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Published: December 12, 2009

IMAGINE you are a physician and a patient arrives in your office with a troubling and mysterious disease. Some of the symptoms are familiar, but others are not. You have never treated anyone with quite this set of problems.
David G. Klein

Weekend Business Podcast: Greg Mankiw on Fiscal Stimulus

Based on your training and experience, imperfect as it is, you come up with a proposed remedy. The patient leaves with a prescription in hand. You hope and pray that it works.

A week later, however, the patient comes back and the symptoms are, in some ways, worse. What do you do now? You have three options:

STAY THE COURSE Perhaps the patient was sicker than you thought, and it will take longer for your remedy to kick in.

UP THE DOSAGE Perhaps the remedy was right but the quantity was wrong. The patient might need more medicine.

RETHINK THE REMEDY Perhaps the treatment you prescribed wasn’t right after all. Maybe a different mixture of medicines would work better.

Choosing among these three reasonable courses of action is not easy. In many ways, the Obama administration faces a similar situation right now.

How hard is it to recognize a shortage of aggregate demand of this magnitude?????

When President Obama was elected, the economy was sick and getting sicker. Before he was even in office in January, his economic team released a report on the problem.

If nothing was done, the report said, the unemployment rate would keep rising, reaching 9 percent in early 2010. But if the nation embarked on a fiscal stimulus of $775 billion, mainly in the form of increased government spending, the unemployment rate was predicted to stay under 8 percent.

In fact, the Congress passed a sizable fiscal stimulus. Yet things turned out worse than the White House expected. The unemployment rate is now 10 percent — a full percentage point above what the administration economists said would occur without any stimulus.

To be sure, there are some positive signs, like reduced credit spreads, gross domestic product growth and diminishing job losses. But the recovery is not yet as robust as the president and his economic team had originally hoped.

So what to do now? The administration seems most intent on staying the course, although in a speech Tuesday, the president showed interest in upping the dosage. The better path, however, might be to rethink the remedy.

When devising its fiscal package, the Obama administration relied on conventional economic models based in part on ideas of John Maynard Keynes. Keynesian theory says that government spending is more potent than tax policy for jump-starting a stalled economy.

Yes, govt spending has a higher ‘multiplier’ than tax cuts, but either way that completely misses the point

With non convertible currency and floating fx. The choice between the two is a political decision. Tax cuts will restore private consumption with income led growth, while spending increases generally first increase public consumption by producing public goods and services. With excess capacity it’s a matter of what we want. Once that’s decided, the ‘multiplier’ only gives some idea of how far to go with either tax cuts or spending increases. The size of the spending and/or tax cuts is of no consequence beyond the effects on the real economy.

Personally, I have a notion of what the ‘right sized’ govt is, and would target that in any case. I’d have it a lot smaller in many areas where it tries to perform tasks directly, while broadening funding intiatives to meet national goals. But that’s another story.

The report in January put numbers to this conclusion. It says that an extra dollar of government spending raises G.D.P. by $1.57, while a dollar of tax cuts raises G.D.P. by only 99 cents. The implication is that if we are going to increase the budget deficit to promote growth and jobs, it is better to spend more than tax less.

This is a disgrace to Professor Mankiw and the rest of the economics profession that might agree and support this view.

The amount to spend and/or the amount of taxes cut per se is of no further economic consequence.

But it is the predominant view thats allowed the US economy to get into this mess in the first place.

Yes, there was a financial crisis, but gross ignorance is the only excuse for letting it spill over into the real economy, and stay spilled over for well over a year.

But various recent studies suggest that conventional wisdom is backward.

Those studies remain ‘out of paradigm’ as well, of course.

One piece of evidence comes from Christina D. Romer, the chairwoman of the president’s Council of Economic Advisers. In work with her husband, David H. Romer, written at the University of California, Berkeley, just months before she took her current job, Ms. Romer found that tax policy has a powerful influence on economic activity.

According to the Romers, each dollar of tax cuts has historically raised G.D.P. by about $3 — three times the figure used in the administration report. That is also far greater than most estimates of the effects of government spending.

Like it matters, as above. It’s the blind leading the blind, and giving each other Nobel prizes along the way.

Other recent work supports the Romers’ findings. In a December 2008 working paper, Andrew Mountford of the University of London and Harald Uhlig of the University of Chicago apply state-of-the-art statistical tools to United States data to compare the effects of deficit-financed spending, deficit-financed tax cuts and tax-financed spending. They report that “deficit-financed tax cuts work best among these three scenarios to improve G.D.P.”

Notice the prefix ‘debt financed’ which is an inapplicable gold standard term.

My Harvard colleagues Alberto Alesina and Silvia Ardagna have recently conducted a comprehensive analysis of the issue. In an October study, they looked at large changes in fiscal policy in 21 nations in the Organization for Economic Cooperation and Development. They identified 91 episodes since 1970 in which policy moved to stimulate the economy. They then compared the policy interventions that succeeded — that is, those that were actually followed by robust growth — with those that failed.

The results are striking. Successful stimulus relies almost entirely on cuts in business and income taxes. Failed stimulus relies mostly on increases in government spending.

All these findings suggest that conventional models leave something out. A clue as to what that might be can be found in a 2002 study by Olivier Blanchard and Roberto Perotti. (Mr. Perotti is a professor at Boccini University in Milano, Italy; Mr. Blanchard is now chief economist at the International Monetary Fund.) They report that “both increases in taxes and increases in government spending have a strong negative effect on private investment spending. This effect is difficult to reconcile with Keynesian theory.”

The problem is none of them have the fundamental understanding of how a currency works to be capable of understanding what they have compiled.

Do they seriously believe, for example, that if govt went out and hired 10 million people private investment spending would go down, all else equal? Any of you want to take that bet???

These studies point toward tax policy as the best fiscal tool to combat recession,

Again with the word ‘best’ that implies taxing less than spending per se is ‘bad.’

particularly tax changes that influence incentives to invest, like an investment tax credit. Sending out lump-sum rebates, as was done in spring 2008, makes less sense, as it provides little impetus for spending or production.

The main incentives for investing are a backlog of orders and cost cutting.

And while the lump sum rebates were not anywhere near the top of my long list for policy options, they did add to aggregate demand and kept things from being even worse.

Like our doctor facing a mysterious illness, economists should remain humble and open-minded when considering how best to fix an ailing economy. A growing body of evidence suggests that traditional Keynesian nostrums might not be the best medicine.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush.

Feel free to send this along to him, thanks.