." Here are some excerpts:
Will government spending get the economy going or slow it down? How long will it take to have an impact? How many jobs will it create? Can we afford it?

You would think economists could answer these questions. And yet there is little or no consensus for what we should do right now. Some of the finest economists in the country, including Nobel laureates, are on opposite sides of the current debate.

I think the real divide between economists isn't over different macroeconomic theories but over underlying differences in philosophy and ideology.

Consider two different government programs for stimulating the economy. The first program borrows $819 billion and hires and pays groups of workers $819 billion to dig a bunch of holes and then fill them in. The second program spends $819 billion to repair a bunch of bridges on the verge of collapse, repair a bunch of sewers about to go bad, and revolutionize the energy and health sectors.

I think most economists would argue that the first program would be a bad use of federal money. Most economists would also agree that the second program would be a bargain.

I think the disagreement among economists is really over which of these two scenarios is closest to reality. The federal budget is about $3 trillion. Is the next $500 billion or so money well spent or money squandered?

I think it will be mostly squandered, so I'm against the stimulus. Plenty of people think it would be money well spent. Many people want a role for government closer to that of Europe's. Most of us against increased government spending want to move in the other direction.

There is an underlying presumption in this debate that if the spending package doesn't stimulate the economy, then tax cuts or monetary policy are better. But maybe we simply don't have the knowledge to repair the economy from Washington. The economy is complex and the interaction between the financial sector and the real economy - between Wall Street and Main Street - is not well understood.

Rather than spending money we don't have, I wish Obama would use his political capital to change the parts of our political system that are dysfunctional - our entitlement programs that are demographically bankrupt, our broken budget system, our Byzantine tax system, our financial system that is in disarray. These changes would be more likely to create the confidence and trust in the future that our economy needs to get healthy again rather than borrowing and spending. Borrowing and spending is how we got into this mess. Let's look in a different direction.


CDLIC said...
This comment has been removed by the author.
Mark A. Sadowski said...

The biggest division in the stimulus debate seems to be between the so called "freshwater" (Great Lakes = Chicago/Minneapolis etc.) and "saltwater" (Ocean = Harvard/Berkeley etc.) economists. Freshwater economists are opposed, and saltwater economists generally are in favor, of a fiscal stimulus. One thing I have observed is that while saltwater economists are quite familiar with the research of the freshwater economists, this knowledge is not symmetric, as the most vocal freshwater economists seem woefully ignorant of the research of saltwater economists. Hence that is why one keeps reading weak arguments against the stimulus such as contained here.

One merely has to look at the research interests of the Nobel laureates involved to understand the debate. The chief opponents are James Buchanan, Edward Prescott and Vernon Smith. They are associated with Public Choice Theory, Real Business Cycle Theory (RBC) and Experimental Economics respectively. The chief proponents are George Akerlof, Robert Solow and Joseph Stiglitz. Robert Solow is associated with the Neoclassical Growth Model, and Akerlof and Stiglitz are associated with Information Economics. Public Choice Theory argues that politicians are self-interested and rational agents that pursue policies that produce distortions in the economy. RBC presumes all behavior to be rational and business cycles are an efficient response to exogenous changes in the real economic environment, so discretionary economic policy is undesirable. Experimental Economics is the application of experimental methods to the study of economic methods and usually starts out with the assumption that all free markets are perfectly efficient. The Neoclassical Growth Model has nothing really to do with the current debate but Solow is connected with the Phillips Curve and it is well known he introduced the concept of monopolistic competition to Paul Krugman so it would not be incorrect to associate him with New Keynesian Economics as well. And of course New Keynesians are interested in other sources of market imperfection such as sticky prices, menu costs, efficiency wages, and multiyear contracts and so on. Information Economics studies how information affects the economy and in particular how information asymmetries result in markets only being perfectly efficient under extraordinary circumstances.

I think Public Choice Theory has some merits and explains why the stimulus bill will be far less than perfect whether or not it is desirable. I am deeply skeptical of RBC because its assumption of rational expectations seems contradicted by recent events and because it is essentially unable to explain involuntary unemployment and other forms of market failure. I am also skeptical of Experimental Economics because I believe the assumption that free markets are always perfectly efficient is incredibly naive. On the other hand, I think information asymmetries are at the heart of the current failure of the financial markets. And New Keynesian economic models are proving to be very accurate in predicting where the economy is going currently.

What do saltwater economists really think? They think that monetary policy, through interest rate targeting, is the least intrusive and most effective way to manage business cycles. The exception is when you are in a deflationary liquidity trap, in which case, with the possible exception of quantitative easing, monetary policy is ineffective, and you must resort to a fiscal stimulus. Most, but not all saltwater economists believe we have fallen into that trap, and that the collapse of the financial sector is complicating the Federal Reserve’s policy of quantitative easing. If a fiscal stimulus is necessary, what form should it take? Most saltwater economists seem to be relying on the research of Mark Zandi, whose fiscal multipliers have played a significant role in designing the current stimulus bill.

Is this a powerful argument in favor of the fiscal stimulus? No, of course not, but at least I've done a better job of explaining the current economic debate on the saltwater side than Russell Roberts.

Scott Grannis said...

Mark: show me a grandmother who can follow your survey of different economic philsophies and I'll show you a PhD in economics. I'm not convinced, and I think you are getting lost in the forest for the trees. To me Roberts boils it down quite concisely. Do you think that Congress can spend $800 billion or so in a timely fashion without wasting most of the money? I just don't see it. They can't spend it fast enough to make any difference to the economy's current condition, and the vast majority of what they do try to spend will be wasted and/or end up creating a permanent expansion of government.

Mark A. Sadowski said...

I can't comment on your grandmother, nor can I comment on either of mine, because both died before I was born. However, I used to talk about academic topics to my mother frequently before she died, and although she only had a high school education, she was fairly bright and usually got the gist of what I was saying.

If you are are in favor of the stimulus you probably believe that a long term general disequilibrium is a possibility. If you are not, then you probably believe that markets always quickly tend to equilibrium. If long term general disequilibrim is a possibility, then what choice do we have but to spend $800 billion inefficiently or otherwise?

Anyone who has ever experienced long term involuntary unemployment, underemployment or part time employment probably believes in general disequilibrium, even if they might not use those words to describe it.

Scott Grannis said...

Mark: I do believe in long-term disequilibrium. In fact, I lived for four years in one, in Argentina. In my anecdotal experience, the problem was one of excessive government intervention in the economy, excessive inflation, and endemic corruption.

I most certainly do not believe that the solution to such a problem is a massive increase in government spending that will most likely be hugely inefficient.

Mark A. Sadowski said...

Well, of course, that is the flip side of the argument, that government intervention only makes things worse. However I don't think your Argentine experience is relevant in our own case.