Arnold Kling  

Against the Big Stimulus

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After reading Willem Buiter's long piece (pointer from Mark Thoma), I decided that it is time to come out firmly against a large fiscal stimulus. Instead, I would prefer a small stimulus.

The case for a large stimulus appears to be based on the notion that small stimulus might fail completely, while large stimulus might succeed. This might be true if there are increasing returns to fiscal stimulus or there are threshold effects of fiscal stimulus. I think it is fair to say that the case for increasing returns or threshold effects is not well established either theoretically or empirically.

On the other side of the ledger, the risks of a large stimulus, compared with a small stimulus are:

1. It is harder to spend larger amounts quickly and cost-effectively.

2. There is a greater risk that we will run into a "sudden stop," in which foreign investors are no longer willing to fund our deficits (this is Buiter's main worry).

3. There is a risk that the intergenerational transfer imposed by the stimulus (from our children to ourselves) is excessive, particularly in the context of other intergenerational transfers of the same sort.

4. There is a risk that fiscal stimulus, large or small, is actually ineffective, so that a large stimulus only means a large failure.

5. There is a risk that much of the spending will kick in after a recovery is underway.

6. The government's capacity to deal with an emergency, such as a major natural disaster or a foreign attack, will be limited, because its credit worthiness will be damaged.

7. There is a risk that government will absorb a permanently higher share of GDP. Policymakers will be reluctant to cut public spending for fear of causing a downturn. Moreover, it will be difficult politically to cut public sending.

I suspect that for some of the proponents of fiscal stimulus, the last point is a feature, not a bug. What they really are proposing is a permanent, Galbraithian shift from the private sector to government, in the guise of a large fiscal stimulus.

Overall, on close examination, the case for the large fiscal stimulus, like the case for the Paulson rescue plan, is really quite weak. However, the same elite groupthink that made passage of the Paulson plan inevitable probably also makes the passage of the stimulus package inevitable. Opponents of the stimulus plan will be mocked and vilified in the media, even though they may very well have logic on their side.

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CATEGORIES: Fiscal Policy

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The author at Three Sources in a related article titled Keep it small writes:
    A guy with an 8.9" laptop finds Arnold Kling's suggestion pretty captivating. Instapundit linked as "Meanwhile, Arnold Kling is against the stimulus bill" which got me thinking of Taranto's "bottom stories of teh day" feature. But when you click throug... [Tracked on January 6, 2009 12:18 PM]
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winterspeak writes:


What about a payroll tax holiday as the mechanism of the stimulus? Would you still feel the same way?

It would be large, quick, easy to turn on and off, and would channel money to individuals, not to politically connected groups. People would use it to pay down debts, spend, etc. etc.

Would you still be against a large stimulus if it was enacted as a payroll tax holiday?

Naskra writes:

Isn't point #7 a certainty rather than a risk?

Noel writes:

I wish to add to your list

8) It is pure nonsense to suppose that government spending ("appropriate" or "excessive" one) can increase overall wealth of the society. Money spent by government must be extracted from taxpayer via taxes, or higher debt, or inflation. There is no free lunch.

dearieme writes:

What's wrong with an intergenerational transfer from my children to me? So far it's been all the other way, and probably will be again when my widow dies.

ryan yin writes:

Isn't point #4 an understatement? There is also a very real risk that a fiscal stimulus is actually detrimental to the economy, particularly in the presence of real shocks. Is there a good reason to exclude the RBC point of view here?

dWj writes:

5) is also probably, in some circles, a feature rather than a bug. Do something big and get credit for whatever follows; post hoc ergo propter hoc.

dcpi writes:

If a fiscal stimulus is good and a bigger fiscal stimulus is even better, why not just create an infinite fiscal stimulus and enter heaven without passing go?

If a fiscal stimulus is only good to the extent it "picks up slack" in the productive economy by putting resources to work that would otherwise be unemployed, shouldn't the size of the stimulus be based on the amount of unused resources?

Has anyone attempted to measure how much of our resources are unused? Shouldn't that be step one?

To the extent that government stimulus "crowds out" resources from private investors, should not the point at which the stimulus is most effective be the point at which the marginal cost of the stimulus reaches the marginal benefit of the marginal private spending dollar usurped by the government stimulus?

Anyone wise enough to know where that point is?

Bob Murphy writes:

Arnold, are you just hedging yourself, or do you really believe small "stimulus" is better than zero stimulus?

Do you think it would be a bad idea for the federal government to slash spending $400 billion and simultaneously reduce marginal tax rates to give the equivalent (on a static computation) tax cut? That wouldn't be a "stimulus" in the Keynesian sense--it would probably be a net harm with the balanced budget multiplier idea--but I think it would do wonders.

Maniel writes:

I agree with Bob Murphy. A reduction in government spending would send a signal to investors that we intend to begin to move away from a debt-based economy to an equity-based economy. Actions taken for the long-term can change attitudes in the near term.

Dustin Wyatt writes:
dearieme writes:

What's wrong with an intergenerational transfer from my children to me? So far it's been all the other way, and probably will be again when my widow dies.

Social Security.

Mr. Econotarian writes:

I think any "stimulus" bill should include metrics, and that the future pay of congressmen should depend on meeting economic goals based on those metrics.

Mark A. Sadowski writes:

Willem Buiter's analysis was excellent but I think he greatly exagerates the relative danger of our current account deficit and negative NIIP. His advice to do nothing about the liquidity crisis and wait for global demand to recover is a recipe for economic suicide. The credit crisis is already hurting the ability of exporters to get financing and it could take a year or more before global demand picks up.

Small stimuluses were tried by Japan and they failed. All of the stimuluses were much smaller than advertised, by about a factor of three. The largest stimulus package was about 1.6% of GDP and was passed in late 1995. GDP growth improved by 0.7% the following year, but deflation continued. In 1997 the Japanese went on an austerity kick and GDP growth went negative for two years. In order to get out of a liquidity crisis (the fed is pushing on a string right now) you need a large fiscal shock to aggregate demand so that monetary policy can once again become effective.

Also, I noticed Bob Murphy's comment on marginal tax rates. A simpler tax system with fewer deductions and lower marginal rates might be desirable in normal times (it is debatable) but these are hardly normal times. The goal of a stimulus is to get the largest multiplier effect for the buck and that would be achieved by what is being proposed right now: tax cuts directed to those with low and middle incomes (not to mention extended unemployment benefits and increased food stamps), relief for financially destressed state governments, and federal spending on infrastructure. Lowering marginal rates will only stimulate the wallets of the wealthy and right now they are closed tight (luxury good sales are off by over a third for example). The goal of marginal rate cuts is of course to stimulate investment but empirically marginal rate cuts have a poor record of doing just that, and there are few if any good investment opportunitues in a global downturn.

ryan yin writes:

Mark Sadowski,

I'm not sure that the entire point of decreasing marginal income taxes is to increase capital investment -- another reason is to encourage labor supply (and anyway if there are indeed few good investment opportunities, we should reconsider the assumption of underutilized resources). But surely part of the reason that marginal income taxes aren't terribly powerful in stimulating output is that they involve both income and substitution effects. Making it just an income effect doesn't sound like a great idea here.

winterspeak writes:

MANIEL: I assume that, by equity based economy, we should all go back to barter?

MARK: I agree. Buiter is too concerned with the Federal deficit.

DCPI: Stimulus should be like porridge. Not too much, not too little, just right. The goal is to increase the deficit and counteract the decrease in money supply generated by banks shutting off credit.

RYAN: The reason to cut taxes is to increase aggregate demand. Taxes reduce aggregate demand. Best way to do this is to enact a payroll tax holiday.

Mike writes:

If you are a free marketeer or dare I say a Masonomist and you believe Prez-elect Obama has a hidden agenda to do what he advocated in his campaign (how weird is that?) and the sooner we get back to free market economics the better than what do we do?

We must acknowledge that the political pendulum has swung to the left and wait for leftist failure to swing the pendulum back while doing the least harm.

Infrastructure investment will not work (see FDR and the Great Depression and Japan and the lost decade of the 1990s) but it has the benefit that at least spending, if carefully vetted, will go to something that builds productive capacity.

Payroll tax holidays are probably the best way to get a quick fix but are not the solution to the fundamental problem which is repairing the damage to financial system infrastructure due to the loss of confidence caused by the collapse of the securitization process and the associated shadow banking system.

We will not come out of this decline until we repair the financial system but what needs to be done is politically unpalatable - namely do what appears to favor Wall Street over Main Street (mostly through the Fed temporarily substituting as lender of last resort in the damaged credit creating sectors of the economy).

This will never be done as long as the left is in control and is the Achilles heal of their ability to successfully repair the economy. The credit meltdown is the left's Iraq War and will be Prez-Elect Obama's ball and chain he will drag around for the duration of his Administration. In my opinion, we are going to limp along until people tire of economic malaise and the pendulum swings back.

Enjoy the ride!

Mario Rizzo writes:

Why is there a case for any (fiscal)stimulus at all? If we are simply talking about indulging the public in their fantasies about an easy way out of the economic mess, then I am no expert on this.
However, since so much of the current problem has its roots in the misdirection of resources we must be careful not to frustrate allocative adjustments by renewing the misdirection of resources towards over-expanded sectors. These are not sustainable in terms of the preferences of consumers and investors. The operative resource allocation principle in the political process is toward those areas with the greatest political influence. (BTW, none of this is to be taken as opposing the maintenance of sufficient high powered money to prevent outright deflation.)

Brian Slesinsky writes:

re: "There is a risk that the intergenerational transfer imposed by the stimulus (from our children to ourselves) is excessive, particularly in the context of other intergenerational transfers of the same sort."

This seems rather unlikely.

Transferring wealth from the future to the present cannot literally happen without a time machine. And for the country as a whole, passing ones and zeroes in bank computers to our children will not benefit them. Only long-term investments can pass wealth to future generations.

So the only way this can happen is that the stimulus "crowds out" long-term investments that would have a more beneficial effect on future generations.

But how can this happen? In a recession, labor and capital are sitting idle. Government spending can't "crowd out" long term investments when there is no shortage of resources for both public and private spending. And even if it did, it's unclear, especially given what just happened on Wall Street, that private investments are wiser or more forward-looking than government spending on things like basic infrastructure and education.

Maniel writes:

Winterspeak wrote: "I assume that, by equity based economy, we should all go back to barter?"

Sir, not exactly. In my view, money still has an important role to play in our economy. However, as a practical matter, money is not the same as debt. True, it can look that way for a while, until the bills come due.

An equity-based economy implies a stronger reliance on equity than on debt, to buy a house, to finance the expansion of a company, and to serve as a general life-style goal (save and invest rather than simply take on debt to consume). [I invite you to visit my own blog for further thoughts on the matter.]

We are currently addicted to debt. If the current recession does not serve as a withdrawal from that addiction, we will have suffered and will have mortgaged our children's future for little or no gain. When an individual sinks over his head into debt, counselors advise cutting up the credit cards.

winterspeak writes:

Maniel: So you "equity based" you mean "less debt based". I think we are already there.

Also, let me ask you, what is a loan that is made even though there is a very slim chance it will be paid back? We're certainly seeing a lot of those these days. Is that debt money?

NormD writes:

I don't think any government can draw upon enough resources to "rescue" its economy. Only the participants in the economy have the power to do this. The focus on government stimulus reminds me of serfs wailing for their king to do something. We need leadership to inspire us to get moving not stimulus and bailouts which are inherently disempowering.

Dan H. writes:

But how can this happen? In a recession, labor and capital are sitting idle. Government spending can't "crowd out" long term investments when there is no shortage of resources for both public and private spending. And even if it did, it's unclear, especially given what just happened on Wall Street, that private investments are wiser or more forward-looking than government spending on things like basic infrastructure and education.

It can happen even if 20% of the country is sitting idle, because the people you need to build the infrastructure you want may not be the idle ones. Labor is not fungible in a modern economy. People are trained for specific things. Capital investment is limited (there are only so many road graders and asphalt machines). If you decide to build the world's biggest bridge to nowhere, you're likely going to have to hire engineers, architects, environmental lawyers, surveyers, and skilled tradespeople who are already doing other, more productive work.

In addition, big infrastructure projects can consume a lot of raw materials, driving up the price for everyone else. One of the compensating factors in a recession is that commodity prices drop, offsetting some of the pain (oil price drops are currently 'stimulating' the economy to the tune of about $200 billion per year). Build a trillion dollars worth of new bridges, and the price of steel is going to go up. There will be shortages of cranes and other heavy equipment (or, if you engage in a crash program to build them, there will be a glut of them after the stimulus money is gone).

And because of the Davis-Bacon act, public works projects often pay more than private sector jobs, meaning you will attract labor that is already working elsewhere, and also that you will drive up the cost of labor at a time when it should be going down.

Japan's experience with infrastructure building is that it didn't work very well, and at the end of the day they now have an overbuilt infrastructure they can't afford.

Maniel writes:

Winterspeak wrote: "what is a loan that is made even though there is a very slim chance it will be paid back?"

Sir, I will assume that your question implies that the lender knows, before making the loan, that the probability of repayment is low. In the case of a private loan - such as you lending directly to me - I would say that the loan is merely mislabeled, that you meant it as a gift (since we're related, you like me, you fear me, ...).

In the case of a loan from a lending institution, I would say that such a loan is imprudent, a violation of the fiduciary responsibility to protect depositers' money. In the case of mortgages, which you may have in mind, the obvious conditions for a prudent loan are predicted ability to repay (based on the borrower's current assets and income) and collateral. While it may appear that, in light of current market conditions, the resale value of the home (used as collateral for a home mortgage) may be difficult to assess, I would submit that had lenders been qualifying buyers according to both ability to repay and reasonable equity (the anti-debt), traditionally represented by a down payment of at least 20% of the purchase price, we would never have had the degree of inflation or deflation in housing prices that we have experienced.

Having government throw your money and mine at the problem (which was largely created by government) will only delay a return to prudent lending.

Mark A. Sadowski writes:

Japan's infrastructure stimulus spending didn't work very well for the simple reason Japan was probably already spending too much on wasteful infrastructure. Even before their economic crisis began infrastructure spending as a percent of GDP was the highest in the advanced world, about 6.5%, mostly due to the strong construction lobby. In fact Japan, a nation about the size of California was already producing as much concrete as the entire United States. At its peak their infrastructure spending was boosted to about 8.5% of GDP but now it is down to a more sane level of less than 5% of GDP.

The United States has no such problem. Our infrastructure spending is about the lowest in the advanced world, about 3.3% of GDP. With collapsing intersate highway bridges in Minneapolis and exploding steam pipes in downtown New York we have a reputation for one of the most decrepit infrastructures around. A boost in such spending, especially right now, would almost certainly be beneficial. According to Mark Zandi infrastructure spending would have a multiplier effect of 1.59. His testimony on fiscal multipliers is available here:

George writes:

I can't remember a time in my life when more government stimulus has been thrown at the economy. Interest rates so low it's hard for savers to earn any interest on savings. No additional stimulus, please. Instead, I would like to establish what the tax rates and regulations are going to be for investment for roughly the next decade. I would love to see an inflation adjustment to the cost basis in long-term capital gains tax calculations. Exempting smaller businesses from some parts of Sarbanes-Oxley would also help. In general, I believe that the federal government should set the rules for private investment and then try to stay out of the way.

Regarding infrastructure spending, last time I checked states had the power to raise fuel excise taxes and spend money on roads and bridges. Maybe full responsibility for roads and bridges plus fuel tax revenue should go to the states.

Charlie Poole writes:

I would appreciate it if people would stop referring to massive increases in govnt spending or tax rebates financed by borrowing from abroad as "stimulus." Why not call these programs what they are and then ask if they will stimulate anything?

Jim Baird writes:

Points # 2 and 3 are simply inapplicable. Dr. Kling needs to take a remedial course in reserve accounting. (Or maybe Econ departments need to start offering courses in reading spreadsheets...)

Since foreign investors do not, in fact, "fund our deficits", there is no danger of them ceasing to do it. Our deficits allow them to accumulate dollar assets - if they were to desire to accumulate fewer dollar assets, that could damage our terms of trade but it can not, as an operational matter, have any effect on the ability of the U.S. Gov to spend.

Similarly, (as stated above) it is physically impossible for spending decisions now to transfer goods and services from the future to the present (I think Mr. Einstein had something to say about this.)

Mark writes:


Supposed we focused the stimulus strictly on your AIPAC, WINEP, Heritage, and AEI Sugar Daddies like Sheldon Adelson?

Would you then feel better about the deal, knowing that some of that stimulus money might trickle down from Shelly and his pals to the offshore bank account they've established in your name?

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