Bastiat again, a little more formally, and then implications for stimulus

1. Bastiat

Bob Murphy has a good post up on my conversation with him on Bastiat. You can read him for context, but what it boils down to is that he and I started parsing out the costs and benefits and we got to a point where he thinks I'm going back on an earlier assumption. In one way I was - and I didn't mean to because I still maintain my earlier assumptions about crowding out. But in a more accurate sense, saying "Daniel's going back on an earlier assumption" is too generous for me because my conversation with him in the comments was simply wrong. So let me clean this up a little bit.

We have a Keynesian economy where 0 < MPC < 1, Y=E, there is some autonomous spending, and there is some investment expenditure unrelated to Y or E, which we'll call "S" (for Bastiat's "shoe spending"). This should bring to mind some familiar dynamics, and it's presented in the first panel of the figure below. Vertical lines mark C and Y=E.

Then, disaster strikes. Underneath that first panel we have a new autonomous component of expenditures, R (for "repairs"). R is done by the same people that do S, and so S declines in response to an increased spending on R.

Now, the $787 billion question is "how does S respond to the introduction of R?". Bastiat's position is that it is completely displaced. Bob Murphy showed us where Bastiat wrote that in this post, which was one of the few enlightening Bastiat posts I've read recently (Do you see a pattern here? Read Bob Murphy!). Keynesians disagree with this, and I disagree with this - under certain conditions. This is the point I botched in the conversation with Bob. On the one hand I assumed a multiplier effect, but on the other hand I said it was completely crowded out (Bob could have pointed out that this was contradictory which means I was dumb, but he gracefully assumed I am not dumb and just agree with him).

Right now we think that a lot of money is being kept liquid, so that new spending doesn't necessarily crowd out old spending. Seems reasonable (to me). So spending on S doesn't completely disappear in the second panel, but it is curtailed. The addition of R2 to S2 and C brings the new Y=E up above the old Y=E: higher GDP due to spending on R at a time when there isn't perfect crowding out. Voila.



Now, I still am maintaining that a net benefit for the economy seems very unlikely, although I have just demonstrated I think there is a gross benefit in the form of an increase in GDP and employment. The reason for this is that there's still a lot of crowding out, so only a small portion of the increase in Y=E (see the horizontal axis) associated with an increase in R (see the vertical axis) is an actual increase - the rest is just a displacement of Y=E attributable to spending on S1.

Hold on a second - what was that? Why does Daniel think so much crowding out is happening? Don't he and Krugman and DeLong and all those other kooks think there are all sorts of free lunches all over the place?

Well you have to think about exactly what is being proposed here. The presumption is homeowners and shopowners are rebuilding, right? They don't have much of a choice but to divert a lot of their spending towards repairs. Doesn't this contradict what I say about the stimulus? No, it doesn't. Why?

2. The Stimulus

The key here is to remember what Keynesians actually propose, which is why the other day I wrote "The boilerplate Keynesian position is to increase spending and lower taxes during a downturn. So there is no proposal of taking money from anybody. The point is to create money or other safe, liquid assets (like, say, Treasury debt) for which there is an excess demand". One commenter said it was "stupid". Another called me a "loon". But the point of this is crucial.

If you really want to analogize cleaning up after a disaster to economic policy, it would have to be analogized to a situation where the government pays for a $787 billion stimulus by levying a $787 billion tax on investors. That would be a real broken window situation. You might have something like I demonstrated in panel 2 of the figure above: a modest increase in output due to the fact that perhaps some of those taxes would be paid out of hoards rather than investments. After all, the government's liquidity preference is essentially zero and investors' liquidity preference is some positive figure. So you might get some growth from that. But not really much of any. That's why Obama didn't demand a $787 billion tax increase with the ARRA bill. That's why Krugman wasn't clamoring for a $787 billion tax increase. That's why I - unlike Krugman or Obama - didn't want to repeal the Bush tax cuts.

So for the reasons Bastiat laid out, paying for window repair with money budgeted for buying shoes is not going to increase growth. A Keynesian might quibble that if the shopkeeper had a non-zero level of liquidity preference you might get a little growth (because not all of his shoe spending would be displaced), but I'd maintain that once you take the loss of wealth into account, you're still likely to end up with a net loss in economic welfare, despite the increase in GDP. Same goes if you tax the shopkeeper and then pass a stimulus package with that tax money.

Of course, tax money and money budgeted for buying shoes isn't the only way to fund these things. Enter, the bond market.

This is what really sets the stimulus apart from any of this discussion about Bastiat. This is why I can say that with a few quibbles I agree with Bastiat, but that I also agree with Krugman and Keynes (and that Bastiat doesn't really contradict Keynes in a lot of the ways people seem to think that he does).

Let's think of the loanable funds market, which I find to be a much better way to think about the origins of the IS curve in the IS-LM model than the modern tendency to derive it from the national income equation.

A lot of Keynesians (maybe not all?) think that the loanable funds market is not clearing because of the zero lower bound on interest rates. There's a lot of bitching and moaning on this point, but let's take that as given for the sake of illustrating why regardless of what you think of the zero-lower bound it's still very different from Bastiat's shopkeeper. In the figure below, Id is investment demand, Ss is savings supply (loanable funds supply), and the market clearing equilibrium point is below the zero lower bound. Since that's inaccessible, the actual equilibrium point is of course the point where the Id curve intersects the x-axis. What happens when government borrows in this market? It depends on how much they borrow, of course.



If they borrow at G1 and hit the market clearing equilibrium exactly, there is no crowding out, because at this price you still have the same amount of investment demanded that you did before. If the government borrows more than that (say, at G2), then you start to crowd out investment. Notice this is very different from supporting stimulus with taxes (which still have a very large opportunity cost) or confiscation, or anything else like that.

This is why the Bastiat talk sounds like such a non-sequitor to Keynesians. Bastiat doesn't sound wrong to us - he sounds irrelevant. When you quote Bastiat to talk about the stimulus we hear "you shouldn't tax people to spend on stimulus", to which our response is "duh". When you quote Bastiat to talk about the GDP response to disasters, we say "well actually what's kind of cool is that you could get something of a bump in GDP because people are hoarding more than usual right now, but disasters still suck".

I feel like these two conversations collide a lot which leads to a lot of the confusion. I think I've clarified my/our position a little bit here.

3. Multipliers

Multipliers depend crucially on the extent of crowding out. That depends on (1.) how spending is financed, and (2.) the macroeconomic facts on the ground. Bob talks about a 1.84 multiplier. Fine. That's a 1.84 amplification of whatever spending you increase, but it's also a 1.84 amplification of whatever spending you reduce (paradox of thrift, anyone?). So the empirically measured multiplier from a debt-funded stimulus, a tax-funded stimulus, and a spending-replacement stimulus (i.e. - cut the Dept. of Education and the Pentagon's budget to build bridges) are all going to be different because there's different levels of crowding out associated with each. What I should have said to Bob Murphy was that we need to take:

1. Minus the $1 billion in damages
2. Plus the $1 billion in repairs
3. Plus the $840 million in the multiplier from the repairs
4. Minus the $X million in reduced shoe purchases
5. Minus the $(X)*(0.84) million in reduced shoe purchase multiplier

Bastiat thinks X = 1,000. I think X < 1,000 but still pretty big. And ultimately, you still have the $1 billion loss of wealth, so I don't see how any of this is likely to result in a net benefit (although it will result in a gross benefit to output.

Now - if instead the government funded $1 billion in repairs through deficit spending, then we'd be looking at some net benefits. But that would be a completely different story from what Bastiat tells - and we don't have to wait for a broken window to fund $1 billion in spending through deficits.

Mercatus Study Shifts My Priors on Fiscal Stimulus

...considerably toward the pro category.

I should have read this more closely yesterday - I read Tyler Cowen on the Jones and Rothschild paper up to his punchline: "…hiring people from unemployment was more the exception than the rule in our interviews" and didn't read any farther, which was a big mistake. I figured this meant that hiring from unemployment was very rare, but actually 42.1 percent of new hires at ARRA receiving firms were previously unemployed. This is surprisingly high (so high that I'm personally curious if there was some selection bias or misreporting biasing it up). The other estimates of this figure that I'm familiar with are associated with job creation tax credits, which I'm writing about for a conference this fall. Bartik and Bishop (2009), two of the most knowledgeable guys out there on these tax credits, estimate using BED data from the Bureau of Labor Statistics and some elasticities reported in Hammermesh (1993) that they expect their tax credit proposal to have 17.7 percent of their newly created jobs filled with unemployed workers. Job creation tax credits are widely considered to be an extremely effective form of stimulus, so to have ARRA funding create 42.1 percent of jobs for the unemployed is truly impressive to the point of being a little unbelievable.

Of course, as many have pointed out by now, you increase employment of previously employed people with these ARRA funds by increasing demand for labor. If these workers are moving from non-ARRA funded employment to ARRA funded employment, presumably they quit, they were not fired (otherwise they more than likely would have been moving from unemployment) and the original firm still demands labor and will try to hire someone else. So we can still expect indirect job creation in addition to these impressive direct job creation figures.

Of course these sorts of studies still can't get at the unseen - the crowding out that may or may not occur from ARRA. But I don't personally need convincing that crowding out is not a problem now, so this Mercatus study seems to suggest a strong stimulus - at least relative to benchmarks we have about what to expect.

Also, I have to complain about one point by Tyler Cowen. He writes: "The paper also sets a new standard for disaggregated data on this macro question". No, it really doesn't. It's a great approach that they take, don't get me wrong. But people have been doing field work of recipients of these sorts of funds for a long time. The Urban Institute does this. Lot's of people do it. And of course - disaggregated analysis of aggregate phenomenon has very real liabilities, as I've discussed on the state-level studies of the stimulus.

Some other reactions to the paper:

- Kevin Drum was one of the first to point out that this is one of the most ringing endorsements of the stimulus we've had.

- Yglesias concurs.

- Steve Horwitz raises a non-sequitor about how labor isn't fungible. Of course it isn't fungible, but it is substitutable. I'm not sure exactly what Steve is so worried about here. He gives no indication of how substitutable he thinks labor is, but it seems like he thinks there's very little prospect of it. I don't know why. And he seems to act like nobody is aware that different workers aren't perfectly substitutable. Not sure what to make of this post.

- Cowen responds to Drum. His first point is about labor market polarization which is what I mentioned the other day that Autor talks a lot about. I think this whole idea of labor market polarization is not as robust or meaningful as people like to pretend it is.

UPDATE (UPDATE 2 below): In the comment section of his post, Steve Horwitz is getting very concerned with my comments about what I thought was a simple point that "fungible" traditionally means perfectly substitutable and that economists think of a range of rates of "substitutability" between factors of production. I'm at home today finishing up a paper on a much less substitutable factor of production: engineering labor. That low substitutability has important implications for the labor market that I spend a lot of time talking about. Other jobs have much higher levels of substitutability. I haven't done construction work in years, but (if there were demand for construction workers) I could probably get a construction job and be more productive at it than I would be at an engineering job (which I wouldn't be hired for anyway - precisely because I wouldn't be very produtive). But even when we think there is low substitutability, we usually think there is still some substitability. My father-in-law was trained as a chemical engineer but currently works as a nuclear engineer. I guess whatever he specifically works on is similar enough that he could get started and that - with some on-the-job experience - he could be productive at. There is often some non-zero rate of substitution for any given worker with any range of jobs. Steve just thinks it's pretty low. Anyway, the idea that this is controversial boggles my mind, and I wanted to repost a comment that I have on that comment section:

"Fungibility is the interchangability of some good. We do not think labor is fungible. We do think it can be substituted at some discount. Am I wrong? Is there any difference in Chait and Steve's understanding except that Steve thinks the discount is steeper (but presumably not total - so that even under Steve's construction of the situation there is bound to be some indirect job creation in addition to the direct job creation)?

To challenge Chait's point you have to think that the firms whose workers were poached by ARRA are unable to hire any new workers to replace the lost workers. If you don't think that you have to agree with Chait that there is some additional indirect job creation.

How much and whether it offsets the cost of ARRA is an empirical question (and a tough empirical question at that)."

UPDATE 2: As Mathieu Bedard points out to me, Chait has a really dumb title to his post. It is wrong. As I subsequently point out, Chait has a really good post, despite the dumb, wrong title. Challenging the point he makes in the post is wrong, and challenging the word choice of the title strikes me as largely pointless - although I suppose right.

How does Steve Horwitz know that monetary and fiscal stimulus failed?

I don't know how he knows that, but if he knows that than he's a lot smarter than me (and pretty much every other economist out there). I had a thought early on in this crisis that isn't entirely uplifting but true nonetheless. I thought "well this is going to give me something to think and write about for the rest of my career". Apparently, that's off the table now, because as Steve Horwitz succinctly puts it:

"Let's look at the record of the last three years:

TARP = Failed.
QE1 = Failed.
QE2 = Failed.
Stimulus = Failed.
Non-existent budget cuts/debt ceiling increase = Failed, at least in S&P's eyes.

Each of these has involved more government activism and each has failed."

I think it's worth reminding people why it's so hard to know these things, despite Steve's own confidence and his disappointing assertion that those of us who are more circumspect about his claims are "religious fundamentalists", hypocrites, practitioners of "state idolatry", dogmatic and insane (in the Einsteinian, rather than the clinical sense, of course).

The problem

Fiscal and monetary policy are endogenous phenomena in human society, which basically means that causality runs both ways with these phenomena. We all think that fiscal and monetary policy affects the macroeconomy, but we also think the macroeconomic conditions and expectations about macroeconomic conditions affect fiscal and monetary policy. We know with a reasonable degree of certainty that the causal relationship running from the macroeconomy to policy is negative (as GDP goes down, policy becomes more expansionary, either through standard policy rules or automatic processes like decreasing tax revenue and automatically increasing social insurance outlays). The other causal relationship is the one where we disagree, and that we'd like to identify.

First, let's consider the case where fiscal and monetary policy has no net impact on the macroeconomy at all. If we simply regress GDP on some policy variable, what sort of outcome are we going to get in this case? We're going to observe a negative relationship between the two variables despite the fact that we know (by assumption) that policy has no effect. In other words, the endogeneity of fiscal and monetary policy implies that uncorrected empirical estimates of the impact will be biased downward.

You can observe this problem in the following graphic. Let's assume for a minute that stimulus actually has a positive impact on GDP, as the large majority of economists have come to agree on in the case of monetary policy and many have come to agree on in the case of fiscal policy. I have two thick black lines - the bottom one shows what the economy would have done in the absence of stimulus, the top one shows what the economy does with stimulus. We never observe either of these lines. What we observe is staggered point estimates of what actually happens:



So the only data we actually have is the red line. If you casually comment on the red line to understand what stimulus does, of course it looks like it doesn't work at all. This is what an unfortunate number of stimulus critics do. What you need to have for a valid empirical assessment of the stimulus is the two thick black lines. Since we can't observe GDP perfectly and instanteously, we could settle for the thin blue line and the thin red line - occasional observations of actual and counter-factual GDP. Unfortunately, we don't even have the thin blue line. We only have the thin red line.

If policy were not endogeneous this would not be that much of a problem. You'd still need to observe a lot of cases (you'd need a large sample), but you could pretty much compare situations with policy to situations without policy. The reason is that when these processes are not endogenous, the expected value of the counterfactual during periods of fiscal and monetary policy is the same as the observed data without periods of fiscal and monetary policy. The problem is, that's not the case here.

The solution (sort of)

The solution to getting an unbiased estimate of the impact of stimulus is to identify variation in policy that is exogenous to what's going on in the macroeconomy and then look at the association between that portion of the variation in policy and the behavior of the macroeconomy. (This is essentially the instrumental variable method that I talked about in this recent post - although macroeconomists are less likely to talk in terms of "instruments"). This is very hard to do. There are two very well known attempts at this, one by Christina and David Romer (on tax policy), and one by Robert Barro and Charles Redlick (on defense spending). I think both are admirable attempts at solving a very tough problem, but both have very large problems with them.

First and foremost, they are each looking at a large swath of the twentieth century, combining estimates for periods where we would typically expect multipliers to be high with where we would expect them to be low. That doesn't give a very useful estimate. As Jonathan Parker recently noted in an NBER working paper: "We do not have a good measure of the effects of fiscal policy in a recession because the methods that we use to estimate the effects of fiscal policy — both those using the observed outcomes following different policies in aggregate data and those studying counterfactuals in fitted model economies -- almost entirely ignore the state of the economy and estimate 'the' government multiplier, which is presumably a weighted average of the one we care about — the multiplier in a recession — and one we care less about — the multiplier in an expansion. Notable exceptions to this general claim suggest this difference is potentially large."

So although Romer and Romer, and Barro and Redlick presumably do a good job dealing with endogeneity, they can only solve it by neglecting the fact that the size of the multiplier itself is not constant over time. This is not easy stuff. What Steve Horwitz claims to know is really stumping a lot of people. One way to get a better handle of what's going on is to compare economies that are in different situations at different times. Ilzetzki, Mendoza, and Vegh do that here (long version here), and Chinn puts his spin on their findings (and a few similar studies) here.

An oft-proposed solution by skeptics

One thing that fiscal stimulus skeptics like to raise is the forecast of unemployment produced by Romer and Bernstein in January 2009. They note that unemployment has been worse than the forecast suggested would be the case without stimulus, so stimulus has hurt the economy. Steve Horwitz has made this sort of argument.

I have never understood the appeal of this argument at all. To make this argument you have to believe a couple things:

1. Forecasts of the future behavior of a complex system can be made with accuracy.
2. Forecasts by political appointees are reliable sources of counter-factuals for empirical analysis.

Both of these claims are so absurd I find it genuinely shocking that anyone that teaches economics would even make this argument - but they do. When Romer and Bernstein made their projections I was worried that Republican politicians would jump on it later and mistakenly use it in this way, but I didn't expect economists would.

My question for Steve

Should be obvious by now: How exactly do you know what you claim to know? Can you let me in on the secret? I'm sure I'd blow my professors away this fall if I could nail down a fiscal multiplier estimate so conclusively. And I don't want to be an ideologue. I don't want to be a dogmatist. I don't want to be insane. I've never practiced idolatry toward the state - never - and I never want to. If I appear to be an ideologue or a dogmatist to you, it's because I'm ignorant, not because I'm an ideologue. Help me get past my ignorance because if there is conclusive evidence I'm wrong that you know, I want to know that too! I don't want to be unwittingly wrong!

Much as I like fiscal stimulus, this is not evidence of its effectiveness

Jared Bernstein calls employment in the DC area compared to the nation a "natural experiment" demonstrating the effectiveness of fiscal stimulus. He writes:

"It’s not like our area is totally insulated from recession, but the countercyclical expansion of federal spending does give the region a notable edge compared to much of the rest of the country. (Though the point of my presentation was that with the fed gov’t poised for contraction, our region needs to diversify.)

Note how the jobs line for the DC region is flat while that of the nation falls steeply. It’s a bit of a natural experiment: if you actually apply some serious Keynesian stimulus, you can minimize job losses."

Nope.

It was wrong when the Conley-Dupor paper did it, and I said it, and it was wrong when the Feyrer-Sacerdote paper did it, and I said it (although I did think they had a nice instrument - it just wasn't an instrument that could identify the parameter they were looking to identify).

You can't look at differences between sub-regions and get macroeconomic impacts. This should bother people for and against stimulus. First, if stimulus has a positive impact, then the fact that the states are open economies on the same currency will create spillover effects that bias the impact estimates downward. If stimulus doesn't have a positive impact and there's crowding out, then any gains in one state are going to come at the expense of other states, and inter-state differentials will be biased upwards. As one of my mentors at Urban in all things econometric likes to put it, "the estimates are mush".

Identification of impacts in macroeconomics is hard. You can't just look at raw data like John Taylor does. You can't do inter-state comparisons like these people do. You have to do hard work identifying your model. Role models in empirical macro should be economists like Robert Barro and Christian Romer.

Communicating the difference between public and private debt

Yesterday afternoon I was doing something I usually avoid - listening to a lot of the Congressional debate on C-Span. Both sides were depressing because both were demanding deficit reduction. The Democrats were a smidgen less depressing because they at least kept pounding the position that maybe reforming some tax credits was a better way to close the gap than cutting into student loans. But overall, it was not what you wanted to hear during what is now increasingly being called the "Little Depression".

One of the things that just about every Republican said was that "Washington needs to do what families do and not spend more than they take in". It's powerful rhetoric that is electoral gold. Getting tough on the deficit is good for politicians - analogizing it to family values is even better.

What's bothersome is that no one challenged this view, which among economists is almost universally considered to be fallacious. Even those economists who don't think deficit spending is good macroeconomic policy do not claim that government has to, on average, run a balanced budget. The people demanding austerity ultimately have a better stump speech than the people who understand public deficits and debt, and this is a problem.


So my question to readers is - what is a good, succinct way for politicians to communicate that (1.) public debt is different from private debt, (2.) it is not fiscally responsible to cut public debt during downturns, and (3.) we can run deficits from now until the Sun burns out and everything would be just fine, so long as their magnitude is manageable over long periods.

Let's put together a good stump-speech phrase and then spread it over the internet - get Paul Krugman, Matt Yglesias, Brad DeLong, Mark Thoma, Menzie Chinn, and lots of others saying it so politicians might start saying it. What should our representatives say when Republicans or others analogize government to families?

[A note on comments - I know I have a large libertarian readership, but I'm not at all interested in challenges to these three points. While (2.) is admittedly a fair topic for debate, the other two simply aren't. I'm really interested in generating a good stump-speech phrase, so comments trying to challenge the premise are just going to get deleted. I'm not interested in a debate on this particular post. Obviously this comment policy doesn't carry over to other posts].

I really don't understand how John Taylor's brain works

This is a draft of a forthcoming JEL paper. I've only skimmed it, but it is entirely consistent with everything he's written about the stimulus in the past. The PCE regressions on page 9 truly astound me.

How are these regressions identified?

I have no idea. ARRA spending is not exogenous, Prof. Taylor. That variable deserves to be on the left hand side of the equation as much as PCE. That's the whole f%#&ing empirical exercise. If we could just do what you've done here we could wrap up this whole economics thing in a matter of weeks and get on to figuring out how many angels can dance on the head of a pin.

On another note entirely - I worked with Ned Gramlich, who he cites in the introduction, before he passed away a couple of years ago.

UPDATE: Another question. Even if Taylor did convincingly identify any of his models, why is he so focused on PCE? You would want to see an impact on everything, but I would have looked at investment first. Isn't that what Keynesian policy is trying to affect directly, with the impact on consumption only indirect?

More on the Conley-Dupor ARRA Paper

More people have weighed in on the ARRA evaluation I mentioned this weekend. I think all of these miss what I still think is the major point - which I reiterate at the end of this post.

- Noahpinion's opinion has been getting a lot of coverage. His major point seems to be that the results are not especially statistically significant. OK, but the point estimates are pretty consistently negative... I'm not sure I entirely buy this as the major point against the paper.

- Noahpinion and Brad DeLong all pile on Karl Smith and Greg Mankiw for posting the paper without comment. I think this is a little much. I post stuff I don't necessarily agree with but find interesting all the time. Often I provide thoughts, but sometimes I don't. We ought to be more critical readers than this.

- Paul Krugman's critique is odd to me too. He argues that Conley and Dupor make no effort to control for the differential effects of boom and bust in different states. But this is the whole point of the Conley-Dupor instrumental variable approach! Krugman seems suspicious of the instruments (not a bad posture to take - people should always be skeptical of instrumental variables), but it's not clear to me exactly what the problem is. The highway funding formula sounds like a fairly good instrument for the spending. I could see some problems with the sales tax intensity instrument. There might be some public finance tradeoffs between sales taxes and property taxes, and low property taxes might be associated with housing booms - I don't know. But Krugman fails to get very specific here.

- Arnold Kling says that Conley-Dupor isn't reliable without elaborating on why he thinks that. Instead, he embraces Taylor and Cogan who make absolutely no effort at all to identify a counterfactual! Ugh. Taylor's work on the stimulus has - in my mind- been essentially worthless.
- Dean Baker has some OK sensitivity suggestions here but he also falls into this "I bet they're doing something dishonest but I really don't know" line. Look, I think we should assume honesty of scientific peers until we have reason not to. I think we should assume there's no blatant data mining going on here. Dean Baker doesn't like the instrument I find convincing (the spending instrument). I wish I knew why he doesn't like it but of course he doesn't say.

*****

The real problem with this paper: The real problem with this paper, which was a problem with an earlier state-level analysis that found a positive effect of stimulus too, is that it is state-level. Fiscal stimulus works through two major mechanisms: (1.) increasing demand for loanable funds, and (2.) the multiplier effect. Both mechanisms will bias state-level estimates in an open economy (like ours) downward. Let's think of the case of Maryland and Virginia. The impact estimator in this paper is produced by asking "what effect does a change in (VA stimulus money - MD stimulus money) have on (VA job growth - MD job growth)?" In other words, if we marginally increase stimulus money, what is the associated marginal increase in job growth? There's one big issue with estimating this that the authors do make an effort to solve. We would think that lower expected job growth would cause higher stimulus payments, right? The instrumental variables are intended to address this "endogeneity bias". Let's assume for the moment that they addressed that sufficiently.

A far bigger problem is that in an open economy we know that financial markets are national markets. So any impact that the stimulus has on these markets that might encourage job growth is going to increase both VA job growth and MD job growth simultaneously. If they both increase simultaneously, you're not going to observe the change with a state-level regression. In the same way, any multiplier effect in an open economy is going to be biased downward. We can decompose the impact estimate I discussed above (with VAst=VA stimulus, VAjc=VA job creation, etc.) into:

(dVAjc/dVAst) - (dVAjc/dMDst) - (dMDjc/dVAst) + (dMDjc/dMDst)

Now - notice which marginal effects have a negative sign in front of them when you decompose this. It's the two cross-state derivatives! Makes sense, right? If higher MD stimulus causes higher job creation in VA, then a regression that uses the difference in VA and MD stimulus to estimate the impact on VA jobs is going to be lowered in the regression even though there's a positive effect in the real world! So the question is, how big are (dVAjc/dMDst) and (dMDjc/dVAst)? A good start would be to figure how substantial interstate commerce. I tried the BEA's state GDP page, but they don't seem to calculate it (and why would they within a monetary and political union like the United States?). Does anyone know of any estimates of interstate commerce as a percent of GDP in the U.S.? That would be a good place to start to estimate how much of an underestimate this is.

So how would we go about checking on this? My first thought is to regress the residuals on state population or state GDP, but I'm not entirely sure that makes sense. I would think that interstate commerce makes up a smaller share of output for larger states, but that could be wrong - after all, a lot of big states are also major economic hubs that you would think smaller states would be more likely to do business with.

The point is, I think everyone is missing the biggest problem with this paper: state level analyses can't capture (1.) interstate effects, and (2.) impacts on national markets.

That's an enormous omission.

Federalism and Interstate Commerce Links

1. I'm not going to bother linking all of them (just the one that bugs me!), but Andrew Sullivan has been writing a lot about Mitt Romney's attempt to present his case on health reform, and the political strategies involved. One of the earlier posts that bothers me is titled "Romney Hides Behind Federalism". It's very troubling to me that federalism is seen as a fake solution that is whipped out for expedience - that Sullivan isn't even serious about the prospect that perhaps Romney did health reform when he was governor because he thought it was a viable decision for governors to make and implement. Instead, people want to turn Romney into a closeted Obamacare advocate. I've said from the beginning that I would have liked to see three things out of health reform. Obama disappointed me on two of those things and succeeded on the third. He did well by relenting and agreeing to John McCain's initial proposal to end (or at least seriously cut back) the tax subsidies on employer provided benefits. He still had an individual mandate, which I opposed, and he also didn't provide a whole lot of flexibility for state experimentation.

*****

2. Greg Mankiw links to an evaluation of ARRA (the stimulus) that finds a negative impact on jobs. What doest his have to do with the states and interstate commerce? Well, the study is done with state-level data and more crucially the model specification is unable to incorporate the impact of interstate commerce which is - to put it mildly - an enormous omission. One nice thing about the study is that it does attempt a sophisticated identification strategy. It uses two instruments - state sales tax intensity (to instrument the decline in state budgets - which I've always noted has been an important contractionary force that people ignore), and state highway funding formulas (which should be exogenous to the recession and are an important determinant of ARRA funding levels). I'm especially glad to see them instrument for state budget losses. But here's the problem - the only impact they can estimate is between states that received relatively more or relatively less stimulus. So if Virginia received $900,000 in stimulus and Maryland received $1,000,000 in stimulus they're going to try and identify the impact of that extra $100,000 of stimulus. Theoretically that could be fine - it'll provide a marginal effect that can be attributed to the whole package. My first (more minor) concern is that when you infuse a lot of money into an economy like this you're ultimately going to run into bottlenecks and - yes - crowding out at least on the margin and in certain areas. Is that marginal effect of the last $100,000 the same as the marginal effect of the first $700,000? Likely it's not.

That's a relatively minor concern, actually. The bigger concern is the interstate commerce point. A lot of commerce is done across state lines and that can't be accounted for with this sort of estimation strategy because the ARRA funds going to Virginia not only are not used to estimate job levels in Maryland - the job levels in Maryland are actually counted against the Virginia impact estimates. To simplify things, you can think of the model as asking "what is the effect of (VA stimulus-MD stimulus) on (VA jobs-MD jobs)". If MD stimulus positively impacts VA jobs or if VA stimulus positively impacts MD jobs, you're going to actually reduce the estimated marginal effect. I don't know if this sort of thing completely eliminates the prospect of state-level studies of fiscal multipliers, but it's certainly something that needs to be taken into account.

*****

3. Matt Yglesias has a good treatment here of arguments against the clear English of the commerce clause that amount to "well if you can do that, what can't you do?". It's never been an especially impressive argument. Yglesias points out some obvious things you can't do, including violating other Constitutional provisions like the first amendment and rights to due process. I've noted before that you also can't violate the general welfare clause - special priveleges for the sake of private welfare skirt Constitutionality in a real way that belies these claims about "if you can do that what can't you do?". But more importantly, these arguments demonstrate a real lack of commitment to the very idea of republican virtue. The Constitution is an important document because it limits the state, thereby protecting incursions on liberty. But since when has it been the only thing standing between the state and liberty? It has always been recognized that for a republic to succeed you need a virtuous populace. You need a populace that won't pursue inappropriate uses of power (or rectify the situation when such powers are pursued).

People act as if we can't have a meaningful and successful republic if the Constitution doesn't provide the ultimate and final demarcations of power. This is an excessively myopic critique, in my mind. We want to be able to achieve public ends with the republican institutions we have set up. Half the petitions raised by Jefferson in the Declaration were complaints about George III not letting the colonial legislatures pass laws that were for the public good. Since the beginning of the republic, it has been understood that we want a government that allows us to govern ourselves - that gives us the ability to make important public investments and decisions. A nit-picking Constitution threatens that, so instead we have a Constitution with real restrictions on the state - but restrictions that are open to interpretation, and yes - deliberation. It amazes me that this very idea that things are left open to deliberation and interpretation is viewed as a threat to liberty, rather than a source of real liberty.

In a free society, we deliberate within a framework of broad restrictions on the state, and if we want to keep that free society we have to preserve the republican virtues that are required for the preservation of liberty. The Constitution is a tool, not a master. It helps us preserve liberty - it's not a free pass on deliberation or a guarantee of success or an ultimate bulwark in defense of liberty. It's like a marriage. The contract itself doesn't guarantee anything. You have to work at your goal.

Why is the Heritage Forecast of the Ryan Plan so Rosy: Two Thoughts

A lot of people are talking about the implications of Paul Ryan's budget plan for Medicare or for the deficit, but something else has caught my eye: the economic forecasts that Ryan trumpets his plan will bring about. Ryan Avent, Brad DeLong, and Matt Yglesias all point out that they are wildly optimistic. How optimistic? Well, Paul Krugman notes that Ryan is claiming he will achieve unemployment rates so low that we haven't seen them since the early 1950s!! Wow!!

So where did these estimates come from? The Heritage Foundation, of course.

This is the Heritage Foundation's analysis of the Ryan Plan. The Heritage Foundation has been quick to point out that they are using the IHS Global Insight (a mainstream forecasting firm) macroeconomic model to make these forecasts. I'll come back to that later. My first reaction was "how did that model get these results?", so I took a look at their methodology and the answer was fairly obvious: the Heritage Foundation put its thumb on the scales. There are two things I noticed: the labor supply elasticity (which I am a little less clear on and would need some clarification), and the impact on private investment.

1. Labor Supply Elasticity (update below): Economists have known for a long time that if you look at how responsive an individual worker is to a change in income and how responsive an aggregate labor market is to a change in income, you get a different result; the aggregate "elasticities" are higher. Something fishy is going on with the labor supply elasticities in the Heritage model. They write: "Taxes on labor affect labor-market incentives. Aggregate labor elasticity is a measure of the response of aggregate hours to changes in the after-tax wage rate. These are larger than estimated micro-labor elasticities because they involve not only the intensive margin (more or fewer hours), but also, and even more so, the extensive margin (expanding the labor force). The change in the labor supply variables were adjusted by the macro-labor elasticity of two, which is a middle estimate of the ranges. The adjustment to the add factors allowed the variable to continue to be affected both positively and negatively by other indirect effects." So there's nothing wrong with this logic and there's nothing wrong that I'm aware of with a macro-elasticity of two. What concerns me is the bolded section. What "change in the labor supply variables" are they refering to? I think they're refering to the labor supply response from the microsimulation that they reference earlier. I looked through the CBO's simulation of labor supply and they seem to only do a microsimulation, which is then put into a macro model. So it looks like (although I'm not clear on this), Heritage's microsimulation estimates a labor supply response and then they have an "add factor" (an adjustment, essentially) in the macrosimulation to make labor supply respond again using a macro elasticity. I'm just suspicious because (1.) the CBO, which usest he same sort of IHS Global Insight model, doesn't seem to simulate labor supply at the macro level, and (2.) double-counting a labor supply effect would be exactly the sort of thing that would get you unemployment rates so low that we haven't seen them in over half a century.

UPDATE: This labor supply elasticity issue may be related to the dynamic scoring question discussed by Ezra Klein. My personal view is that there's nothing wrong with dynamic scoring - indeed it's a good idea - but it offers the opportunity for puting in a lot of assumptions that help your case. I'm not entirely sure the apparent use of both micro and macro labor elasticities is the same thing as dynamic scoring, though. Dynamic scoring is supposed to impact feedback effects that influence revenue estimates ("tax cuts pay for themselves" type stuff). Since you're looking at aggregated revenue, you're going to want to use a macro-elasticity to predict feedback effects influencing revenue. I'm still not sure if that means that labor supply itself should react twice to tax changes (once in the microsimulation and again in the macrosimulation) as the Heritage methodology seems to suggest it does. In other words - this might make sense for the revenue estimates, but it may still be overly optimistic about the labor force estimates. I'm crossing the above section out since I'm not sure - hopefully people can still read it and provide their own insights.

2. Private Investment: This one should be old hat by now. The Heritage Foundation writes: "Economic studies repeatedly find that government debt crowds-out private investment although the degree to which it does so can be debated. The structure of the model does not allow for this direct feedback between government spending and private investment variables. Therefore, the add factors on private investment variables were also adjusted to reflect percentage changes in publicly held debt. This can also put upward pressure on the cost of capital (thus helping the model balance the demand and supply effects on the cost of capital)." Yes, government debt crowds out private investment when we're at full employment. I will poll readers on this: do we appear to be at full employment? This is exactly the same assumption that gets theoretical results that say fiscal contraction is expansionary. Yes, if you assume away all the problems that economists are pointing to that we are dealing with right now, things look rosier. That's no surprise. It's also no help in providing an assessment of what to expect from the Ryan plan. Note that this is another "add factor". This is something that they went into an existing, tested, widely acknowledged model and said "I don't like that - I'll change that". These people aren't dumb - they knew exactly which change they were giving themselves when they made that adjustment.

Macro Model Controversies: One interesting thing about this Heritage forecast is that it uses an adjusted IHS Global Insights model, which is the same model that predicted that stimulus would be stimulative. This model, and others much like it, got a lot of criticism in the libertarian community, because the model results are essentially determined by the assumptions about how the macroeconomy would respond (things like the labor supply elasticity and the response of private investment). Russ Roberts called the IHS Global Insight model and models like it a "hoax" and "not meaningful" when it predicted a positive impact on the stimulus. His point was the same as mine, that they are dependent on the assumptions that we feed into them. Unlike me, though, he thinks this makes them illegitimate. I think they're perfectly legitimate as a statement of the implications of our theory - we just need to know the assumptions that underly them and dispute or promote those assumptions. When IHS Global Insight, CBO, Macroeconomic Advisors, and Moody's Economy.com came out with their positive assessment of the stimulus, Russ wrote a post called "The Great Stimulus Hoax" criticizing them and suggesting that these sorts of models aren't meaningful. If Russ had any consistency at all, I'd like to see him write a post today called "The Great Austerity Hoax", providing essentially the same critique of the Ryan plan analysis which was done using the same methods.

I'm not holding my breath on that one. Cafe Hayek is a quite political blog, and on top of that a graduate from the George Mason University economics department and a former president of the Institute for Humane Studies at George Mason University were both authors of the Heritage report.

Don Boudreaux and Charles Krauthammer seem to be confused on Social Security

Don Boudreaux points us to a Charles Krauthammer op-ed decrying the whole Social Security lock-box thing. Krauthammer writes:

"The Social Security trust fund contains - nothing. Here's why. When your FICA tax is taken out of your paycheck, it does not get squirreled away in some lockbox in West Virginia where it's kept until you and your contemporaries retire. Most goes out immediately to pay current retirees, and the rest (say, $100) goes to the U.S. Treasury - and is spent. On roads, bridges, national defense, public television, whatever - spent, gone.

In return for that $100, the Treasury sends the Social Security Administration a piece of paper that says: IOU $100. There are countless such pieces of paper in the lockbox. They are called "special issue" bonds. Special they are: They are worthless. As the OMB explained, they are nothing more than "claims on the Treasury [i.e., promises] that, when redeemed [when you retire and are awaiting your check], will have to be financed by raising taxes, borrowing from the public, or reducing benefits or other expenditures." That's what it means to have a so-called trust fund with no "real economic assets." When you retire, the "trust fund" will have to go to the Treasury for the money for your Social Security check."

Boudreaux has opined similarly in this video he created:



Somebody oughta forward Krauthammer's article to China. They'd probably be interested in learning that Treasury debt is "worthless". It's amazing this non-issue is still such an issue.

If you insist on thinking of the OASDI trust fund (the "Social Security lockbox") as being the same financial entity as the U.S. Treasury as Don does, that's fine - but then there's nothing to be concerned about - it's as if the bonds were never issued. It's just the way it's written down on paper. Another way to look at it is the government redeeming its own bonds. Corporations do that all the time. All you have is the Treasury paying out the Social Security benefits later. If you really think the Treasury and the trust fund are the same entity, then it shouldn't matter that the Treasury puts up the cash to fund the benefits later.

If the OASDI trust fund and the U.S. Treasury are not the same entity, then who cares if they hold each others' debt? Again, in the corporate world this would just be one company holding another company's bonds. There would be no issue with it whatsoever.

Krauthammer probably just doesn't know what he's talking about. I'm not sure if Don doesn't know what he's talking about or if he does and he's just trying to pull the wool over people's eyes. I don't know which is the more charitable option, so I'll refrain from guessing which.

But here's what Krauthammer and Boudreaux are arguing - they're essentially saying that when FICA taxes come in the U.S. Treasury and the OASDI Trust Fund are the same entity, but that when Social Security benefits get paid out they're not the same entity. I don't care what way we want to think about it. Most policy analysts treat it like the latter situation - that these different funds are different entities. But it works either way. What you can't do is pretend that sometimes they're the same thing and sometimes they're not the same thing. That's what Boudreaux and Krauthammer are doing, and it makes for very bad analysis.

Mulligan on the Stimulus

Can anyone provide me with a stimulus critic that actually tries to grapple with endogeneity issues when they look at the data?

I know it's just a blog post, but Casey Mulligan has a post up today that just looks at the raw data. His version of a counter-factual is to assume economic projections early in the downturn were right (hmmm...). He's not alone. John Taylor regulalry dumps some BEA numbers into excel and calls it a day. In a recent working paper by Cogan and Taylor, their counterfactual is that most of the stimulus spending to states went to reduce borrowing, and that purchases would not have changed at all in the absence of the stimulus (see page 13 and 14). Guess what - when you assume a "no effect" multiplier when designing your counter-factuals, you end up getting no effect in your results. Shocking! This is Stanford University and the University of Chicago being represented here.

I would be more open to these positions if any of these guys made any effort at all to even acknowledge the endogeneity problems and tried to objectively deal with them, rather than assuming their own conclusions and passing it off as economic science. I can think of one stimulus skeptic who has done this: Robert Barro. And he has a very interesting identification strategy. I like to highlight Barro's work whenever I criticize others' work because he actually makes a good effort. My critique of Barro is not that he does something wrong, but that his findings aren't generalizable. When you estimate multipliers outside of depressionary conditions you can't claim to have an estimate of what the multiplier would be in a depression. We expect it to change. But Barro provides good evidence that government spending crowds out private spending in normal times.

Anyway - just frustrating to see Mulligan this morning. These guys essentially assume their conclusions and a lot of people still take these to be reasonable claims.

Keynesianism and Consumption, "Keynesian Humanitarianism", and a few links

I think one of the hardest transitions from "vulgar Keynesianism" to real Keynesianism for people is the stumbling block that is consumption. Sometimes the mistake is a misuse of the national income equation. Sometimes the mistake is that they think "demand" and "consumption" or "spending" and "consumption" are synonyms. Sometimes people take the Keynesian worry about the paradox of thrift and assume they don't like saving, and therefore don't like investment and prefer that more income be consumed.

A very thrown-together and hopefully not misleading illustration

All of this is quite confused, and ironically gives you not just a non-Keynesian, but a quite anti-Keynesian view of the economy. I like to think of the Keynesian approach to investment and consumption in pretty basic Econ 101 terms - I like to say that Keynesians "want to move along the consumption demand curve, but they want to actually shift the investment demand curve". It doesn't exactly translate over from microeconomics, but here's an illustration of what I mean:

Let's start with the left panel. Here we just have simple loanable funds market. Supply of loanable funds is constant, but demand for loanable funds shifts to the left because firms increase their preference for liquidity and decrease their preference for new investments. The same loanable funds are available. So without getting into any assumptions about reduced consumer demand, we now have aggregate demand shifting down purely due to the reduction of investment demanded at market prices from I' to I''. Now - should we assume that consumption demand changes? Maybe a little - cautionary saving is certainly plausible on the part of households for the same reason that liquidity preference is in play for firms. But there are good reasons not to change consumption demand relationships that much. Keynes thought that the marginal propensity to consume out of income was a psychological law - certainly informed by time preferences, but not something that shifted around a lot. This is what we see in the data - consumption volatility does not play a very big role in the business cycle compared to investment volatility. Keynes certainly would have been aware of this.

What you see on the Keynesian cross panel on the right is the shift in income resulting from this reduction in investment demand from C+I' to C+I''. Because the diagram assumes some autonomous consumption (i.e. - there is some consumption out of savings even when income is zero), the share of income that is consumed is increased somewhat as income is reduced (this stands to reason if investment is more volatile than consumption). I've added a horizontal line that I think may be useful for understanding how consumption shifts in a Keynesian framework - it's the dashed line I call the "fully depressed investment level of consumption" (FDILC). This is the level of consumption when investment is so depressed that there is zero investment. The first vertical line extending up from the FDILC notes the additional consumption above FDILC for the C+I'' equilibrium, while the second vertical like notes the additional consumption above FDILC for the C+I' equilibrium. What you'll note is that investment demand recovers, we will see a recovery in consumption too. You will observe improvement in consumption data, without any changes in underlying consumer preferences or confidence. Unlike the investment level I never moved that consumption curve. The change is due entirely to an increase in income - in other words, the existing consumer demand became more "effective" as more income came online to spend.

Implications for consumption, a few links, and humanitarianism

So, what does this say about consumption boosting policies like unemployment insurance? Well to be clear, first and foremost it says they might do something. If you actually can boost the consumption curve you are going to shift out to a higher income level. The problem is, you are remedying a symptom and not the underlying disease. As the FDILC line illustrated, the fluctuations in the consumption level are a result of the changes in the income level. You can bolster that consumption short-fall, to be sure - but you're not doing anything about the underlying cause. If investment demand is still depressed, then as soon as you turn off the unemployment insurance spigot you'll go right back to where you started. Maybe consumer confidence plays a big role in the reason for depressed investment demand. If that's the case, then investment may recover somewhat. But Keynesians usually point to more than just consumer confidence - particularly if there are concerns about a liquidity trap.

This all means that consumption-driven policies are not entirely useless, but in the end they're symptom-treating policies from a Keynesian position. As I've pointed out in the past, you can see this in the General Theory, where Keynes himself ridicules the very idea of unemployment insurance. A real Keynesian perspective is pretty agnostic and skeptical when it comes to unemployment insurance, which I think is illustrated by recent thoughts from Greg Mankiw on the UI extension that you can read here. One of the posts that actually got me thinking about this problem was one by Russ Roberts where he ties concerns about consumption to Keynesianism. The post is simply titled "Keynesian sentence of the day" - and the sentence from the Washington Post that he's refering to is "After two years on the sidelines, American consumers are spending again and raising hopes that they are ready to shoulder the burden of the nation’s economic recovery." What frustrates me about Roberts and many other commenters on his blog is that it seems like they think "anything a liberal ever says about the economy is Keynesianism". The blog is rife with suggestions that Keynesians want to see people consume more and invest and save less. Another example is this video featuring Hiwa Alaghebandian which was recently shared by Don Boudreaux as a video that demonstrates "some of the flaws of Keynesian economics":

The video is riddled with problems (a major one being the unsupported assumption of perfect crowding out), but one of the most obvious problem was the consumption-centric interpretation of Keynesianism. It's a little embarassing, because Hiwa is a senior at my alma mater, the College of William and Mary. Maybe there has been staff turnover, but I know that none of the macro professors that were there when I was there would have taught her this. She has, however, had internships at Cato and AEI. I imagine she picked up this understanding of Keynes there.

So what do we do about consumption-related policies like unemployment insurance extension? Different people are going to split different ways on this, but I'm personally cautiously sympathetic to UI extension. One thing you won't hear me arguing quite as often is that we should think of it as a depression-fighting policy. Because I take the Keynesian view that most of our problems have to do with investment demand, I primarily support UI extension as a humanitarian policy and a structural unemployment policy. The humanitarian justification should be obvious - workers are unemployed through no fault of their own in the midst of a tough job market. They have obligations and they have fulfilling lives to lead. It's simply a humanitarian imperative, apart from any macroeconomic concerns, to provide a cushion for them. But there are other more calculated economic reasons for doing it. Unemployment insurance supports active job search, and that will help keep "the unemployed" from becoming "the unemployable". Long-term unemployment poses serious risks of higher structural unemployment in the future, and UI can help fight that. Ideally, to do this UI would be paired with options for training, job search assistance, and new hire incentives for businesses who hire unemployed workers, or even public employment options. Again, though, there's no argument here about the cyclical benefits of UI.

So are there any cyclical benefits? There are a few. First, as I noted above, shifting the C curve up will improve output, and this may improve investor outlook. UI is also paid out of unemployment insurance trust funds - which are exactly what they sound like: pools of saved payroll tax funds that are invested, but kept relatively liquid to be paid out in the form of unemployment checks. Drawing down on these trust funds can be thought of as making use of relatively idle capital. In other words, we're not just shifting money earned today from the employed to the unemployed: we're shifting money from an idle fund to the unemployed.

Mostly, though, I think of UI and many other consumption-oriented policies as being humanitarian and perhaps structural policies, rather than primarily cyclical or "Keynesian".

This message leaps off the page of the General Theory, too. The General Theory is all about investment, and much less about consumption. As I like to point out, Keynes has (if I remember correctly) about twice as many chapters dedicated to investment as he has dedicated to consumption, and he's famous for advocating the "socialization of investment", not the "socialization of consumption". And when consumption is addressed, it's usually addressed as a stable relationship that investment oscillates around.

A fascinating idea...

Vote-share bonds: "How can excessive public debt be avoided? This column proposes a novel solution: “vote-share bonds”. These government bonds are tied to the share of the vote that the adoption of the underlying deficit has received in parliament. A bond with a higher vote-share is considered senior. Vote-share bonds inspire fiscal responsibility, while retaining the flexibility to stabilise negative macroeconomic shocks."

The mess of a theory that is the "social contract" causes a lot of problems for democratic legitimacy. This may be one step in the right direction: make less collective decisions more expensive. It really cuts two ways - those who can only eke out a majority are also responsible for saddling the country with greater debt. More broadly appealing legislation is cheaper. At the same time, I think those who oppose a specific piece of legislation for purely partisan reasons could also legitimately be blamed for the high costs. If they had compromised or offered a compromise the other side accepts (or if their position had simply garnered a majority), costs would be lower.

If federal and state bonds were measured on the same standard, this could also make borrowing easier for states which might help make a more robust, progressive federalism. My impression is that state houses are usually either (1.) less partisan, or (2.) more dominated by one party than Congress is, which means that holding everything else equal, state bonds would be lower cost under this plan.

Assault of thoughts - Politics/polling edition - 11/4/2010

"Words ought to be a little wild, for they are the assault of thoughts on the unthinking" - JMK

I don't usually get too invested in politics unless there is a historical, ideological/philosophical, or policy issue to talk about - but there are a few interesting electoral/polling things to go over:

- Andrew Sullivan ponders how the new Republicans will react to raising the country's debt limit. He predicts there may be enough votes against it, and quotes Tim Rutten who says that would be "apocalyptic". I'm not entirely sure if that's true. So what would happen if they refused to approve it? Marginal spending cuts, tax increases, and accounting gimmickry to cover it. It would not be good for the economy at all, but I'm not sure it would send shock waves. Our creditors are going to have the first lien on our revenue, and until that changes I can't imagine "apocalyptic" is the right word to describe what would happen. Certainly it wouldn't be good, but Republicans are interested in halting spending, not snubbing creditors.

- Paul Krugman argues that nobody cares about process and chides the Obama administration for spending too much political capital on health reform and too little on stimulus. This is similar to a lot of the far left complaints that Obama lost because he was too centrist, but I think it's a little more sensible. The Krugman point is more that Obama didn't do macroeconomic policy right, which leaves us with a bad economy, which is ultimately the biggest factor in this election loss. Populists grow out of bad economies, and it would be a lot harder to spin Obama as a socialist if employment was lower. This I can agree with, although I disagree with a lot of other far-left critiques of Obama that complain about his centrism. Krugman ties it up nicely and probably pretty accurately, albeit perhaps a little optimistically: "If Obama had used fancy footwork and 2 AM sessions to pass a big public works program, and this program had brought unemployment down, Republicans would be screaming about the process — and Democrats would have comfortably held control of Congress."

- Jonathan Catalan blogs his reaction to the failure of Proposition 19 in California (the most exciting ballot measure I got to vote on was a bond initiative...)

- Evan shared with me the unfortunate loss of a candidate and acquaintance of his, Ben Lowe in Illinois's 6th district. Lowe is a twenty-something graduate of Evan's very well-regarded evangelical undergraduate alma mater, Wheaton College, who ran an uphill battle against Peter Roskam - a Republican with a firm grasp of the district that actually attends Evan's old church. The updates of the race that Evan sent me really drove home how dumb and ironic some of the Republican rhetoric has been. Roskam went on and on about Washington insiders and bureaucrats and the people rebuking politicians, and elitist Democrats, etc. - and the guy is running against a young kid that raised less than three percent of the money he did. Roskam's biggest donor? Goldman "we own Washington D.C." Sachs. Lowe's biggest donor? No-name, private, Presbyterian, Whitman University. Lowe frequently mentioned the environment and working families in his campaign... Roskam harped on the "liberal agenda" and even used Bible stories as a political prop to attack "the left". And all the while Roskam refused to debate and wouldn't even acknowledge the fact that he had an opponent. Every time Evan would update me on this it would piss me off in the same way that it pisses me off when a millionaire former-governor or a tenured university professor has the condescension to call me an elitist that doesn't understand regular Americans. Anyway, Lowe lost but it may not be the end of his political career. Who knows. Thanks to Evan for the regular updates on this particular campaign.

- Andrew Sullivan shares the age composition of the 2008 and 2010 election cycle. Republicans and Tea Partiers often try to claim that they are looking out for the interests of future generations... well the future generations themselves seem to beg to differ.

- Finally, Andrew Sullivan identifies a Keynesian (that's KEYNESian, not Keynan) majority of the electorate. Forty percent of the electorate favors deficit reduction while 54 percent of the electorate favors tax cuts and stimulus spending (the problem, of course, is that the share of the 54% that support tax cuts and the share that support stimulus spending don't like each other very much).

UPDATE: I did want to mention one election I just learned about last night that I'm very happy with - Alan Grayson (D-Florida) lost to his Republican opponent. Grayson has been bothering me long before he got the attention of the Daily Show crowd... with Ron Paul he's a big threat to central bank independence, which is an important defense against irresponsibly inflationary monetary policy. He's also just an old-style demagogue - slandering his political opponents rather than marshalling real arguments. We haven't seen that much (certainly some) of that on the left lately but Grayson represented a disconcerting example of it that I was a little worried about. I'm glad he's out after only two years. Actually, this election wasn't quite as bad as a lot of people are making it out to be - quite a few of the Republican demagogues lost too, which is nice. It's still probably going to be a pretty rough Congress in these next two years.

Don Boudreaux, what say you?

At Cafe Hayek, Don Boudreaux writes, in a post titled "What say you, Keynesians?":

"One data point proves nothing – but it is suggestive that Germany’s economy (including employment) is starting to boom (as reported here by The Economist) while the US economy continues to sputter: government in the former nation is following a policy of (relative) fiscal austerity while government in the latter nation is following a policy of wild-spending and deficit-bloating fiscal expansion."

I didn't know what to make of this when I read it last night. I don't know Germany that well. I know that they weren't hit as hard in the first place and that their banking sector came out largely unscathed which seems... ummm... important to mention. But besides that I honestly didn't know how accurate Don's characterization of the fiscal policies of the two countries was. Since he failed to furnish any data on that, I decided to check for myself. Readers of the blog know that I've been tracking the miserable trend in government spending in the U.S., and pointing out that you can only think we've done anything like fiscal stimulus if you're only looking at the federal government - if you look at all government spending, fiscal stimulus has been largely absent. The feds are filling the hole that the states are digging, that's essentially what things have amounted to.

Anyway, I checked out German and American quarterly percentage change in public spending, and here it is:

Fig. 1 Quarterly percentage change in government spending

It's somewhat hard to compare, but it certainly doesn't look like the U.S. is trouncing Germany in fiscal policy, does it? Particularly in more recent quarters, Germany seems to be spending more in the public sector than the U.S. - and in the first quarter of 2010 (the last year of German data I found), they're beating the U.S. substantially. But let's take these figures and look at cumulative quarterly percent change to see if my eye-balling it is meaningful:

Fig. 2 Cumulative quarterly percent change in government spending

These data seem to confirm my suspicions - for most of the crisis, Germany has been outpacing the U.S. in government spending and the gap isn't closing because Germany has kept up its fiscal policy. This is due to two factors:

1. Germany has stronger automatic stabilizers which are so integral to German political economy that Merkel doesn't even think to mention it on the public stage - and certainly not when she's brow-beating other countries about austerity.

2. The U.S. is a federal system where a substantial portion of government spending is done at the state and local level. Germany is too, of course, but the German Länder don't seem to have the pro-cyclical proclivities that U.S. states do.

If Don checked the data, he'd realize he doesn't quite have the case he thinks he does. As a rought cut, Germany seems to have stronger, not weaker, fiscal stimulus than the U.S. does, particularly in early 2010 (which of course is going to make a big difference in GDP numbers that come in now). I don't think this is firm evidence in favor of Keynesians either, but it's certainly not evidence against us.

Add to these stubborn facts that Germany didn't have nearly as bad a crisis as we did in the first place, and I'm really struggling to see Don's point. Perhaps he can tell us.


*All data is from Eurostat's national accounts. I compared their figures for the U.S. to the BEA's, and they look quite comparable - a few small discrepancies probably due to different national accounts definitions. If you look at earlier posts of mine on U.S. public spending trends, you'll see essentially the same pattern in the BEA data that I present here in the Eurostat data.

Nevermind...

This week I had written an op-ed I was going to submit to the Washington post, emphasizing the point I made earlier that we really haven't done much of any fiscal stimulus and that the only reason why everyone thinks we have is because nobody thinks about states and localities when it comes to issues of national significance (like macroeconomic performance). I was waiting for the Friday GDP numbers to come out to make my case based on the last three quarters - when they did, though, total government spending was actually positive for the second quarter of 2010. So nevermind on that op-ed. The previous two quarters were still negative, although they had change slightly. This was the original text of my submission:

*****

"The American economy faces a major threat to economic recovery that most of the public probably isn’t aware of: government has been slashing spending for the last nine months. This Friday it became official when the Commerce Department released its quarterly economic statistics. In the second quarter of 2010, total government spending fell by [X] percent. In the first quarter of 2010, it had been reduced by 1.9 percent while in the fourth quarter of 2009 it dropped by 1.3 percent.

Recently, economists have been debating the merits of precisely this kind of “austerity.” Some have argued that reducing public spending can spur economic growth. Others are convinced that it is a sure way to kill the recovery. This discussion has generally revolved around Europe, which is increasingly pursuing austerity measures, and whether Europe offers a model or a cautionary tale for the United States. What this debate often leaves out is that belt-tightening by the government has already come to our shores, and it has been with us for the better part of a year now.

This seems to contradict what everyone knows: that the Obama administration has been running record-breaking deficits. Politicians and cable news commentators bombard us with concerns about our profligacy over the radio during our commute to work every morning and on television every night. How can it possibly be true that government has been slashing spending for the past nine months?

What the public often forgets is that the United States is a federal system with state and local governments as well as a federal government. We don’t “forget” about federalism in the sense that we don’t realize these other levels of government exist; they are an important part of our lives. But we do forget their relevance to problems of national significance, such as the current recession. This is a serious oversight, because together state and local government budgets are about one and a half times the size of the federal budget. That means that amidst all the discussion of the role of government in the economy during a downturn, many of us are completely forgetting about a significant portion of the government spending that goes on. Unfortunately, the economy and the job market don’t have the luxury of forgetting this. The economy can’t tell the difference between a dollar appropriated by the federal government and one appropriated by a state or local government.

Government spending has been shrinking for the last nine months because the federal government has been almost entirely preoccupied with filling in the hole that state and local governments have been digging, and the states have been digging that hole faster than the federal government has been filling it since the third quarter of last year. This results in a net reduction of government spending in the United States. If you think that government spending during a recession is harmful, you may be comforted by this news. However, those inclined to celebrate this reduction in government spending should consider the fact that the economic outlook began to darken again precisely when total government spending (federal spending, plus state and local spending) started to shrink.

Austerity is pursued in state and local governments for many reasons. Municipal bond markets aren’t always as accommodating as the market for federal debt. Some of these entities are constrained by balanced budget requirements in their constitutions, or statutory limitations on running deficits. Local governments that rely on property taxes have been hit hard by the housing crash. In addition to all these real constraints, though, a lot of state and local leaders simply believe that tight-fistedness is a virtue during a recession. Many governors, mayors, and county boards don’t seem to have received the memo from much of standard economic theory that responsible governments are supposed to lean against the economic winds. They should take a step back when the economy is heating up and government spending risks crowding out private activities and jump in to buy and use idle resources when the private sector is too fearful of what the future holds.

While some states, such as California, have a legitimately difficult time convincing creditors to lend to them, others, like my home state of Virginia, have no such excuse. Virginia has an excellent credit rating, but our governor and our state legislature apparently feel an abiding need to run a budget surplus during the worst downturn since the Great Depression. This decision in Richmond has the same impact on the economy as the recent decision of many big businesses to sit on profits instead of using that income to hire and invest. The Virginia state government is essentially telling us that it makes more sense to sit on our tax dollars right now than it does to use them to put unemployed Virginians and unused equipment to productive work. Yet for this, Governor McDonnell gets celebrated by voters and the press.

The growth of the federal government in the decades since the last downturn of this magnitude in the 1930s leads many Americans to forget about the significance of our federal system of local, state, and national governments. The public debate over economic policy is distorted by the fact that we’re not even talking about the majority of government spending that occurs outside of the federal government. Those of us who acknowledge the importance of stimulus get complacent because we aren’t aware that government spending is actually being reduced right now, not increased. Those who argue against stimulus are galvanized by false claims that total government spending is soaring.

State governments have always played a fundamental role in the history of our republic, and they are just as essential today as they have been in the past. We can no longer afford to write them out of the story of the government response to the recession."

*****

The argument itself still stands, of course. The logic is still good, and we still overestimate how much fiscal stimulus we're doing because we forget about the states. The positive numbers for quarter-to-quarter change this quarter are also probably related to several previous quarters of negative growth in government spending (i.e. we're still down from where we should be but they can't fall forever so you're going to get periods of positive growth). But it's harder to make that case convincingly when one of the three quarters you're looking at runs against your thesis.

So how do we interpret these recent GDP numbers?

1. It's good news public spending is not shrinking again. Private spending probably would have looked better if we didn't have six months of austerity at the end of 2009 and the beginning of 2010.

2. Fiscal policy has a lag, just like monetary policy. Shortly after spending initially stalled out we saw a weakening (also due to the fiscal crisis). Then public spending picked up dramatically with the stimulus package, after a quarter or two GDP did too. Then after an early spring of weak stimulus, we're seeing a continued weakening in GDP. In three to six months we may see another upward trend (hold me to it - we can check the data) as a result of this increase in fiscal stimulus, but a lot of that depends on whether it is sustained through the third quarter and what else happens.

3. This all is just going to contribute to confusion over what is exactly going on, which is unfortunate. We're still doing tepid, on again-off again stimulus which isn't good for the economy or for clear analysis. Informally eye-balling it, we're seeing a something like a delayed wave pattern (I demonstrate it here) with output lagging a quarter or two behind public spending. We shall see, though.