The Two Sides of the Coin

Well, three weeks into the Obama administration and we are getting a real lesson in the two major alternative approaches to macroeconomic analysis that exist within the profession of economics today. The first approach, generally favored by those supporting President Obama, is Keynesian in nature. The second approach, generally favored by those not supporting President Obama, but not necessarily Conservative in their leanings, nor do these people necessarily believe that they are of the Republican Party, tend to work with a different model of the macroeconomy.

The Keynesian approach, developed in the post-World War I era, contends there is a problem in how the macroeconomy works itself out if there is insufficient demand coming from the private sector. This initiating factor in this model is that business expectations about the future drop off considerably…there is a decline in “animal spirits”…and as a consequence investment expenditures collapse. The normal response to this when the economy has not fallen apart is to have the monetary authorities lower interest rates and this action will stimulate investment demand and re-charge the economy.

The problem with this is that when “animal spirits” really collapse and there seems to be a cumulative downward movement in the economy, the monetary authorities cannot stimulate business investment expenditures so that the central bank cannot stop and reverse the downward spiral. Keynes suggested that in such situations the only possible vehicle to stop the cumulative collapse is for the government to come into the picture and substitute government expenditures for the business expenditures that have gone away.

The government can either finance these expenditures by printing money or issuing debt. The idea here is that this spending, even if financed by printing money, will not have an impact on prices (inflation) because of the un-used resources in the economy. That is, the government expenditures will just pick up the slack in demand and then through the multiplier effect created by increasing incomes and consumption expenditures, aggregate economic activity will pick up.

The major question here is about the size of the multiplier. There is much speculation on this, but the figure most people feel that people in the Obama administration are using is 1.5. That is, if the stimulus bill totals about $850 billion, then the total impact on the economy of this program will be $1.275 trillion…a hefty boost to aggregate economic activity.

There are several attacks on this way of thinking that lead us into the conclusions presented by the second approach under review. The first one is that the Keynesian approach, as described above, does not take into account that Keynes constructed his model in a period in which international capital flows were severely limit. Thus, what was done in a sovereign country generally stayed in that country.

The international financial system broke down during World War I…this was the old gold standard system. Keynes fought hard at the Paris Peace Conference which followed the war for fixed currency exchange rates between countries and limited international flows of capital. One of the things that Keynes was most worried about was the Russian Revolution and the spread of the ideas connected with the uprising of the workers and the leadership of the Proletariat. This seemed to be a worldwide concern that lasted in the mid-thirties. The worst fears of many, many people were that economic collapse or depression would result in a movement in which the workers took over.

Economic nationalism was designed to prevent such an occurrence. Fixed exchange rates, restricted international capital flows, and protective tariffs were designed to achieve this result. This was why Keynes wanted countries to be independent of one another so that those that wanted to could follow they own stimulus program without having to worry about currency depreciation or an international loss of capital. His stimulus programs were designed to work in such a country.

This is not the world that we find ourselves…we have floating exchange rates…we have relatively open world capital markets and a free flow of capital to almost anywhere…and in recent years there has been great efforts to promote and expand free trade. The government expenditures promoted by those that support the Keynesian approach have not accounted for the difference between the construction of the world in the 1930s and the construction of the world in the 2000s. The modern argument is that the spending of the government will just be dissipated through open world markets and capital flows and will not be able to achieve the level of stimulus they hope for.

Furthermore, the Keynesian effort will just increase…by substantial amounts…the amount of debt that exists within the world. As I have reported in recent posts, Niall Ferguson has claimed that the proposals of these “born-again” Keynesians are treating a situation where too much debt exists by adding on major amounts of new debt. Or, in other words these proposals are attempting to solve the problem of too much leverage in the system by adding on more leverage. Ferguson, as reported, does not believe that this will work.

In terms of the alternative economic model we find two major editorials published in recent days that lay out some of the concerns of this other school of thought. These are the articles by Robert Barro, “Government Spending is No Free Lunch,” WSJ on January 22, 2009, (http://online.wsj.com/article/SB123258618204604599.html), and Gary Becker and Kevin Murphy, “There’s No Stimulus Free Lunch,” WSJ on February 10, 2009, (http://online.wsj.com/article/SB123423402552366409.html?mod=todays_us_opinion). They are not too optimistic that the Obama stimulus plan will be very effective.

This school of thought emphasizes more the supply side of the economy and is concerned that the appropriate incentives are set up. For one, both articles contend that the multiplier is substantially below 1.0…I have used 0.4 in my writing. If the multiplier is 0.4 then the $850 billion in government spending will only produce approximately $340 billion in additional output…not much bang for the buck. The reason why is that the spending part of the program will draw resources away from other, private spending so there will not be the add-on effect, but a substitution effect in which resources that would have been used in other areas of the economy are now drawn to these areas. In terms of tax cuts, they argue that the way the tax cuts are structured the additional funds available to consumers will go into savings or a “rainy day” fund to protect against future economic difficulties. Thus, in neither effort is the government getting much for its spending.

In terms of the “right” incentives, Barro would like to see a reduction or elimination of the corporate income tax. In this way Barro believes that the incentives would be right for businesses to spend and put resources to work for they would be getting that extra boost from the lower or non-existent tax rates. In this way the supply side of the economy is stimulated…which Barro contends will be much more effective than the spending and tax-reduction programs that have been proposed.

The differences are great and they are now starting to get full exposure. We will talk more about these in the future.

Deliberative Government

President-elect Obama is pushing hard to formulate his economic stimulus plan and have it enacted at the earliest possible date. First, he was shooting for January 20, 2009, the day of his inauguration as President of the United States. Then he was aiming for President’s Day in February. Now…there is a good deal of uncertainty.

The idea of an economic stimulus plan is popular with the people of the United States. It is also popular in Congress. But, Congress is a deliberative body…and…this raises the level of uncertainty of when the package will be passed and signed into law.

We have just experienced this past fall when Congress was stampeded to act…we even had a panicked Federal Reserve Chairman Bernanke tell Congress on a Friday evening in September that the bailout package had to be passed the next Monday or “all hell would break loose.” And, so Congress gave up some of its deliberative power and moved quickly…although not as quickly as the pale and frightened Bernanke called for.

And, Congress has been regretting the quickness with which they passed the bailout bill ever since. Basically, Congress gave Hank Paulson, Secretary of the Treasury, and the Treasury Department a blank check with not controls and no oversight…at least for only $350 billion of the package. And, Congress…and apparently the Treasury Department…has no idea where the $350 billion has gone and how it has been used. It is, apparently, just gone!

Action like this is expected when there is a royal head of state or a dictator. That is, a dictator or a tyrant can change his or her mind on the spot and move this way or that way on a whim. The founders of the United States did not believe that this was a good idea. The policies and programs of a government should be discussed and debated and lingered over…and not just rushed into. There should be some “conservative” element within the government so slow down the process and get all sides of the issue a chance to be resolved. The founders created Congress to slow things down and muddy the waters.

Of course, there are times when decisions must be made in relative quick fashion…but, even issues that require relatively quick action can stand some time for reflection. Obviously, a balance has to be reached between rapid decision making and deliberation, but the general idea of the founders was that a country should err on the side of deliberation rather than on the side of hasty decision…frustrating though it may be.

Coming back to the present, I believe that the United States government, Congress, should err on the side of deliberation on the stimulus package. We are talking about a lot of money…and for a relatively long time frame.

We are talking about federal deficits of $1.0 trillion or more, not only this year…but next year…and the year after that…and so on…

We are talking about how much of this debt will be monetized…this year…next year…and so on.

Some are even talking about the United States becoming, financially, like a banana republic.

Yes, there are potentially real dangers on the other side. The economic slowdown could become an economic collapse…a second Great Depression.

But, there is no indication that the stimulus package will do what many are saying it will do. There is uncertainty about the combination…increasing spending or producing tax cuts. There is uncertainty about the speed at which programs can be implemented. There is uncertainty about whether the proposed spending will even have the desired effect of stimulating other spending. There are further questions about the ability of the financial system to support the large package.

Deliberation must take place! Even though the situation is serious…we cannot be rushed into this without discussion, debate, and contention. Yes, we want the result to be supported in a bi-partisan way…but this may not be fully possible. However, we want those that are not in favor of the stimulus program to be able to fully express their concerns.

There are too many concerns surrounding the whole situation to move precipitously.

Bernanke panicked the Congress in September to move hastily on the bailout package. There are many, many regrets about this. And, the feeling is that maybe Congress really did not have to move so quickly.

In my experience, many decisions that seem so urgent at the time they occur can really be reasonably postponed. Again, this is a judgment call so the answer is not cut and dried. Still, I have found that it is good to slow down and discuss things in most cases. This leads to a consideration of more alternatives and results in better decisions in the end.

I believe that the founders of the United States were correct in their wish to have this “conservative” element built into the structure of government. We need to take some time to examine issues and the potential solution to the problems the issues contain. We need a deliberative body that will do its work…deliberatively.

Let’s give Congress some time to consider the Obama stimulus plan. Let’s not be rushed into a program that has been hastily conceived and forced through into law by the new administration.

As that world famous philosopher Winnie-the-Pooh said, “A thought may sound very thingish when it is inside your heard, but it may not sound thingish at all when it gets out into the air.”

Let’s follow the advice of Winnie-the-Pooh and get these ideas about the stimulus plan out into the air and see if it is thingish or not!