June 21, 2010


Crisis Economics (N. GREGORY MANKIW, Summer 2010, National Affairs)

Macroeconomists especially have good reason to be humble, for there is a great deal we do not know. Teaching the "Principles of Economics" course at Harvard — a full-year survey — I start each year with what we economists are confident is true, and then move to material that is less and less certain as the course progresses. We look first at supply and demand, the theory of comparative advantage, profit maximization, and marginal revenue equaling marginal cost — the premises that almost every economist shares and accepts. As the course goes on, we move from micro to macroeconomics: examining classical monetary theory, growth theory, and, at the very end of the year, the theory of business cycles. This is the topic we economists understand least of all: We are still deeply divided on the validity and utility of the basic Keynesian paradigm. But it is precisely the topic that government macroeconomists work on most, especially during times of recession.

Even as a believer in many aspects of Keynesian theory, I appreciate that one cannot approach this subject matter without showing some humility. Economics is a young science, and much of our knowledge is necessarily tentative. Humility need not result in resignation or fatalism; nor does it mean we can't make economic policy. But it should mean that we constantly test our assumptions and policies against real-world results. We should seek in retrospect the data we cannot have in advance, and use those data to improve both our understanding of the economy and the policies we put in place.

At first glance, the Obama administration would seem to be taking such an empirical approach. In an attempt to "know" as much as possible about the consequences of the stimulus bill, the administration has been compiling data to measure its effects. Indeed, the vaunted stimulus web site (recovery.gov) claims to provide state-level job-creation "data," reported to two decimals of accuracy.

In reality, however, this ostensible effort at transparency is actually the least credible part of the whole case for the 2009 stimulus bill. For one thing, the reporting errors involved in the data collection are enormous, as hardly anyone accurately fills out the government's questionnaires about the jobs "saved or created" with stimulus money. Some employers, for instance, have counted money used to provide pay raises to existing employees as "creating" jobs. Thus the Wall Street Journal reported last November that the Mid-Willamette Valley Community Action Agency in Oregon had claimed to create 205 jobs with its $397,761 in stimulus money — spending less than $2,000 per "new" job.

The results of gathering economic data this way can be downright comical. A shoe-store owner in Kentucky who sold boots to the U.S. Army Corps of Engineers (for work on a project made possible by stimulus funds) claimed to have created nine jobs with $889 — a feat that would certainly make him the most efficient job creator in the country. The store owner apparently reasoned that he was creating one job for every pair of boots he sold the Army; after all, a soldier could not go to work on the project without a pair of boots. The episode received attention only because a reporter discovered the ridiculous claim, and the owner then asserted that he had been confused by the government form.

The administration has nevertheless accepted such reports, using them as the basis of their stimulus evaluations. But even if the reporting were perfectly correct, the exercise would still make little sense as a way of assessing the broader macroeconomic effects of the stimulus money. When we talk about the impact of government purchases on aggregate demand, and therefore on job creation, we must take into account an enormous number of "general equilibrium effects" — that is, the indirect effects that occur as one economic variable influences another, which in turn influences yet another, and so on. Such effects can be modeled and analyzed to some extent, but they cannot possibly be captured by crude job-creation surveys, or easily conveyed through administration web sites and talking points.

These general equilibrium effects are tremendously important to the economy — sometimes in positive ways, sometimes in negative. The positive effects are those that underlie the conventional Keynesian fiscal-policy multipliers: Higher government spending leads to higher incomes for some people, which causes higher consumption, and therefore higher incomes yet again, such that the effect cascades and multiplies. Economists can certainly track some of these effects, but the "data" on recovery.gov cannot possibly account for them.

The negative effects are even more challenging to trace. For example, if people observe the government issuing substantial debt (required to finance a stimulus), they may anticipate higher future taxes and therefore cut back on their current consumption. Increased government borrowing may also drive up long-term interest rates, which could make it difficult for people to borrow money and could therefore reduce spending today. Obviously, recovery.gov has no way to take account of these consequences, either.

So even if recipients of stimulus funding filled out their government reports reliably and correctly, the data they provided would not accurately describe the effects of the stimulus on job creation. Nor would data about job creation by itself actually resolve the underlying question about the administration's economic-recovery effort: whether it was right to pursue a spending-heavy stimulus plan, instead of one focused more on tax cuts.


Addressing this question requires not only data about the past year or two, but also analysis of some key assumptions at the core of the administration's approach to fiscal policy. In particular, that approach seems to take for granted that the question in choosing between spending and tax cuts is which would have the greater multiplier effect, and that the answer to that question is spending rather than tax cuts.

The first assumption overlooks an important difference between spending and tax cuts in the context of economic stimulus. When the government is seeking to revive its sick patient — the economy — time is of the essence. And time must be considered in any analysis of multipliers and other economic effects of stimulus policy. Chief among these considerations is whether government can spend money both quickly and wisely.

Many of us can draw on our own experiences in addressing that question. Anyone familiar with government projects even at the municipal level knows that the process is usually prolonged and onerous. Even if the design phase is managed well, the project is built efficiently, and the end product proves to be of good use to the community — all big "ifs" — the time involved in debating project proposals, securing approval from citizens and local boards, planning the design, hiring contractors, and completing the construction often stretches to years. Cram the process into a dramatically shortened time frame, and the likelihood that the project will be an example of "wise" government spending diminishes significantly. Expand the scope of the government spending from town planning to national fiscal policy, and the likelihood shrinks even further.

This is not just a matter of government waste, but also a question of whether money spent under such circumstances actually helps the economy grow in a way that best enhances citizens' well-being. Whenever public money is involved, it is important to ask whether the spending will produce something society needs, or wants, to improve the general economic climate. Money spent on a new road that allows farmers to get their products to market faster and in better condition, for instance, creates more value than money spent building a "bridge to nowhere," even if both projects create the same number of construction jobs.

To look at it another way: If a person pays his neighbor $100 to dig a hole in his backyard and then fill it up again, and the neighbor hires him to do the same, government statisticians will report that the economy has created two jobs and that the gross domestic product has risen by $200. But it is unlikely that, having wasted all that time digging and filling, either person is better off — economically or otherwise. Each person's net financial gain is zero, and all anyone has to show for the effort is a patch of fresh dirt in the backyard, which is unlikely to improve anyone's standard of living.

Private individuals don't usually spend their money on things they don't want or need. So when money is kept in the hands of citizens, and transactions take place in the private sector, there is less cause to worry about inefficient spending. The same cannot always be said of government. This means that government spending designed to stimulate the economy must first be subjected to serious cost-benefit analysis, which is hard to do in a big rush. Not all government spending is created equal — and rushed spending is, in many important ways, likely to be less efficient and less useful than spending that is carefully planned.

...but as personalized government stimulus.

Posted by Orrin Judd at June 21, 2010 6:08 AM
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