Elementary Questions About Keynesianism

I think I asked this question back in '09 or early '10, but I didn't get a satisfactory answer so I'll ask it again. I am certain that there is a simple answer to it, but I haven't yet seen it. I know some Keynesian economists occasionally read this blog, so I'm hoping they'll set me straight.

As far as I can tell, the whole Keynesian framework depends on the existence of a liquidity trap. Without it, as Krugman keeps repeating, normal rules of macroeconomics apply: trade is good, monetary policy is effective, etc. But in Depression Economics all that is turned upside down. The rules of the game change because of the constraint imposed by the liquidity trap. Normal macroeconomics doesn't work.

In the Keynesian framework monetary policy is ineffective at the zero lower bound because people (banks, businesses, households) hoard cash. Thus there is a decrease in aggregate demand, economic activity slows, unemployment increases, etc. I get all of that. Here's the leap that I can't make: why isn't that true of fiscal policy as well? If I use monetary policy to give people money and they hoard it, why would they not hoard money if I use fiscal policy to give them cash?* The whole idea of Depression Economics depends on a psychological model of mass peoples -- what Keynes called "Animal Spirits"** --  that would seemingly apply universally to all public policy intended to stimulate demand. I see no reason why businesses or households would respond to cheap/free money from the monetary authorities by not hiring, but respond to cheap/free money from the fiscal authorities by hiring.

In other words, if the monetary multiplier is small because of the hoarding impulse derived from animal spirits, then the fiscal multipler should be no greater and probably smaller, for a few reasons. Cash transfers on the fiscal side only moves the money once, and then it should be hoarded in the same way as cash from monetary policy (which is also moved once). But fiscal policy also incurs new debt, which must be serviced. That imposes real future costs in the form of interest -- which is admittedly quite small or even negative in the present environment -- and fiscal drag from future taxation, both of which can be anticipated. Tack on some waste/corruption/deadweight loss and it's hard to see how fiscal policy would be more effective than monetary policy at the zero lower bound or anywhere else. Even at a high discount rate monetary policy can always be cheaper than fiscal policy, so it should seemingly have a higher multiplier.

I freely admit my ignorance and stupidity in this matter. I understand that economics often makes no sense until someone explains it to you, and my economics education effectively ended with my undergrad major. So I'm asking someone to explain it to me: why do animal spirits negate monetary policy at the zero lower bound but not fiscal policy? I'm guessing it has something to do with financial intermediaries, but then doesn't that require an additional, separate assumption about psychology?

*The closing scene in the HBO adaptation of Sorkin's Too Big to Fail has Poulson muttering to one of his deputies something like "We gave the banks the cash; now they better spend it and get the economy moving". I'm sure that's apocryphal, but the whole point is that they didn't. They hoarded it, as a Keynesian would expect from monetary policy, but not from fiscal policy. Poulson, of course, was most concerned with the fiscal intervention.

**While I'm here, there's something else I don't understand: Why is it that Keynesians smirk at assertions that businesses aren't hiring between of "uncertainty" when their entire underlying model depends on precisely that claim? Partisans on the right surely miss part of the story when they attribute this uncertainty only to Obama's policies -- I agree with Summers when he said that the biggest uncertainty is over the entries on the order books, i.e. aggregate demand --  but the uncertainty that matters is over expected profits. One part of that equation is revenue, the other part is costs including regulatory and tax costs. Decreasing uncertainty over the former (in a positive direction) increases confidence and thus investment, but so does decreasing uncertainty over the latter (in a positive direction). Both sides seem to be right and wrong. Or, rather, incomplete without the other.

In Which I Don't Understand What Smart People Are Saying

I guess I'm an idiot, as I can't understand simple things. Paul Krugman says:

One clear result of the midterms is that we won’t have anything like a further round of stimulus. And this, in turn, means that the narrative all the Very Serious People will tell is that fiscal policy was tried, it failed, and that’s that.

To support this he presents two points of data, and only two. They are:

1. Germany's economic decline has been worse than the U.S.'s.

2. Germany's government spending has been higher than the U.S.'s.

From this, he concludes:

3. U.S. government should spend more in order to boost growth. (Or, alternatively, the U.S. didn't really try fiscal stimulus at all.)

As far as I can see, that conclusion is a non sequitur given the data he's presented. He updates the original post to say "Just to be clear, I’m not saying that the Germans were big Keynesians; the point is that neither of us were". Fine. But if there is a correlation between government spending and economic growth during this downturn, that correlation is very clearly negative given the data he's given us. How can we conclude from this that the election narrative that "fiscal policy was tried, it failed" is wrong? The data that he's given supports that very conclusion.

This is not a sophisticated analysis, and there are all kinds of relevant variables that aren't included. But Krugman doesn't say which of those might be mitigating factors. He doesn't qualify the data he presents. It's a really strange conclusion for him to reach. As I've noted before, Germany really messes with the standard Keynesian analysis. Tyler Cowen built off of that post here.

Brad DeLong writes about this post, but doesn't square the circle either. Like Krugman, DeLong is much smarter than me, so I guess I'm missing something obvious. I wish they'd point out what it is.

Also note that this crude analysis supports this recent study on the fiscal multiplier, since Germany has a fixed exchange rate with many of its trading partners, while the U.S. does not.

What am I missing?

Fiscal Stimulus and The Unholy Trilemma

A new NBER working paper (earlier ungated version here) presents a more nuanced view of the effectiveness of fiscal stimulus:

How Big (Small?) are Fiscal Multipliers?

Ethan Ilzetzki, Enrique G. Mendoza, Carlos A. Végh

We contribute to the intense debate on the real effects of fiscal stimuli by showing that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level of development, exchange rate regime, openness to trade, and public indebtedness. Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero.

In other words, maintaining an open economy with flexible exchange rates prevents a country from using fiscal policy to stimulate during downturns. Note that under their definition (total trade = 60% of GDP), the U.S. is far from being an open economy. As such, the authors find that the post-1980 multiplier in the U.S. is 0.3 - 0.4. Additionally, when debt-to-GDP is greater than 50%, fiscal multipliers are nil or negative.

It appears that, once again, governments face a tradeoff between maintaining an open economy and being able to effectively moderate downturns using countercyclical policy tools. More specifically, the effect of monetary vs. fiscal stimulus appears to be moderated by exchange rate policy. Under fixed exchange rates, either capital mobility or monetary independence must be sacrificed. Under floating exchange rates monetary independence may be kept, but there's less room to maneuver on the fiscal side. That can leave a country in trouble if it runs up against the zero lower bound.

We may have to further complicate the Unholy Trilemma. In any case, this is a reminder that policy choices can have far-reaching effects.

Why German Leaders Aren't Sado-Masochistic Lunatics, or, Why Krugman Is Either Wrong or Irrelevant

All of the debate over Germany has focused on stimulus vs. austerity, which has been recast as an ideological battle of technocratic purity: Keynes vs. not-Keynes. I covered a few of these bases here, and Tyler Cowen quoted and extended them here. Let's try to think of it in another way. Suppose for a second that Krugman and his camp has the economics completely correct. Germany and other leading states should not be even considering fiscal retrenchment at the moment, nor should they be encouraging any of the sort from smaller states like Spain and Ireland. Instead they should be doing the opposite, by engaging in a large ramp-up stimulus program. Let's assume that this is, as Krugman says, simple and basic economics, easily understood by anyone who's passed Econ 101 or taken a cursory look at economic history.

For this to be the case, German policymakers and officials at the IMF and elsewhere (the "Pain Caucus") are so worried about some mystical beings ("Invisible Bond Vigilantes") that they genuflect to gain approval from other mystical beings ("Confidence Fairies"). A few prophetic voices in the wilderness ("The Ancient and Hermetic Order of the Shrill") scream into the void, to no avail. Krugman is obviously a very public figure, so it is unlikely that policymakers are ignorant of his arguments. The only conclusion is that these policymakers are sado-masochists, insane, or both. I believe this is Krugman's default position.

How helpful is it to assume, as a starting point, that leaders are masochistic lunatics? Not very, in my view. There's a lot of political science theory and research dedicated to the idea that politicians are office-seeking, voters are sensitive to the state of the economy, and therefore sado-masochistic lunatics have a very difficult time controlling policy. So even if Krugman is completely correct about the economics, it doesn't really matter. There must be something else going on, so even if correct his analysis would appear to be irrelevant.

At the start of the crisis the Obama administration pushed European governments hard to enact strong stimulus packages to kick-start their economies. The Obama administration worried that if they did not, that much of the American stimulus spending would be "leaky", i.e. would stimulate other countries' export industries, but not domestic industries. They also worried that American exporters would suffer if demand in other countries remained low. Encouraging other countries to enact stimulus, then, was really about encouraging other countries to buy more goods from the U.S. while U.S. consumers bought domestically. The goal was to boost domestic (American) employment.

This ploy is obviously transparent, and Germany responded almost immediately by saying that they felt their "automatic stabilizers" (things like unemployment insurance) were sufficient stimuli. At the same time, Germany was beginning to realize that they were going to have to spend quite a lot of money to rescue Greece and potentially other southern European economies from Quite-Visible Bond Vigilantes. As you'd expect, bailing out profligate countries during a recession was very unpopular domestically, so the pound of flesh the Germans extracted in return was austerity in debtor countries, and tougher new fiscal rules for the E.U. to prevent a similar outcome from recurring. If Germany ran large deficits by engaging in ramp-up stimulus spending, it would under-cut their own Euro-wide debt-reducing initiative, and might push the economic and monetary union to the brink of collapse.

But Germany's automatic stabilizers were real. The result was that Germany largely engaged in neither ramp-up stimulus nor austerity. Ryan Avent has a good post about this, in which he links to this interactive Brookings map showing which countries did how much stimulus. Germany did much more than France, Italy, or the U.K., and their proposed budget cuts for 2010 and 2011 are the lowest in the eurozone. As Avent concludes, "This doesn't mean that stimulus is the key to German success. But Germany is absolutely not an example of strong growth despite austerity."

In other words, Germany has taken a measured approach: let their stabilizers run their course, but don't blow a huge hole in the budget at a time when they are insisting the rest of the E.U. get their fiscal house in order. Let the recovery come from exporting sectors and productivity gains rather than ephemeral short-run consumption. The Germans are balancing short-run political incentives (a fairly quick economic recovery) with longer-run goals (maintain a strong, stable economic and monetary union). Not only is this strategy not masochistic or insane, it is actually pretty savvy. It's also Germany's only hope for securing the long-run health of the economic and monetary union along with the domestic economy. Maybe the Obama administration would like to see more, but that's hardly Germany's problem, is it?

The takeaway here is that even if Krugman is completely right about the economics, he is wrong about the political economy. This makes his analysis irrelevant at best, completely wrong at worst. I guess I'll let him decide which.

About Those GDP Numbers

See Munger and McMegan.

Look, we've spent something like 4-5% of GDP in stimulus, from the American Recovery and Reinvestment Act (a.k.a ARRA a.k.a. stimulus bill) to the bailouts. (You can track ARRA spending here and bailout spending here). We've spent about $120bn in ARRA and $575bn in other bailouts. That represents ~ 5% of GDP spent in deficit by the government: $700bn/$14.25tn ~ 5%. Those expenditures affect GDP evaluations, since GDP = Consumption + Investment + Government + Net Imports. If GDP's "natural" state rate now if government spending had stayed constant is negative 1-2%, then that translates into roughly 4% growth: -1 + 5 = 4. We actually got 3.5%, which is right in the back-of-the-envelope range.

But it's unclear if that means anything good. If the fiscal multiplier is greater than one, as CEA head Christina Romer believes, then that spending should have led to higher reported GDP than we actually saw (something like 5-6%, using Romer's estimate of the multiplier as close to 1.5)*. If the multiplier is less than or equal to one, as these folks argue, then at best this quarter's GDP report is a statistical mirage based on an accounting identity rather than actual economic improvement. If the multiplier is close to zero or even negative, as Robert Barro thinks, then economy is in great shape indeed.

I tend to take the middle view: the multiplier is probably close to 1 most of the time (although context is important), and I think the present circumstance backs that view up. In the 2nd quarter, GDP fell by about 1%. The government spends about 5% of GDP in deficit, and the next quarter GDP grows by about 3.5% despite falling employment. Coincidence?

This is one reason why talk of a "jobless recovery" is at least partially missing the boat: there hasn't actually been a recovery yet. We've just pushed some numbers from one side of an accounting ledger to other by taking on more debt and called it progress. It's not.

*Yes, I know that the lags matter too. But these, too, are unclear and you could just apply the same argument to next quarter or several.

Stimulus Spending in Comparative Perspective

The NY Times ran a series of articles on how stimulus funds have been spent in the U.S., E.U., India, and China. Let's have a look:

In the U.S., for all the talk of "rebuilding America's infrastructure" the need to fund "shovel-ready projects" has meant that stimulus funds have gone to some dubious projects, like a sports complex at a community complex in suburban Chicago. Actual new spending on infrastructure has been slow. And if the point was increase employment, it hasn't done that very well either: more money should have gone to state and local governments, and expanded education and job re-training. It's not that stimulus has done no good; it's just that the government hasn't gotten much short-term bang for its buck, nor has it led to long-term reform or structural improvement.

The record in the E.U. is even more spotty. The Stability and Growth Pact prevents local governments from engaging in much fiscal stimulus directly, and the broader E.U. has done very little. Some think that the E.U.'s "automatic stabilizers" are sufficient, while others are not interested in using E.U. funds to prop up individual countries (e.g. Spain). Additionally, many member states had high debts before the crisis, which has limited their abilities to fight it. In short, the crisis has shown -- once again -- that E.U. member states do have to sacrifice some sovereignty to join the union. But this may not be a terrible thing: Ireland's recent passing of the Lisbon Treaty shows that many in Europe have confidence in the union than has not been shaken by the crisis.

India responded to the crisis with aid for rural workers and tax cuts, but they may have overshot: growth is back to 6%/year, but inflation is now a worry. And the rapid response by the government was somewhat unfocused, leaving many questioning why more money wasn't spent on improving India's infrastructure and expanding opportunities for the poor. The recent decline in the dollar has also adversely affected exporters.

China's response to the crisis was swift and large: huge fiscal stimulus, a loosening of monetary policy, and injections of liquidity into the banking system. A good bit of the stimulus is going to infrastructure projects, but China had so many "shovel-ready" projects in the pipeline that some wondered whether this stimulus spending represented new spending or just planned expenditures under a new name. But China has not used the crisis to build up domestic institutions (like a social safety net and access to credit for private small businesses) that would increase domestic consumption and begin reversing the global imbalances that contributed to the crisis in the first place. Perhaps that transition is too much to ask of a short-term stimulus package, but they could have started programs to that end.

In short, a mixed record. And despite all the talk of reform, very few concrete actions have been taken to address the major issues in global or domestic economies. I suppose those will have to wait for the next crisis.

Multipliers and Rational Expectations

Back in March I wrote this:

Presumably, Krugman thinks we are in a liquidity trap because the Fed can't credibly commit to boost future inflation. In other words, expectations of (low) future inflation prevent monetary policy from taking hold in the present circumstances, thus reducing the monetary "multiplier" (i.e. velocity of money). In Krugman's mind, this is so self-evident that he doesn't even need to consider things like quantitative easing or eliminating interest payments for excess bank reserves. Banks (and investors) have expectations of [low] future inflation, which makes monetary policy ineffective in a liquidity trap, full stop.

Why, then, are Krugman and his minions so dismissive of the "Treasury View" that the fiscal multiplier is greatly diminished by crowding out private spending because of expectations of future tax increases? Why are one set of expectations enough to make monetary policy completely ineffective, but not have any effect on fiscal policy? For this view to be coherent, there must be some fundamental difference between expectations over future inflation and future taxes, but I can't see what it is. Both expectations come from beliefs about future real net income.

Especially since, as Krugman himself noted earlier today, both banks and consumers are hoarding cash right now. I would expect Krugman to say that we need to government to spend precisely because banks and consumers are hoarding cash. But that only moves the money once: after the government spend the cash, whoever receives it will just hoard it and there is no stimulative effect. In order to get the money moving on a more sustained basis, there has be a story about how consumer expectations improve when faced with fiscal stimulus but remain unchanged when faced with monetary stimulus.

Today, Tyler Cowen said the same thing:

It is frequently suggested that the multiplier today is best estimated at 1.5 or 1.6. My point today is this: if you postulate a potent multiplier you cannot easily also postulate a liquidity trap. The whole point of the multiplier is that if the government buys cement from my company (say for a road) I as the company owner take those cash receipts and spend them elsewhere. Maybe so but that means people are willing to spend cash when they receive it. It means that a helicopter drop (and maybe other forms of monetary policy as well) would stimulate AD quite readily and for free. You don't need exotic or balance sheet-distorting QE here, a simple injection of cash will do.

Indeed, the Christiano, Eichenbaum, and Rebelo model of fiscal policy in a liquidity trap, no matter what you think of it both implies and states that monetary policy will work too. And if that monetary policy is truly a free lunch in terms of gdp, it should be quite credible (if it's not credible in the real world maybe the problem wasn't AD in the first place).

This in response to Robert Barro's recent research (see this op-ed for a summary) and the chatter it has inspired. Just to be clear here: Krugman's position is incoherent. That doesn't mean that Barro's argument is empirically true. But if there is a way that fiscal money multiplies while monetary money does not multiply then Krugman or one of his fellow-travelers has to show how that happens.

On Krugman on Macroeconomics

Everyone should read the Krugman essay on the state of macroeconomics, if only to see where the faultlines lie. The piece is basically Krugman's victory lap: he thinks that he and the other paleo-Keynesians have been vindicated, the Chicago school has been vanquished once and for all, and the New Keynesians have been forced to take a side: you're with Keynes or you're against him. No more trying to have it both ways.

He has good reason for thinking this: the Chicago School's strong-form belief in markets as efficient price aggregators has been tempered, if not refuted, by the current crisis*. But as Krugman notes, this is nothing new: financial crises happen with alarming regularity all over the globe, and only a fool or ideologue would suggest that these manias, panics, and crashes are efficient. In short, the current crisis tells us nothing about the truthiness of the Efficient Markets Hypothesis (EMH) that the Asian financial crisis, or the Argentinian depression, or the collapse of LTCM didn't tell us. All financial crises have very significant costs, and it takes a very brave person to argue that bubbles are good for an economy.

Krugman is also right to question economists' faith in the Fed. To be sure, the Fed had a great run during the "Great Moderation" from 1982-2008, where recessions were generally brief and mild. Perhaps such successes lulled economists into a "In Fed We Trust" mentality, and Krugman claims that this is the fundamental failing of the New Keynesians: the Fed can do quite a lot to stabilize the economy, but it is not omnipotent. In such circumstances where the Fed's normal tools of management fail to gain traction -- when the Funds rate reaches its zero bound -- the New Keynesians have no answer (according to Krugman). Krugman proposes paleo-Keynesianism.

But Krugman fails to acknowledge the weakness of his own position, and paleo-Keynesianism certainly has its faults. Not only is the academic literature on the effectiveness of fiscal policy mixed**, the justification for it seldom holds. In order for fiscal expansionism to succeed where monetary expansionism has failed, Krugman must model individuals as holding contradicting expectations. Second, actual incidents of Keynes' "paradox of thrift" are very rare, and maybe non-existent. Without these theoretical supports, the Keynesian view of fiscal stimulus is severely weakened.

Perhaps worse for Krugman's case is our actual experience over the past year. It is now clear that the Fed was effectively able to fight the recession and stave off deflation, and that bumping against the zero bound does not necessarily involve getting snared by the liquidity trap. As Krugman himself acknowledges, the U.S. economy is most likely already out of recession despite very little stimulus spending (something like $100bn). Unless you believe that $100bn in stimulus spending was enough to shock a $14tn economy out of recession, you must conclude that monetary policy was effective (if unconventional) and thus the main justification for stimulus advanced by Krugman and other paleo-Keynesians was wrong. Score one for the faith of New Keynesians in the efficacy of the Fed.

Never mind, says Krugman, fiscal stimulus is still justified to fight a "jobless recovery" in which GDP growth is positive but high unemployment persists. In fact, the data seem to show that this is happening in the U.S. at present. It's possible that Krugman is right and stimulus could have a positive effect in fighting unemployment. But employment is often a lagging indicator and the recovery is barely underway. It is more likely that employment would improve without stimulus over the next year than that it wouldn't. Moreover there is no theoretical tradition that believes in the persistence of high unemployment during economic expansion. The case for stimulus doesn't look all that strong at the moment, so Krugman is on very shaky ground. But even if he's right, this sort of "mission creep" is worrisome.

All of that said, Krugman's main point stands -- economic theory is not as sound as it appeared a year ago -- and is in fact stronger than he believes since he exempts his own theoretical tradition from criticism. As I said, the whole thing is worth reading to get up to speed on the arguments. But keep in mind the source: Krugman has a strong interest in denigrating any school of thought but paleo-Keynesianism; he has plenty at stake in this debate. There is more of benefit in the Chicago and New Keynesian schools than Krugman acknowledges, and less in the paleo-Keynesian school. So if there is to be a "New Economics" it should combine the best from all three traditions and others besides.

P.S. After I wrote all this, I saw that Scott Sumner addressed some of the same concerns and came to some of the same conclusions, albeit in a different way. Sumner, like me, sees Krugman's dismissal of monetary policy as premature and therefore sees his core argument in favor of paleo-Keynesian fiscal stimulus as a non sequitur. Please read his post.

*The weak-form belief in markets as most efficient price aggregators has not, I think, been refuted by the crisis. It simply states that markets reflect all information about the prices of a good, and thus represent the best estimate of a good's value. It is possible for the best estimate to be very wrong and still be better than even-more-wrong "other" estimates of value. Or fluctuations in financial markets reflect changes in information, and thus be rational. Tellingly, neither Krugman nor any other critic of EMH even propose an "other", much less defend it, which is why some version of the EMH has persisted for so long and will continue to persist: markets may not be infallible, but they are better than anything else. The Chicago school might not be quite dead after all.

**Yes, I know about Romer/Romer, but all other studies are less positive. And as this Brookings report states, the negative consequences of debt accumulation and deadweight loss from implied future tax increases must be weighed against any positive benefits from stimulus.

Round and Round We Go

Krugman praises DeLong for once more trashing the Chicago School's view of the (in)effectiveness of stimulus. One bit from Krugman:

Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.

This is a non sequitur. To my knowledge, nobody is arguing that taxpayers should view temporary spending as permanent; they are saying that taxpayers will view present deficit spending as having future costs. The bill will come due, and whether it's a one-time $100bn expenditure or a perpetual $100bn expenditure is irrelevant.

Although in the present case, taxpayers don't know how much taxes will be increased, because the Obama budget projections are ludicrous. Taxpayers have every reason to be skeptical when faced with an uncertain future, so it's certainly possible that they might overestimate the future costs of present-day deficit spending. If that happens, then taxpayers might save even more than if there was no stimulus spending at all, and the multiplier will not just be less than 1, it could actually be negative.

The point of stimulus spending is to, er, stimulate. That depends on the multiplier being greater than 1. That depends on two things: taxpayers thinking that they will be better off by spending money than saving it, and having a functional banking system that can move the money from savers to borrowers. So even if Krugman and DeLong are right on the first point, and I don't think they've proven their case, the banking system is still in chaos. Given that, our expectations for the multiplier should be downgraded.

Hegemoaning

The argument that U.S. hegemony is beneficial on net to the rest of the world is most famously made in this book, but the arguments in support depend on the U.S. behaving a certain way. I was planning to write a post on how the United States is not fulfilling its unofficial responsibilities as hegemon to provide public goods in the midst of a global economic slowdown, but I see that Drezner has beaten me to the punch:

There's something else going on that should bother IR scholars. One of the benefits of having a hegemon is supposed to be greater provision of global public goods. According to hegemonic stability theory, if the United States is really still the hegemon, then it should be providing the following things:

Provisions of liquidity
Market for distressed goods
Long-term counter-cyclical lending
The U.S. did all of these things during the Asian financial crisis, for example.

This time around, the U.S. grade is not as high.

Drezner says the U.S. is doing the worst at counter-cyclical lending, linking to this NY Times piece that discusses how the continuing strength of the dollar indicates that the U.S. is hoarding capital that is strongly desired by other countries.

There's an aspect of this that may yield benefits for the rest of the world, however, especially countries that heavily rely on exports. The Times piece is about private capital flows to the U.S. Treasury, which have then been turned around and disbursed to the American populace as fiscal stimulus. If the stimulus has any positive effect at all, it will mean that U.S. consumers are spending their stimulus checks. And with the dollar high relative to almost every other currency in the world, that means that American consumers will be importing a lot. In other words, the American stimulus could function as something of a subsidy to the exporting industries of the rest of the world, which could boost employment and government revenues in places like Eastern Europe and Southeast Asia that desperately need a boost.

Indeed, this aspect is exactly what U.S. policymakers were hoping to avoid in the stimulus bill. Thus, the "Buy American" provisions. But those only apply to government infrastructure projects (and possibly not even then); American consumers are free to spend their money however they like. And discount chains like Walmart, which are often heavy importers, can reap some countercyclical benefits in a downturn. The net result could be a transfer from private investors to the U.S. Treasury, from the Treasury to American consumers, from consumers to retailers selling (imported) inferior goods, and from those retailers to the export-biased economies in the developing world.

It's not clear that this sort of movement is what the global economy needs, as it could prolong needed adjustment, but it is line with the theoretical role of the hegemon as a global stabilizer. The mechanism is more indirect, but that doesn't mean it isn't real.

When Expectations Converge

An open letter to Paul Krugman, from monetary economist Scott Sumner.

And Krugman's (non)response. It's embarrassing to see a Nobelist respond to serious arguments with snide put-downs. But here's the closest thing to a counter-argument offered by Krugman:

My view, which I thought was pretty clear, is that the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another. If the Fed could credibly commit to inflation at rates higher than the 2-ish percent target it’s already believed to have, that would be effective. But right now I don’t see that as a realistic option, hence the emphasis on fiscal policy and bank recapitalization.

Presumably, Krugman thinks we are in a liquidity trap because the Fed can't credibly commit to boost future inflation. In other words, expectations of (low) future inflation prevent monetary policy from taking hold in the present circumstances, thus reducing the monetary "multiplier" (i.e. velocity of money). In Krugman's mind, this is so self-evident that he doesn't even need to consider things like quantitative easing or eliminating interest payments for excess bank reserves. Banks (and investors) have expectations of future inflation, which makes monetary policy ineffective in a liquidity trap, full stop.

Why, then, are Krugman and his minions so dismissive of the "Treasury View" that the fiscal multiplier is greatly diminished by crowding out private spending because of expectations of future tax increases? Why are one set of expectations enough to make monetary policy completely ineffective, but not have any effect on fiscal policy? For this view to be coherent, there must be some fundamental difference between expectations over future inflation and future taxes, but I can't see what it is. Both expectations come from beliefs about future real net income.

Especially since, as Krugman himself noted earlier today, both banks and consumers are hoarding cash right now. I would expect Krugman to say that we need to government to spend precisely because banks and consumers are hoarding cash. But that only moves the money once: after the government spend the cash, whoever receives it will just hoard it and there is no stimulative effect. In order to get the money moving on a more sustained basis, there has be a story about how consumer expectations improve when faced with fiscal stimulus but remain unchanged when faced with monetary stimulus.

So what's the story?

Macroeconomics: Dismal Once Again

Economics used to be called "the dismal science" because of its Malthusian predictions: economies were always on a feast-or-famine cycle: the long-run standard of living was not high, and the long-run standard of living did not change. The Industrial Revolution changed all that (we think!), but that doesn't mean that the "dismal" tag doesn't still have its uses. Gregory Clark, chair of the Econ department at UC-Davis, says the state of the macroeconomic discipline is dismal, and not getting much better:

The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.

The bailout debate has also been conducted in terms that would be quite familiar to economists in the 1920s and 1930s. There has essentially been no advance in our knowledge in 80 years.

I got an A in Econ 1 and Econ 2, but I pray that I'm not an expert in this debate, and I know that I'm not the equal of Summers and Geithner. Still, I know I can do better than this:

Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing the Obama's stimulus plan. As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus -- thinking that would be a timely and lively session. But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that "all I know on this issue I got from Greg Mankiw's blog -- I really am not equipped to debate this with anyone."

Ouch.

(ht: DeLong)

The Obama Tightrope

It will be difficult not to fall off:

For Mr. Obama, the national debt has become a pressing dilemma. If he transitions too quickly from priming the economy with money to pulling back for the sake of fiscal rectitude, the president risks choking off whatever economic recovery he might spark in the next year. Ms. Romer points to the seesaw nature of the New Deal, when President Franklin D. Roosevelt would spend big one year and then back away the next, never allowing the economy really to get traction.

But if the administration waits too long to address the deficit, long-term interest rates may have to rise to attract buyers for all those Treasury bonds. That too could send the economy back into recession.

I'm defining "fall off" as a fate similar to Japan's since the mid-90s: lots of "stimulus" but no recovery. Lots of new infrastructure, but much of it wasteful. High debt-to-GDP ratios but little or no growth. An aging population putting increasing pressure on the budget through entitlement obligations. A banking system in flux, with a number of "too big to fail" zombie banks whose outright collapse would be massively damaging (see: Lehman Bros.) but whose continued existence prevents necessary adjustment in the financial sector.

The U.S. is not Japan, and we have some advantages over the Japanese (i.e. greater demand for our debt at lower yields, less dependence on exports to fuel the economy), but there are some parallels here and it is worth keeping them in mind.

The Largest Earmark in History

Back in December, I wrote that the stimulus bill would be the largest rent-seeking opportunity in history. Hate to say, but "I told you so":

That’s what Republican critics charge in the case of clean-coal funding in downstate Illinois. The Senate bill included a section dedicating $4.6 billion to “fossil energy research and development,” with a $2 billion line-item “for one or more near zero emissions powerplant(s).”

Sure, that doesn’t name one powerplant, and it leaves open the idea of funding multiple powerplants, but there’s plenty of evidence that this line was intended as—and will function as—an earmark for the FutureGen coal gasification powerplant in Mattoon, Illinois.

“There’s no other plant that would be eligible,” says John Hart, spokesman for Sen. Tom Coburn, R-OK. Durbin’s office, the Mattoon project’s champion, didn’t return calls for comment.

Mattoon isn't too far from my old neck of the woods, so I'm fairly familiar with this story. You see, central and southern Illinois used to be home to a large coal industry. But coal from Illinois is high in sulfur, which makes it burn less cleanly than other coal. The downstate coal industry was effectively shut down by Clean Air acts and shifting anti-pollution public opinion. The collapse of the coal industry, combined with the closure of several manufacturing plants, devastated the downstate economy, and the area hasn't yet recovered.

So this plan to develop FutureGen, a coal-gasification plant, was cheered by many. The problem is that the plant has never been anywhere near economically viable. In order to get it off the ground, it was always going to require large amounts of federal money. So Governor Rod Blagojevich hired lobbyists, and paid them very well with state funds, to lobby Congress. One of these lobbyists was Senate majority leader Harry Reid's chief of staff (who received over $300,000 from the state of Illinois). Another is former Representative Dick Gephardt. Obama has long supported the project in the Illinois legislature. Now, apparently, he's doing the same from the White House.

So here's the funny part: this FutureGen plant came about in Dick Cheney's much-maligned Energy Bill, which was written with the aid of energy groups. The goal was promote clean-energy. But environmentalists claim that there is no such thing as "clean coal".

So, this is a "green" plan that environmentalists hate, a payoff to Obama's old state with a barely-disguised payout to Senator Reid's chief of staff included, created by Dick Cheney (but opposed by Illinois Republicans), strongly supported by future inmate Gov. Blagojevich (who spent state funds to hire lobbyists to get the funding) and comes with a price tag of at least $2bn.

What's not to like?

(ht: Wilkinson)

What Is This 'Politics' Of Which You Speak?

Wilkinson unwittingly explains why I decided to become an international political economist rather than an international economist:

The deeper problem, I think, is that the textbook theory doesn’t have any politics in it. In macroeconomics textbooks, government is a benevolent central planner beyond politics. It is assumed, for simplicity’s sake, that governments can act in perfect compliance with theory. It is also assumed that theory is settled before coming to a policy problem, that motivated disagreement over theory is not an essential element of democratic policymaking. But of course, there is politics, which trashes hope of either consensus on or compliance with theory. And that’s how we ended up with the legislative monstrosity actually under consideration in Congress.

Economists are often befuddled when politicians act "irrationally" by not putting standard economic theory into practice, and when voters reward them for this sort of behavior*. Strangely, the answer to the conundrum is often explained best by the economists' best friend: incentives. Politicians, interest groups, and the electorate all respond to their own incentive structures, and quite often that leads to "perverse" economic outcomes. Political scientists, on the other hand, spend our days looking at precisely these questions, and we even (sometimes) have answers to them! See, for example, this recent post by Dr. Oatley. Unfortunately, Wilkinson (and most of the rest of the commentariat) seems to be completely unaware that international political economy exists as a formal discipline.

Still, the whole post is worth reading. Two Nobel Prize-winning economists make appearances, and Wilkinson lays into Krugman's style as a commentator.

*Public choice economists do better at this. But public choice economists are a relatively new breed, and comprise a small minority of economists. Additionally, the public debate over the stimulus bill is being conducted by old-school macroeconomists, economic historians, and international economists. Public-choicers have barely had a cameo.

What You Don't Know Can't Hurt You, But What You Do Know Can

[Updated to better represent Robin Hanson's intent; mea culpa.]

Robin Hanson asks whether macroeconomists should clam up during times of crisis:

Wise taxpayers who get stimuli tax rebate checks should mostly save them, realizing that future taxes must rise to pay for those checks. For similar reasons, wise taxpayers should also spend less upon hearing about government spending increases. So with wise taxpayers it is not obvious that tax rebates or government spending increases would help much with the downturn.

The consensus among macro-economists seems to be that people can in fact be fooled by such stimuli, but as Tyler indicates, it is not clear which policies most fool us. In particular, the more public attention we give to the stimuli, the less they might work. We might make people realize that they need to compensate via saving, and the more we scare folks into thinking we need huge stimuli, the more we might scare them away from normal economic activity levels.

Believe it or not, there's a pretty deep literature on "rational ignorance" but Hanson is wondering about the potential social benefits of intentionally keeping the populace in the dark.

I'll extend the question even further: If it's appropriate to keep the populace in the dark, then why not take the extra step and deliberately mislead them in order to get them to operate in the most socially beneficial ways? To ask that question is to answer it.

If Keynesian macroeconomic models really are contingent upon the populace acting irrationally, then we're all in trouble. Since I don't think that is the case, it would be better to have public debates and discussions about economic policy, even if it means having to listen to Joe the Plumber and Michelle Malkin from time to time.

"Channel Fog Thickens; Continent Cut Off."

Martin Wolf at the FT writes, "Unfortunately, what is coming out of the US is desperately discouraging. Instead of an overwhelming fiscal stimulus, what is emerging is too small, too wasteful and too ill-focused."

Paul Krugman writes, "As a wise man recently said, failure to act effectively risks turning this slump into a catastrophe. Yet there’s a sense, watching the process so far, of low energy. What’s going on?"

The picture above nicely depicts my answer to Krugman's question (which although typically viewed as mocking New Yorkers, I always suspected was in fact New Yorkers' way of mocking those of us who live in the tiny world beyond Manhattan in a way they figured we wouldn't get). But I digress. My point is that this picture nicely represents the typical Congress person's view of the world--just substitute "My congressional district" for 9th and 10th avenues (and maybe shrink the world outside considerably more). If you're British, I think the equivalent lies in the apocryphal but still amusing headline, "Channel Fog Thickens; Continent Cut Off."

All of which is just to say that the typical Congress person has a strong incentive to do things that he or she thinks will be good for his or her district and absolutely no incentive to think about much less do things for the world beyond. When you put 435 (or 255) of these similarly incentivized individuals together in a room, you don't magically wind up with a macroeconomist who has an incentive to care about "fiscal stimulus." You get 435 (or 255) individuals who ask "what's in this for my district." The result is exactly the bill the House passed, which in summary form is 13 single-spaced pages of spending on backlogged projects in (I bet) 244 districts (and I can only hope that the "Davis Bacon" provision is named for the man who proposed it rather than an ironic salute to the nature of the bill. Are representatives as sophisticated as New Yorkers?).

A relevant question, posed by a student in my class (Logan), is whether these District-driven spending plans aggregate into something that approximate the impact of an effective fiscal stimulus package. Krugman and Wolf seem to think not.

Playing Both Sides

From the FT:

The US Senate voted on Wednesday to soften a ”Buy American” plan in its $900bn stimulus bill after President Barack Obama expressed concern the original language could trigger a trade war.

Senators, on a voice vote, approved an amendment requiring that provisions that upset Canada, the European Union and other trading partners be ”applied in a manner consistent with US obligations under international agreements.”

The underlying Senate bill had required that all public works projects funded by the stimulus package use only US-made iron, steel and manufactured goods -- potentially putting the United States in violation of its commitments under the North American Free Trade Agreement and the World Trade Organisation’s government procurement agreement.

Obama, asked about the Buy American provisions in television interviews on Tuesday, said the United States had to be careful not to include any provisions in the stimulus bill that could ”trigger a trade war.”

”I think it would be a mistake ... at a time when worldwide trade is declining, for us to start sending a message that somehow we’re just looking after ourselves and not concerned with world trade,” Obama said on the Fox network.

Okay, so, the way I read this is that the US Senate, under pressure from President Obama (who himself is under pressure from Canada and the EU), decided to so weaken the 'Buy American' provision of the stimulus bill as to make it pointless. The original point of the 'Buy American' provision was pure protectionism. The "provisions that upset Canada, the European Union and other trading partners" were the parts that were protectionist. So if we're gonna remove the teeth from the 'Buy American' section of the bill, why not just remove it entirely?

An incident from the early years of the last president may be instructive. Recall 2002, when President Bush signed steel tariffs into law in exchange for fast-track negotiating authority for the Doha round of WTO negotiations. One the one hand, this move made little sense: Bush was a convinced free-trader, and he had a Republican majority in both houses of Congress. So why do it?

Fast-track authority in the Doha round gave the US credibility in negotiations that it would lack if any agreement required Congressional approval. President Bush could have known that the Doha round was fraught with difficulties that would make reaching an agreement difficult, and any sign that Bush was negotiating without pre-approval from Congress would make negotiating even more difficult. President Bush also could have known that the steel tariffs would be immediately challenged in the WTO dispute settlement court. Indeed, this happened, as the EU, Japan, Brazil, Korea, China, Switzerland, and others challenged the US policy. The steel tariffs were an obvious violation of WTO obligations, and the dispute settlement body ruled against the US. In 2003, Bush removed the tariffs, but kept the fast-track authority. Plus, he could credibly tell the American people that his hands were tied: he had to abide by our international agreements. It was win-win-win for Bush.

Perhaps President Obama is hoping for something similar: keep the 'Buy American' language to appease domestic political factions and get the stimulus bill passed, but sufficiently neuter it to avoid a confrontation with the EU, Canada, and the rest of the world.

(ht: DeLong)

... And Out Come the Wolves

We're about to witness the greatest rent-seeking moment of all time: the 2009 Economic Stimulus Package. It's gonna make the Farm Bill look like nothing at all.

Remember When Europe Was Going to Lead the Way?

Germany refuses to enact stimulus until after Obama is elected:

Germany will wait to launch its next fiscal stimulus until it has a clearer view of the economic plan of Barack Obama, who is to be sworn in as US president on January 20, say German officials.

Michael Glos, economy minister, said – after a meeting of government officials and business leaders on Sunday night – the government would decide late next month whether to adopt more measures to stimulate the economy, Reuters reported.

That would mean Berlin would not top up its €12bn ($16bn, £10.7bn) growth-boosting package at an extraordinary meeting of leaders of the governing coalition on January 5, as many economists and international leaders had hoped.

“We will probably know what Obama is going to sign before January 20 but I would be surprised if any decision were made on January 5,” said an official before the meeting.

All indications are that Obama plans to enact a large-scale spending program -- probably in between $700bn and $1,000bn -- to boost economic activity in the short run while improving infrastructure in the medium run. The fact that Germany refuses to move until it gets even more specifics signals that America's standing as the leader of the international financial system has not taken such a great hit after all.