Macroeconomic Policy for a Stronger Recovery, Part 1

A Little Background

About a year and a half ago—in the days after the forced merger of Bear Stearns into J.P. MorganChase (JPM), say—there was a near consensus of economists that an additional dose of expansionary fiscal policy was unlikely to be necessary. The Congress had passed a first round of tax cut-based stimulus, the impact of which in the summer of 2008 is clearly visible in disposable personal income and perhaps visible in the tracks of estimated monthly real GDP. The near-consensus belief back then, however, was that that was the only expansionary discretionary fiscal policy move that was appropriate.

With the Bear Stearns forced merger it appeared that the Federal Reserve and the Treasury had settled on a policy: they would punish as severely as they could the shareholders of and the managers at institutions too-big-to-fail that required rescue, but they would insulate bondholders and counterparties. The incentives to avoid bankruptcy would thus be concentrated on those who actually had power to do something to manage organizational risk. As for the rest—well, the markets interpreted the forced merger as the Federal Reserve guaranteeing and making riskless essentially all the unsecured debt of all the large commercial and investment banks in the country.

Figure 1: (Nominal) Disposable Personal Income

Figure 2: Monthly Real GDP Estimates from Macroeconomic Advisors

The resulting “approaching liquidity tsunami,” as more than one senior policymaker described it to me, meant that the risk of a deep recession was very low—or so the situation looked in the spring of 2008.

Late 2008’s Need for Expansionary Fiscal Policy

By the late summer of 2008 things looked significantly different. The tax-based expansionary fiscal policy of early 2008 had had less than the desired effect—perhaps it had prevented a decline in the economy and kept things marching in place, but it effect was not overwhelming and not entirely obvious. It was clear that the formal announcement that the economy had fallen into recession was only a matter of time.

By August 2008 Lawrence Summers was writing of a gap between actual and sustainable production of $300 billion at an annual rate, forecasting that that gap was likely to more than double over the following year, and predicting sustained weakness thereafter—“unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances…” in a time when “the remaining scope for monetary policy to stimulate the US economy is surely very limited…”[1] Take an initial output gap growing from $300 to $600 billion over the first year and then declining to zero over the next three and you have a cumulative output gap of $1,350 billion in a situation in which monetary policy on its own can do little to correct it. Suppose that a prudent use of fiscal policy would be to enlarge the government’s budget deficits by a third of the forecast output gap, and you have an estimate of the appropriate size of expansionary fiscal policy as the situation looked in August 2008: $450 billion in cumulative deficit spending spread out over the next four years.

Then came the nationalization of Fannie Mae (FNM) and Freddie Mac (FRE) on September 7, 2008; the bankruptcy of Lehman Brothers on September 15, 2008; and the nationalization of AIG on September 22, 2008. In the aftermath it was immediately clear that the recession problem was at least twice as bad as it had looked in August, and over the next four and a half months until the February 17, 2009 signing of the ARRA, the magnitude of the likely cumulative output gap doubled again as the magnitude of the financial crisis’s impact on the real economy became clear.

If $450 billion was the appropriate size of a short-term deficit-spending program for the $1,350 billion cumulative output gap anticipated as of August 2008, then simple extrapolation suggests that the appropriate size of the boost to short-term deficit spending as of February 2009 was $1.8 trillion (over three to four years).

What we got was a cumulative number of $600 billion—roughly 1/3 aid to states, 1/3 tax cuts (in a good-faith effort by the Obama administration to propose a bipartisan plan that legislators of both parties could sign on to), and 1/3 infrastructure and other direct government purchases intended not so much to slow the decline as rather to boost the recovery. We also got an extension of the AMT and other measures that no economist I have talked to believes are properly counted as part of an effective fiscal boost under any currently-live theory of how the economy works. Figure an increase in deficits of $200 billion per year spread out over the next three years. At the technocratic level, the disproportion between the size of the response and the magnitude of the need is obvious.

Today’s Arguments Against More Fiscal Expansion

Now if you go outside and, addressing the air, ask why it is that we did not pass a larger short-term deficit-spending fiscal boost program of $1.2 or $1.8 trillion last January and February and why we are not acting to boost it now, I hear four different answers coming back on the wind:

1. This was the most that the Obama administration could get sixty senators to vote for—and with a Senate that, in Majority Leader Harry Reid’s words, takes forty-eight hours to flush the toilet, it needs to spend its time on legislative initiatives that might pass, rather than on those that certainly will not.

2. Further expansionary fiscal policy would be counterproductive in this current situation because of the long-run U.S. budgetary and global balance-of-payments imbalances. More short-run deficit spending would require the U.S. to issue more debt which would cause a sharp spike in U.S. long-term interest and a flight from the dollar that would generate a much bigger crisis and deeper depression—as Austria’s issuance of huge amounts of additional debt in 1931 set off the wave of crises that turned the recession of 1929-1931 in Europe into the European half of the Great Depression.

3. Further expansionary fiscal policy would be counterproductive because it never works—because it is theoretically impossible for it to work—because it is a “fairy tale.”

4. The ARRA is only one of a large number of initiatives to stimulate the economy outside of the normal open-market operations monetary expansion framework. When you include the likely effects of all of the acronyms—TARP, PPIP, MMIFL, TALF, CPLF, TAC, etc.—you find that even though there is only $600 billion of cumulative expansionary fiscal policy, there is much more in terms of total non-standard-monetary stabilization policy.

Argument #1 I will pass over. I understand why Rhode Island and Delaware have as many senators as New York or Florida or Texas or California: it seemed a reasonable price to pay back in 1787 to keep not just Montreal but also Providence and Wilmington from becoming British imperial fortresses and bases on the North American continent. I understand that a “cooling” chamber might wish to have an effective supermajority requirement. I don’t understand why in a good system it takes the votes of 60% of senators rather than of senators representing 60% of the people to actually get an up-or-down vote. But that is not my area.

Argument #2 is, I think, a genuine thing to fear. But if that fear were to cease being a nameless dread and instead take a shape and a name, the first sign would be an unwillingness on the part of global investors to hold U.S. Treasury debt. But right now the U.S. government can borrow for ten years at 3.34% in nominal dollars—much less than the projected growth rate of nominal GDP over the next decade at between 5% and 6% a year. The time since the summer of 2007 has seen a collapse in the value of private securities and a substantial elevation in the price of U.S. government securities. The first rule of the market is that the market’s prices are there to signal what things are more valuable and that we should make more of. Right now the market is sending us a very strong signal that it really wants us to make more U.S. Treasury debt—to undertake more short-term deficit spending. And when Argument #2 ceases being a nameless dread but takes form and shape in an upward trend in interest rates on long-term U.S. Treasuries, I will be the first to say that the global bond market is cutting off our running room for more expansionary fiscal policy. Right now, however, it is not.

Argument #3—that there is some deep principle in economic theory somewhere that says something that prevents debt-financed government spending from boosting employment and output—is an argument that, by this stage, I can do nothing but laugh at. When the venture capitalists of Silicon Valley decided to give their money to high-tech engineers in the 1990s so they could spend it trying to figure out how to make money off of the internet, employment and production rose (even though few of them figured out how to do so). When the financial engineers of Countrywide in the 2000s decided to give investors’ money to construction companies to build more houses, employment and production rose (even though the promises to investors of healthy returns with little risk were wrong). Milton Friedman’s quantity-theory-of-money monetarism says that the reason open-market operations that expand the money stock boost spending and employment is because once people have more money in their pockets they step up their spending. Boosts to employment and production come when any group with substantial money in an economy decides to boost its rate of spending—and, at this level, the government’s money is as good as anybody else’s.

And when I try to read the arguments of those making Argument #3, my head explodes. The kindest thing I can say is that they must not have spent even half an hour thinking about the issues. John Cochrane of the University of Chicago writes that models in which fiscal policy affects anything are logically inconsistent because they require that people’s plans of how much to spend exceed what their incomes actually turn out to be. But Chicago models of an earlier generation like Milton Friedman’s are full of situations in which planned expenditure is greater than or less than income as people try to run down or build up their cash balances. Eugene Fama of the University of Chicago writes that any increase in government purchases must be automatically offset by an equal decrease in business investment or household consumption spending—a conclusion that had eluded every other monetary economist since the 1910s, and a conclusion which would make not just fiscal policy but monetary policy impotent.[2]

At this stage all I can do is two things. First, I can gesture at the Republican office holders and policy advisors of last year—at the Doug Holtz-Eakins, the Mark Zandis, the Phil Swagels and the others who are now saying that you should be “skeptical” of “anyone who tells you [expansionary fiscal policy] has had no impact.” Second, I can point out that had John McCain won the 2008 presidential election, the Republican administration would have no more hesitation in proposing expansionary fiscal policy than they did in 2008, 2003, and 2001, and that the only reason the views on macroeconomics of Cochrane, Fama and company are now getting a hearing as Republican witnesses in congressional hearings is that Republican legislators need some form of ideological cover for their just-say-no-to-everything-whether-it-is-good-for-the-country-or-not legislative strategy.

Part 2 >>

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