Archive for the ‘Fiscal Policy’ Category
This post shows — using Federal Reserve economic data — that transfer payments increased at a faster rate during the final years of the Bush administration than during the Obama administration. This is obviously counter-intuitive, as one (or, more precisely, I) would have thought, given that the unemployment rate didn’t begin to spiral upward until the final months of Bush’s presidency. The data also shows that in the most recent quarters, there has been no growth in transfer payments. This is concrete evidence that the February 2009 stimulus program has run its course and, correspondingly, the transition from fiscal stimulus to fiscal drag has taken place.
According to census data and as reported by the Wall Street Journal (no link), nearly half the population lived in a household that received some type of government benefit in 2010′s first quarter. As show in Chart 1, this compares to about three in ten people in 1983.
Unsurprisingly, the dollar amount of government benefits — transfer payments — has increased at a more rapid rate. From less than $20 billion in 1983, transfer payments have grown to more than $170 billion at a seasonally adjusted annual rate in August of this year. Note that, as shown in Chart 2, transfer payments have leveled off in recent quarters.
Now comes the surprising part. Since the passage of the February 2009 stimulus bill, the annual rate of growth of transfer payments (measured on a continuously compounded basis) has steadily declined; in the most recent quarters, there has been no growth.
The Economist isn’t impressed with the past week’s speculation in some quarters that Europe’s leaders had at long last put together a a plan to save the euro. It cites three reasons for being skeptical:
- First, for all the breathless headlines from the IMF/World Bank meetings in Washington, DC, Europe’s leaders are a long way from a deal on how to save the euro. The best that can be said is that they now have a plan to have a plan, probably by early November.
- Second, even if a catastrophe in Europe is avoided, the prospects for the world economy are darkening, as the rich world’s fiscal austerity intensifies and slowing emerging economies provide less of a cushion for global growth.
- Third, America’s politicians are, once again, threatening to wreck the recovery with irresponsible fiscal brinkmanship.
With each passing week, the negative ramifications of fiscal austerity (the primary topic of my recent essay) are being noted more widely and frequently. But neither governments nor monetary authorities are as yet listening to the drumbeat from those without the power to do anything about it.
But I digress. Let’s get back to what the Economist has to say.
- On the eurozone:
The doom-laden lectures from the Americans and others in Washington last week did achieve something: Europe’s policymakers now recognise that more must be done. They are, at last, focusing on the right priorities: building a firewall around illiquid but solvent countries like Italy; bolstering Europe’s banks; and dealing far more decisively with Greece. The idea is to have a plan in place by the Cannes summit of the G20 in early November. That, however, is a long time to wait—and the Europeans still disagree vehemently about how to do any of this (see article). Germany, for instance, thinks the main problem is fiscal profligacy and so is reluctant to boost Europe’s rescue fund; yet a far bigger fund is needed if a rescue is to be credible. The most urgent solutions, such as restructuring Greece’s debt or building a protective barrier around Italy, require the most political courage—something that Angela Merkel, Nicolas Sarkozy et al have yet to exhibit. The chances of a bold enough plan will shrink if markets stabilise. The less scared they are, the more likely Europe’s spineless policymakers are to jump yet again for a plan that does just enough to stave off catastrophe temporarily, but lets the underlying problem get worse.
[...] Even if the euro-zone crisis were to be solved tomorrow, the region’s GDP would probably shrink over the coming months.
- On the U.S.:
Whatever it does, America is currently on course for the most stringent fiscal tightening of any big economy in 2012, as temporary tax cuts and unemployment insurance expire at the end of this year. That could change if Congress came to its senses, passed Barack Obama’s jobs plan and agreed on a medium-term deficit-reduction deal by November. If Democrats and Republicans fail to hash out a compromise on the deficit, draconian spending cuts will follow in 2013. For all the tirades against the Europeans, America’s economy risks being pushed into recession by its own fiscal policy—and by the fact that both parties are more interested in positioning themselves for the 2012 elections than in reaching the compromises needed to steer away from that hazardous course.
- On emerging economies:
Some emerging economies, including China, have less room to repeat their 2008-09 stimulus because of the debts that splurge left behind. Monetary policy can be loosened: several central banks have cut rates. But, overall, the emerging world will be less of a buoy to global growth than it has been hitherto.
- The bottom line:
. . . governments are not just failing to act: they are exacerbating the mess . . . more often than not, policymakers seem to be getting it wrong. Their mistakes vary, but two sorts stand out. One is an overwhelming emphasis on short-term fiscal austerity over growth . . . The second failure is one of honesty. Too many rich-world politicians have failed to tell voters the scale of the problem . . . At a time of enormous problems, the politicians seem Lilliputian. That’s the real reason to be afraid.
To which I say, amen.
A little history . . .
. . . and a forecast:
Now that’s a presumptuous title if I ever saw one. Well, maybe not. The policies being followed by the governments and central banks of the U.S. and Europe clearly aren’t solving the economic crisis. The anemic economic recoveries on both sides of the Atlantic have run out of steam and the world’s stock, credit and commodity markets have plunged in anticipation of worse to come. The markets are telling us that time may be running out to preempt another Lehman moment and a further slump in economic activity that would turn recession into depression. Despite rising investor angst and an ever-growing avalanche of weakening economic indicators, there’s no evidence that the individuals in positions to alter the course of economic events are starting to have second thoughts about current fiscal and monetary policies.
How have the advanced industrial countries of the West arrived at what increasingly appears to be a tipping point?
Immediately after Lehman’s failure, fiscal and monetary policies were loosened in true Keynesian fashion. The West didn’t fall into the financial abyss and the recession didn’t turn into a depression. Asset values recovered and the recession officially ended in June 2009. The economy ended its 18-month stay in intensive care. As it became evident that the world economy would soon be discharged from the hospital, governments, central bankers, economists and the public refocused their attention to the aftereffect of its stay in intensive care: ballooning public debt. Preventing financial and economic collapse resulted in the shifting of trillions of dollars of debt from the private sector’s to the public sector’s balance sheet. Rapidly rising unemployment reduced government tax revenue and increased government spending. Government debt-to-GDP ratios rose to unprecedented peacetime levels. With economic recovery underway, concern about the future solvency of government rose to the top of the worry list.
Fiscal Policy: Tightened
With fear of public sector insolvency having overtaken fear of depression, economic policy was ripe for change. The change has taken the form of calls for and the implementation of increasingly austere fiscal policies. Austerity, its advocates argue, is the path to economic salvation. In every country, those who would rely primarily on reduced spending and those who would rely primarily on higher taxes on the wealthy have something in common: both assume that heightened fiscal rectitude will reduce their government’s debt-to-GDP ratio. By lowering the perceived risk of future insolvency, they aver, the private sector’s confidence will improve. Facing the future more confidently, consumers will buy more and business will invest more. This positive feedback loop involving consumers and business will create a self-sustaining, accelerating economic recovery. That recovery will create more jobs, leading to reduced government spending on unemployment insurance and related items and increased government tax revenues. The budget deficit will contract, borrowing requirements will diminish, the debt-to-GDP ratio will fall, and the real –as well as the perceived — risk of insolvency will vanish.
The ramifications of faith in fiscal austerity as the exit strategy from hard times extend beyond the economic to include the political sphere. Intrinsic to this exit strategy are political disagreements over the mix of spending reductions and tax increases. The issue of the distribution of austerity’s pain came to the fore during this summer’s debate — I use the word advisedly — in the U.S., which heavily contributed to the downgrading of the credit rating of America’s sovereign debt. More significant than that downgrade was the public’s disgust with the spectacle in the House of Representatives. It can’t be doubted that the extreme partisanship so vividly on display further undermined consumer and business confidence in the ability of the government to come to grips with a sputtering economy. This feedback from the political to the economic realm revealed itself in the aforementioned steep market declines, which can best be interpreted as a discounting of further economic weakness.
It’s as simple as that, or is it? Spending decreases and tax increases have something in common: if everything else remains constant, they both drain purchasing power from the private sector. The “everything else” is the effect of fiscal austerity on confidence. For austerity to boost consumption, the positive impact on the propensity to consume of a reduction in the perceived risk of insolvency in the long-term must exceed the negative impact of the reduction of purchasing power in the short-term. Said another way, for austerity to have its intended effect, it must result in a decline in the propensity to save. Only if this requirement is met will business have an incentive to accelerate hiring and capital investment.
If, as I anticipate, fiscal austerity has the opposite of its intended effect, the circle will be vicious rather than virtuous. Budget deficits, borrowing requirements, debt-to-capital ratios and insolvency risks (both perceived and real) will increase. Confidence will erode. The evidence, as highlighted by the unfolding Greek tragedy, indicates that the adverse outcome is the likely outcome. But this conclusion doesn’t rest upon Greece, which might be considered an exceptional case. More significantly, as fiscal impetus has turned into fiscal drag, the economies of both the U.S. and Europe have slowed and are now either on the verge of, or already in, a contraction phase. If governments react to this development by further tightening fiscal policies, they will assuredly produce a second worldwide recession. Should this occur, the 2010s will be remembered by future generations as the decade of the Second Great Depression. As noted earlier, there is at present no reason for optimism that governments and a broad swath of the public understand the predicament we now face. Absent such an understanding, the likelihood of further contractionary fiscal actions is disturbingly high.
Monetary Policy: Loosened
Three weeks after Lehman’s bankruptcy, the Fed lowered the Fed funds rate (the interest rate banks charge each other for overnight loans) to 1.5 percent from 2 percent. Two more reductions were announced by the end of 2008. At year’s end, the rate had been reduced to zero percent (more accurately, for technical reasons, the rate was 0.00 to 0.25 percent). For the first time ever, banks in the U.S. with insufficient liquidity could borrow from banks having more liquidity than they needed without incurring interest expense. One need not look further than this to appreciate the seriousness of the financial situation as seen by those closest to it. The Fed funds rate is still zero percent.
The European Central Bank (ECB) is the equivalent of the Federal Reserve for the 17 countries that employ the euro as their currency. In the eurozone, the “deposit facility” interest rate has the same role as the Fed funds rate. As shown in the following table, the ECB’s monetary policy has been somewhat less accomodative. Most importantly, it has twice raised the deposit facility rate during 2011. Inflation fears were the stated reason for the interest rate increases. Still, at 0.75 percent, the interest rate is far below the inflation rate.
Overnight Interest Rates, 2008-2011
European Central Bank
|Before Lehman bankruptcy||
|Oct 8, 2008||
Oct 29, 2008
|Nov 12, 2008||
|Dec 10, 2008||
|Dec 16, 2008||
|Jan 21, 2009||
|Mar 11, 2009||
|Apr 8, 2009||
|Apr 13, 2011||
|Jul 13, 2011||
During the 12 months following the end of the recession, real (inflation-adjusted) U.S. GDP grew at a disappointingly slow 3.3 percent — far below the norm for the first year of a recovery. What made this sub-par performance particularly worrisome was that it happened while short-term borrowing costs in the private sector, reflecting the zero percent Fed funds rate, were at historically low levels. During the summer of 2010, Fed Chairman Bernanke telegraphed the Fed’s intention to implement a policy — subsequently dubbed “quantitative easing” — aimed at stimulating the economy by driving down long-term interest rates. In a speech delivered on August 26, 2010, he said that one of the options for providing additional monetary accommodation was “to expand the Federal Reserve’s holdings of longer-term securities,” and added that he believed “that additional purchases of longer-term securities . . . would be effective in further easing financial conditions.” By the time this policy was implemented in late 2010, market participants had fully discounted its intended effect by driving down yields on longer-term fixed-income securities.
Still, the economy refused to cooperate. Real GDP growth fell to 3.1 percent during calendar 2010, two-tenths of a percentage point lower than it had been during the 12 months ending in June, 2010. Growth continued to decelerate during the first half of 2011. The Fed’s reaction to the persistent and growing weakness in the economy was to announce “operation twist” on September 21. In a press release titled “What is the Federal Reserve’s maturity extension program (referred to by some as “operation twist”) and what is its purpose?,” the Fed explained:
Under the maturity extension program, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio.
By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery.
For three years, the Fed’s policy has been to deflate interest rates. What began as the deflation of short-term rates has been extended all the way out the maturity spectrum to include 30-year Treasury bonds. This latest interest rate deflation, while helping borrowers — in particular, home owners with variable rate mortgages and first-time home buyers — entails noteworthy risks. The most significant of these risks is its impact on bank profitability. Banks, of course, borrow short and lend long. Accordingly, the outlook for bank profits is at its best when the yield differential between short- and long-term fixed-income securities is large. Operation twist narrows the differential; it “flattens” the yield curve. This new headwind facing the banks comes at a time when another headwind — the eurozone’s sovereign debt crisis — is intensifying, with no end in sight. U.S. banks have an exposure of $650 billion to the debt of Greek, Irish, Italian, Portuguese, and Spanish governments. With the housing market still in the doldrums and the mounting possibility of having to write-down the value of their holdings of eurozone public debt, the flattening of the yield curve could not have come at a less propitious moment. The Fed is betting that operation twist won’t increase systemic risk in the U.S. financial system. It’s a bet that the Fed had better win.
The Problem — And the Solution
The U.S. and Europe are suffering from the same underlying disease: economies that never really recovered from the financial crisis and which will continue to stumble along or soon experience the long-feared double-dip. The European situation is worse, and far more complex. The American states are married; they have one monetary policy and one fiscal policy. The eurozone countries are engaged; they have one monetary policy and 17 fiscal policies. Adding to their problems is the fact that their engagement documents don’t allow them to voluntarily break their engagement or to have other members of their extended family force them to call off their engagement. This is reason enough to conclude that, if a way out of the worldwide economic crisis is to be found, it will start in the U.S.
By now, it should be obvious that credit cost deflation — reducing interest rates — isn’t going to revive the American economy. It should be equally obvious that budget deflation — reducing government spending and/or increasing taxes — isn’t going to revive the American economy, either. If the U.S. is going to lead the industrialized West out of the economic wilderness, it must fundamentally change its fiscal and monetary policies.
We should reverse both of these policies. Fiscal policy should become expansionary. Monetary policy should become restrictive. The eurozone’s sovereign debt crisis provides us with a window of opportunity to do both.
The arguments against fiscal stimulus and my counter-arguments are as follows:
- Fiscal stimulus doesn’t work — Those who support this argument point to the anemic economic recovery that began four months after the February, 2009, passage of the Obama administration’s $787 billion stimulus package. Top advisers within the administration wanted a larger stimulus, but political realities prevailed. In particular, Christine Romer, who was then the chairperson of the Council of Economic Advisers argued for a stimulus package of at least $1.2 trillion. As reported in the New Yorker,
The most important question facing Obama that day [in December 2008] was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion.
Would a $1.2 trillion plus stimulus have launched the economy onto a faster growth trajectory? There’s no way to know for sure; the best I can do is to provide an analogy. The economy is frequently referred to as an engine. An immobilized car needs to be jump-started. If the external power source that’s connected to the car’s battery isn’t powerful enough, the engine won’t start. A more powerful external source will succeed where the less powerful one failed. Returning to the economy, it’s a fallacy to assert that, because a stimulus program of a certain size produced a disappointing result, any stimulus package, regardless of its size, will be unsuccessful.
- Fiscal stimulus is inflationary — In some circumstances, this is true. But not in the current circumstances. Chart 3 shows that the velocity of money — the rate at which money changes hands in the economy — is now falling after a brief, mild acceleration following the implementation of the stimulus program. With a stagnant or contracting economy ahead, it’s more likely that money velocity will decline further than to reverse direction. Another analogy will drive home this point. The Fed has been pouring billions of gallons of gasoline (money) into the gas tank (the economy), but fewer miles (purchases) are being driven (made).
- The dollar will weaken — Perhaps, but that’s not necessarily a bad thing, as it would improve our export competitiveness. In fact, as shown in Chart 4, the dollar has significantly strengthened against the euro in recent days. Since the last day depicted in the chart, the value of the dollar has climbed further.
At the beginning of this section, I said that the eurozone’s sovereign debt crisis provides us with a window of opportunity to reverse the directions of our fiscal and monetary policies. Now it’s time to explain why.
To safeguard their wealth from the effects of the crisis, Europeans are selling euros, buying dollars, and using their dollars to buy U.S. sovereign debt — Treasury notes and bonds. Notwithstanding occasional glimmers of hope, the eurozone’s crisis admits to no simple solution and will continue for an extended period of time. Accordingly, our interest rates will remain at or near their current historical lows. This means that federal government interest expense as a percent of GDP will not become a budget-buster. Simply stated, for as long as the eurozone’s sovereign debt crisis continues, the U.S. will not have a sovereign debt crisis. This provides us with an opportunity to implement a very sizable fiscal stimulus program without risking the deleterious side-effects that such a program would normally entail.
Changing our fiscal policy is only a part of the solution. A sizable stimulus program will put more money into more people’s pockets, but will they, in this age of deleveraging, spend it or save it (paying down credit card debt counts as saving)?
This is where reversing our monetary policy enters the picture. The price of credit has been declining for three years. Consciously or not, this trend has undoubtedly seeped into the minds of American consumers. This credit price deflation provides an incentive to defer major purchases. The best example, of course, is housing. If, in addition to expecting a further erosion of home prices, a family also anticipates that mortgage rates will continue to decline, it has an added incentive to wait.
With the stimulus program boosting economic activity, the Fed should announce that, starting on a certain date and every three or six months thereafter, it will increase the Fed funds rate by a quarter percentage point and reduce its holdings of long-term government securities by a specified amount. Replacing credit price deflation with credit price inflation will provide the incentive to purchase now rather than in the future.
There you have it. My solution to the economic crisis is to implement policies that are the exact opposite of those currently in place. Replacing one without replacing the other won’t suffice. Fiscal stimulus without credit price inflation would put more money into more pockets without providing an incentive to spend. Credit price inflation without fiscal stimulus would further weaken the economy.
I haven’t been looking forward to writing these final words. Setting forth a solution to the economic crisis is one thing; expecting that for now and the foreseeable future it has a snowball’s chance in hell of being enacted is another. The current momentum favoring fiscal rectitude is irresistible. Public opinion being what it is, opposing it amounts to political suicide. We will continue down the current path until it has been completely discredited. What will it take for public opinion to reverse direction? One way or another and by the end of this year, we will have started to walk down the path, instead of just talking about it. If my analysis is on the money, it won’t be a pleasant walk. Stagflation without the “flation” is the most optimistic scenario I’m willing to countenance. If, as seems more likely, the unemployment rate rises into the double digits as the effects of fiscal stringency accumulate, it will be interesting to see whether either of our political parties changes its mind as election day approaches. The ideological rigidity of the Republicans makes it next to impossible for them to undertake an about-face. So, if either of the parties is to change its mind, it will be the Democrats. For now, all we can do is to wait and see.
TODAY’S RECESSION does not merely resemble the Great Depression; it is, to a real extent, a recurrence of it. It has the same unique causes and the same initial trajectory. Both downturns were triggered by a financial crisis coming on top of, and then deepening, a slowdown in industrial production and employment that had begun earlier and that was caused in part by rapid technological innovation. The 1920s saw the spread of electrification in industry; the 1990s saw the triumph of computerization in manufacturing and services. The recessions in 1926 and 2001 were both followed by “jobless recoveries.”
The above quotation is from an essay in the current issue of The New Republic. Written by John B. Judis, titled “Doom!” and subtitled “Our economic nightmare is just beginning,” it synthesizes the economic and political angst currently being experienced here and in Europe, as well as the disturbing parallels between the Great Depression of the 1930s and what could easily become the Great Depression of the 2010s. It’s an essay I would be proud to have written. I encourage you to read every word, and would appreciate your comments.
On numerous occasions, I’ve expressed my view that reducing government spending and increasing taxes, whatever the mix, will likely backfire by increasing rather than decreasing the budget deficit. I’ve tried to present this view in a dispassionate manner. Rightly or wrongly, I’ve always felt that it’s better — and more convincing — to speak than to yell.
Beneath my mild words, there’s a seething anger. After all, just like the rest of you, I’m going to be hurt by the ill-timed focus on fiscal rectitude. I’ll let Paul Krugman do my yelling for me:
If the downgrade of U.S. debt had any effect at all, it was to reinforce fears of austerity policies that will make the economy even weaker. So how did Washington discourse come to be dominated by the wrong issue?Hard-line Republicans have, of course, played a role . . . But our discourse wouldn’t have gone so far off-track if other influential people hadn’t been eager to change the subject away from jobs, even in the face of 9 percent unemployment, and to hijack the crisis on behalf of their pre-existing agendas.
Check out the opinion page of any major newspaper, or listen to any news-discussion program, and you’re likely to encounter some self-proclaimed centrist declaring that there are no short-run fixes for our economic difficulties, that the responsible thing is to focus on long-run solutions and, in particular, on “entitlement reform” — that is, cuts in Social Security and Medicare. And when you do encounter such a person, you should be aware that people like that are a major reason we’re in so much trouble.
For the fact is that right now the economy desperately needs a short-run fix . . . Unfortunately, giving lectures on long-run fiscal sustainability is a fashionable Washington pastime; it’s what people who want to sound serious do to demonstrate their seriousness. So when the crisis struck and led to big budget deficits — because that’s what happens when the economy shrinks and revenue plunges — many members of our policy elite were all too eager to seize on those deficits as an excuse to change the subject from jobs to their favorite hobbyhorse. And the economy continued to bleed.
It’s not often that I wouldn’t change a word in a commentary on financial and economic affairs. I found one today. It was written by Bill Gross. As the founder and co-chief investment officer of the investment management firm PIMCO, he knows a thing or two about these matters.
His column in today’s Washington Post is a must read.
The German economy — the biggest economy in Europe — is thriving. German views of what’s happening here are therefore of considerable interest and importance. Spiegel Online reports that Germans have been following events here with a jaundiced eye:
The German press has heavily covered the US debt ceiling debate, which is often juxtaposed with the current debt crisis in the euro zone. Editorial cartoonists, too, have tackled the issue. Some have even featured pictures of vultures, an image associated in Germany with someone or something that is bankrupt. One cartoon showed Mount Rushmore with four vulture heads replacing those of the four presidents. And a cartoon in the Financial Times Deutschland Wednesday shows a vulture running from Capitol Hill, uttering a promise that he will return.
Concerns about the debt crisis play themselves out Wednesday in the editorial pages of German newspapers, where some commentators continue to analyze what the debate in Washington over the debt ceiling means for the world.
Below the fold are comments from the conservative Die Welt, the left-leaning Die Tageszeitung, and conservative Frankfurter Allegemeine Zeitung.
Recently, the Commerce Department’s Bureau of Economic Analysis issued revised GDP estimates going back to 2007. The revised numbers show that the recession was far worse estimated:
The decline in output during the intense period of financial crisis was significantly more severe than economists had thought. In 2008, the economy shrank 0.3%, rather than holding flat, as earlier estimated. In 2009, the economy shrank 3.5%, worse than the earlier 2.6% projection. During the ugliest months of the crisis, in the fourth quarter of 2008 and the first quarter of 2009, output declined at a shocking 8.9% and 6.7% annual pace, respectively.
The Economist bemoans the absence of accurate data when Obama was inaugurated in January 2009 and speculates on what might have been if what we had known then what we know now:
President Obama was inaugurated on January 20th, and a stimulus bill was introduced in the House of Representatives on January 26th. A stimulus package worth $819 billion passed in the House just two days later.
Two days after that, Americans received grim news about the economy: in the fourth quarter of 2008, GDP contracted at a 3.8% annual pace—the worst quarterly performance since the deep recession of 1982. More bad news hit on February 6th, when the BLS released new labour market figures. It reported an employment decline of 598,000 in January, following on revised drops in employment of 577,000 in December and 597,000 in November—a three-month drop of 1.8m jobs. On February 10th, the Senate passed its version of the stimulus, worth $838 billion. In conference committee, the bill shrank to $787. On February 17th, Mr Obama signed the bill into law.
In the months and years that followed, Washington provided additional support to the economy, perhaps ultimately contributing approximately $1 trillion in total stimulus. But that first bill was the big bite at the apple. The White House looked at the economic situation, sized up Congress, and took its shot. Unfortunately, the situation was far more dire than anyone in the administration or in Congress supposed.
Output in the third and fourth quarters fell by 3.7% and 8.9%, respectively, not at 0.5% and 3.8% as believed at the time. Employment was also falling much faster than estimated. Some 820,000 jobs were lost in January, rather than the 598,000 then reported. In the three months prior to the passage of stimulus, the economy cut loose 2.2m workers, not 1.8m. In January, total employment was already 1m workers below the level shown in the official data.
We can’t know exactly how things would have played out in a world in which key policymakers had better data. If the true scope of the economic disaster in the fourth quarter had been clear, however, it seems certain that . . . the White House would have agreed to push for more (and perhaps a lot more), and that Congress would have been much more receptive to a bigger bill. A drop of 8.9% does seem much more terrifying, after all, than a 3.8% decline. Bigger stimulus would have reduced the economic deterioration in subsequent months. The Fed might also have been more aggressive.
Of course, it’s not impossible that knowledge of the dire state of the economy would combine with a bigger stimulus plan to shake faith in American finances. It is unlikely, however. At the end of 2008, America’s net debt-to-GDP ratio was less than 50%. Other large economies were also tanking, and money was flooding into Treasuries. In late December of 2008, yields on 10-year Treasuries fell to near 2%.
America had plenty of room and every reason to borrow and spend heavily. What it didn’t have, unfortunately, was an accurate picture of the economic situation. And that was a crippling limitation indeed.
There remains an unanwered question: why were the estimates that prevailed until the recent revisions so far off the mark? This is a question that must be answered before faulty data again results in faulty policy.
Mention the word “stimulus” and two Presidents — Obama and FDR — immediately come to mind. After Obama set forth his stimulus plan, some of his right-wing critics (he has left-wing critics, too) contended that FDR’s “pump-priming” failed to rejuvenate the American economy and use this flawed reading of history to argue against Obama’s proposal. As an example, here’s an excerpt from “Politicized Champion” by The Weekly Standard’s Fred Barnes:
He shares the worst economic instincts of his political hero, FDR. Like Roosevelt, he’s had little practical experience in the private sector. Once the free market appears to have failed, today as in the Depression, government alone is seen as the answer. “With the private sector so weakened by this recession, the federal government is the only entity left with the resources to jolt our economy back into life,” Obama said in February. And he thinks government is efficient.
And in “Infatuated with the New Deal,” Barnes opined that “[l]ike many liberals, Obama resists the painful truth about the New Deal, that it was largely an economic failure.”
Was the New Deal largely an economic failure? Take a look at this chart of the industrial production index. Between April 1933 (the month after FDR’s inauguration) and June 1937 (the month before the start of the recession within the depression), the index rose from 54 to 121. That’s an increase of 124 percent. The New Deal wasn’t a failure. There is no factual basis for asserting that the deficit spending that financed the pump-priming didn’t work.
Source: Federal Reserve Bulletin, August, 1940.
If you accept the validity of my analysis, you might reasonably ask why the title of this post is “Obama Is FDR in Reverse.” To explain this choice, a little historical background is necessary.
That the man whose name would become synonymous with deficit spending promised during his 1932 presidential campaign to balance the budget is undisputed. He didn’t change his mind during the three months between his election and inauguration. In his budget message to Congress delivered a week after taking office, he said:
For three long years the Federal Government has been on the road toward bankruptcy . . . With the utmost seriousness I point out to Congress that profound effect of this fact upon our national economy. It has contributed to the recent collapse of our banking structure. It has accentuated the stagnation of the economic life of our people. It has added to the ranks of the unemployed.
Only ten months after this budget message, FDR, in a startling about face, announced that the public debt would grow by $7.3 billion in the fiscal year ending in June, 1934.
Why did he flip-flop in such a dramatic fashion? According to the New York Times, the major cause was the growing concern about the long-term unemployed and their plight:
It was not that their numbers had increased: the estimate of the American Federation of Labor [the government did not collect its own unemployment data!] on the number of unemployed for March, 1933, was 13,689,000, the highest figure on record; the estimate for January, 1934, was 11,755,000. What made the problem increasingly disquieting was its mere prolongation—the failure of private industry to recover with the hoped-for rapidity to absorb this great army. More and more of the unemployed were coming to the to the end of their small resources; their plight was obviously desperate; and it was beginning to be recognized more widely that a long continuance of their enforced idleness might bring increasing demoralization. [My emphasis]
The evolution of FDR’s fiscal policy preference was from budget balancing, which required that government spending be constrained, to fiscal stimulus, which necessitated the loosening of the government’s purse-strings. The failure of budget-balancing to reduce the ranks of the long-term unemployed prompted the change. Note that he had another alternative: he could have doubled-down on the existing policy by further reducing government spending in the hope of producing a budget surplus. Perhaps he was persuaded otherwise by the data shown in the following table. At the time, the federal government operated on a June fiscal year (FY); the first budget to bear FDR’s imprint was the FY 1934 budget. The tight rein on government spending during the FY 1930-to FY-1933 period was accompanied by sharp contractions in the economy’s output that, through its impact on tax collections, resulted in a swing in the budget from surplus to deficit and a more than doubling of the government’s debt-to-GDP ratio.
Dollars in Billions
|Fiscal Year Ending June 30||
Gross Domestic Product
Federal Government Receipts
Federal Government Expenditures
Debt-to-GDP Ratio (Percent)
Now, almost eighty years later, we have the same problem that FDR faced: the swollen ranks of the long-term unemployed. As shown in the following chart, the current average duration of unemployment is double that of any time since such data began to be collected in the late 1940s.
Obama, however, is following a course that’s the opposite of FDR’s.
When Obama walked into the Oval Office for the first time as president, the credit markets were frozen, the economy was in free-fall, and unemployment was hemorrhaging. The last thing on his mind was balancing the budget. The first was to stabilize employment as quickly as possible, and the way to do that was through a stimulus program that, in the near-term, would further enlarge the record budget deficit he had inherited from his predecessor. Non-farm employment bottomed one year after the stimulus program was enacted.
Since early 2010, less than two million of the almost nine million jobs that were lost during the preceding three years have been added. This accounts for the surge in long-term unemployment. Some of the President’s opponents claim that the stimulus program, which is now winding down, didn’t create a single job. Others go so far as to claim that it made matters worse; by adding to the deficit, they say, the private sector was “crowded out.” I will leave it to them to explain how the private sector could be crowded out when interest rates have been and are at record-low levels.
What seems clear to me is that the stimulus program helped to stabilize the economy and employment, both of which would have fared worse in its absence, but has not resulted in an economic recovery of sufficient strength to prevent the explosion in long-term unemployment.
In theory, Obama now faces a choice akin FDR’s: he can double-down, by pressing for another stimulus program, or he can chose to pursue another fiscal policy. But this choice exists only in theory, as neither the American people nor the Congress have the stomach for another “budget-busting” stimulus package. Politically, then, he can’t double down. There’s only one alternative fiscal policy: to cut the budget deficit in the hope that a smaller deficit will restore the “confidence” of both consumers and business. In fact, the President has put his weight behind a large deficit reduction program — the so-called “grand bargain.”
This is a slender thread upon which to depend for an improvement in America’s economy. As I’ve said before, the government’s out-go is the private sector’s in-come. Assuming default is avoided, our politicians, with the concurrence of the President, will soon reduce government spending. That spending is a source of revenue that provides the wherewithal to pay workers. If you take some of it away, some people will lose their jobs, adding to the ranks of the unemployed and reducing consumer spending. If confidence is to be increased, it must somehow more than offset the injury to confidence that this sequence of events will induce. Do you believe in magic?
Obama’s fiscal policy path — from deficit spending to deficit reduction — is the opposite of FDR’s. He has no choice but to be FDR in reverse. And that’s a pity because the box in which he now finds himself isn’t very pretty.
For the historically-minded, I’m including below the fold extensive excerpts from a lengthy review article published by the New York Times on January 6, 1935. It’s focus is the debate between “spenders” and “savers,” a topic that has a rather familiar ring. So lean back, pretend it’s early 1935, and you have to decide whether you will support the spenders or the savers.