Friday, July 29, 2011

Charting the Disappointing Economic News

The sad economic story in this morning’s GDP release can best be told with three simple charts.

First, economic growth in this recovery has been even slower than previously thought, and has averaged less than 1 percent so far this year. This is the main reason why unemployment has remained so high. And the recession was even deeper than previously estimated.

Second, inflation has been higher in the past two years than previously estimated. The broad GDP price index inflation rate has averaged 2.4 percent so far this year

Third, this recovery looks even worse in comparison with the sharp 1983-84 recovery from the deep 1981-82 recession. Real growth in the past eight quarters has averaged only 2.5 percent and has never exceeded 4 percent.

Wednesday, July 27, 2011

The Boehner and Reid Budget Plans Compared

Today the CBO released its updated score of the Boehner budget proposal and the Reid budget proposal. So we can now do an apples-to-apples comparison of the year-by-year numbers in the two plans, and thereby get a better understanding of the differences between the two. A couple of charts will help.

The first chart shows the impact of the Boehner proposal on federal discretionary outlays. Compared to the March CBO baseline it reduces discretionary outlays by $756 billion over 10 years, which, with interest saving of $156 billion and other smaller changes, reduces the deficit by $917 billion. That is of course a lot less than the $6 trillion in the House budget resolution, but it is a good step in the right direction. The proposal correspondingly increases the debt limit on a nearly dollar-for-dollar basis by $900 billion, which should take us into early 2012. Since this increase will not last through the upcoming presidential election, the proposal also enacts a process to increase the debt limit by another $1.6 trillion with matching spending cuts, which would then last through the end of 2012.

As the chart shows the Boehner plan gets started reducing discretionary outlays in 2012 (by $25 billion) and again in 2013 and then remains well below the baseline. The chart also raises doubts about claims like the New York Times editorial page made yesterday saying that the Boehner plan “would eviscerate discretionary programs.” That is not what the CBO numbers show. If you look at the graph you can see that with the Boehner plan discretionary spending remains far above the levels of only 5 years ago: In 2012 the level of outlays is 27% above 2007, just before the financial crisis—another indication that there is more work to do following this step.

The second chart shows the Reid proposal, which also places caps on discretionary spending. Two lines are needed to explain how the Reid proposal works. The upper Reid line shows the caps on spending excluding Iraq and Afghanistan; this line is nearly the same as the Boehner line in the first graph; it saves $751 billion over 10 years.

The lower Reid line shows that by also capping outlays for Iraq and Afghanistan, well below current CBO baseline for those operations, the Reid plan can be scored as cutting more from outlays than the Boehner plan. However, the CBO baseline for Iraq and Afghanistan simply extrapolates existing budget authority for these operations; it is by no means a forecast of future spending; rather it is an overestimate given current stated policy of the Administration and others regarding Iraq and Afghanistan. But by capping spending below this overestimate of spending and then counting the difference as budget saving, the Reid plan overstates budget saving. It is in this sense that critics say that the Reid proposal is based on gimmicks. And the amount is large; by capping spending in this way the Reid plan brings deficit reduction up to $2.2 trillion over 10 years, thereby justifying a larger increase in the debt limit which goes past the 2012 election.

If the Reid proposal removed this second type of cap it would be very close to the Boehner proposal. And this suggests--assuming that the House votes to pass the Boehner plan tomorrow--that the Senate could vote to approve the Boehner plan or something close to it, perhaps with some compromise about how to treat Iraq and Afghanistan spending projections going forward. 

Like the Boehner proposal, the Reid proposal avoids a tax increase. Following the ‘Boehner principle,” the Reid proposal ties the debt limit increase to reductions in spending growth in roughly dollar for dollar fashion; it is not a “clean” debt limit increase. And the Reid plan caps discretionary spending excluding Iraq and Afghanistan at the same level as the Boehner plan. In all these ways the Senate has moved dramatically toward the House in the last few weeks, and dramatically away from the White House, which this year has called for tax increases, a “clean” debt limit hike untied to spending, and no cuts to spending relative to baseline.

Tuesday, July 19, 2011

What Does Anti-Keynesian Mean?

In the latest edition of his excellent series of podcast interviews, Russ Roberts asked me toward the end what I thought about being characterized as anti-Keynesian as I was in this Economist post The rise of the anti-Keynesians. In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view.

Milton Friedman wrote a wonderful review essay on Keynes’ influence on economics and politics which touches on these issues and is still well worth reading. Friedman distinguished between Keynes’ political bequest—the advocacy of discretionary actions taken by powerful government officials—and his economic bequest—the emphasis on aggregate demand as a source of business cycle fluctuations. In the last section of the essay Friedman argues—quoting extensively from Keynes’ famous letter to Hayek on the Road to Serfdom—that the political bequest was very harmful while the economic bequest has many important insights. For simlar reasons using rational expectations models with rigidities or advocating policy rules which react to real economic variables is not inconsistent with an anti-Keynesian or rules-based approach to policy in practice.

Wednesday, July 13, 2011

A Way Out Of the Budget Impasse

In a column posted today on Bloomberg Views I suggested a way to resolve the budget impasse. It starts with the fact that about $6 trillion in deficit reduction is needed over 10 years to get to balanced budget.The proposal is that the President and the Congress  agree now to $2.5 trillion spending growth reductions and increase the debt limit by the same amount. The question about how to close the remaining $3.5 trillion gap--tax increases or more spending reductions--is then left to debate next year as part of the 2012 election.

This chart--which I have used before--shows the feasibility of the idea. In a speech on April 13 President Obama already suggested about $2 trillion in spending growth reductions. So we are almost there.

Friday, July 8, 2011

A Tale of Two Labor Markets: Today and '83-'84

Today’s jobs report provides yet more evidence that this is a recovery in name only. The 9.2 percent unemployment rate is certainly a serious problem, but you can understand the problem a little better by looking at the percentage of working-age Americans who are actually working. This percentage declined again to 58.2 percent in June, and is well below what it was when the recovery officially began.

The chart below shows the change--during the 24 months of this so-called recovery--in the percentage of people working and compares it with the recovery after the most recent deep recession of 1981-82. You can see the general recent decline. In contrast the percentage of people working rose sharply in 1983-84. So this time there really has been no recovery in the labor market.
The chart also tells you what might have been. For example, if the employment to population ratio had increased (rather than decreased) in the past 24 months by as much as it did in the 24 months following the 1981-82 recession, then 8.9 million more Americans would have jobs than actually have jobs.

Yesterday the House Budget Committee released a report on the jobs problem and, while mentioning several explanations, argued it is due to an economic policy problem, including the increase in the debt and deficit caused in part by the stimulus packages and spending boom of the past few years. My Bloomberg News column of yesterday shows that the Keynesian revival, which has its ten-year anniversary this month, hasn’t helped.

Monday, July 4, 2011

Time To Renew the Principles of 1776

What’s the best way forward for American economic policy? On Independence Day it’s natural to look to the country’s founding principles—political freedom and economic freedom—for an answer. 1776 was not only the year when Thomas Jefferson wrote the Declaration of Independence, it was the year when Adam Smith wrote the Wealth of Nations. We can learn what to do by studying the alternating periods in American history when careful attention was paid to these principles and when they were recklessly neglected.

From the perspective of today’s dismal economic performance—high unemployment and a nearly non-existent recovery from a devastating recession—the final two decades of the 20th century are particularly relevant for they stand out as unusually good economic times. With lessons learned from the 20th century’s tougher decades, including the Great Depression of the ‘30s and the Great Inflation of the ‘70s, America entered a period of unprecedented economic stability and growth in the ‘80s and ‘90s. Not only were 47 million jobs created, economic growth was more stable than ever before in American history.

Economic policy in the ‘80s and ‘90s was less interventionist in comparison with earlier 20th century decades. Attention was paid to the principles of economic and political freedom: limited government, incentives, private markets, and a predictable rule of law. Monetary policy focused on price stability. Tax reform reduced marginal tax rates. Regulatory reform encouraged competition and innovation. Welfare reform devolved decisions to the states. With strong economic growth and control of government spending the budget moved into balance. As the 21st century began many hoped that applying these same principles to education and health care would create greater opportunities and better lives for all Americans.

But economic policy went in a different direction. Some public officials found the limited government approach to be a disadvantage; they wanted to do more—whether to tame further the business cycle or increase homeownership. Others took the good economic performance for granted, forgetting that good economic policies made that performance possible. Still others forgot the earlier lessons that interventionist policies frequently made things worse. Complacent about the success in the ‘80s and ‘90s, they let down their guard against political pressures that thwart good policy and lead to reckless ones.

So policy moved in a more interventionist direction. The result was not the intended improvement, but rather an epidemic of unintended consequences--a financial crisis, a great recession, and the high unemployment and wasted resources we see now. The change in direction did not occur overnight. We saw increased federal intervention in the housing market in the late 1990s. We saw a countercyclical fiscal policy in the form of rebate checks in 2001, and then a failure to control of government spending growth from entitlements to defense. We saw monetary policy moving in a more activist direction in 2003-2005, and interventionism reached a new peak with the bailouts before and after the panic in 2008. In the past three years Washington doubled down on the interventionist approach, and deficits and debt have exploded. With high unemployment and fears of a secular American decline, there is now an urgent need to get back to the principles of political and economic freedom put forth in the Declaration of Independence and in the Weath of Nations. The good news is that it’s not too late.

Sunday, July 3, 2011

No, A Bigger Stimulus Would Not Have Worked Either

Paul Krugman writes (citing Noah Smith) that he agrees with the empirical findings in my critique of the revival of Keynesian activism in the 2000s (the stimulus packages of 2001, 2008 and 2009). In particular, he writes that “it’s far from clear that the ARRA actually led to much of a rise in government spending, while the tax cuts that made up much of the stimulus were probably largely saved.”

But he then goes on to say that the stimulus was too small. That’s not what I found in my paper. As I stated in the paper, my “results do not lend support to” the view “that the stimulus was too small.” Rather the paper showed that “a larger stimulus package—with the proportions going to state and local grants, federal purchases, and transfers to individual the same as in ARRA—would show little change in government purchases or consumption.”

Now, I know that Krugman is trying to distinguish between good and bad Keynesian stimulus packages, and that he would like a stimulus package with higher proportions going to federal, state, and local government purchases than the 2009 stimulus, or, for that matter, the 2008 stimulus or the 2001 stimulus. But experiences from the 1970s raise serious doubts about the political and operational feasibility of such discretionary fiscal policy. So do recent experiences in many other countries, as shown by Hyun Seung Oh and Ricardo Reis.

In a simple Keynesian model, all the government has to do to combat a recession is quickly increase government purchases, but the difficulty with doing so in practice is one of the classic arguments against discretionary fiscal policy. Of course, it is not the only argument. Small or unreliable multipliers, the legacy of increased debt, the unpredictability and temporariness of such policies are some of the other arguments. Using dynamic models with expectations and incentives, I have found very small multipliers (around .5)

For these reasons I argued in the November 2008 article which Krugman cites that a better fiscal policy would be to rely on the automatic stabilizers and enact more permanent reductions in tax rates (or at least pledge not to increase tax rates in a recession).

As early as the summer of 2009 it was clear that ARRA was not working as intended, as John Cogan, Volker Wieland and I reported. Research since then has uncovered the reasons why. One reason is that very large stimulus grants to the states did not go to infrastructure spending as intended, and that’s what Ned Gramlich found out about Keynesian stimulus packages thirty years ago.