Streetwise Professor

January 24, 2009

Hey, Big Spender

Filed under: Economics,Politics — The Professor @ 9:37 pm

When I was an undergrad, and in my first year of grad school, my goal was to become a macroeconomist.  I took Bob Lucas’s grad macro sequence as a senior at UC, and was excited by the subject.  But while in grad school, I became disenchanted with macro.  For one thing–and I will expand on this below–I found the focus on aggregates misleading.  As a result, I switched into a microeconomics/industrial organization concentration, and haven’t really kept up with the macro literature in any serious way (except insofar as to see seminars time to time where macro issues crop up in finance.)

Therefore, the opinions I am about to offer about the proposed stimulus package are not those of a professional macroeconomist.  However, hopefully they will be somewhat useful, in that my skepticism about a good deal of macroeconomics arises from what I perceive to be tenuous–at best–microeconomic foundations.  By pointing those out, and raising some other questions that have not been answered adequately (in my mind, anyways) by stimulus advocates, perhaps I can make my readers more critical consumers of stimulus news and advocacy.

My basic objections to the stimulus fall under several heads.

Beware Offers of Free Lunches.  The multiplier effects that are the basis for pro-stimulus arguments always seemed arbitrary and ungrounded to me, the macroeconomics version of perpetual motion machines.  They sound like free lunches.  

Robert Barro argued that multipliers are less than one, and has caught grief from the pro-government spending crowd.  One of their objections is that Barro used WWII spending as his main measure of the effect of spending on GNP.  ”But Wait!” the stimulus gang has shouted–multipliers are likely to exhibit diminishing returns, and the WWII stimulus was huge (about $5 trillion in 2009 dollars), so it does not tell us the average or marginal effect of a $1 trillion stimulus.

But that seems to raise other difficulties.  First, what is the basis for the claim that there is diminishing returns to government spending?  Since the multiplier models are on such shaky theoretical footings, how can one be so sure?  This claim seems to rest merely on the common sense notion that everything is subject to diminishing returns.

Second, there is a potentially more damning empirical issue.  If multipliers are subject to diminishing returns, and are on the order of 1.5 (according to Romer) for the huge stimulus Obama has proposed, normal variations in government spending should show up in the data as having big, measurable effects on the variation in consumption and aggregate income.  But it’s my understanding that this isn’t the case.  So, by attempting to shield our eyes from the lessons of WWII, the pro-spending folks merely draw attention to the lack of robust empirical support for the multipliers.  

It seems that the pro-stimulus folks are playing Goldilocks.  WWII stimulus was TOO BIG.  Variations in government spending in most times DON’T OCCUR WHEN THERE ARE SUFFICIENT IDLE RESOURCES.  But it just so happens that the Obama Stimulus is JUST RIGHT–just big enough to avoid diminishing returns, and implemented when there are just the right amount of idle resources.  I wouldn’t be so sure ’bout dat.

Also, I wonder whether costs and benefits are actually being computed properly.  Government spending on infrastructure, for instance, is essentially computed as the total expenditure on inputs used on the infrastructure projects.  That’s not how the value of output is calculated for other goods and services.  That value depends on the price which the seller receives for the output when it is sold on the market.  No market for infrastructure, so no market estimate of its value.  Bridges to nowhere are valued at cost.  This makes the accountants happy, but it is economically idiotic.  

Also, most calculations of the benefits of a stimulus that I’ve seen assume that the opportunity cost of idle resources is zero.  Leisure is valuable, so it’s worth more than zero.

Perhaps most importantly, the fiscal spending will be determined by political means, reflecting political considerations and the lobbying power of different interests, rather than by market means which guide resources to their highest value use.   Again, when you don your green eyeshades, it may look like income has gone up when the government spends more, but that could well be an accounting mirage based on equating value and cost.  Bridges to nowhere, or more holes, or broadband rolled out to people who don’t have it and aren’t willing to pay for it, are almost certainly worth less than cost.  Businesses that spend resources to make investments that turn out unprofitable report losses.  With its bizarre accounting, the government doesn’t do this.

Relatedly, How Will the Stimulus Be Paid For?  The stimulus can be paid for either by printing money, or through taxes on the Fram Filter Plan–you can pay now, or you can pay later.  (Paying later means that the spending is financed by debt.)  The first method is a tax too–on holdings of money balances.  

The pesky detail of paying for a dramatic increase in government spending creates serious doubts that this spending will indeed stimulate.

The first source of my doubts is Ricardian equivalence.  If consumption is driven by wealth (including the discounted stream of income flowing to labor and human capital), an increase in government spending will not increase current consumption as individuals will realize that their current income has increased, but their future income has decreased due to the increased future tax burden.  So, they will save, rather than consume, the increase in current income so as to be able to pay their future tax burden.

Now, there is some debate about whether there is full Ricardian equivalence.  Probably not, so current households may perceive that their wealth has risen, and hence consume more.  But that isn’t necessarily good news when one considers why Ricardian equivalence may fail.  One reason that current households (those making decisions today) may ignore future generations.  If not completely altruistic towards their progeny, those currently living (or those currently making decisions) will gladly consume more today at the expense of the consumption of future generations.

That’s good news?  Seems like a market failure to me.  

Similarly, those who receive an income windfall today may figure that others will bear the tax burden. That is, to the extent that the stimulus has distributive impacts, if those who pay and those who don’t have different marginal propensities to consume, consumption may increase.  But again, is a good thing? In particular, it means that saving goes down.  And the welfare implications of this redistribution are not obvious.  Even if aggregate consumption goes up, the spending and taxation policy may not be Pareto improving because there is no Mr. and Mrs. Aggregate.  There are numerous individuals, some of whom are likely to be hurt by the stimulus policy.  

This all bears on the spenders’ common retort to suggestions that it would be better to merely distribute cash to individuals (by reducing taxes, for instance) and let them choose what to do with it rather than have the government direct the spending: “They’ll just save it.”  Uhm, maybe that’s because individuals are Ricardians, who realize that the “windfall” is not really a windfall–it’s just a loan that has to be paid back with higher taxes in the future.   (Analogy–if the IRS sends you a check by mistake, would you spend it?)  I don’t see how to square a belief in multipliers (which seems to presume that people are not Ricardians) with a belief that direct payments to individuals will not lead them to increase consumption (which suggests that they are.)  

Another issue is the deadweight effects of any tax policy.  As I recall, a good deal of the literature assumes non-distorting lump sum taxation–taxation that exists only on blackboards and academic journals.  Here on earth, all taxes distort.  This creates deadweight losses, which may be very large indeed.  (Martin Feldstein has presented evidence that income taxes create very large deadweight losses.)

What a Fine Mess You’ve Gotten Us Into, Ollie–And You Plan to Get Us Out the Same Way?    One theory of the current economic mess is that individuals consumed too much, bought too much housing, all financed by too much debt.  So we’re supposed to fix this by having the government issuing huge amounts of debt in order to stimulate consumption and pay for construction.  Huh?  And remember, apropos Pogo, We have met the guvmint, and it is us, so government borrowing is a form of identity theft–somebody borrowing money in our name.  The logic behind the stimulus proposal therefore seems to be that we address a crisis caused by overconsumption and overborrowing by borrowing and consuming more.   So, presumably the stimulus is the hair of the dog cure.  

There’s No Such Thing as Aggregate Output.  Aggregate output is a social construction, a modeling fiction that helps advance our understanding of certain issues, but which also obfuscates essential facts.  In most   models, output is homogeneous, capital is homogeneous, labor is homogeneous.  As a result, if labor is idle, lumps of it can be lured into producing lumps of output.  Here on the planet with the blue sky, however, labor, capital, and output is anything but homogeneous.  Idle autoworkers in Michigan are not perfect substitutes for health care workers, or engineers, or road builders.

There will be no discriminating match between the demands for resources created by a political process, and the supplies of “idle” resources.  There will be bottlenecks in everything the government spends on, and the owners of the bottleneck resources will be the main beneficiaries of government largesse.  This will limit the beneficial effects of the stimulus to the population at large.

So, I am deeply skeptical that big spending will deliver the goods.  It is most likely to be a big boondoggle that creates windfalls for some, and greater tax burdens for others.  

The usual response to such skepticism is: Well, smart guy, what would YOU do?  

My reply–rather than giving a spendthrift Congress a trillion or so to blow on their pet projects and political pals, we should address a massive problem that (a) is the root source of our current difficulties, (b) is potentially fixable, and (c) will cost huge sums: the banking system.  We will need every dollar we can muster to address our colossal banking problems, and every one flushed down useless infrastructure projects is one less that can be used to stanch the bleeding in the banking sector.  

Of course, it is possible to screw up a banking system fix too.  I’ll solve that problem in a future post;-)

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  1. Amen to that, SWP

    As long as we fail to address that banks are still holding bad paper and until we fix that we are setting ourselves up for the lost generation that plagued Japan when they failed to clean up their banking system after their real estate crash.

    Wasting money on GM so it can make hybrids that no one will buy is stupid. Increasing the public payroll by putting 600,000 at that wasteful trough is stupid and smacks of European socialism.

    How about cutting the losers loose, cutting individual and corporate taxes and letting this recession play itself out as in “first do no harm” in good medicine.

    Comment by penny — January 24, 2009 @ 10:18 pm

  2. [...] Streetwise Professor: Hey, Big Spender Written for Americans but seems even more applicable for the UK. particularly the bit about [...]

    Pingback by Sub-prime mess & World Economics - Page 57 - PPRuNe Forums — January 25, 2009 @ 4:30 am

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