Fiscal Stimulus: What the Christ?

I apologize for such a long post before hand but...

Akaash, Lion and I were in the kitchen last night talking over one another, trying to make sense of an economic theory that can't be made sense of, when Dave rudely interrupted us with a question that was actually relevant:

"Is the Obama fiscal stimulus package too big or too small?"

Obviously, I am not an economist. I will therefore answer--and hopefully kick off a broader economically-oriented discussion not exclusively devoted to the number of new ones China will be tearing us--in a way that no self-respecting gainfully employed economist ever would: I have no idea. Economics, as Lion has repeatedly and rightly pointed out, is not a hard science despite what some may have you believe. Conceptually speaking, an "economy" is the sum total of all transactions within an arbitrarily defined space (or among an arbitrarily defined group of people), with all the seemingly infinite and infinitely complicated and unquantifiable incentives, assumptions and externalities that may correspond. Which is just a needlessly wordy/douchy way of saying that this shit is complicated and so predicting anything is pretty hard. Right now, we face a recession and a pretty nasty one at that. But with all the variables involved, it might serve us well to think of a recession like a snowflake. Or, better yet, a flesh-eating bacterium. Each one is entirely unique and uniquely horrible. And so while each school of economic thought has its very own toolbox full of policy prescriptions (ranging from the most intensive Keynesian intervention to the old "sit on our hands and hum" method favored by those with a more laissez-faire oriented outlook), each economic clusterfuck is its very own little miracle.

That being said, most mainstream economists think a pretty much tried and in some cases true Keynesian economic stimulus package is the way to go. According to Keynes, a recession like that of the Great Depression and (in most cases) like the one that is currently making it so damn difficult for me to find a job...


About: what I am not referring to

...is a problem of "deficient demand." In short, this means that people are not buying enough stuff and not investing enough money. If people aren't spending enough, companies can't afford to keep paying employees, which causes those employees to spend less, which leads more people to be laid off, etc. Right now, with housing prices falling, job insecurity on the rise, and common commercial interest rates riding high, most individuals are cutting back--understandably so. It is therefore the government's place, so the argument goes, to supplement that "deficiency" with spending or tax cuts.

The traditional critiques (that is, those levied by some of the more hard-line neoclassical schools) can summarized as follows:

a) The unregulated economy is inherently efficient--that is, demand and supply will rapidly converge upon a new so-called "market clearing price". On the broadest possible level, the implication is that if aggregate demand has fallen throughout the economy, this may lead to a temporary decrease in output and therefore an increase in unemployment, but that the decrease in the wage rate resulting from that increase in unemployment and all other falling input prices resulting from the general fall in aggregate demand will all constitute declines in costs for firms. Firms will therefore be able to start producing more, which pushes prices down further, which convinces more people to start buying stuff, which increase employment. In the end then, the economy in real terms is back to where it was at the beginning, without the help of the socialists in Washington, thank you very much. The failure of the economy to react this way, so this criticism goes, must have to do with regulations imposing rigidities on the ability of firms to adjust in this way. Thanks a lot, minimum wage.

b) Government spending is not dictated by market signals and therefore is prone towards inefficiency. Whereas investors are thought to spend their money prudently so that the maximum return is guaranteed (haha), and whereas market prices are an indication of the social value of a good, government bureaucrats are supposedly blind to such considerations. If a private businessman sees it fit to invest in the materials, labor and time to build a road, so the argument goes, it is because he expects a return on his investment that will exceed by some margin the sum of material, labor and time costs. While his estimation may not be perfect, it is likely that in having to raise the funds to make this investment, his estimation will be re-evaluated by his financial backers. On the other hand, when a bureaucrat decides to spend money on a road, he/she is subject to no such considerations. Therefore, so the argument goes, it would be better for the government to leave that tax money/borrowed money in the hands of others. If you're thinking that its possible that it might be in the public interest for the government to spend money on certain things that the private sector does not provide equitably or sufficiently, it's because you're anti-American.

c) Crowding Out: when the government spends money, it must often do so by borrowing money. If the government has to borrow quite a bit of money, that puts upward pressure on interest rates (since there is at any time a fixed constraint on available loanable funds). Therefore, again so the argument goes, any stimulatory effect that government spending has will be offset by the increased interest rate resulting from the borrowing.

d) "Ricardian Equivalence": If I may editorialize, this is pretty silly. The concept, attributed falsely to the 18th century philosophy David Ricardo by world-renowned dumb-dumb Robert Barro, is that for the government to spend more money it must either borrow money now, tax now, tax in the future, or just print more money. The common citizen, an avid follower of his own government's fiscal policies, will take this into account. Knowing then that this government spending increase will result in either an interest rate increase (see point c), an immediate tax hike, a future tax hike, or an increase in inflation, he or she will save a little bit more and spend a little bit less to compensate.


Above: a knowledgeable and well-informed citizen taking a break between studying fiscal spending bills

The above critiques are are worth knowing and understanding but will always exist for any proposed government spending bill, almost regardless of economic conditions. That said, for the most part, in my humble opinion its largely a bunch of phooey.

What I think is more interesting are those critiques of the current stimulus proposal coming not from a strictly and predictably Anti-Keynesian perspective. The two most notable ones that I've come across (and I'd be interested to see some more if any of you should come across them) relate to first, the sensitivity of the treasuries market to a flood in supply and, second, America's chronic trade imbalance.

First, the United States government borrows money by authorizing the Treasury Department to sell various kinds of bonds. These bonds, essentially interest-paying IOUs to the U.S. government that anyone can buy, are particularly important because, as they are considered the safest of all financial investments, their yields (the interest rates at which they pay back the lender/buyer) guide interest rates throughout the entire economy.
The U.S. government has been selling quite a lot of these in order to support its sizable debt-burden. This is quite different from the 1929-early 1930s scenario when it was the United States that was playing banker to the world.
So the question is, given the enormous amount of debt the government current has, can we afford to increase our debt by another few trillion-dollars in a relatively short period of time? At what point do those who are buying these treasury bonds, both at home and abroad, decide that all this spending might lead to inflation (or worse yet, a default), and therefore demand a higher return?

I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear. There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard. The US dollar and US Treasury bills and bonds are still viewed as a safe haven by many. But learning takes place. (Source: William Buiter)

Essentially, what Buiter is saying is that before too long, the U.S. will have to start paying a little bit more for its loans. If this transition occurs in as dramatic a way as Buiter suggests (which may or may not be likely), the U.S. treasury market will suffer a severe downturn, interest rates will rise dramatically, the dollar will fall, and suddenly its diet time for Uncle Sam who has for the past thirty years been mainlining imports into his eyeballs like it was piping hot french fry grease.

Again, I don't know how accurate Buiter's analysis is, but it certainly is food for bed wetting thought.

The second possible problem with pushing forward fiscal stimulus right now is that our current trade dynamic severely dampens the effect of any stimulus package. As the argument goes, because the U.S. relies so much on imports, any stimulus of domestic consumption will go in a large part towards propping up the economies of our import partners. Given that so much of our spending is going towards goods from China and Taiwan and Korea and Mexico and a few other countries that I've never heard of, spending a bunch of tax money to stimulate domestic consumption isn't going to do anything effectively except increase our import bill. In the words of one economist:

"[T]rying to stimulate the economy without fixing the trade deficit is like trying to pump up a tire without fixing the leak...THE STIMULUS PACKAGE WON'T WORK UNLESS TRADE IS BROUGHT TOWARD BALANCE AT THE SAME TIME"(Source: TradeandTaxes)

While I'm sure there is some truth to this, and though I'm partly swayed by their enthusiastic use of the caps lock, I think it overstates the so-called "marginal propensity to import" of the U.S. economy. This is just yet another douchy way of saying, yeah, the U.S. spends a lot of money on imports, but given the enormous task of changing the entire structure of an economy and the urgent need for some form of stimulus right now this minute, mending the tire can wait. To switch up the metaphor, if a syphilitic patient has just experienced heart failure, the first priority should be to get that heart beating again, not begin the antibiotic regimen.

And yes, I've been watching a lot of House lately.

Ultimately, none of this has really answered Dave's initial question. Is the stimulus too big? According to any of the arguments above, probably. On the other hand, a lot of economists, the most notable of whom is Paul Krugman, think the package is too small. Almost everyone thinks it too heavy on the tax cut side, but that's a different issue.

For now, all I can say is that the size of the package is only as important as its effectiveness.
How, for example, will the credit market react to extensive government spending? And if banks start lending again, will that money go towards the expansion of production? On top of that, will less panic in the financial market pop the bubble in the treasury market, like Buiter suggests?
And as for the spending itself, how productive will it be? What kinds of things will the money go towards and how much will these projects stimulate long-term economic activity as well as short-term job creation?
And once the government starts hiring people and contracting with firms, how much of that wage and contract money will be spent? How much of that spending will go towards domestically produced goods? How much will go towards durable goods or investments rather than non-durable, unproductive goods?
Looking at the package itself, how much of the stimulus package will be in the form of tax-cuts and toward which groups will these tax cuts and rebates be aimed?

If you really want to get into it, Paul Krugman has run through some numerical estimates about the efficacy of fiscal spending--the "fiscal multiplier" in economese. As for how good those estimates are, I can't say. Like I said, I'm not an economist.