Dr. Keynes-love
Or, how I learned to stop worrying and love tax cuts
Unless you’ve been living in a cave for the past year (better luck next time with that mortgage), this should come as no surprise: The recovery is not going well. The stimulus bill, passed at the start of 2009, failed to bring the economic growth and employment predicted by its architects. Unemployment is higher than the White House projected it would be without the stimulus, suggesting, in the ultimate of political embarrassments, that the administration’s own numbers prove their policies have been counter-productive.
In response, President Obama claims foreign countries are the guilty parties — they have failed to increase their public spending as much as they should, leaving less demand for U.S. products. The charge is politically clever — foreigners are nothing if not good scapegoats — but as a matter of economic fact it is more than a little lacking. Exports account for roughly 7.5 percent of U.S. GDP. If our trade partners had increased their public spending as much as the U.S. (5.5 percent of GDP) instead of the 3.5 percent boost they actually did pass, the increased demand in the United States would be on the order of $20 billion. It is hard to believe that the $787 billion stimulus package failed on the scale that it did for want of a measly $20 billion in consumer demand.
Moreover, it should come as no shock to the president that German voters do not believe it their duty to spend hard earned public monies on the rescue of a foreign economy (good luck with Greece, Mrs. Merkel). If Obama really believed the recovery hinged on the cooperation of other nations, he is guilty not just of bad economic thinking, but naivete as well.
In reality, the reason for sluggish growth is not that the stimulus was $20 billion too small — it’s that it was a trillion dollars too small. At the time of the bill’s passing, the Congressional Budget Office projected a difference between actual and full national output of $2.1 trillion over the next two years. $787 billion, even if allocated wisely, was at most a half measure.
Much as it was with Donald Rumsfeld and his war planning team, Obama and his stimulus crafters bought into the politically convenient delusion that it is possible to achieve all of one’s goals without paying the full measure of their cost. And even more so than it was in Iraq, the United States can ill afford taking four years to overcome its delusion before finally putting more troops on the ground — we need an economic surge today.
In an ideal market, a sudden fall in consumer spending would not lead to unemployment. As consumers reduce their spending, they increase their saving. This increase in saving means more loanable funds and cheaper rates of borrowing, and, as a consequence, businesses and individuals invest more. That means more construction, more education, more capital goods and so on — in an ideal market, there would be a near one-to-one correspondence between the number of workers lost in consumer goods production and the number of workers gained in capital generation. There might be efficiency losses in the transition — not all economic resources are fungible across the two sectors — but there would not be involuntary underemployment.
Unfortunately, we do not live in an ideal market. Price and wage signals are sticky, and the real economy takes time to adjust to a new set of signals. The production of future goods cannot be ramped up as quickly as the production of present goods can be slashed. The worker laid-off today does not find new employment or return to school. He sits idle, like many of this nation’s factories and offices, a victim of the paradox of thrift. The old adage is wrong — there is such a thing as a free lunch, and it comes in the form of putting an unemployed worker back into use.
The solution, as most good economists will tell you, is to ease the transition from a low-saving equilibrium to a high-saving equilibrium by temporarily boosting aggregate demand. In an ideal market this would not only be unnecessary, but it also would not work — the borrowing done by government to pay for its stimulus would absorb loanable funds and reduce private sector investment — but in the imperfect market there is no such trade-off, as the loanable funds, like the workers, are sitting idle. Today, despite massive government borrowing, the interest rate remains at rock bottom; investment crowd-out should not be a salient concern.
There are two fiscal strategies for increasing aggregate demand: The first is spending, in which the government purchases some good or service for its use, and the second is tax cuts or transfer payments, in which the government returns money to citizens.
Government spending, in its ideal form, is the first-best strategy to boost aggregate demand, for the simple reason that it attacks the problem most directly. A dollar spent by the government is a dollar increase in aggregate demand. Conversely, not all of a dollar that is put in the hands of a consumer will go directly to increasing demand. The fraction of the dollar that is spent boosts aggregate demand, but the fraction of the dollar that is saved is like pushing on a string — it merely increases the amount of loanable funds sitting idle.
There are other compelling reasons for government spending. In the long run, government spending during a recession can reduce the budget deficit. Interest rates are low, wages are low, material costs are low... there is never a better time for government to invest on the cheap. Now is the moment to stock up on roads and bridges and any other inevitable outlays.
Regrettably, we do not live in the economists world of benevolent dictators, where the first-best solution exists as an option. We live in a world of myopic legislators who would rather promote their own parochial interests over the general good. If the first round of stimulus proved anything, it was that theory and practice are two very different birds. Handed an unassailable majority, the Democrats passed a “stimulus” whose spending components better resembled a partisan wish list than a cool-headed attempt at boosting the economy. Spending sooner is better than spending later, but as of today, $210 billion of the recovery act spending has yet take place, and another $65 billion in tax cuts have not been issued. It is also better to direct funds towards productive outlets, yet the stimulus was full of pork-barrel projects that in better times had been dismissed as wasteful and not serving the public welfare.
If our politicians are not responsible enough to execute the first-best solution, then the next round of stimulus will perforce consist primarily of the second best solution: tax cuts. Though some of their effect is lost through saving, tax cuts can be implemented quickly and have the added bonus of decreasing deadweight loss. Already the discussion in Washington has turned to this alternative, spurred on no doubt by the coming expiration of the so-called Bush tax cuts.
Currently, Democrats and Republicans are locked in a difficult struggle over the composition of tax relief. Democrats would like to cut taxes where the boost in aggregate demand will be highest (lower class income taxes), and Republicans would like to cut taxes where the removal of deadweight loss will be highest (capital gains, upper class income taxes). This is a worthy debate. But both sides are missing the bigger picture: Regardless of composition, the Bush tax cuts are simply not large enough. The demand gap that we face should compel us not merely to extend them, but to double or treble them for a period of two years.
Is this politically feasible? That depends. If Democrats truly believe we must stimulate, and are not, as some would claim, using the crisis as justification for wasteful spending and class warfare, and if Republicans really do buy into their own deification of tax cuts and do not treat seriously the notion that long-term debt problems must be solved before short term emergencies, then a major short-run tax cut seems imminently achievable.
There is an urgent need to restore consumer demand, and only one policy alternative that is both economically capable and politically viable: We should temporarily triple the Bush tax cuts.