Euro troubles apart, there is plenty of stuff going on with relation to the US economy in general and fiscal policy in particular. The super committee cannot agree, deficits and debt are not under control and the economy isn't producing anywhere near full capacity.
In a couple of posts we'll try to see whether the US needs another shot in the arm, but that question cannot be answered if we don't look at the 2009 American Recovery Act, the $787 billion package to revive the American economy.
Data shows that the economic crisis is mainly caused by a lack of demand and the economy can remain in a deep funk for extended period of times as households are de-leveraging (paying down debt to restore their balance sheets, which is why this recession is often called a balance sheet recession).
The logical conclusion would be to propose a large fiscal stimulus in order to make up for the fall in demand by households repairing their balance sheets. Indeed, since the beginning of the crisis people like Stiglitz and Krugman have pleaded for a big stimulus program and the latter has argued that the original stimulus was too small and would discredit the idea of a fiscal stimulus. Do they have a point?
Stimulus Disappointment
President Obama promised that with the $787 billion stimulus (the American Recovery and Reinvestment Act of 2009), unemployment would be back to 8% or below, and since that hasn't happened, many people believe that the stimulus has been useless (or worse).
Christina Romer has shown how such a simple conclusion can be misleading. For instance, John Taylor argued that the Bush Economic Stumulus Act of 2008 (a $130M tax rebate for households) wasn't successful because consumption did not rise with disposable income.
Romer quotes Mark Zandi from Moody's Analytics, who shows that adding household wealth to the picture, this becomes understandable as house prices were falling steeply at that point which would normally have taken consumption down with it. Since this didn't happen, there is some evidence that the Bush stimulus was in fact successful, despite it not being visible in the economic data (at least, not at first sight).
The irony is that a stimulus will show up in output figures exactly when there is no need for a stimulus, that is, when the economy is growing. A stimulus during a recession is not likely to show first-hand effects on output as the economy is shrinking, and it's very difficult to know by how much it would have shrunk without the stimulus. This immediately shows that it is difficult to isolate the effects of any fiscal stimulus.
However, we do know something:
The Big Recession
When we, like Eichengreen and O'Rourke have done, compare the evolution of economic variables like industrial production, world equity markets and world trade with how these behaved after the big crash of October 1929 we arrive at a rather alarming picture:
You'll notice that the decline in economic variables was as steep or steeper as that in the 1930s Great Depression, until something arrested the decline. Here are Eichengreen and O'Rourke:
To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a depression-sized event.
What was different this time (in relation to the 1930s) is the policy response (quick fiscal and monetary expansion, unprecedented bail-uts), it's hard to escape the conclusion that the policy response has (at least for now) prevented another 1930s style depression from materializing. If not, what else?
But it's difficult to disentangle the effects of the bail-outs, the monetary and fiscal policy reactions, so this isn't necessarily a conclusive endorsement for fiscal stimulus (although it most certainly is a ringing endorsement for the policy reaction overall).
Too Small?
Another reason why the stimulus has been disappointing is that it, according to many, has been too small. Krugman even argued this at the time, and there seems some vindication for that perspective from a lengthy Ezra Klein article called 'Could this time have been different?' The reason why the stimulus was of inadequate size was rather simple:
The Bureau of Economic Analysis, the agency charged with measuring the size and growth of the U.S. economy, initially projected that the economy shrank at an annual rate of 3.8 percent in the last quarter of 2008. Months later, the bureau almost doubled that estimate, saying the number was 6.2 percent. Then it was revised to 6.3 percent. But it wasn’t until this year that the actual number was revealed: 8.9 percent.
Jared Bernstein (Biden's chief economist) argued in that context:
“We’ll be lucky if the unemployment rate is below double digits by the end of next year.”
Bernstein says, “is that if you look at the trajectory of job losses, you will find that right on the heels of the Recovery Act, the rate of job losses began to diminish and then the jobs numbers turned positive. The Recovery Act worked. The problem is we didn’t keep our foot on the accelerator.” That’s not the sort of success the president had promised, though. He said the stimulus would “jolt our economy back to life.”
The latter statement comes from a figure in an Alan Blinder and Mark Zandi study, which shows the following:
It also shows that growth falls back when the stimulus is wearing off, another indication that it had an effect. Calculating from the output gap (the difference between trend growth in output and actual output), the stimulus should have been something like $2.5 trillion. A figure like that surely would not have stand a chance passing Congress, but there is an indication (although not more than that) that it could have worked.
In China, with its export dependent economy and regime depending on economic growth for legitimacy, they were rather scared by the cold winds from the West in 2008 and embarked on a proportionally much larger stimulus (close to $500 billion, almost 2/3 as big as the American stimulus while the Chinese economy is much smaller). Nobody has argued that it didn't work in China, which made a surprisingly fast recovery from the 2008 crisis.
Some Empirical Studies
There is a host of empirical evidence to support the claim that the stimulus did work, here are a few: Alan Blinder and Mark Zandi found that:
the effects of the fiscal stimulus alone appear very substantial, raising 2010 real GDP by about 3.4%, holding the unemployment rate about 1.5 percentage points lower, and adding almost 2.7 million jobs to U.S. payrolls
Brad DeLong summarizes a couple of studies, all of them show a positive contribution to GDP. Since many countries embarked on demand stimulus policies, one can look whether the relative size correlates with bigger effects:
As it happens, there is a significant correlation between the size of the stimulus and the economic effects (note also Italy, that paragon of fiscal irresponsibility!)
There is the Congressional Budget Office Study of February 2011
- Real GDP impact was between 1.1% and 3.5%
- Lowering unemployment between 0.7% and 1.9%
- Increased the number of employed people by 1.3-3.5 million
There is Feyrer and Sacerdote (as summarized by Bill Mitchell; you'll have to scroll down quite a bit) which argued that the stimulus was particularly effective when it had the form of income support for low income families and infrastructure and not effective insofar it consisted of transfers to local government to fund teachers and police at the local level.
This isn't terribly surprising. Low income families spend most (if not all) their income. This is also a reason why the stimulus might very well have been more effective had it consisted of fewer tax cuts (as tax cuts, especially for richer households are proportionally saved more).
Indeed a study done by Claudia Sahm and others (as summarized by Romer) concludes that the Making Work Pay tax credit (which was part of the stimulus) wasn't very effective. The lack of positive effects on local spending on teachers and police could simply be that existing jobs were maintained.
Ezra Klein summarized nine studies:
Of the nine studies I’ve found, six find that the stimulus had a significant, positive effect on employment and growth, and three find that the effect was either quite small or impossible to detect.
And of course, there is the very accessible summary by Christy Romer (pdf), who is able to explain stuff in very simple terms, especially the various problems to tease out meaning from raw data. She concludes from her own work and other studies that:
At the very least, the estimates suggest that about 3 million people were employed in 2010 who would not have been if it weren't for the act.
by stopping the freefall in the economy, the Recovery Act greatly helped to heal the financial system.
Why Shouldn't it Work?
So on the whole, there is a significant amount of empirical support for arguing that the stimulus worked. This isn't that surprising, because the way it worked can be explained in rather simple terms:
If we decided to build a couple of new carriers, thousands of workers would be hired for the shipyards. Thousands of employees would be hired for the steel mills that would provide the steel for the hull and various sub contractors would hire thousands. Do you know what that means? It means they would receive paychecks and go out and spend that money. That would help a recovery. That is a shovel ready project! [Judson Phillips, head of Tea Party Nation]
No, you don't normally see Tea Party members raving about expansionary effects of public spending, but there is nothing wrong with this analysis.
There isn't an a priori reason to argue that a credit financed household spending boom would produce an economic boom (as it has just before the 2008 crisis) while credit financed public spending would not be able to get any economic traction, especially considering that the credit terms for the public sector are considerably better.
Conclusion
It's quite difficult to isolate the effects of fiscal policy. For instance, when the economy is already shrinking (typically circumstances when a stimulus would be implemented), it's difficult to know how much the economy would have shrunk without the stimulus. Or when people get a tax rebate which they would normally spend to a considerable degree, they might not do so because there is other stuff going on (falling house prices reducing wealth, rapidly worsening economy increasing employment security, etc.)
However, most studies that attempt to isolate stimulus effects arrive at positive contributions, and this is not surprising, as in a depressed economy with many spare resources, people receive employment and/or money which they did not previously had, which they will spend at least in part, creating income for others.
We plan to look at some objections to this in a follow-up post.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
