Is Government Spending Too Easy an Answer?
By N. GREGORY MANKIW
WHEN the Obama administration finally unveils its proposal to get the economy on the road to recovery, the centerpiece is likely to be a huge increase in government spending. But there are ample reasons to doubt whether this is what the economy needs.
Arguably, the seeds of the spending proposal can be found in the classic textbook by Paul A. Samuelson, “Economics.” First published in 1948, the book and others like it dominated college courses in introductory economics for the next half-century. It is a fair bet that much of the Obama team started learning how the economy works through Mr. Samuelson’s eyes. Most notably, Lawrence H. Summers, the new head of the National Economic Council, is Mr. Samuelson’s nephew.
Written in the shadow of the Great Depression and World War II, Mr. Samuelson’s text brought the insights of John Maynard Keynes to the masses. A main focus was how to avoid, or at least mitigate, the recurring slumps in economic activity.
“When, and if, the next great depression comes along,” Mr. Samuelson wrote on the first page of the first edition, “any one of us may be completely unemployed — without income or prospects.” He added, “It is not too much to say that the widespread creation of dictatorships and the resulting World War II stemmed in no small measure from the world’s failure to meet this basic economic problem adequately.”
Economic downturns, Mr. Keynes and Mr. Samuelson taught us, occur when the aggregate demand for goods and services is insufficient. The solution, they said, was for the government to provide demand when the private sector would not. Recent calls for increased infrastructure spending fit well with this textbook theory.
But there is much to economics beyond what is taught in Econ 101. In several ways, these Keynesian prescriptions make avoiding depressions seem too easy. When debating increased spending to stimulate the economy, here are a few of the hard questions Congress should consider:
HOW MUCH BANG FOR EACH BUCK? Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.
In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment. Most is for what the government has ordered, which raises the next question.
WILL THE EXTRA SPENDING BE ON THINGS WE NEED? If you hire your neighbor for $100 to dig a hole in your backyard and then fill it up, and he hires you to do the same in his yard, the government statisticians report that things are improving. The economy has created two jobs, and the G.D.P. rises by $200. But it is unlikely that, having wasted all that time digging and filling, either of you is better off.
People don’t usually spend their money buying things they don’t want or need, so for private transactions, this kind of inefficient spending is not much of a problem. But the same cannot always be said of the government. If the stimulus package takes the form of bridges to nowhere, a result could be economic expansion as measured by standard statistics but little increase in economic well-being.
The way to avoid this problem is a rigorous cost-benefit analysis of each government project. Such analysis is hard to do quickly, however, especially when vast sums are at stake. But if it is not done quickly, the economic downturn may be over before the stimulus arrives.
HOW WILL IT ALL END? Over the last century, the largest increase in the size of the government occurred during the Great Depression and World War II. Even after these crises were over, they left a legacy of higher spending and taxes. To this day, we have yet to come to grips with how to pay for all that the government created during that era — a problem that will become acute as more baby boomers retire and start collecting the benefits promised.
Rahm Emanuel, the incoming White House chief of staff, has said, “You don’t ever want to let a crisis go to waste: it’s an opportunity to do important things that you would otherwise avoid.”
What he has in mind is not entirely clear. One possibility is that he wants to use a temporary crisis as a pretense for engineering a permanent increase in the size and scope of the government. Believers in limited government have reason to be wary.
MIGHT TAX CUTS BE MORE POTENT? Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.
The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.
Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.
Christina Romer, incidentally, has been chosen as the chairwoman of the Council of Economic Advisers in the new administration. Perhaps this fact helps explain why, according to recent reports, tax cuts will be a larger piece of the Obama recovery plan than was previously expected.
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All these questions should give Congress pause as it considers whether to increase spending to stimulate the economy. But don’t expect such qualms to stop the juggernaut. The prevailing orthodoxy among the nation’s elite holds that increased government spending is the right medicine for what ails the economy.
Mr. Samuelson once said, “I don’t care who writes a nation’s laws or crafts its advanced treaties, if I can write its economics textbooks.”
The coming stimulus bill, warts and all, will demonstrate brilliantly what he had in mind.
N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President Bush.
Some Obama aides once had qualms about econ ideas
Some Obama aides once had qualms about econ ideas
WASHINGTON (AP) — Several proposals in Barack Obama's mammoth economic recovery plan will result in only modest or even uncertain benefits if they become law.
Says who?
A pair of the president-elect's top economic advisers — at least that was their view, in previous roles, before they joined his team. Those assessments, plus recent complaints from Democratic lawmakers, underscore the challenges Obama faces in selling the merits of his nearly $800 billion package of tax cuts and spending initiatives.
He may indeed prevail, especially because critics have not coalesced behind an alternative and the economy is so troubled that many former skeptics now embrace huge efforts, proven or not, to try to fix it.
If nothing else, the comments and articles point to the spotty track record of using government tax-and-spend policies in hopes of preventing or ending recessions.
For example, giving more federal aid to states, one of Obama's proposals, falls in the "medium" range of cost-effectiveness and carries much uncertainty about its impact on the economy, Peter R. Orszag told Congress a year ago. He headed the nonpartisan Congressional Budget Office then, and now is Obama's pick to direct the Office of Budget and Management.
Other Obama proposals such as giving businesses more leeway to write off losses from 2008 and 2009 "have little effect by themselves," Orszag testified at the time. "The historical record on the effectiveness of efforts to provide discretionary fiscal stimulus is mixed," he concluded.
Christina Romer, who will head Obama's Council of Economic Advisers, held a similar view in 1994, when she co-wrote an essay, "What Ends Recessions?"
"Our estimates suggest that fiscal actions," which are what Obama is proposing, "have contributed only moderately to recoveries," she and her husband, David, wrote. "Economists seem strangely unsure about what to tell policy makers to do to end recessions."
Now, 15 years later, Romer is a principal shaper and defender of Obama's strategy. She says plenty of uncertainty remains, and some proposals are more promising than others.
"Tax cuts, especially temporary ones, and fiscal relief to the states are likely to create fewer jobs than direct increases in government purchases," says an analysis of the Obama plan co-written by Romer and released Saturday. But government spending takes time to have an impact, the report says, whereas "tax cuts and state relief can be implemented quickly," and therefore "they are crucial elements of any package aimed at easing economic distress quickly."
The analysis predicts that Obama's plan would create 3.5 million jobs over the next two years.
Under the plan, about $300 billion would go to tax cuts. Hundreds of billions more would go to job-creation efforts including public works, and to investments in green technology, education and other long-term projects.
Many lawmakers have praised the plan's outlines, but some indicate they want changes.
Senate Budget Committee Chairman Kent Conrad, D-N.D., opposes using the plan for permanent spending increases. That puts him at odds with House Democrats who hope to broaden eligibility for unemployment insurance and boost education spending on a long-term basis.
The idea of a $3,000 business tax break for each new job created is drawing particular criticism from lawmakers who call it impractical and subject to abuse.
Some Republican leaders have gone further, attacking the very premise that ramped-up government spending, and the resulting deficits, are justified when the economy is tanking and millions of people are losing their jobs.
"The empirical evidence overwhelmingly rejects federal government deficit-spending as the best method for stimulating the economy," Indiana University economist Justin Ross said in a statement distributed by House Minority Leader John Boehner, R-Ohio.
Obama said Friday he welcomes input from lawmakers of both parties. "If members of Congress have good ideas," he said, "if they can identify a project for me that will create jobs in an efficient way that does not hamper our ability over the long term to get control of our deficit, that is good for the economy, then I'm going to accept it."
Some aspect of his plan seem more likely to help the economy than do others, according to economists and the January 2008 analysis by Orszag, now a chief architect and explainer of Obama's efforts.
Obama wants to give tax credits of $500 a year to individual workers and $1,000 to couples if at least one is employed. Such flat-rate credits give proportionally bigger income boosts to low-wage workers, who are more likely to spend the extra money and spur the economy, whereas wealthier people might simply save it, economists say.
Still, Orszag suggested a year ago, even low-income Americans might hoard their extra dollars and thereby defeat the stimulus plan's purpose. "In a period of high uncertainty," he told Congress, "fiscal stimulus may have a more modest effect because households are reluctant to spend."
"A household's consumption also varies for other reasons that are little understood," Orszag said in his 27-page testimony.
Obama wants to spend as much as $200 billion to help states pay for Medicaid and education. Such efforts can have merit, Orszag testified a year ago. But he warned that if federal aid to states "merely provides fiscal relief by paying for spending that would have occurred anyway," it may provide little or no stimulus to the economy.
Obama proposes to pour billions of dollars into infrastructure and public works projects, including roads and bridges. He favors those that are ready to break ground right away.
Orszag said a year ago, however, "even those that are 'on the shelf' generally cannot be undertaken quickly enough to provide timely stimulus to the economy."
Obama wants the economic package to greatly increase the production of renewable fuels and to make federal buildings more energy efficient. Such efforts would have immediate as well as long-range benefits, Obama says.
Orszag, in early 2008, seemed to think only half of that was true.
Some public works proposals, "such as grant-funded initiatives to develop alternative energy sources are totally impractical for countercyclical policy," he testified, using a term for trying to reverse harmful economic trends promptly.
Soak the Rich?
Soak the Rich?It's a perilous path for Democrats.
By Michael G. Franc
[Obama’s advisers] said no tax increases were included in the [stimulus] plan because it is focused on measures that create jobs. Obama aides have signaled that they will wait to let Mr. Bush’s tax cuts for the wealthiest Americans expire in 2010, rather than try to repeal them right away.
— New York Times, January 4, 2009
Liberals who want to extort untold billions in new taxes from the “rich” have been mugged by economic reality.The president-elect has quietly distanced himself from his campaign pledge to boost the tax burden of the wealthiest five percent of Americans. It’s an implicit acknowledgment that increasing taxes on our most productive citizens will throttle job creation and delay economic recovery. So far, so good.
But even as they postpone their soak-the-rich agenda, Obama and the New Deal revivalists on Capitol Hill are readying a mind-boggling $1-trillion-plus “stimulus” package — as well as other budget-busting initiatives, such as universal health care. Ultimately, taxpayers will have to foot the bill for all of this, not to mention the grab-bag of “shovel ready” fitness centers, parking garages, baseball museums, mob museums, and music halls that Congress intends to fund as public works.
The unstated assumption behind the stimulus package is that Congress will recoup all this spending a few years down the line by strapping a hefty tax hike to the backs of a very small minority of “rich” Americans. Then, all will be well.
Yah. Sure it will.
Before Obama and his Capitol Hill allies open the spending floodgates even wider, they should study the ongoing saga in New York State. Empire State politicians recently tried this approach to budget balancing, and wound up scalded by the financial meltdown. It turns out that taxing the “rich” is tougher than the class warriors might think.
First, a little background.
Last August, the hyper-liberal New York State Assembly voted overwhelmingly to boost the state’s top income tax rate on millionaires by as much as 1.75 percent, thereby jacking the top rate to 8.6 percent. Albany’s green-eyeshades brigade estimated the tax hike would reap an extra $2.4 billion annually.
But as Wall Street cratered and all those multi-million-dollar bonuses evaporated, it dawned on Assembly Speaker Sheldon Silver (D.), the brains behind this tax hike, that it wasn’t such a bright idea after all. “Because of what is happening to the New York economy,” a Silver ally helpfully explained to New York Post columnist Frederic Dicker, “Shelly doesn’t believe this is the time to be raising a tax on the wealthy.”
With the Empire State’s budget deficit now projected to exceed $15 billion —in the face of a constitutional requirement to balance the state budget — New York lawmakers are fighting a five-alarm fiscal fire. But rather than slash billions in wasteful spending (not long ago, the state’s chief Medicaid investigator estimated that 40 percent of New York’s Medicaid spending — about $20 billion annually — was fraudulent or “questionable”), the state’s political class remains committed to raising taxes. And this time, they’ve trained their sights not on the barons of Wall Street but on Joe Sixpack.
Gov. David Paterson (D.) has drawn up a laundry list of 137 tax increases that target the creature comforts enjoyed by ordinary New Yorkers. Included are new or increased taxes on soft drinks, malt beverages, beer, wine, cigars, cable television service, music downloads, and — most unthinkable of all — a new tax on Knicks tickets.
“If anybody’s contemplating leaving the state of New York,” one Republican lawmaker groused, “this should push them over the top.”
The lesson for Washington is this: The current economic climate is so dismal that what liberal theorists considered a modest tax increase on millionaires sent even limousine-liberal New Yorkers into a tizzy. From Manhattan’s co-op canyons and the ritzy oceanfront palaces of the Hamptons came cries of bloody murder. And since they’re the folks who host and attend political fundraisers, it quickly became more politically acceptable to raise taxes on Joe Sixpack’s cigarettes and his kids’ iPod downloads than on the earnings of hedge-fund managers.
The liberals’ entire class-warfare edifice, it seems, rests on extremely thin ice. It’s New York, New York, for heaven’s sake. If you can’t tax the filthy rich there, can you tax them anywhere?
Obama’s tax-the-rich agenda is on even thinner ice. Unlike the lawmakers in Albany, he believes families with incomes as low as $250,000 (approximately four million households nationwide) qualify as “rich.” Yet the overwhelming majority of these “rich” reside in states and congressional districts represented by his fellow Democrats. Obama may well discover that slapping new taxes on these 4 million households will give an unwanted political headache to those same liberal lawmakers whose votes will be required for its passage.
If the New York experience is any guide, Americans may already have reached the limits of politically acceptable taxation. Even before the financial meltdown, the national tax burden stood at about 19 percent of GDP, higher than the post–World War II norm and awfully close to the 20 percent level that has marked previous taxpayer revolts.
Lawmakers in Washington have displayed zero inclination to actually cut spending. And now we see that the politically acceptable default is to raise taxes on ordinary Americans.
Clearly, the incoming administration and its allies on Capitol Hill aim to spend literally trillions — trillions — of our tax dollars in the coming months without enacting any of the offsets that were promised so earnestly by their leadership.
Get ready, Middle America, for the largest, across-the-board tax increase in our history.
— Michael G. Franc is vice president of government relations for the Heritage Foundation.
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