The Demand For Treasuries.

There have been a number of things lately such as the SS debate, reading both the General Theory and Hyman Minsky's "Stabilizing and Unstable Economy", and--not least of all--my dissertation that have got me thinking about the demand for treasuries. We are used to thinking about government debt as a supply side phenomenon, simply politicians turning on the printing presses so to speak.

To illustrate, here is a question from my final (both Marco and Money and Banking) that I asked:

In the US right now corporate investment is extremely low as corporations are now holding historically high levels of liquid assets instead of spending their profits. As well, foreign savings continues to flow into the US because US assets/investments increasingly looks good compared to European assets. Finally, private savings rates are increasing as American households try to "repair their balance sheets" and make up for wealth lost when the housing bubble popped. Use the “Savings/Investment Identity” to show what must happen if capital inflows and households savings are increasing while at the same time investment is decreasing.

To answer this question you need this identity:

Investment (I) = Private Savings (PS) + Capital Inflows (KI) +Government Savings (GS)

Necessarily, if the events I outlined are true, Government Savings has to fall, that is, the government has to run a deficit. Now, this is an idenity and it doesn't tell you anything about what is driving what. But the way I framed the identity it is all about the demand side for treasuries. In a weird way, the extension of the Bush tax cuts following on the heals of the Eurozone crisis can be seen as a kind of market response to demand.

Anyway, I decided to dig around in the Fed's Flow of Funds and the Federal Government's Budget data to see what the demand side has looked like historically.

Right away I'm gonna deal with the mot controversial part of this little exercise. I am including the Social Securty Trust Fund as part of the demand for debt. Here is my version of a graph I'm sure you've seen a million times:

Figure 1

So Social Security is about half of the debt that the federal government owes itself. The reason I have included social security is because even though it is classified as debt that the government owes itself it also represents (potentially) future public debt. Social Security debt is held in special "non-marketable" treasuries and so currently they aren't part of the market for treasury bonds and to that extent the debt is actually different than debt to the public.

However, as the Social Security system starts to take in less money than gets paid into it the Social Security Administration will cash in those bonds. In order to pay back those bonds the federal government will have to pay that back with taxes or issue new debt issued to the open market. Social Security is "postponed debt to the public". I need to be careful and point out that this is not a problem with SS. I'm not much of a deficit/debt hawk and to the extent the debt is worrisome the issue is how we manage the debt/GDP ratio. The shift of trust fund debt to the public would have no effect on the debt/GDP ratio. Depending on how rapidly the trust fund got used up it may have an effect on treasury bond yields but that seems to me like mostly a secondary concern.

I don't want to dwell on Social Security. The dudes (gender neutral!) over at Planet Money have a really good podcast about social security. Maybe my next post will be about Social Security. Anyway, I do need to admit a couple of things. First, it's a little unfair to single out social security for my analysis but I had to make my graphs intelligible. The social security trust fund made up about $2.6 trillion of the $4.3 in debt the government owes itself at the end of 2009. So I'm ignoring $1.7 trillion which is a lot even when talking about an $11.8 trillion deficit.

That $1.7 is mostly made up of the:

Civil Service Retirement Fund ($750 billion)
Department of Defense retirement and Medicare funds ($144+ $295 billion)
The Medicare trust fund ($390 billion)

Anyway, the vast majority of the debt the government owes itself is the investment of retirement entitlements of one kind or another. But like I said, i had to keep my graphs reasonably clear so I'm ignoring $1.7 trillion!

Alright so here is the first graph:

Figure 2

This graph is included for completeness but its kind of hard to read because the Great Recession kind of explodes the graph. It's a good place though to look to explain a few things. First, of all these are "flows" which means what is being shown here are either new (net) purchases or sales of treasuries by each sector for each year. Secondly, the "Remainder" line represents the total new treasury issued in each year minus the sectors show in the graph. It just shows how much of the new treasury debt issued was bought by the sectors I'm looking at. If the Remainder is positive it means the sectors shown under account for new treasury issues in each year. If the Remainder is negative the sectors shown over account for new treasuries. Finally, I chose 1975 as the starting point because that's around when the post-war debt/GDP ratio bottomed out.

I'm going to chop off the Great Recession (and come back to it later. Here we have a picture of what should probably be called the structural deficit that started in the early 80s:

Figure 3

In figure 3 I have lopped off 2007-2010 or, roughly speaking, the Great Recession. I have also put everything into 2005 prices. I am not so sure that was a good idea but I felt like keeping it in nominal dollars distorted the relative importance of each sector over time. I would have preferred to make this a logarithmic chart, but I can't because there are negative values. Anyway, this this is essentially unreadable and won't make sense until after looking at figure 4. However, two things are pretty clear. First, the financial industry seems pretty important to the demand side through the 80s. Second, while state and local government (includes "regular budget" and pension funds) sell off a lot of treasuries in the 90s their purchases seem to recover in the mid 2000s. However, in the 90s households start dumping treasuries and don't look back (until 2008!). Did all the money wind up in the stock market? Did treasuries become a quaint, old timey way to save?

Okay so Figure 4 can help make sense of Figure 3:

Figure 4

So figure 4 is not really "to scale" in any way. Each bar represents 100% of treasury purchases by the sectors I'm looking at (plus the remainder) for each year. However, this does not give any sense of the relative scale of each year. For that look at figures 1 and figures 2.

What's interesting about this chart is that there seems to be a clear shift in the demand for treasury bonds that takes place in the mid 90s. It looks to me like "core demand" shifts from the financial industry to foreign demand. As well in the 90s there seems to be shift of demand from state and local government to Social Security. However, remember these are all shares of a pie that is growing every year. If you look back at figure 2 it seems more that state and local demand remains steady (though falls a little) while SS demand starts to take off in the late 80 due to the 1983 Social Security Amendment.

I found the results from figure 5 to be pretty surprising:

Figure 5

I chose 1971 because that's when the US went off the gold standard (officially) and I was curious to see if that meant anything. Now what'ss obvious here is how important foreign "official" institutions (mostly foreign central banks) are as a source of treasury demand. I had taken the role of the US dollar as a "reserve currency"--as a currency other central banks hold as a way of managing their own currencies-- for granted. However, it is quite striking how important our role as a reserve currency is in creating demand for our treasury bonds. Other countries prefer to hold treasury bonds instead of dollars because they are essentially as safe as dollars and they pay a return.


I want to go over two things. First, I don't think this post would be complete without a graph of the last couple of years (at least through 2009, which is all I have numbers for):

Figure 5

The scale of figure 5 is nominal dollars. The Fed sold off a whole bunch of treasury bonds in 2008 in order to purchase (or sometimes exchange) for things that were not treasury bonds like a Mall in Oklahoma (Planet Money Again). Foreign demand went through the roof and financial business came back to buying treasuries. Foreign demand is probably going to get stronger now that Europe is becoming more and more of a mess, a phenomenon called "flight to quality". As far as the financial industry buying treasuries that's a function of the Fed loaning tons of money to banks basically for free. Banks and other financial intermediaries then take the money and buy safe as houses treasury bonds and take home the difference. It helps keep treasury bond yields low and Wall Street bonuses flowing.

Finally, I'm not 100% sure I've done a good job making it clear how important governments are to the demand for treasuries. Here is one more homemade chart:

Figure 6

I double checked this graph after I made it because I find it really surprising. I feel that this really makes it clear how important political entities are to the demand side of the treasury debt market. I know I'm trying to play both sides of the fence here by saying that SS should be thought of as simply postponed debt to the public and then putting it up here as part of "political" debt. But I think its justifiable because a lot of the discussion these days is about "the market" for treasury bonds and how market bond vigilantes may soon send us the way of Greece and Ireland. However, the vast majority of treasury debt is dependent on political decisions and political entities (in 2009, the gray area of figure 6 was only $3.4 trillion of 11.9 trillion). Here again Social Security is useful as illustration. While I do believe Social Security is "real debt" the political debate today seems to be all about trying to avoid having to turn these non-marketable securities into "general fund" debt very quickly or at all either by cutting benefits or by raising current taxes. As well, it seems highly unlikely that the Chinese are going to stop pegging the Yuan to the dollar any time soon even if they are going to tweak it here and there. As well, the Fed is obviously extremely sensitive to what it does to the treasury market and even a good portion of the private market debt are essentially back door "open market purchases" made through arbitraging financial intermediaries.

Now, I'm not willing necessarily to call demand based on political decisions more stable, but it's not obvious that even if the fantasy of bond vigilantism came true that they would have necessarily that much of an effect.

Oh and also on the "we aren't Greece or Ireland" tip. I feel like this is a good place to put this graph from the Financial Times:

Figure 7

The basic point to be made here is that the analogy is not between the US and the second tier developed nations of the Eurozone. The proper comparison is the comparison between the US, the financial center of the world with the world's reserve currency is with the UK when it held that position. However, I do have to admit it's not entirely clear which UK we are talking about. The post Napoleon UK was an empire experiencing very robust growth on the whole. The post Hitler UK on the other hand was the shell of a collapsed empire that eventually needed to be bailed out by the IMF in the mid 70s.

it should be pointed out that the post WWII UK had lost it's prominent position as the worlds financial center with the world's reserve currency. The US remains strong on both fronts. While there is much talk of China, their financial markets are still in their infancy and you aren't even allowed to trade Yuan. Before their own subprime crises the EU looked like it could possibly be a contender but that seems far more remote now although this crisis may bring the Eurozone closer to a fiscal union which they would need to compete effectively with treasury bonds. At any rate the US seems pretty secure as the worlds tallest midget.

Naked Capitaism: Deficit Doves, the Gift that Keeps on Giving

Deficit Doves, the Gift that Keeps on Giving

The first section of this post is by Warren Mosler, the President of Valance Co. who writes for New Deal 2.0

Deficit doves are doing more harm than the hawks — here’s what they need to know.

The deficit hawks are prevailing. The economy remains an economic and social disaster. Medicare has already been cut by the Democratic majority in the new health care bill. Social security is now under attack by the new bipartisan Congressional Commission on Fiscal Sustainability and Reform. Meanwhile, the media tries to present a balanced approach, pairing deficit hawks with deficit doves.

But the deficit hawks aren’t the problem. They do the best they can with arguments that feature empty rhetoric supported by the underlying assumption that deficits are ‘bad.’

Actually, it’s the well-intentioned but misinformed deficit doves featured by the media that may be doing the most harm. They don’t understand actual monetary operations and reserve accounting, and therefore incorporate the same fundamentally incorrect assumptions as the deficit hawks. They agree deficits are ‘bad,’ but try to argue that’s the case only in the long term. They agree that deficits can be too high, but try to argue they have been higher, particularly in World War II, and therefore larger deficits should be easily manageable, while agreeing there is a level that could not be manageable. They agree markets could be ‘unfriendly’ and a lack of confidence could translate into far higher interest rates, but argue that the current low rates for Treasury securities are the markets telling us that at least for now confidence is high indicating markets are eager to fund current deficits. And they agree that ‘bang for the buck’ matters and support tax cuts and spending increases based on higher multipliers.

The problem is that the two sides of the story are in fact fundamentally on the same side. The media does not feature the true deficit dove story. Nor do any of the true doves have even a small piece of the administration’s ear, or the ear of anyone in Congress willing to speak out. There are maybe a hundred true doves, including many senior economics professors. The problem is this professional, highly educated, highly experienced collection of true doves does not get a fair hearing.

The true deficit dove positions include:

1. Since government spending is merely a matter of changing numbers in bank accounts on its own spread sheet, there is no solvency issue or sustainability issue
2. The right size deficit is the one that coincides with our stated goals of full employment and price stability.
3. Interest rates for government are set by the government, and not by the market place.
4. Bang for the buck considerations are moot as the size of the deficit per se is not an issue.

The answer to why the true doves capable of articulating the above points don’t’ get a fair hearing may be credentials. My BA in Economics from the University of Connecticut in 1971 doesn’t cut it, nor the fact that the very large fund I managed was the highest rated firm for the time I ran it. And my net worth never getting anywhere near a billion hasn’t helped either. Seems billionaires get celebrity status and lots of airtime for just about anything they want to say.

The same is true of the economics professors who’ve got it right. Without being from and at the usual ‘top tier’ schools, none can even get published in main stream economics journals, where submissions featuring obvious accounting realities are routinely rejected. In fact, any economist who states accounting identities and operational realities such as ‘deficits = savings’ or ‘loans create deposits’ or ‘Federal spending is not constrained by revenues’ is immediately labeled ‘heterodox’ and unworthy of serious mainstream consideration. Even the late Wynne Godley, who did have reasonable credentials as head of Cambridge Economics, and was the number one UK economics forecaster, was labeled ‘unorthodox’ because his mathematical models featured the deficits = savings accounting identity.

My three proposals that can immediately turn the tide and get us back to full employment and prosperity remain:

1. A full payroll tax (fica) holiday
2. $150 billion of Federal revenue sharing to the States on a per capita basis
3. An $8/hr Federally funded job for anyone willing and able to work to facilitate the transition from unemployment to private sector employment.

The only thing between today’s state of the economy and unimagined prosperity is the space between the ears of policy makers that’s filled with the deficit hawk rhetoric, and unfortunately further supported by the rhetoric of the deficit doves the media selects to present the ‘opposing view.’

Yves here. Mosler wrote this piece to address the debate over the federal budget deficits in the US, which meant he could skip over some important caveats.

Modern Monetary Theory does describe how the world works in a fiat currency regime, meaning the “government” is the issuer of sovereign currency. Despite all the hyperventilating about default, governments that issue their own currency will never be forced to default (note that Greece, Spain, Ireland, and California are not in this position). They can create a lot of inflation, but that is a separate issue.

The times in the modern era when sovereign states have defaulted is:

1. Under a gold standard

2. When they either are not currency issuers OR have adopted a currency they do not control (eg. countries like Argentina that dollarized their economies)

3. Countries that have overly large banking sectors relative to GDP AND those banks have large liabilities in foreign currencies AND those banks have major solvency problems (Iceland, this would also be the reason for a UK default)

The lone exception is the Russia default of 1998, which remains a bizarre, opportunistic incident. Russia’s sovereign debt was under 20% of GDP, and there was no reason for it to have defaulted, even if its debt levels had been higher.

Now to a general point about MMT. The negative responses to it are almost reflexive, shoot the messenger: deficit = bad, we aren’t prepared to listen to anyone who says otherwise.

Sorry, gang, it IS more complicated than that. We’ve provided this formula before:

Domestic Private Sector Financial Balance + Fiscal Balance – Current Account Balance = 0

Now let’s consider what has happened in the US, and some other advanced economies. Our corporations, in their infinite wisdom, have decided increasingly to offshore and outsource, which means move operations outside the US and to turn big chunks of their operations over to other companies, again often foreign ones.

Let’s go back to the formula. First result is that we have a current account deficit. So that means that the sum of the other two parts of the economy, the private sector plus the public sector will run deficits, as in borrow more than they spend. Maybe one is a net saver, the other a bigger net borrower, or both are net borrowers. But at least one sector will be a net borrower.

But let’s consider another set of issues. The fixation of public companies on quarterly earnings plus the offshoring/outsourcing phenomena have led them to become net savers, even in expansions (see here for a long-form discussion). Normally, the household sector is a net saver (households generally try to save for retirement and for emergencies). Most readers appear to implicitly assume that those funds should be used by business, that government borrowing crowds out private sector borrowing. But while INDIVIDUAL businesses do borrow, recall they also generate cash. The trend, even in periods of growth, when businesses as a whole ought to be borrowing and investing in growth, is instead that they are net savers.

In that scenario, even if the US had no trade deficit, the government would need to run a deficit to accommodate the desire of the private sector to save. The alternative would be that the US would need to go from its assumed trade balance to a trade surplus. That would happen through a fall in prices and wages in its tradeable goods sector (which can happen via domestic deflation, which will make debt burdens worse in real terms, or a fall in the dollar) and/or an increase in productivity so that our exports gained market share.

Now the private sector in the US is deleveraging, which and reducing debt is tantamount to saving. We have pointed out that the euro would likely have to fall to 60 to 80 cents to the dollar to prevent the eurozone from falling into deflation (which will make debt levels in real terms worse and almost certainly precipitate the defaults that the austerity programs being implemented are meant to avoid.

The certain continued fall in the euro (the trajectory is a given, the open questions are how far and how fast), and China’s signaling that it is likely to devalue its currency if the euro falls materially means the dollar is likely to remain strong, Right now, every country with overly high debt levels wants to break glass, weaken currency, and use exports to provide it with some lift to offset the contractionary impact of deleveraging. It appears unlikely that the US will be able to play that game. Odds are high that we will continue to be a net importer.

So, if we decide to run government surpluses now, the result is almost certain to be deflation, at best a Japan-type stagnation with high unemployment (and the US has far less social cohesion than Japan does), at worst a deflationary downspiral. But in either case, austerity becomes self-defeating. The value of outstanding debt rises as prices fall and GDP contracts. Default becomes more likely, and as defaults rise, banks become more impaired, investors more cautious, and the downturn can easily accelerate and become self-reinforcing.

Now some readers are correctly concerned about the wisdom of letting the cohort in DC spend more, given our misadventures in the Middle East, and healthcare “reform” serving as a Trojan horse for further entrenchment and enrichment of Big Pharma and the heath insurers. I am certainly not keen about handing a blank check to the likes of Geithner (oh wait, we did that already, it was called the TARP). We also need to keep pressure high on the need to reform governing structures.

As much as the logic of continued government spending is unpalatable to many, be careful what you wish for. If you think the economy now is not so hot, just wait to see what happens if deflation takes hold.

This recent post from Peter Droman at the EconSpeak blog: A political Economy Moment reminded me that I have wanted to make a post about a philosophical problem with the debate about fiscal policy and the role of government.

I think it is in some ways unfortunate that economics is caught in a Keynesian/Monetarist (or classical) binary. Broadly speaking the debate is about whether government can have a positive effect on the workings of the economy. The problem is that this binary does not capture the full spectrum of attitudes towards government and it causes some philosophical problems for any leftists cum economists. Tiny, tiny, minority they may be.

Simplistically speaking, I subscribe to the Marxian point that the state is a "committee for the management of the affairs of the bourgeois". Oddly, I think there is a lot of overlap in the way I see the world as your walk-a-day libertarian who similarly sees governments as constraining the potential of the world. In fact, the idea that governments are simply the tools of corporations is a large component of libertarian ideology. After all such things as bailouts, "regulatory capture", and even the Fed are all seen as distorting the playing field in favor of the politically connected few. I find myself more often than not nodding in agreement with libertarian or Hayekian critiques of how the current system is managed.

Libertarians, however, lose me when they start prescribing solutions. In a nutshell their solution to the problems with capitalism is simply more capitalism. The intellectual work is simple, governments distort the natural process of the market and once the market is set free from government control manna will rain from heaven.

But what if you don't believe that the solution is more capitalism? Solutions become very messy. The problem is that, in a universe of atomistic firms and households (the world of the economist) the only point of conscious intervention in the economy is government. So we are stuck putting lipstick on a pig so long as we are forced to defend the efficacy of government. I, personally, am willing to hold my nose and pull the lever. A defense of government intervention is--baring some kind of miracle of theory or reality--a defense of conscious intervention into our own history.

However--and I want to point out I'm not entirely cynical about this--there is always an endless stream of caveats. For instance, from the EconSpeak post above after talking about the "center-to-left prescription for the recession Mr Dorman goes on to point out:

In a sense yes: those who make the decisions summon economic arguments to justify their actions. But who gets to make the decisions and what arguments they find appealing is not the outcome of academic seminars. What got us into this mess in the first place, and what now threatens to throw us back into the maelstrom, is the political hegemony of the “finance perspective”, the interests and outlook of those whose main concern is maximizing (and now simply protecting) the value of their financial assets.

Within the world of elite interests, this is almost a mass constituency. While the bulk of such assets are held by an infinitesimal few, perhaps the top 10-20% of the population in the industrialized countries have significant financial wealth and actively monitor their returns. Their understanding of how economies work and what priorities policy-makers should adhere to follow from their personal position. Inflation is a constant threat to asset-holders. They fear the laxity of central banks as well as the buildup of government debt, which can serve as an incentive to future inflation. They want their portfolios to have a component of absolutely risk-free government securities, and the very whisper of sovereign default chills them to the core. They believe in the inherent reasonableness of financial markets and believe that anyone who wishes to borrow from them should demonstrate their prudence and fiscal rectitude. They were willing to relax their principles temporarily during the panic, but now that they have caught their breath they want to see a return to “sound” practices. Governments will bend to their wishes not because they have better arguments, but because they hold power.

How do you get business done in such an environment? I have found myself disagreeing with Paul Krugman's call for a larger stimulus. It seems that within a democratic system the nature of compromise necessarily means any kind of stimulus would be too small. Whats more, the mishmash of the stimulus bill was qualitatively inadequate. So why should we insist that congress mismanage more stimulus? Here, though, it is not just my politics but my professional chauvinism that finds the process aggravating. As a side bar, I'm fairly certain that the last generation of economists have been preoccupied with monetary policy not only because the stagflation of the 70s was their founding trauma but because monetary policy is largely the sole technocratic purview of economists. Anyway, disagreeing with the call for more stimulus then means retreating into a weaker position that "in theory this would work."

The real solution to this impasse is not intellectual. It's political, for those of us who desperately do not want to be cynical about the role of government also have to assume that it is possible for political life to operate properly. What we ultimately need is a government--while not perfect--is something that can be believed in and trusted. I feel a great nostalgia for the immediate post war era when governments had proven they could respond to a crisis and there was--even in the US--a consensus about the legitimate role of government in economic life.

The 70s of course changed all that. The documentary filmmaker Adam Curtis' four part "The Century of the Self" traces the individualism of the baby boomer generation from its political expression to its transformation into "lifestyle consumerism" in which individualism get channeled and expressed through differentiated consumption goods. Curtis contends that Ronald Reagan's declaration that "Government is the problem" spoke precisely to this individualism which had been shaped over the turbulent and dysfunctional national politics of the 60s and 70s but had become cynical and satiated. I think, in a way, that process has been repeating itself or I suppose it is the new political reality. The new rise of libertarianism seems to be siphoning off significant proportion of people who should be properly left leaning. The critique is the same either way you go but but leaning right offers a simple and consistent prescription. Unfortunately, in the absence of something simple and coherent a functioning left requires some kind of demonstrable proof. That proof has been fairly short in coming over the last 30 years as Reagan's prophecy fulfills itself.

The net fiscal expenditure stimulus in the US 2008-2009: Less than what you might think

The crisis led to significant fiscal stimulus efforts by the US government to offset the downturn. But this column argues that, properly adjusted for the declining fiscal expenditure of the fifty states, the aggregate stimulus was close to zero in 2009. While a net decline was avoided, the stimulus did not raise aggregate expenditure above its predicted mean. This can explain the anaemic reaction of the US economy to the alleged “big federal fiscal stimulus”.

Bailout packages have dominated political debate in the US and elsewhere. The global financial crisis led to a massive bailout of the US financial system and significant fiscal stimulus efforts by the US federal government to offset the resulting severe economic downturn. The sheer size of the federal commitments, at a time when the unemployment reached two digit figures, has led observers to question the efficacy of fiscal policy. Moreover, questions were raised with respect to the size of the fiscal multiplier in the US, as well as about possible adverse effects of higher future debt overhang (see de Resende et al. 2010, Barro and Redlick 2009, Spilimbergo et al. 2009 and the references therein).

Given that the counterfactual of the performance of the US economy in the absence of the fiscal stimulus is hard to ascertain, one may thus question its effectiveness, and hence the logic of continuing it. Before taking a position on these vexing issues, it is vital to ascertain the net size of the fiscal expenditure stimulus of the real sector. This issue is of key importance in a federal system like the US, where the fifty states are restrained from borrowing in recessions and frequently refrain from raising taxes at times of collapsing tax bases. While stabilising the financial system is useful in preventing bank runs, deepening credit constraints facing key sectors like local government expenditures imply that financial bailouts would not prevent, in the short-run, a sizable contraction of aggregate demand.

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VoxEU: The timing of fiscal interventions: Don’t do tomorrow what you can do today

The timing of fiscal interventions: Don’t do tomorrow what you can do today

Karel Mertens Morten O. Ravn

The composition and timing of the fiscal stimulus is a major concern for policymakers. This column presents research showing that anticipated tax cuts result in reduced economy activity before they take effect. During the current downturn, that constitutes a strong argument against stimulus policies that phase in tax cuts over time.

The current macroeconomic downturn has sparked repeated calls for fiscal stimuli to combat the ensuing decline in activity and labour market conditions (e.g. Blanchard and Cottarelli 2008; Corsetti 2008; Krugman 2008). Common to the proponents of a fiscal intervention has been the appeal for the immediate use of fiscal levers. The prime reasons for this are the fact that the current downturn has been unusually deep (and probably associated with tightening financial constraints) and the view that fiscal policy changes have their fullest effect on the economy only with a considerable delay. Procrastination therefore runs the risk of stimulating the economy when it – we hope – is already recovering.

Anticipation of tax changes

But, there are other aspects of procrastination that also may matter. Not only may a delay in the application of fiscal measures end up stimulating a recovering economy, but anticipation effects may actually depress the economy until the fiscal changes are implemented. Anticipation effects arise when policy makers announce – or legislate – future fiscal interventions. This phenomenon is quite common as far as tax changes are concerned. Tax laws often contain pre-announced changes in future tax rates because of phase-ins and due to the not so infrequent use of sunsets associated with temporary tax changes.

To the layperson, it would seem obvious that the announcement of a low future price of a good may delay its purchase. A supermarket wishing to sell beer today at good profit margins would probably be ill advised to announce a reduction in the price of beer next week. Such principles of forward-looking behaviour and intertemporal choice are deeply rooted in much of macroeconomic theory and apply also to the impact of tax changes (see Hall, 1971, for an early example of the impact of pre-announced tax changes). Yet, empirical investigations have failed to purport the idea that anticipated tax changes affect current choices. Indeed, a number of studies of consumption behaviour have indicated that consumption appears to react little to announcements of future changes in taxes and that consumption does adjust to the implementation of tax changes that were known in advance.

Some economists have concluded on this basis that a substantial fraction of households are liquidity-constrained (or fail to be able to make simple forward-looking decisions). In a provocative and influential piece, Mankiw (2000) argues that perhaps up to half of US households may be described as rule-of-thumb consumers that simply consume their current income due to the presence of binding liquidity constraints. For that reason, the fact that tax changes may often be pre-announced matters little – the tax changes simply affect the economy when they are implemented.

Procrastination: Does it matter?

Nonetheless, while there is little evidence that consumption choices are affected by announcements of future changes in taxes, other key macroeconomic aggregates do react to such policy announcements. Figure 1 shows the dynamics of aggregate output, consumption, investment, and hours worked following announcements of changes in tax liabilities six quarters in the future, which we estimate for the US post-1945 (Mertens and Ravn 2009). The vertical scale show percentage deviations from trend and the size of the change in taxes is normalised to one percent tax liability cut relative to GDP. The announcement dates correspond to the dates at which tax laws were signed by the president relative to the implementation dates stated in the tax legislations.

Figure 1. The response of output, consumption, investment, and labour to announced tax changes

The figure makes it clear that pre-announced tax changes cause important adjustments in aggregate activity, hours worked, and investment. Announcing a cut in taxes six quarters out leads to a steep drop in aggregate investment, a decline in aggregate output, and a gradual slide in hours worked. Once the tax cut is implemented, each indicator recovers and peak responses are reached about 2-2.5 years thereafter. Thus, while aggregate consumption appears relatively insensitive to announcements of future tax changes, this is certainly not shared by other main macroeconomic indicators. This evidence challenges the view that lack of consumption responses to anticipated tax changes is evidence for rule-of-thumb behaviour or the absence of forward-looking economic agents.

To take one example, the Reagan tax cut of 1981 (the Economic Recovery Tax Act of 1981) introduced new depreciation guidelines and major cuts in personal marginal income tax rates and corporate tax rates. Signed by President Reagan in August 1981, it included changes in taxes that were phased-in from August 1981 until the first quarter of 1984. In fact, the largest change in tax liabilities was the cut of more than $57 billion in 1983, dwarfing the $9 billion tax liability cut of 1981. Therefore, the Economic Recovery Tax Act of 1981 was associated with major anticipation effects. According to our estimates, these expectations of future tax cuts actually contributed to the recessionary impact of the Volcker disinflation that took its course during the early 1980s. Once the economy was back on track in the mid-1980s, the tax cuts were being implemented and therefore further stimulated the uptake in aggregate activity.

Relying on news effects

So, if this evidence is correct, why do policy makers use phased-in policies, temporary tax changes, and other means of tax changes that introduce anticipation effects? After all, Reagan probably did not intend to deepen the early 1980s recession. Potential reasons likely include concerns about government debt or a desire that economic policy appear predictable rather than haphazard so that households and firms can adjust to changes in taxes (even if some theories of optimal taxes call for the opposite), and one can even write down theories that call for gradual changes in taxes.
Another potential reason is the idea that current good news about future economic fundamentals stimulates current activity. Such news effects, if true, would imply that the promise of future tax cuts lead to an uptake in activity even before they are implemented. If this was true, then you can almost “eat your cake and have it too” as the pre-implementation boom that should follow the announcement of future lower taxes would lower government debt through higher tax revenues and therefore help paving the way for a cut in taxes without having to cut spending (at least partially).

Conclusions

The evidence presented here suggests that there may be good reasons for phasing-in tax changes – relying on news effects, however, does not seem to be one of them. Thus, in the present environment, a good advice to governments is that the use of phased-in tax policies, temporary tax cuts, and other tax policies associated with anticipation effects should be used with great care.
Whether the same also holds true for changes in government spending is another question that is still not clear.
References
Blanchard, Olivier and Carlo Cottarelli (2008), "IMF Spells Out Need for Global Fiscal Stimulus", interview in IMF Survey magazine, 29 December.

Corsetti, Giancarlo (2008), “The rediscovery of fiscal policy?” VoxEU.org, 11 February. Hall, Robert E. (1971), “The Dynamic Effects of Fiscal Policy in an Economy with Foresight”, Review of Economic Studies 38, 229-44.

Krugman, Paul R. (2008), “Optimal Fiscal Policy in a Liquidity Trap”, Princeton University mimeo.

Mankiw, N. Gregory (2000), “The Savers-Spenders Theory of Fiscal Policy”, American Economic Review 90(2), 120-25.

Mertens, Karel and Morten O. Ravn (2009), “Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks”, CEPR Discussion Paper no. 7370.This article may be reproduced with appropriate attribution. See Copyright (below).

J. Bradford DeLong: Why we need noyt fear that a bigger stimulus will be counter productive

Why we need not fear that a bigger stimulus will be counterproductive
J Bradford DeLong
16 March 2009

There are legitimate reasons to fear that deficit-spending fiscal boost programs will not work well enough and have high enough longer-term costs to be not worth doing. This column says we do not need to fear bottleneck-driven inflation, capital flight-driven inflation, crowding-out of investment spending, nor reaching the limits of debt capacity because we will see them coming in time.

My favourite line from Jaws is uttered police chief Martin Brody (Roy Scheider) when he finally sees the shark: “You are going to need a bigger boat.”

We are at last seeing the shape of this downturn – and we are going to need a bigger fiscal stimulus than the deficit-spending package President Barack Obama pushed through the US Congress in February. We might get lucky; maybe the next four months will be months of unreserved good luck; maybe four months from now we will think that what we have collectively done to stabilise the North American and world economies is appropriate. That is not very likely; mixed news would mean that four months from now we are going to want to do another round of government spending boosts and tax cuts to try to keep the unemployment rate from rising too much higher and capacity utilisation from falling too much lower. (And the legislative calendar means that we should start thinking about laying the groundwork for such a second round of stimulus right now; in order to be in the budget reconciliation bill that will pass the congress in August, provision for fiscal stimulus must be in the budget resolution that will pass the congress in April.) Moreover, if the next four months are months of worse-than-expected bad news – well, let’s not go there right now.

Getting another round of spending boosts and tax cuts will, however, be problematic. Partisan opposition is mounting. That there is partisan opposition is very strange. We know John McCain’s chief economic advisers – people like Douglas Holtz-Eakin, who made an excellent reputation for himself as head of the Congressional Budget Office, like well-respected forecaster Mark Zandi, like AEI’s Kevin “Dow 36000” Hassett. We know how they think. We know that had John McCain won last November’s presidential election a very similar stimulus plan (but with fewer spending increases and more tax cuts) would just have moved through congress with solid Republican support. So the current 98% Republican opposition (except by governors who have to, you know, govern) leaves us scratching our heads.

So as we get ready to try to go and buy a bigger fiscal stimulus boat to deal with this Jaws recession, whose bite pushed the unemployment rate up to 8.1% in February, it is important to be clear why we ought to be doing this. And the first point that needs to be made is that the strange right-wing talking point that a government fiscal boost would not spur the economy because... because... well, it's not sure why... is badly mistaken at best and disingenuous at worst.

Four legitimate fears

But there are legitimate reasons to fear that deficit-spending fiscal boost programs would not work well enough and would have high enough longer-term costs to be not worth doing. I classify these legitimate fears into four groups.

• Bottleneck-driven inflation. The fear is that although more deficit spending will increase total spending, and although businesses seeing increased demand for their products will indeed try to hire more workers to boost production, they will succeed only by offering their new workers higher wages – wages higher enough that they then have to boost their prices – and by snatching scarce commodities out of the supply chain by paying more and then having to boost their prices more as well. Thus rising inflation will make the increase in real demand an order of magnitude less than the increase in nominal demand. And if the inflation produces general expectations that prices will continue to rise – well, then we are back where we were in the 1970s, with everybody focusing on changes in the overall price level rather than whether their business plan made sense given individual goods and services prices. An inflationary economy is one in which the price system does not do a very good job of telling people and businesses where to focus their energy. It is likely, over the decades, to be a slow-growth economy. Breaking an inflationary spiral would require another recession on the order of 1979-1982. It is better not to go there, and a fiscal stimulus plan that takes us there is not worth doing.
• Capital flight-driven inflation. The fear is that the stimulus package will cause foreign holders of domestic bonds to believe that inflation is on the way and trigger a mass sell-off of US Treasuries and other dollar-denominated assets that will push the value of the dollar down. And as the value of the dollar falls, the dollar prices of imported goods and services rise – and we are off to the inflation races once again.
• Crowding-out of investment spending. The fear is that additional government borrowing may – not will, not must, but may, for this is a fear not a certainty – push up interest rates, make financing expansion even more expensive for businesses, and so discourage private investment. The boost to spending would thus come at a high cost-benefit ratio as much additional borrowing leaves us with only a little additional demand. Moreover, it would leave us with a low productivity-growth recovery that has too little productivity-boosting private investment and too much government spending in the mix.
• Reaching the limits of debt capacity. The fear is that the long-term costs of additional fiscal boosts via deficit spending will be very large because those from whom the US government will have to borrow the money to finance spending will only loan it on lousy terms – high and unfavourable real interest rates that impose substantial amortisation burdens and associated deadweight losses from taxation on America’s taxpayers.

All of these are legitimate fears when a government undertakes a deficit-spending plan. We can all recall historical episodes when they turned out to be not just fears but realities. We remember bottleneck-driven and wage-push inflation from the late 1960s and from the oil shock-ridden 1970s – those episodes were the first fear coming home to roost. Nobody today is happy with American fiscal policy in the late 1960s or American demand management policy in the 1970s.

The second fear became a reality in France in the early 1980s. Capital flight and anticipated-depreciation-driven inflation were the immediate result of Francois Mitterand’s attempt to institute Keynesianism in one country and drive for full employment when he became president of France in 1981.

The third fear was perhaps not a reality but it certainly was greatly feared in the winter of 1992 and 1993, back when I carried spears for Lloyd Bentsen and his subordinates Roger Altman and Lawrence Summers in the Clinton Treasury. They argued that the Clinton-era economy could not afford the crowding-out of private investment that even the steady-course deficits then projected for the mid-1990s were threatening to produce through high and rising interest rates.

And the fourth fear is an even older legitimate fear yet. It goes back to Adam Smith and his Wealth of Nations, which contains pages warning that deficit spending on the imperial adventures of George III and his ministers would produce an unsustainable debt burden that would crack the British economy like an egg – as had been the consequences of debt-financed wars in Holland, France, Spain, and the Italian city-states over the previous three centuries.

Why we need not fear

These four fears are all legitimate fears, but I believe that we, here, now do not need to fear them.

In each of the cases in which these fears are legitimate, we can see in advance that the stimulus program is going wrong. Stimulus packages produce increases in nominal but not real demand when exchange rates fall and prices rise; we can watch the exchange rates fall and the prices rise, and we can watch as financial markets anticipate these events beforehand. Stimulus packages crowd-out private investment when the government’s borrowing causes medium-term interest rates on corporate borrowings to rise. Stimulus packages impose a heavy financing burden on the government when they cause long-term interest rates on government securities to rise.

In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead.

Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds.

If any of these start to materialise, expect me and a number of other stimulus advocates to start backpedalling rapidly. But so far, so good.

Editors’ note: This was first posted on theweek.com. Reposted here with permission.

Richard Clarida: A lot of bucks, but how much bang

A lot of bucks, but how much bang?

Richard Clarida
16 March 2009

Policymakers have committed substantial sums to addressing the global recession and the global financial crisis, but there is real doubt about their effectiveness. This column explains why the fiscal stimulus might fail.

“We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand” - John Maynard Keynes, “The Great Slump of 1930”, published December 1930.

I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts to discuss the state of global markets, geopolitics, and the many and varied ways that Russia factors into these complex domains. The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me, from the two-and-half-hour session that included probing questions from a number of the audience members assembled for the event.

That theme suggests the title I’ve chosen for this column; there are, at last, a ‘lot of bucks’ now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much ‘bang’ we can expect from these bucks.

In the US, President Obama has just signed a nearly 800 billion dollar stimulus package and the Fed has cut the Federal Funds rate to zero. Monetary policy in the rest of the G7, while lagging behind the US, will follow the US lead and soon come close to zero. (In the case of the ECB, the policy rate may end up at 1%, but the effective interbank rate has been trading well below the official policy rate in recent weeks so a policy rate of 1% could translate into an effective interbank rate of nearly zero). Likewise for fiscal deficits – they are rising globally and headed higher, propelled by a combination of discretionary actions and automatic stabilisers.

To date, however, these traditional policies have been insufficient for the scale and scope of the task. Recall that the Obama stimulus package is actually the second such US effort in the last 12 months. The 2008 edition was deemed to be a failure because a big chunk of the rebate checks were saved or used to pay down debt and not spent. The Obama package includes tax cuts and credits that will provide a boost to disposable income, but how much of these will be spent rather than saved or used to pay down debt? The package also includes a substantial increase in infrastructure spending, as well as transfers to the states, but the infrastructure spending is back-loaded to 2010 and later, and the transfers to states will most likely just enable states to maintain public employment, not expand it appreciably.

Bucks without bang

What is the source of this concern that the US fiscal package will not deliver a lot of ‘bang’ for the ‘bucks’ committed? Because of the severe damage to the system of credit intermediation through banks and securitisation, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Recall the Econ 101 idea of the Keynesian multiplier – the impact traditional macro policies are ‘multiplied’ by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It important to remember why and how policy multipliers actually come about. Policy multipliers are greater than 1 to the extent the direct impact of the policy on GDP is multiplied as households and companies increase their spending from the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand from the initial round of stimulus.

Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001, the economy was in recession, but households took advantage of zero-rate financing promotions – as well as ready access to home equity withdrawal from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts and income earned from government spending on goods and services will not be leveraged by the financial system to nearly such an extent, resulting in (much) smaller multipliers.

There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates. Just in 2008 alone, I estimate that the net worth of US households fell by some 10 trillion dollars, with much of this concentrated in older demographic groups who, in our defined contribution world, must now be focused on building back up their wealth to finance retirement, which is not that far away. This means more saving, less consumption, and smaller multipliers.

Global challenges

Outside of the G7, many of the major countries (certainly including Russia) are commodity exporters. The global recession has triggered a collapse in commodity prices, turning 2007’s fiscal surpluses into deficits and turning property and capital spending booms into busts in a matter of months. For example, as I am writing this, a headline has just popped up confirming that Dubai has received a “10 billion dollar bailout” from the UAE central bank to help provide financing for the rollover of debt backed by thousands of unfinished and unsold houses and apartment projects. Immense reserve stockpiles, which only months ago were criticised by some as excessive and without any purpose other than to manipulate national currencies so as to prevent appreciation are now, in Russia and some prominent other countries, being drawn down rapidly in a futile attempt to slow speculative depreciation of their currencies.

In Russia’s case, Deputy Prime Minister Shuvalov spoke at the conference and made very clear that 2009 will be a year of hard choices for the Russian government. Most importantly, Shuvalov made clear that Russia is unwilling to spend more than the 200 billion (a third) of the reserves they have already spent in what has turned out to be a futile attempt to support the Ruble. This will mean that companies and some banks will be allowed to fail, and that fiscal outlays will be scaled back and not funded at previous levels through a further draw down of reserves. So in Russia’s case, and I suspect some others, a lot of ‘bucks’ remain in reserve coffers, but they will be mostly saved, not spent to finance a major discretionary expansion in fiscal policy.

Will the Fed pull it off?

So where does this leave us? A LOT is riding on the efforts of the Fed and other central banks to stabilise the financial system and restore the flow of credit.

Officials recognising these challenges are now seriously considering “non-traditional” policies that combine monetary and fiscal elements. Cutting rates to (near) zero has not been a mistake, but it has been ineffective – really the most striking example of ‘pushing on a string’ I have witnessed in my lifetime. The reason, again, is the impaired credit intermediation system. The private securitisation channel, which at its peak was intermediating nearly 50% of household credit in the US, has been destroyed. Banks are hunkering down in the bunker, hoarding capital as a cushion against massive losses yet to be recognised on the trillions of dollars of ‘legacy’ assets that they have been unable or unwilling to sell at the deep discount required to attract private investors. For this reason, the Fed and Bank of England – with many other central banks likely to follow suit in some form or fashion – are filling the vacuum by directly lending to the private sector. The Fed aims to purchase 600 billion dollars worth of mortgage-backed and agency securities this year and, via the soon to be launched Term Asset-Backed Securities Loan Facility (TALF), to finance without recourse up to one trillion dollars worth of private purchases of credit cards, auto loans, and student loans. Since last fall, the Fed has also been supporting the commercial paper market via the Commercial Paper Funding Facility (CPFF).

Altogether, between the MBS, CPFF, and TALF programs, the Fed is committing nearly 2 trillion dollars of financing to the private sector. While these sums may be necessary to prevent an outright economic collapse that extends and deepens into 2011 and beyond, it is not clear to me that they are sufficient to turn the economy around so that it returns to robust growth. Moreover, based on the Fed’s just released economic forecast and Chairman Bernanke’s recent testimony to the Senate Banking committee, the Fed is also not convinced that these policies are sufficient to turn the economy around. On 24 February, knowing that an 800 billion stimulus had passed, that the Fed has committed nearly 2 trillion dollars of lending to the private sector, and that the Treasury’s Public Private Investment Fund will aim to support up to one trillion dollars of private purchases of bank legacy assets, Chairman Ben Bernanke said,

“If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability – and only if that is the case, in my view – there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,”

As I said in my remarks at the conference, I think of myself as an optimist, and that outlook on life has served me well. However, the last nine months have severely tested that mindset, at least as it pertains to my professional endeavours. But old habits are hard to break, so I am casting aside the contrary evidence and putting my ‘bucks’ on the Fed. But it is a close call.

Richard Clarida © voxEU.org

Contributions to the recession 2008q2 to 2009q2

I was curious about this, so I downloaded some some GDP data from the BEA (bea.gov).



Below is a graph showing the change in Private Investment from quarter to quarter. These changes are important because they mean different things. In particular, the collapse in the housing industry shows up in investment because housing is counted as an investment final good, not a consumption final good. Lots of debate has centered around what will "replace" the permanent fall in consumption as a percent of GDP due to higher savings rates. An equally important question to ask is 'What will replace residential housing in investment'. Histrocially speaking residential housing has been around 30% of total investment. In 2004 and 2005 9the peak) residential housing made up over 36% of total investment. If we are lucky housing will return to trend quickly, but even then a gap of 5% of total investment will have to be made up for elsewhere.

Yves Smith explains the inventory component:

There was a $140 billion reduction in inventories in Q2. I have been saying for some time that this would set us up for lots of upside come Q3 and Q4 as the inventory purge dissipates. So, we will get a technical recovery in my opinion. The question is whether there is any underlying demand uptick behind the inventory changes. In the data below from the BEA website, you can clearly see highlighted in red on the right that consumers are not even spending on basic items. Spending on non-durable goods was down 2.5% annualized. That is not good.

My overall take here is this:

• The downward revisions to 2008 should have been expected. They confirm how deep the mild depression was. It started in December 2007, creating a weak economy early in 2008, and only intensified due to the meltdown post-Lehman. Those like Larry Kudlow who were saying well into 2008 that no recession was going to occur were misguided.
• Because inventories have been purged so much in Q1 and Q2, I fully expect much better numbers in Q3 and Q4. Remember, a less negative inventory number translates into a net ADD to GDP. So, we don't need to build inventories, only purge them less. That's a guarantee for Q4 if not Q3.
• However, the fly in the ointment is consumer demand. It is still weak. Look at non-durable spending. If we don't see a significant uptick come Q3, you should be worried.
• My call for Q4 2009 or Q1 2010 end to the recession still stands.

Finally, I found this interesting:

% of the GDP pie made up by its slices
		2008q1		2009q2
Personal consumption expenditures		70.23%		70.59%
Gross private domestic investment		15.41%		11.21%
Net exports of goods and services		-5.18%		-2.46%
Government		19.54%		20.66%

Economist's View: FRBSF: Fighting Downturns with Fiscal Policy

FRBSF: Fighting Downturns with Fiscal Policy

Sylvain Leduc of the San Francisco Fed reviews several studies on the effectiveness of fiscal policy and concludes:

The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output. Nevertheless, the uncertainty regarding those estimates remains high. ...

This brings up a point about tax cuts I've been meaning to make (again). The effectiveness of tax cuts depends, in part, on how hard the recession hits household balance sheets. In a recession where balance sheets are relatively unaffected, a tax cut may very well translate into spending, and do so fairly quickly.

But when balance sheets are hit hard, the result is different. In this case tax cuts may be used largely to rebuild balance sheets - to recover what was lost - rather than for new spending. Thus, in this recession the stimulative effects of tax cuts may not have as large of an immediate effect as in the past (there are also reasons to suspect the government spending multipliers shown in the table below are underestimated due to the fact that this recession is not like those in the data used to produce the estimates, e.g. for one, the historical data may overestimate the crowding out effect, but for now I want to focus on taxes).

The fact that in this recession tax cuts may not have as large of an immediate impact as in the past should not necessarily lead us to conclude that the tax cuts were a waste. That is, households will not turn back to consumption until they have saved enough to make up for what has been lost, at least in part, so how long it takes for the recession to end depends upon how quickly household balance sheets are refilled (once this is over, I expect saving rates to be higher than in the past, but I also expect that saving will fall some from where they are now once balance sheets are in better shape). The faster they are refilled, the sooner people begin to spend more, and the sooner this thing ends.

So in that sense, the tax cuts were not a waste at all. Unfortunately, however, during the time when the balance sheets are being refilled it will look like the stimulus package is not having any effect - all you see is higher savings rate - but again, the higher saving rate brings the end of the recession nearer in time, and that is important in and of itself. That's a hard effect to estimate, even if you are looking for it after the fact, but again, it shouldn't be dismissed as inconsequential.

Finally, because tax cuts are likely to be saved more than in the past, and hence have a smaller impact than tax multipliers from historical data suggest, and because there is reason to think that government spending multipliers rise as recessions get more severe (e.g. even if interest rates go up, investment is likely to be insensitive when conditions are bad), the logic of using both tax cuts and spending to stimulate the economy is sound.

Here's more:

Fighting Downturns with Fiscal Policy, by Sylvain Leduc, FRBSF Economic Letter: Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals. The main argument is that monetary policy can act quickly when output falls below an economy's potential or when inflation varies from its optimal rate, and that these actions can be reversed quickly as conditions change. By contrast, modifications to the fiscal code take a long time to enact and implement and can be very difficult to undo.

However, the current recession is clearly not a typical downturn. In particular, unlike other post-World War II U.S. recessions, monetary policy has run out of its usual ammunition to boost economic activity. The federal funds rate, the principal tool that the Federal Reserve uses to stabilize the economy, is now hovering near zero. Because interest rates cannot be negative in nominal terms, monetary policymakers are unable to lower the federal funds rate further. In this situation, the Federal Reserve has turned to unconventional tools to get around this barrier, commonly called the zero lower bound.

Because of the severity of the recession and the uncertain effects of unconventional monetary policy tools, Congress and the Obama Administration have also enacted a fiscal stimulus package. The $787 billion program approved by Congress in February includes a mix of tax and spending measures aimed at creating jobs and boosting output. Yet, economists and political leaders heatedly debate whether tax cuts or increased spending are more effective, a dispute that's hard to resolve because of the difficulty of determining the precise magnitude of fiscal policy's impact on real GDP. This Economic Letter examines some recent empirical studies analyzing data on the relative effects of higher spending and lower taxes on output.

A simple theory of the effects of fiscal policy

Basic Keynesian theory suggests that the effect of a change in fiscal policy on real GDP is more than one-for-one. For instance, since government spending is one component of GDP, an increase in government purchases, by putting idle resources to work, boosts income one-for-one when the money is initially spent. In addition to that, though, since consumption is a function of current after-tax income in this framework, households also increase their consumption in line with their higher incomes, multiplying the effect of the initial government spending on GDP. The "multiplier effect" of government spending on GDP is thus greater than one.

This simple framework also predicts that the multiplier effect of a tax cut on GDP will be less than that for government spending. This is because a change in government spending affects GDP one-for-one, while part of a tax cut will be saved and will, at least initially, translate into a less than one-for-one increase in GDP.

Clearly, these results hinge on many underlying assumptions. One is that households are not assessing their future income when deciding how much to consume. Instead, they are assumed to spend a lot as long as their current income is high. However, households may be concerned about the impact of fiscal measures on their future tax bills. Households may not decide to consume as much if they expect taxes to rise and their future after-tax income to be lower. Moreover, this framework assumes that investment and net exports are insensitive to the change in fiscal policy. However, the response of investment will clearly depend on the behavior of interest rates, which in turn will depend on monetary policy. If monetary policy changes in response to fiscal policy, investment would be affected.

Large-scale econometric models often used in policymaking institutions make adjustments for household behavior and investment (see, for instance, Elmendorf and Reifschneider 2002). Nonetheless, the relative size of their fiscal multipliers is in line with this simple framework's predictions. For instance, earlier this year, Christina Romer, the chair of the Council of Economic Advisers, and Jared Bernstein, an advisor to Vice President Biden, estimated that the effects of permanently increasing government purchases by 1% of GDP would be to raise output by 1.5% two years after. At the same time, their model predicts that a tax cut of 1% of GDP would increase output by only 1% two years down the road.

Challenging the model

In a recent paper, Cogan et al. (2009) challenged the Romer/Bernstein estimates using an alternative New Keynesian model in which households and firms are more forward-looking than in typical large-scale econometric models. Using this model, the authors argue that a 1% increase in government spending would produce a mere 0.5% rise in output two years later.

In this framework, household and firm decisions to spend, invest, and produce are heavily influenced by their expectations of the future. Households anticipate that higher budget deficits will ultimately be financed with higher taxes, and they consume less as a result. Higher government spending thus crowds out consumption. Moreover, Cogan and his coauthors assume that, as the economy recovers following the increase in government spending, monetary policy becomes more restrictive, choking off investment. In contrast, Romer and Bernstein assume that the Federal Reserve keeps the federal funds rate constant, thus mitigating the adverse effect on investment. The crowding out of consumption and investment is relatively strong in the New Keynesian framework, offsetting much of the stimulatory impact of higher government spending.

In other words, the effects of fiscal policy on real GDP are quite sensitive to underlying modeling assumptions regarding the behavior of households, firms, and monetary policy. This creates fertile ground for good empirical work.

Recent empirical work

Empiricists interested in calculating the impact of movements in government spending and taxes on real GDP face multiple challenges, but the biggest hurdle is distinguishing fiscal policy changes that are fundamental from changes that are responses to economic conditions. Many influences other than tax and spending policy determine the trajectory of economic output. And taxation and spending vary over the course of the business cycle. The difficulty is to make sure to capture the effect of a change in fiscal policy on the economy and not the effect of changes in the economy on fiscal policy. Those fiscal policy changes that are independent of economic circumstances are called exogenous, and those that are reactions to economic conditions are called endogenous.

This is a particularly relevant issue because government spending and taxes respond endogenously to economic activity via automatic stabilizers--features built into the fiscal system to stimulate or depress economic activity automatically. Taxes automatically fall in recessions as household incomes decline. Transfer payments, such as unemployment insurance, rise. Moreover, government spending and taxes may have complex relationships with each other. For example, the payroll tax increased in 1965 to offset the costs of the new Medicare program on the federal budget (Romer and Romer 2008).

Typically, empirical studies adjust for the automatic stabilizers built into fiscal policy by taking into account movements in GDP when measuring government spending and taxes. Recent empirical analyses have taken a number of additional approaches to separate endogenous from exogenous factors.

Romer and Romer address the impact of tax changes by performing a narrative analysis of U.S. tax policy since 1945. Using the historical record, they try to isolate exogenous tax changes by identifying the key reasons underlying each modification to the tax code and rejecting those that were clear responses to economic activity. Alternatively, Blanchard and Perotti (2002) use a timing restriction to identify changes in government spending and taxes that are exogenous to unexpected movements in output. They argue that, because it takes time for legislators to understand a sudden movement in activity and then pass legislation to address it, it is reasonable to assume that, at high enough frequency, changes in taxes and government spending are independent of current output.

In contrast to these studies, Mountford and Uhlig (2005) use a mix of economic theory and time series analysis to identify exogenous movements in government spending and taxes. They build a small empirical model of the U.S. economy and look at the behavior of different "shocks" to that model, that is, disturbances that are unrelated to other variables in the system. They identify as exogenous movements in government spending those disturbances that end up raising government spending in the empirical model for a defined period of time. Similarly, exogenous movements in taxes are classified as those disturbances that end up raising tax revenues.

An interesting aspect of this new literature is that, notwithstanding their vastly different methodologies, they reach surprisingly similar conclusions. Regarding the impact of tax cuts on the level of real GDP one year after the change in taxes, the three studies predict a multiplier of roughly 1.2, as shown in Table 1. Moreover, Table 2 shows that, in contrast to theoretical predictions from the simple Keynesian framework, the analyses found that government spending had less bang for the buck than tax cuts. For instance, one year after the increase in spending, the impact on the level of real GDP is less than one-for-one, partly reflecting a decline in investment. There is more disagreement, however, about the effects of tax cuts on output two years after they are implemented, as Table 1 indicates. The analyses of Romer and Romer and Mountford and Uhlig find very large tax multipliers, while Blanchard and Perotti continue to find effects similar to those occurring after one year.

The stimulus package: Will it work?

Earlier this year, Congress passed a $787 billion fiscal stimulus package spread over 10 years. Of that total, $584 billion are spent in 2009 and 2010, with 19% of the funds allocated toward increases in government spending, 33.4% in transfers to the states, and 47.6% toward tax cuts. The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output.

Nevertheless, the uncertainty regarding those estimates remains high. Several economists remain skeptical that fiscal multipliers--whether from spending or taxes--are very large (see, for instance, Barro 2009). Moreover historical relationships may prove much less reliable during this downturn. Faced with a large decline in wealth and tight credit availability, households may very well respond differently to tax cuts today than they have in the past.

References

[URL accessed June 2009.]

Barro, Robert J. 2009. "Government Spending Is No Free Lunch." Wall Street Journal, January 22.

Blanchard, Olivier, and Roberto Perotti. 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output." Quarterly Journal of Economics (November) pp. 1329-1368.

Cogan, John F., Tobias Cwik, John B.Taylor, and Volker Wieland. 2009. "New Keynesian versus Old Keynesian Government Spending Multipliers." Unpublished manuscript.

Elmendorf, Douglas W., and David Reifschneider. 2002. "Short-Run Effects of Fiscal Policy with Forward-Looking Financial Markets." National Tax Journal 55(3, September) pp. 359-386.

Mountford, Andrew, and Harald Uhlig. 2005. "What Are the Effects of Fiscal Policy Shocks?" SFB 649 Discussion Paper 2005-039.

Romer, Christina, and Jared Bernstein. 2009. "The Job Impact of the American Recovery and Reinvestment Plan." Manuscript.

Romer, Christina, and David Romer. 2008. "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks." Manuscript.

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