Tyler Cowen and Greg Mankiw linked to a Keith Hennessey graph that has been getting a lot of attention. It shows the ratio of spending to GDP over the next 10 years as estimated in Obama’s proposed 2010 budget (last year), as well as the spending/GDP ratios expected in his current budget.
It’s easy to look at the graph and assume spending is out of control, and that Obama hasn’t kept his promise to reduce spending in the out years. But that is slightly misleading, as DeLong argues here:
Left out of Hennessey’s “analysis” is the reason that an 8.3% of GDP deficit is warranted: that the economy is very weak.
Left out of Hennessey’s “analysis” is the reason that President Obama projects bigger deficits this year than he did last year–that the economy is extremely weak, and is much weaker than we expected it to be, and when the economy is weak the deficit goes up as revenues fall and social-insurance spending rises: a year ago the administration expected the unemployment rate now to be 7.7%, but it’s 10.0%; a year ago the administration expected the unemployment rate at the start of fiscal 2011 to be 7.0%, but now it expects it to be 9.8%; a year ago the administration expected the unemployment rate at the start of fiscal 2012 to be 6.4%, but now it expects it to be 8.9%.
All very good points, but in the end they lead to a dead end. If Hennessey is wrong, then DeLong is just as wrong, albeit for two different reasons.
DeLong says we need more fiscal stimulus because the recession is far worse than predicted. Let’s stop right there. Last January Obama knew exactly the sort of financial crisis we faced. He proposed a major stimulus, which he claimed would spur the economy. New Keynesian models say that the expansionary effect of stimulus begins occurring when it is announced. New Keynesian theory suggests that current AD is strongly influenced by changes in future expected AD. So here is my question; what was the impact of the first stimulus package? Yes, we know it wasn’t as big as DeLong would like, but what was its impact?
To answer that question, it would seem logical to look at how NGDP grew, and compare that growth to the trajectory expected in the absence of the stimulus. Trust me, if you are a Keynesian you don’t want to do that. Instead, a Keynesian would argue that things quickly deteriorated after the first projections were made, but the stimulus somehow prevented the deterioration from being even worse. Possibly, but there are two problems with that explanation. It still leaves us without a shred of evidence that the stimulus worked, it merely indicates there might be an excuse for it seeming not to work. Even worse, that near-term deterioration is not supposed to happen in forward-looking New Keynesian models where the stimulus is expected to boost output later. So the Keynesians don’t have any good explanation for the horrible performance of NGDP in 2009 relative to the expectations back in January. Banking problems? We already knew about that, they occurred in 2008. Mysterious drop in consumer confidence? Animal spirits? Those are terms people throw around when they haven’t a clue as to what’s going on.
To summarize, the Keynesian complaint is “the economy deteriorated far more severely than we expected when we proposed our massive $800 billion dollar stimulus, consumer confidence has been shattered by all those scary stories on FoxNews about a government near bankruptcy, so we need to run even bigger deficits.”
I admit all this is highly debatable, but here is my real complaint with DeLong’s post, (or the Republican view for that matter.) Everyone wants to set the debate up as follows:
1. Do you favor massive deficits or are you content to have the economy self-correct, risking high unemployment for several years?
I want to scream when I see the debate structured that way. That is not the issue. Rather there are two distinct issues:
1. Is more AD desirable, or should we let the recovery take its natural course?
2. If we need more AD, is monetary expansion preferable to massive budget deficits?
Let’s review a few simple ideas. Fiscal stimulus does not boost AS, it boosts AD. (OK, MTR cuts can boost AS, but Obama’s opposed to those. And some public investment like education might have a long-term payoff. But let’s get serious. We are talking about high unemployment over the next 5 years. A more educated workforce won’t have much short term impact.) So if fiscal stimulus is to help the recovery, it does so by exactly the same method as monetary stimulus—boosting AD.
I happen to favor more stimulus, although I understand that some thoughtful economists disagree with me. I happen to think monetary stimulus is preferable to fiscal stimulus, and in this case there aren’t any thoughtful economists who disagree with me. Not one. If there was going to be one, it would be Paul Krugman. But even he admitted late last year that monetary stimulus is the first choice, and you only move on to fiscal stimulus is the Fed won’t play ball.
So here is the debate: Do we need more monetary stimulus, or should we let the economy recover naturally. But DeLong wants to say the debate is between fiscal stimulus and stagnation. How can he do that? Buy simply assuming away monetary stimulus. Presumably he would say that Obama doesn’t control monetary policy, so he can hardly be blamed for relying on fiscal stimulus. Has Obama made a single public statement calling on the Fed to promote higher NGDP growth, or higher inflation, or higher whatever? And then there is the little problem that Obama just re-appointed Ben Bernanke last month. Bernanke’s now his guy at the Fed.
I am actually not trying to blame Obama personally. As with all other politicians I assume he does not understand that low interest rates don’t mean easy money. Most economists don’t even seem to understand that. Rather as with any President, the term ‘Obama’ is really shorthand for the entire policy-making apparatus.
Don’t get me wrong, I’m not that naive. I understand it would be very hard getting the Fed to change its ways at this point. But can we at least have a debate? I was about to ask if we’ve reached the level of passivity of the Japanese, but then I recalled that they are engaged in a fierce debate right now, and Finance Minister Kan is putting strong pressure on the BOJ for more stimulus. So compared to us, the new Japanese administration is almost Rooseveltian.
If Obama doesn’t want to have that debate, that’s fine. But then don’t tell us fiscal stimulus is the only answer to high unemployment. And don’t tell us that Obama doesn’t understand monetary policy. I thought the whole point of replacing Bush with Obama was to get an intellectual in the White House. Someone who understood the issues. If we have “grown-up” intellectuals in the White House, then let’s have that debate. Let’s see some discussion of unconventional monetary stimulus. Can’t Congress at least pass a law repealing the interest on reserves program?
BTW, I’m just as frustrated at the right-wingers at the Fed. We are running up trillions of dollars in debt precisely because the elected leaders of our country think we need more AD, and the Fed doesn’t. I understand the need for the Fed to be independent, but how about some honesty at least. If these inflation hawks really believe what they are saying, show some guts and come out and say “We are not doing more monetary stimulus because we feel a need to offset what we regard as excessive fiscal stimulus, and prevent it from raising the expected inflation rate.” If they really have the courage of their convictions, then why not admit what they are doing?
In February I said fiscal stimulus wouldn’t work, as the Fed had some sort of nominal aggregate target in mind, and was going to simply offset the fiscal stimulus. And that is what happened. In March when things looked scary, like a Depression was possible, the Fed announced its big program of buying Treasuries and MBSs. Later in the year when things picked up a bit, and we were clearly going to avoid a depression, the Fed started furiously back-peddling. They started talking about ending the bond buying program and “exit strategies.” Ask yourself this; what does that back and forth behavior tell you? It tells me the Fed has some sort of implicit nominal target, and if the economy seems to fall short they’ll pull out all the stops and flood the economy with liquidity. That’s why the $800 billion dollar fiscal stimulus was a complete waste of money; the Fed wasn’t going to allow NGDP to fall much further than the actual 2.5% it fell. Shame on us for not figuring that out, and shame on the Fed for not explaining that to us.
Oh, and shame on the Fed for not having a more aggressive policy even with the stimulus.
And shame on me for writing this post just one day after I resolved to be less opinionated.