Arnold Kling  

The Anti-Stimulus

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Greg Mankiw reports that the yield curve is steep, meaning that long-term interest rates have risen. In my view, this is perfectly rational, and it shows that the short-run effect of the fiscal stimulus is negative, as Jeff Sachs predicted.

This is all based on a Keynesian type of macro analysis. As we know, most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy.

According to this standard analysis, the stimulus is going to hurt GDP now, when we could use the most help. Much of the spending will kick in a year or more from now, with multiplier effects following afterward, when the economy will need little, if any, stimulus.

This is the flaw with using spending rather than tax cuts as a stimulus. The lags are longer when you use spending.

Of course, if the real goal is to promote government at the expense of civil society and to create a one-party state in which business success is based on political favoritism, then the stimulus is working exactly as intended.

[UPDATE] It is important not to confuse the outlook for economic activity with the effect of the stimulus. Even if the stimulus has a negative impact, the outlook for economic activity could be positive, and this could cause an upward-sloping yield curve. But I'm not sure that the outlook is necessarily positive. Bond investors could simply be taking the view that with or without a strong recovery in real output, the deficit spending is going to be monetized at some point, leading to inflation and higher interest rates.


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CATEGORIES: Fiscal Policy



COMMENTS (19 to date)
Grant Gould writes:

As someone in the telecoms industry, I see this a lot -- folks are deferring capital expenditures in the hopes that when the feds succeed in finding their asses and cutting some checks (inevitably a 6-14 month process) then those same capital expenses will be subsidized. The result is that capital spending is deferred, exactly the opposite of what even a Keynsian would prefer.

I am open to the possibility that some stimulus might in some case somewhere work. But the notion that the US federal government can do it strikes me as unlikely in the extreme.

Michael writes:

Why does everyone take it as given that deficit spending causes interest rates to rise? This chart says its not the case: http://www.optimist123.com/optimist/2009/05/do-deficits-cause-higher-interest-rates-you-decide.html

Floccina writes:

To me this is evidence that if you do not know what to do you should probably do nothing. Evidence needs to very strong before you acting, especially if the actions go against fundamental principles. I think that we seeing the FDR approach verses the Warren G harding approach. Hopeful in a few years the postmortem evidence will be strong enough to show whether we are better off for the stimulus or worse off.

jb writes:

Of course we should do nothing! Nothing is the appropriately rational response almost all the time. Doing nothing forces people to become caretakers of their own future. It forces them to determine their own comfort for risk, and lets overconfident businessmen (and women) proceed forward with their crazy plans, without that little voice in the back of their head saying 'but what if the government screws it up'.

But doing nothing isn't politically viable, because it undermines the narrative that "government fixes problems that businesses and people can't"

And so we will continue to do "something" when nothing will suffice, and ultimately, we will do "something" that pushes us into collapse. Preferably not anytime soon.

David writes:

"Of course, if the real goal is to promote government at the expense of civil society and to create a one-party state in which business success is based on political favoritism, then the stimulus is working exactly as intended."

Yup.

El Presidente writes:

Post hoc ergo propter hoc?

There couldn't be other reasons for rising long-term rates, could there?

Greg writes:

Where is the economic analysis?

You start off with link to Mankiw who says in that link: In general, a steep yield curve--that is, a high value of this variable--is a positive indicator of future economic growth.

Now you could point to Mankiw's caveat in your defense: In many ways, however, this is an unusual downturn, so it is not entirely clear to what extent historical relationships are a useful guide going forward.

But if you did, then that caveat throws as much doubt on your arguments as on the arguments for stimulus.

So again, where is the economic analysis?

Arnold Kling writes:

This is freshman macro.

The government announces a big fiscal stimulus to take place in the future. Long-term interest rates rise, which weakens the economy in the near term.

Later, the spending kicks in, and the economy expands. If you can't follow that, then take a basic macro course.

El Presidente writes:

Arnold,

Can't follow and don't agree are two different things. Nobody disputed the plausibility of your conclusion given the portion of Keynesian theory you've chosen to apply this time, but you don't seem to entertain other explanations. If you can explain away the concept of effective demand, I'm all ears. I'd hate to think we are persistently misinforming freshmen . . . though it might help to explain their confusion.

Boonton writes:

The government announces a big fiscal stimulus to take place in the future. Long-term interest rates rise, which weakens the economy in the near term.

Later, the spending kicks in, and the economy expands. If you can't follow that, then take a basic macro course.

OK, in 2000-2002 Bush announced both tax cuts that would be in effect for about 8 years or so and a War in Iraq. While one honest general was fired for saying the war would cost more than $100B, I'm sure the market was smart enough to know that there would be big deficits and big spending in the future.

Therefore, short term interest rates should have gone up, the economy should have entered a serious recession say from 2003-5 or so. Yet the recession started in 2007/8 and interest rates are still lower than what they were then. So whats up Professor?

Dale K writes:

Arnold,

Some are saying excessive (deficit) spending will not lead to inflation because nowadays the multiplier has shrunk (what we called the "velocity of money" back in my college Econ class). Can the multiplier change enough to allay inflation fears, or is it more or less stable?

Arnold Kling writes:

Boonton,
It is important to distinguish actual outcomes from other-things-equal outcomes.

For example, one can have an economic expansion even if the other-things-equal effect of a policy is contractionary.

Other things equal, the Bush tax cuts and spending/war policies should have raised interest rates. I believe that, other things equal, those policies did raise interest rates--but other things were not equal. On the short end, you had the Fed pushing down rates. On the long end, you had the "global savings glut" holding down rates. I addition, we had the financial euphoria, which held down the risk premium.

Boonton writes:

And the Fed holding down short rates should have raised long rates making the yield curve even steeper. After all, the Fed can only push down short rates by printing money. If the market is thinking more debt, more inflation in the long run that would just encourage them to insist on higher long term rates. So your 'stimulus caused recession' should have shown up earlier.

That leaves financial euphoria and 'savings glut' as the only two explanations left and they really sound like the same thing. 'Financial euphoria' sounds like the market was overvaluing investments. Overvalued investments means the market was saving more than was justified by the expected rational rate of return.

But we are still left now with lower rates than then and the question is why? If the market thinks the economy is going to be overstimulated two or three years from now due to the delayed spending of the stimulus package....well rates are still lower than during the previous period of euphoria where everyone was assuming fantastic growth and presumably high inflation.

Boonton writes:

And not to be snarky to the good professor but why exactly is 'everything else held equal' from the day Obama got into office but all those other variables were flying all over the place before that disconnecting theory from actual results???

The 'theory' here seems to make no useful predictions. If the stimulus fails the result will be a steep yield curve....if the stimulus didn't fail the result would again be a steep yield curve since economic recovery would imply higher long term interest rates.

unemp writes:

There is a single aspect of the stimulus which is working now ... right now.

And that is unemployment compensation.

However, that just ran out. People who were depending on the extended unemployment benefits in order to make their house payments have exhausted those benefits.

They will now begin to default on their home loans, creating a new larger wave of foreclosures.

The Obama Administration is aware of this, but refuses to act. So, we're in for an extended Obama Depression.

Obama Depression writes:

Yes, we understand that the President and all of his men would have flunked freshman econ 101. That much is obvious.

The question is what do we do now?

Craig writes:

Why does everyone take it as given that deficit spending causes interest rates to rise?

As your charts show, this has not always been the case. But, in the past, there have been plenty of foreign governments willing to buy so much of the debt that interest rates remained low. If that is still the case, we don't have to worry.

The bet now is that those countries will not want as much of our debt -- China is making noises in that direction. If they slow down their buying, the rates will go up.

newscaper writes:

Arnold is right about the counter intuitive dampening effect.

To use an analogy (which,yes, always has limitations)...

The short term effect is very much like a consumer electronics manufacturer eager to get a jump on the competition by cutting its own throat as it announces the big next gen product (better and costs less, too!) too soon while it has tons of the existing product (that it just obsoleted in the minds of its customers), still in inventory and the supply chain. Current sales drop as consumers wait to make a better future purchase, sometimes resulting in a terrible cash crunch.

That's an even simpler no-econ-course-needed explanation.

stan writes:

I'm amazed that some folks don't seem to grasp the size of the deficit spending. There's ordinary deficit spending and then there's Obama's deficit spending. Apples and oranges.

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