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From Washington Wire

The latest stimulus showdown in the Senate: should money from the $787 billion package pay for signs that say a project is being funded with stimulus money?

No way, said New Hampshire Republican Sen. Judd Gregg, who today tried to ban funding for the signs, which are prominently displayed at the highway projects around the country. "Considering the questionable effectiveness of the stimulus bill, it is completely unreasonable that signs are being constructed at a price tag of hundreds to thousands of dollars apiece for lawmakers to pat themselves on the back about this legislation," he said in a statement. And offered an amendment to the transportation spending bill that would ban funding for the signs.

Democrats said the signs were absolutely fine. California Sen.Barbara Boxer said on the Senate floor that it didn't matter whether lawmakers voted for or against the stimulus plan, they should still fund efforts to tell people what it was doing.

...

At stake: jobs for sign makers, jobs for others if the money were to be used differently, and control over how the stimulus package is perceived. Since the plan was enacted, Democrats and Republicans have fought over how fast the money is being spent, and whether it has delivered results.

The signs present risks to both parties, though. If voters decide the spending was a waste, the signs will remind them of the Democratic program. If the stimulus is ultimately seen as helping the economy, the signs remind voters that Republicans largely opposed it.

Let's not delude ourselves.  It's all about how the stimulus package is perceived.  I seriously doubt the senators cared a whit about jobs for sign makers when debating this proposal.  But the proposal failed.  The signs will stay.  Which, if you take the writer's interpretation, suggests that the Democrats are more confident that people will see it their way.

Edmunds.com:

Interest in the Cash for Clunkers program is slowing, and, if the current trend continues, vehicle sales could be back to pre-Cash for Clunkers levels by August 20, Edmunds.com calculates.

Edmunds.com's analysis of purchase intent on the car-shopping Web site shows sales activity tied to the government's Car Allowance Rebate System (CARS) remains well above the period leading up to its July 27 public launch.

However, activity is 15 percent below the peak of the Cash for Clunkers frenzy, which occurred the last week of July and specifically on July 29. Barring any intervention such as a major incentive program or a significant uptick in the economy, sales will be back to pre-clunker levels by next week. 

...

The funding for the original program was low relative to the size of the auto market, creating a Gold Rush mentality where consumers hurried to take advantage before funding ran out. In fact, it largely sopped up the pool of buyers who owned clunkers and had the ability to buy or finance a new vehicle. In addition, automakers are running extremely low on inventories of vehicles eligible and popular for clunker trades. 

With additional funding now approved, the sense of urgency to participate in the program is gone and the pool of eligible clunker owners who can buy a new vehicle has shrunk. Interest in the program is fading as fast as the first billion was used up. Quite possibly, some of the extra $2 billion will go untapped.

Despite this decline in clunker activity, however, Edmunds.com expects auto sales to be improved through the summer as the economy slowly improves and value-oriented consumers look for deals before the new 2010 models start arriving, said Jessica Caldwell, director of Industry and Pricing Analysis. "The real risk is this fall. Will the economy have picked up enough momentum to keep sales at these levels?"

Some of the extra $2 billion will go untapped?  I find that a little hard to believe.  But by the looks of it, CARS has already attracted the buyers who were on the fence and ready to jump.  It will get progressively harder to get additional buyers to take the plunge--simple marginal analysis in action there.  The low hanging fruit has been picked.

Remember also that the increase in sales at the end of the model year would have happened with or without CARS.  And remember that auto sales right now are so low (with or without CARS) that there is practically nowhere to go but up.  Look at the data (Econbrowser has some good charts).  We are down hundreds of thousands of units per month relative to the past few years.  And while the Big-Three's loss of market share means that some of that loss is permanent, a lot of it would have come back anyway.  If CARS uses all $3 billion, at $4,500 per car, that would mean a few hundred thousand unit sales.  According to this table, we're down about 30%, or just under 2 million unit sales YTD compared to 2008 (which was a really bad year as well).    By my back-of-the-envelope calculation, CARS cannot even come close to erasing the sales deficit experienced in the last 6 months.

And that means that any meaningful increase in production going forward would have happened anyway.  The increased sales from CARS could not possibly explain even a return of production to the levels of a year or two ago.  The sales declines have been too large, and the CARS program too small.

But I have to give the politicians credit for setting up the illusion that they made the recovery happen.  Sales (and production) will turn up eventually.  They have nowhere to go but up.  And when they do, CARS will get the credit, just you watch.

But make no mistake.  When and if production recovers, it won't be because of CARS.  The numbers just don't add up.

Mark Thoma makes a comment on his blog that is worth a response.

I've seen lots of objections to the Cash for Clunkers program based upon the fact that all the program does is shift consumption intertemporally, it doesn't actually create sales that wouldn't have occurred anyway.

But that is not, in and of itself, a valid objection. Shaving the peaks in output and consumption to fill the valleys stabilizes the economy. When the economy is in recession, creating brand new things that wouldn't have existed otherwise to lift the economy back toward full employment is preferred, but generally there aren't enough opportunities along these lines to give the economy the help it needs. In the cases where we cannot create enough new output and consumption to bring the economy back to health, moving consumption from a time when the economy is overheated to a time when it is underperforming helps by bringing both time periods closer to the long-run trend.

Now, Cash for Clunkers is not the the best way to shift consumption from the future to the present, or anywhere close since the intertemporal shifting is generally only for a month or two rather than from good times to bad, so this should not be interpreted as a defense of the program on this basis. But that doesn't mean the idea of intertemporal shifting is inherently flawed.

There seems to be an idea that policy must create something new, that simply rearranging consumption intertemporally is of no value. But there is value in avoiding large cyclical swings in the economy, i.e. value in stability, and when we have the opportunity to shave the peak of housing and other booms - times when the overheating is dangerous as it could result in bubbles, inflation, and other problems - and then use the "shavings" to fill the troughs of recessions, we should do so.

Now, I don't think I was the only one to make the argument, but when you Google "cash for clunkers intertemporal substitution" I am at the top of the list.  So I guess I should respond.

Mark characterizes the intertemporal substitution argument thusly:  "it doesn't actually create sales that wouldn't have occurred anyway."

While that is certainly true, I took it a bit farther, particularly in my second post.  My point is that it might not even affect production much at all since the dealers were overstocked with inventory anyway.  The production took place before CARS, and it is unclear (unlikely in my estimation) that CARS will meaningfully stimulate production afterward.  The increase in consumption and the decrease in inventories create basically no effect on GDP.  In a world without CARS, the dealers would have had to slash prices at the end of the model year (which is fast approaching).  As I said before, the dealers benefit, but it is unclear if anyone else does.  (Ironically, the dealers are having problems getting paid, but that's a story for another day.)

Mark then says, "But that is not, in and of itself, a valid objection. Shaving the peaks in output and consumption to fill the valleys stabilizes the economy."

I don't know.  If the program shifts consumption but not production, maybe it is a valid objection.  Don't you think?  Plus, there's the link in my first post that seems to have been overlooked.

I didn't quote from the article because I thought that people would read it, get the point, and see the connection.  But here it is in case you missed it.  The article is about the tech slowdown post Y2K, Internet boom, etc.

That has left many equipment and chip makers with much of the stuff they built in 2000. Motorola's Burgess figures that by and large, chip makers booked two years' worth of sales last year. The market for communications and networking chips grew 37% in 2000. But Burgess says "we got 12% last year that we shouldn't have had" because those sales were simply moved up from 2001. The result will be a decline in sales this year and continued slow growth next year. (emphasis mine)

The beauty of that article is that it was written after the fact, not speculating about what would happen.  Yes, I am speculating here, but I think I've got a pretty good script to work from.  I would not bet the farm on CARS providing a "stabilizing" force in the auto industry or beyond, and as noted in my second post, I don't think Detroit is either.

Again I ask, if the production has already occurred and would have occurred without CARS (and those workers were paid for that production before being laid off when demand slumped), then who benefits from the shift in consumption besides the dealers (who may have had to sell these cars at a huge discount without CARS)?  Remember, I don't dispute the fact that the dealers benefit.  And there is a (small) multiplier effect from that perhaps, but surely there are more effective ways to stimulate demand, aren't there?

Maybe Mark secretly agrees that there are better ways...

Now, Cash for Clunkers is not the the best way to shift consumption from the future to the present, or anywhere close since the intertemporal shifting is generally only for a month or two rather than from good times to bad, so this should not be interpreted as a defense of the program on this basis. But that doesn't mean the idea of intertemporal shifting is inherently flawed.

There seems to be an idea that policy must create something new, that simply rearranging consumption intertemporally is of no value. ...

I think Mark misses the point that effective stabilization policy does in fact intertermporally shift output--which should shift consumption as well because they are contemporaneously correlated.  And in fact, just about any policy is an attempt to intertemporally shift output.  Monetary policy surely is.  But an intertemporal shift in consumption and inventories alone (which this quote from Mark seems to acknowledge this is) really is of little value in the aggregate.

Of course, maybe Mark wasn't referring to my posts at all since there wasn't a link.

Just to be clear, my real issue with the "Cash for Clunkers" program is the same as the reasons that I oppose the income tax rebates brought to us by President Bush and the gas tax holidays embraced by politicians of all stripes.

These policies have almost no real stimulative impact.  Consumers don't benefit much from gas tax holidays.  And income tax rebates mostly get saved.  I will repeat what I said during the gas tax holiday debates:

My criteria for good public policy is that it be well out of the neighborhood of "pointless."

I apply this criteria without regard to the political party that advances the policy, and I encourage you to do the same.

Basically I get really irritated when any politician from any party tries to score points with a policy that is bound to be popular for obvious reasons even though it produces little or no real positive effect.  It irritates me that so many people can't see through the smoke and mirrors.  It irritates me that politically popular but nearly pointless policies crowd out other policies that are less politically popular but could produce far better results.

I've been irritated a lot in the last 10 years, and I don't see it getting better anytime soon--regardless of which party is in the big chair.

It is quite fashionable at the moment to refer to the "cash for clunkers" program as an example of the "broken window fallacy".  See here, for example (Seeking Alpha).  Well, at least "cash for clunkers" is not mandatory.  A hurricane or a tsunami doesn't give you a choice about whether to participate in the destruction.  That is certainly an important difference.  But as the article from Seeking Alpha makes clear, the real similarity that matters is that it results in a net loss of value.  Let's explore this idea.

My last post on the subject made the observation that it just shifts the spending intertemporally, and therefore the auto industry will likely see a decrease in demand when it's all over.

Commenter "Lord" remarks that this is ok, even desirable.  It means a boost in production when you need it and a decline later that will reduce the threat of inflation.

First of all, it is unclear what effect this will have on production.  Sales have increased, and it is drawing down inventories.  But the automakers know that this might not be sustainable.  This article from Edmunds Auto Observer makes the point:

"If we can sustain this momentum in the industry, it will translate into having a very good ability - for the first time in a long time - to increase production," said Michael DiGiovanni, GM's executive director of global market analysis. "And that will help stem the rising tide of unemployment, and will feed on itself to revive the economy. Recoveries are usually fed by the auto sector."
 
But displaying appropriate caution, neither DiGiovanni nor any other auto company executives pledged immediately to boost production in the wake of CARS mania. LaNeve said that GM is "looking for ways to add production" during the third and fourth quarters, but he didn't make specific promises.

Read the rest of the article.  You will see that industry experts really don't know what will happen going forward after this rebate comes to an end.  Good for dealers?  Yes.  They get rid of inventory they've been unable to move.  Enough to save the Big-Three?  I don't see it.

If the argument is that this is a sort of Keynesian "pump-priming" that will get us out of a bad equilibrium (coordination failure, for all you grad students out there), then I admit to being skeptical.  I guess if 3rd quarter GDP is positive we can pretend it was CARS that did it (even though a lot of folks have been predicting that for a while anyway).

Commenter "Jake" concurs with "Lord" that it will end the recession faster and adds that the net effect of the program will be positive.  "Jake" doesn't go into detail about how he arrives at that conclusion.  So I'm left to try to fill in the blanks.  Luckily, people have made similar arguments about natural disasters (and committed the "broken windows fallacy").

One positive effect usually mentioned is the increased spending.  But as we've stated (and "Lord" would seem to agree), this is just intertemporal substitution.  If you don't buy the pump-priming argument, then this isn't a long-run benefit.  (Is a billion dollars really enough to prime the pump?  Seems like a drop in the bucket.)

The other positive effect is that we have exchanged--in aggregate--inefficient cars for more efficient ones.  We'll save energy and the environment.

Ok.  But as Mark Perry points out, with more fuel efficient cars people might drive more because it costs less.  I would stop short of saying that it would actually harm the environment without more information.  But it is perfectly reasonable economic logic to say that the environmental benefits will be less than advertised... especially in light of this.

But I'll be generous and say that there is some environmental benefit.

Now, those cars would have been taken off the road at some point anyway, right?  So the net present value of the environmental benefit would only be the reduced emissions that would have gone out from now until the time of that car's eventual disposal.

So again, it is less benefit than is being advertised.  But if the environment benefits at all, it's all good right?

Not necessarily.  There's no such thing as a free lunch.

It still cost the government something.  That's money that won't be spent on something else.  Granted, a lot of the praise for CARS is that it is a better way to spend money than bailing out banks and so on.  But a dollar of spending today equals a dollar of future taxes in present value terms.  No free lunches.  Are the environmental benefits worth the money being spent?  If not, then we're just breaking windows.

I don't know the answer to that question with certainty, nor do I think that Congress had enough information to answer that question.  The truth is that this program is easy to administer and easy to explain to people.  It's politically expedient, and that carries a lot more weight in Washington than its economic merits (or lack thereof).

As policies go, it's probably better than some ways to spend money and worse than others.  But to those who think it is undeniably a net benefit to the economy, then I would ask, why stop at cars?  Why not distort the prices of some other things that could be replaced with more energy efficient versions and let the government pick up part of the tab?  Why not tear down rodent and asbestos infested old inner-city school buildings and replace them with safer high-tech environmentally sound buildings?  Sure it would cost more upfront, but the energy savings and the environmental impact would be enormous.  And think of the jobs!

It's not about the environment or the jobs, is it?  It's about politics.

I'll keep this simple.

Consider a market for a good that most people purchase once every few years.  Suppose that the purchasing decisions of consumers is somewhat influenced by cyclical and seasonal swings in the overall economy, but that no other large external factors synchronize the buying habits of many people at once.

Now suppose that an external factor (such as a government policy) caused many people who would have purchased cars in the next few years to make those purchases now.

Intertemporal substitution, anyone?

And the implications for demand in that industry in the years that follow these synchronized purchases would be...?

Oh, right, this happened once before.

That is all.

John Jansen (Across the Curve) links to the administration's draft version.  Enjoy!

President Obama wants his cabinet to find $100 million to cut.

In other news, I found 35 cents in a desk drawer today.

Is this simply rearranging the deck chairs, or is there more to this?  I want to know.

Barely. Here's an update of the graph I created last month. Payroll figures continue to be ugly. The labor market is now deteriorating at a faster pace than the 1981 recession.

Brad DeLong thinks we need a bigger stimulus. I'll credit him for consistency in that he has argued for a larger stimulus all along. However, I don't think that today's data should really change anyone's opinion on what is necessary or advisable. I think we all knew when we went to bed last night that the morning news would not be pleasant. Next month's news will not be pleasant either, but I've already built that into my expectations. I am expecting continued losses but perhaps not the 600,000 numbers that we've been seeing lately. I'm hoping for under 500,000. That would be encouraging, but I'm not supremely confident.

The Wall St. Journal Real Time Economics blog asked a number of economists what people should do with the average $8/week reduction in taxes withheld from our paychecks.

One fun game to play is to try to guess how each economist would respond.

Some of them took it seriously, I think.  Here are some highlights.

Justin Wolfers gets the award for the fundamentalist Keynesian response.

Justin Wolfers, The Wharton School: Find a cash-strapped soup kitchen. If they are looking at having to make cutbacks, then your $8 donation really will yield $8 worth of extra soup purchases. A good Keynesian will point out that this $8 in extra spending will enter the circular flow, creating the much-needed economic stimulus. (By contrast, university giving may simply prop up a sagging endowment.) But more importantly, the $8 you spend helping the hungry really can have a big bang-for-the-buck at a time when food spending is plummeting and unemployment rising.

Mr. Cliggott and Mr. Kasriel must have thought the question was asking what you would do with an extra $8 million.  I'm not aware of too many venture capital investments or hedge funds that require just $8.

Doug Cliggott, Dover Investment Management: You should invest it, not consume with it. Preferably a venture capital investment that will have a significant multiplier effect. This is why tax cuts are the worst type of stimulus. They are usually consumed or invested in a secondary market with little or no multiplier.

Paul Kasriel, Northern Trust: I would use the extra cash to start a hedge fund, which would purchase newly-issued asset-backed securities. I would finance my position through the Fed's TALF program.

Ricardo Reis and Alan Blinder get the De Gustibus Non Est Disputandum Award for their answers.

Ricardo Reis, Columbia University: You should use the money in the way that is best for you and your family, whether that is saving or spending, buying this or paying that. Doing what is in your best interest usually leads to doing what is best for the economy. (And when it is not, the economic policymakers should have figured that out when deciding whether to, and how to, give you the $8, so that by pursuing your best interest you end up doing what is best for all.)

Alan Blinder, Princeton University: While I might have my own personal favorites, each citizen should spend the money on what he or she sees fit. The idea is to get more spending, more jobs, higher incomes, etc. in the nation's economy.

Martin Feldstein answered it like an exam question.  I give him an "A".

Martin Feldstein, Harvard University: I don't think individuals make spending decisions based on attempts at good citizenship. If they think this $8 is a permanent increase, they will add it to their overall budget. More likely, they will recognize that this is temporary and will use it to pay down debt or add to their liquid assets

Guessing Greg Mankiw's response is left as an exercise for the reader.  Hint:  He implicitly assumes that you'll save up a couple months worth of your $8/week.

And finally, the cleverest response was from the always clever Tyler Cowen.

Tyler Cowen, George Mason University: In my view, fixing the banking sector is more important than getting the stimulus right. So if you can afford to lose the money, go to a large bank (more likely to be insolvent), find their most overpriced service, and buy as much of it as you can. That way you are doing your part to recapitalize our banking system.

If you're stuck for ideas, just keep on using ATM machines, owned by other banks, so you can pay large fees to take out small sums of money from your checking account. When you need to, take all of your withdrawals and deposit them back in the account once again and start all over with the process.

Honestly, Letterman should have 10 of these economists record their answers for his top 10 list.  I would love to see a straight-faced Tyler read that as the number one thing to do with your $8/week stimulus.

What would I do?  I like Reis's and Blinder's answers as a general principle.  In fact, had I been asked, I might have said "whatever you want."  Why waste words?

Go read the other responses.

Oh, and it goes without saying that the WSJ readers have at it in the comment section.  Enjoy.

Bill Conerly raises an interesting question on his blog, Businomics, today.

A good question asked yesterday: Is this recession different from others in degree or in kind?  No recession hits the historic averages smack in the middle, so this one would have to be at least a little different in degree of severity or duration.  But might it be fundamentally different from the types of recession we've seen in the past?

...

Now we are in a bust and we hear "This time it's different."  Those are the most dangerous four words in economics.  I don't think this recession is different.  Oh, it's different in magnitude and duration, it's different in the specific combination of factors that led to the recession, and its different in the level of panic that policy-makers have expressed.  But the fundamental process of recession and recovery?  I think it will prove to be pretty much like the rest.

I wholeheartedly agree that the words "This time it's different" are some of the most dangerous words in economics.  Like Conerly, I'm trying to make the case that it's not all that different.  In fact, in my comments to this post, I converse with my readers about some of the ways that this is just nothing like a Great Depression and that it is more like pre-1990s recessions.

Also, while we're on the subject of trying to communicate about the recession, the stimulus, and other matters to the general public, here's an observation.  Non-economists (including politicians) tend to fall into two camps regarding the stimulus.  One camp maintains that we have to act quickly to create jobs building roads and bridges because this is the worst recession since the Great Depression and if we don't do something quickly we'll be in another depression.  The other camp says government is too large, so cut taxes.

I am not finding much in the way of middle ground.

Mark Thoma also suggests that opposition to the stimulus is driven by opposition to big government rather than belief in small multiplier.

I think that much of the discussion in the economics end of the blogosphere has been a little more nuanced.  I imagine that there are a lot of economists out there who acknowledge that the spending will have some multiplier effect, but that the efficiency of that spending may leave a lot to be desired.  Those of us that are predisposed to that sort of thinking may then also get our hackles up a little when we think about how some of the spending creeping in could come with a lot of strings attached that might actually stifle growth.

It's not different this time.

For as long as I can remember, I have heard pundits say that the American economy is in decline for one reason or another.  Depression has always been right around the corner.  Such predictions sell books.  So the fact that there are some people who are predicting complete collapse of Depression-like proportions is not surprising.  Those undercurrents have been with us for the last few recessions.  It's not different this time.  But by the same token, this recession is not the beginning of a prolonged decline in the long upward trend of economic growth.  At least, it does not have to be.

The U.S. economy is always in a state of flux--dynamic and ever-changing.  We face challenges today.  But so has every generation, and some of their challenges were much more serious.  Things are not perfect.  We have kids going to school in 100 year old buildings.  Access to broadband Internet lags behind Europe.  I could go on.  Government can and should take on these challenges, but not for the sake of short-term stimulus.  Take on the challenges that will lead us to a more dynamic and prosperous 21st century economy.

When we conflate the short-term stimulus with the long-term dyanamism of growth we get confused policy that does not serve our citizens well.  Further, we run the risk of constructing policies that are so ill-advised that we could end up slowing our growth.  It does not have to be that way.

I admit to being at a loss as to how to solve this problem.  Only a proper understanding of the economic history of this country will open people's eyes to what is happening.

Only a proper understanding of economic history will make people realize that it's not different this time.  Where we go from here depends on that understanding.

After writing these two rather more lengthy than usual posts, I read Brad DeLong.  Though DeLong and I disagree on a few things, I have always found him to be very reasonable on the things that really matter in economics.  To wit:


It is a bit of depressing news, but then I was already expecting that the next revision of GDP might show it a little lower.  So I can't say that I'm incredibly surprised.  And remember, I'm not saying that a fiscal boost would be a net negative.  Whatever the present plan does to shore up GDP will be appreciated.

But I'm still a skeptic.  And Brad himself said that's ok a few days ago!

Arnold Kling feels lonely and unloved:

I'm feeling somewhat lonely these days. My understanding of macroeconomics is closer to that of Paul Krugman, Mark Thoma, and Brad DeLong than it is to that of Robert Barro, John Cochrane, or Eugene Fama. And yet I am a stimulus skeptic...

It's fine to be a stimulus skeptic! But stimulus skeptics need to be stimulus skeptics for reasons that are (a) theoretically coherent and (b) empirically relevant. To be a stimulus skeptic because you fear that the bill that emerges from congress will have a very low bang-for-buck, or fear that the long-run drag from amortizing the extra debt will cost us more than we gain from the short-run fiscal boost.

I'm a little from column A and a little from column B.  Mostly I question the bang-for-the-buck, as I explain at length in the previous post.

I'm just trying to puzzle out in my head how the present stimulus package will materially affect the trajectory of this chart.  And I'm just not seeing it.

This is continued from part 1.

We are in a recession.  This is a more serious recession in many ways than the last two.  However it is far from the proportions of the Great Depression, and the constant comparisons are beginning to wear on me.

This fall I gave a couple of public talks on the economic situation.  This was before it was announced that the recession began in December '07.  I told my audiences that I did expect that a recession date would be announced soon and that the start date would be between December '07 and July '08.  But I was also very quick to point out that although the job losses were already substantial, this was nowhere near the level of severity of the Great Depression.  Furthermore, the lessons that we learned from the Great Depression would be key in preventing something like that from ever happening again.  Of course, monetary policy is just about tapped out (barring some more drastic maneuvers) having already done what it can to prevent an even more serious failure of the financial market, so this brings us to fiscal policy.

Do we need $800 billion in spending to keep another Great Depression at bay?

Opinions among economists vary widely concerning the stimulus.  There are those who support it because they believe it will work (the multiplier is significant) and are not philosophically against larger government.  There are those who oppose it because they are philosophically against larger government and therefore the size of the multiplier does not matter (though many of them suspect that the multiplier is small and therefore use that as a supporting argument).

There are those who support tax cuts as stimulus because they support tax cuts all the time.  There are those who oppose the tax cuts because they believe consumers will save rather than spend them.

You need a scorecard to sort it all out.  We are not speaking with one voice.

This post is already getting too long to get into all of the problems with macro.  Besides, Arnold Kling is all over that.  While I don't necessarily agree with everything he says, I have enjoyed following his comments. 

It will suffice to say that macro folks have some work to do.  This is an exciting prospect because it was the inability of macro to answer many of these questions (and the debates that raged as a result) was what captured my attention and made me want to study this crazy stuff.

As for the stimulus package itself, I am a little disappointed.  I have my doubts about the size of the multiplier, but am willing to listen to evidence.  And while I'm cautious about increasing the size of government, I accept that there is a place for government in the economy.  But while watching the cable talk shows last night, the real reason for my skepticism bubbled to the surface.

Everyone is saying how the stimulus is going to "create jobs".  After all, job losses are the big story right now.   But will this stimulus actually create jobs?  Are we in a position to make this work?  Before you scoff, consider this:

The Federal Highway Administration has warned the state agency its payroll might be too depleted to handle the monstrous load of projects that a proposed $800 billion federal stimulus package could drop on Illinois' doorstep.

...

The Highway Administration is particularly concerned about professional positions such as engineers.

Good grief!  Has it not occurred to people that building roads and bridges is different in 2009 than it was in 1932?  Even minor projects need engineering support all the way from inception to completion.  How much of the $800 billion will go for that?  Do we have enough engineers to support that?

Then there is the fact that at the present time many of the layoffs I'm hearing about are temporary.  Unlike the last two recessions where plant closings and outsourcing were major factors.  I'm not hearing about plant closings and outsourcing this time.  Extensions of unemployment benefits and education tax credits would seem to be a reasonable way to address this.  I'm not sure a big construction push is the optimal way forward here.

Infrastructure and energy policy are laudable goals, but are they the way out of this recession?  I don't believe so.  My disappointment with the stimulus package and much of the debate around it in the media (as opposed to the professional debate among economists, which is of a higher quality) is that so many people think that building roads, bridges, and solar panels is the way to fight the recession.  That just doesn't wash.

The tax cuts will be saved rather than spent.  A lot of money will go to projects with questionable social value.   But yes, taken as a whole, the package will probably cushion the downturn somewhat.

And so once again, I am frustrated by the fact that this stimulus is being identified so closely with job creation.  I just don't think that in the final analysis there will be a lot of bang for the buck in terms of job creation, certainly not this year--which is when we really would need it.

Will it keep GDP from falling more than it would otherwise?  Sure it will!  Even a conservative estimate of the multiplier would concede that.  This bill is around 5% of GDP.  Even spread out over several years it will be felt.  But is it the right spending at the right time?  That is less clear.

I don't find anything in the bill that I believe is truly necessary to prevent a Great Depression scenario.  But could you argue that this amount of spending (on something, anything) is needed to shore up GDP?  You could argue it.  You could even argue that because of policy lags we need it now just in case the bottom falls out next year.  I'm skeptical but not dismissive.  I do believe that a certain amount of fiscal stimulus is a good insurance policy at a time like this, but I also suppose that I wouldn't be happy with any outcome of this political process.  So be it.

And that's the problem of fiscal policy in general.  Politicians like to believe that they can write legislation and create jobs.  It's not as simple as that.  There are no free lunches... no matter which party is in the big chair.

When the wheels started to come off the financial markets in September, I contended that swift action was necessary.  The Fed, for its part, did well in doing what it could within the bounds of its mission to prevent a complete collapse.  But the Fed was running out of options that were feasible for it to do on its own.  It was time to bring in the Treasury, and by extension, Congress.  I was not overly optimistic, but stood behind the effort.  I believed then, as I still do today, that if no legislation had been passed the probability of a further chain reaction in the financial markets during the presidential transition would be greatly elevated.  And the consequences of that would be potentially quite severe.  A legislative measure brought with it a measure of confidence during that transition.

$700 billion is a lot of money.  It's too much to risk letting go to waste, and still not enough to cover all of the potential losses out there.  Given the problems encountered so far, I believe it is prudent to slow things down.  We need triage.  Put the remaining TARP money where it will do the most good at preventing counterparty failures rather than frittering it all away on things of questionable value and purpose.

Yeah, right.  That's easier said than done now.  But no matter--buckle down and do the hard job.  Continue to let the market unwind.  The TED spread is way down from October, which is one sign that things are working themselves out.  There will be some more pain on Wall Street.  Accept that as inevitable, and do not prolong the inevitable.  Walking the fine line between preventing counterparty failures and not prolonging the inevitable pain is Mr. Geithner's job.  I think he's well equipped to walk that line, but the jury will be out for some time.

Now comes the fiscal stimulus.  This post is already getting long, so let's address that in part 2.

From the NY Times:

Treasury Secretary Henry M. Paulson Jr. outlined the plan on Monday to nine of the nation's leading bankers at an afternoon meeting, officials said, in which he essentially told the participants that they would have to accept government investment for the good of the American financial system. This capital injection plan will use a huge chunk of the money authorized for Troubled Assets Relief Program.

Citigroup and JPMorgan Chase were told they would each get $25 billion; Bank of America and Wells Fargo, $20 billion each (plus an additional $5 billion for their recent acquisitions); Goldman Sachs and Morgan Stanley, $10 billion each, with Bank of New York Mellon and State Street each receiving $2 to 3 billion. Wells Fargo will get $5 billion for its acquisition of Wachovia, and Bank of America the same for amount for its purchase of Merrill Lynch.

The goal is to inject massive liquidity into the banking system. The government will purchase perpectual preferred shares in all the largest U.S. banking companies. The shares will not be dilutive to current shareholders, a concern to banking chie executives, because perpetual preferred stock holders are paid a dividend, not a portion of earnings.

The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.

Two weeks ago, I would not have guessed I'd be writing this tonight.  But here we are.  Now we wait and see what these banks are able to accomplish with that money.  I am reminded of Matthew 25:14-30.

Alex Tabarrok at Marginal Revolution writes:

The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.  Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself.  Krugman would prefer a recapitalization in the form of nationalization.  In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.)  In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.

...

There is also a consensus among economists that the bailout bill is not the right policy.  None of the above economists, for example, is enthusiastic about the bailout.  My bet is that all of us think that the bailout has a substantial likelihood of failing.  The support that exists is born out of hope and fear not judgment and experience.  Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.  

Count me among those not enthusiastic.  My grudging support is not out of fear, per se--that's too strong a word.  Rather, I am convinced that we're in for a bumpy ride either way, and even a suboptimal plan like this has the potential to make the ride less bumpy.  Furthermore, I think that the moral hazard risks are small in the short term, and there is plenty of time to deal with the long term later.

But what is done is done.  Payrolls fell another 159,000 in September.  The unemployment rate did not rise this month, but it will catch up in time.  And let's be clear once again.  This bailout bill will not prevent a recession.  As James Hamilton says, that's a "done deal".  This bill will not restore calm to the financial markets either.  The best we can hope for out of this bill is that it can help facilitate the revealing of information in the markets sooner than would take place without it.  That might prevent an unnecessarily protracted downturn.

You won't find me celebrating this bill, but I am looking ahead with anticipation to see if it can get counterparties trading with each other again.  If it can do that, it will achieve some measure of success.

It's a familiar phrase to anyone who regularly reads legislation.  Most people would call it "pork."  It's the extra stuff that goes into a bill to make it palatable to legislators who are not totally in favor of the main purpose of the bill.  These items are not necessarily enough to convert a staunch opponent, but enough to get those on the fence to come to your side.  It's a political application of the economist's old friend, "thinking on the margin."

With that as prelude, I offer you this link to the bill passed by the Senate and now before the House.  It is now 442 pages long.  The pork "other purposes," begin on page 110 and continues for the next 330 pages (there are a couple of essentially blank pages at the end).  The math works out nicely to be 75% "other purposes" by volume though not by money.

Ever since this latest and most intense phase of the ongoing crisis began a few weeks ago, I have been convinced of the need for a coordinated approach to unclogging the credit markets.  Efforts to manage the specific incidents (AIG, WaMu, etc.) have been generally pretty good--if pretty good means that there have been no runs on banks and no catastrophic failure of the financial system.  In fact, as I have pointed out in a couple of media interviews lately, the response of the FDIC has been superb.  So far, they have my vote for the "most valuable player" in the handling of the situation.  Because of their experience and efficiency in handling bank failures, I would fully support a measure that would guarantee that FDIC continues to have access to the Treasury to meet its mission.  FDIC was created for just this sort of thing, so let's utilize them.

But there is a limit to what FDIC can do.  The Fed can do a little bit more.  They have the authority to respond to emergencies by lending to entities outside their normal purview.  While there is always a danger that such authority could be used unnecessarily, in my estimation they have acted responsibly thus far.  But even the Fed is limited to the role of responding to emergencies rather than acting entirely proactively.  To act more proactively, that is, to systematically purchase troubled assets in a way that many think needs to be done, requires Congressional authority.  And that's why we're here having this discussion.

There are, however, many reasons to be cautious about granting that authority.  Obviously it requires transparency and oversight.  Provisions that limit golden parachutes and give the taxpayer a chance to share the upside are also unobjectionable to me.  Assessing financial institutions for a portion of the costs is also a good idea.  Handing the Treasury Secretary a blank check would clearly be a very bad idea.

The biggest problem right now is clearly a lack of information (asymmetric information as well, but in some cases it is truly lacking).  It is evident from the TED spread and other data that lending among the major institutions is being constrained by uncertainty over how to assess counterparty risk.  This is not healthy, and it's not going to go away until some more information is revealed.  Any bailout package should be designed with that in mind.  If the Treasury is allowed to take some of the bad assets off of a bank, it may send a signal to counterparties that they are less risky.  This would help to get funds moving again.

And let me just head off anyone who would say that we don't need to "get funds moving again" because that's what got us into that mess.  That's just wrong.  Getting the counterparties creditworthy again will not create an undue amount of moral hazard.  This market has been slammed--big time.  Getting the funds moving in a more normal way will not bring about a return to subprime, interest only, no-doc loans.  At least not for a long time, and in that time we can talk about smart regulation to prevent that from happening again.

In summary, here's what I like about the proposal going through Congress:

• Wall Street shares the cost (see pages 9-12 of the legislation)
• Limits on executive compensation
• Making the $700 billion available in tranches

Things I don't like as much:

• A temporary increase in the $100,000 per account limit on FDIC insurance to $250,000.  Why?  I don't like fiddling with such important institutions on a temporary basis.  That figure is due for an upward adjustment due to inflation (and an increase in the premiums banks pay).  Why not do that and make it permanent?  (UPDATE:  But don't do it during the crisis, see below).
  
• Ability of the Treasury to suspend mark-to-market rules.  Why?  Similar reasoning.  I rarely would favor a temporary change in rules that are meant to foster transparency.  Mark-to-market may be flawed, but I'm afraid that temporarily suspending it right now would only add to the confusion.

Things I just don't like:

• "...and for other purposes"  Why?  You figure it out.  (Look at page 294 for an example.)
  

Is this legislation better than nothing?  All week I've been wanting to be able to say yes, but I am finding it difficult to do so.  There is something to be said for having a plan in place in case we need it in the next three months that Congress is out of session.  And yet, I find myself disappointed in the process and not that crazy about the final product.

There is no doubt in my mind that on balance this legislation is worse than what was voted down on Monday, but this one might actually pass.  That's how Congress works.  This legislation is not something that we urgently need to prevent a depression, and it simply will not prevent whatever recession may be in the works.  If it passes, it might reduce some of the anxiety in the credit market sooner.  If it fails, the Fed will probably be called on to use its emergency lending authority again.  The latter is not optimal, but it is probably workable.

The really sad thing is that the "other purposes" are not really out of the normal realm of business.  While it grates at me, it is part of the legislative game.  But if you think that facilitating price discovery and getting institutions to show their cards well help reduce counterparty risk, then this might be the best plan you'll get.  It's not a solution.  A solution seems very far away at the moment.  But it's probably marginally better than doing nothing and hoping for the best.

And I think I'll just leave it at that.

For today's other commentary, see Arnold Kling (who has had very good material lately) and Tyler Cowen (with whom I am in general agreement).

UPDATE:  King Banaian doesn't like the increase in the FDIC limit either.  He is worried about the moral hazard and that it would lead to banks taking more risks to try to recover their losses (as in what led up to the S&L crisis).  He's right about that.  I still think the temporary aspect of it makes it worse.  Let me be clear.  I think the limit should be increased permanently to adjust for inflation, but it does not need to be done in this bill.  It is not an urgent matter.  And furthermore, if and when the limit is raised, the insurance premiums paid by banks should increase as well.  In the meantime, the present practice of the FDIC in insuring the first $100,000 with certainty and making any decision to insure deposits beyond that on a case-by-case basis is sufficient for now.

Five days ago, I wrote:

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

I was wrong.  At least for now.  There's always the possibility that something will happen later this week.  I don't know what the likelihood is.  Obviously the party whips don't know either--and they're the ones who should. 

At the moment, the way I am organizing my thoughts about the situation is in the form of questions and answers.  So here are the questions I've been asking myself, and my best attempts at some answers.

Q:  Did we need this bill?
A:  I would be careful not to say that we needed this bill.  That is, neither this bill nor any bill was or is a necessary condition for preventing financial Armageddon.  Certainly there were some other options out there other than this bill that I may have preferred.  But after the bill failed, the Federal Reserve announced additional lending measures.  This represents another stop-gap measure that hopefully will help us limp through tomorrow.  The Fed could (with the assistance of special treasury issues) continue to do this for some time.  But of course this is not what we like to see either.  It would be nice to get a legislative solution.  However, if Congress is too dysfunctional to do it, then so be it.  There are other ways.

Q:  What is the biggest mistake that Congress and others are making?
A:  Actually, I see two misconceptions being perpetrated out there.  One is the framing of this issue as Wall Street versus Main Street.  That is, that the government is taking from Joe Six-Pack to give to big bankers.  On the other side of the aisle, there are those who oppose this or any "bailout" out of an unwavering commitment to free market principles.  That is, the bailout is just socialism by another name and should be rejected outright.

Both views have an element of truth, but both views also miss the point.  I think most of my readers understand the connection between Wall Street and Main Street.  However, it is becoming clearer that many people have never made that connection.  And let's be clear, it's not about the stock market!  The fact that the stock market dropped over 700 points is a symptom--not the disease.  The reason to do the deal is not to prop up the stock market--though that certainly gets (and deserves) a lot of attention.  But the drop in the stock market is just an indicator of the drying up of liquidity.  If you doubt this, just read John Jansen's excellent blog (Across the Curve).  If this continues for much longer, it WILL cause firms to have difficulty meeting payroll, paying for inventory, and financing expansion.  At that point, Main Street is affected.  That is what happened in the Great Depression in a very big way.  We may be able to stave off a Great Depression, but there is the potential for a very severe recession.

Those who say the bailout is socialism may say that a severe recession may be the price we have to pay and is not an excuse for such an intervention.  I understand this argument, and it is not entirely without merit.  If the situation, as I understand it to be, was less dire, I might even agree.  But Ben Bernanke is a student of the Great Depression.  If he's worried, then I am too.  My own study of history tells me that this is the closest we have come to such a scenario since the Great Depression.  So I am willing to put aside the "bailout is socialism" argument and argue that a strong government response is warranted.

Let's take a look at some very smart words from Robert Shiller, an economist that I respect a great deal:

So is the government's bailout a major departure? Hardly. Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles -- as long as the bailout promotes, rather than hinders, financial democracy.

Which, so far, it seems to. Congressional critics may be right to demand more help for homeowners and more accountability for Wall Street blunders, but the core idea of the plan is sound: to protect the financial infrastructure. Remember, Fannie Mae used to be a government entity, and by taking it over, the federal government is merely returning to the status quo ante. The measures to take toxic debts off the hands of financial and insurance firms are intended only to deal with a crisis, not to transform our financial system. The proposals do not represent any landmark change in the American way of prosperity. Everyone should take a deep breath. Changing our thinking about finance does not mean abolishing capitalism, but it does raise questions about what the changes mean.

Indeed.  Whatever "bailout" happens, if any, it will not be a permanent intrusion of socialism into the financial markets.  In fact, this represents a tremendous opportunity to modernize the financial system.  By "modernize", I don't mean the kind of derivatives that got us into trouble, but rather a sensible set of regulations that acknowledge the moral hazard problem and prevent institutions from doubling-down on a bad bet.  Read the rest of Shiller's column for more specifics.  I agree with his assessment.

This is a profoundly unique moment in our financial history.  The Fed and the Treasury will do what they can with or without Congress--they have made that clear.  Hopefully that will allow us to limp along.  But I am really starting to worry about the possibility of a stagnant economy for many months if the normal lending channels are not unclogged very soon.

Lawrence White explains why the gold standard may not be such a bad idea. It's a Cato podcast... with a briefing paper to go along with it.

Tim Duy gets frustrated with people comparing our current problems with Japan in the 1990s. Me too. He also gives his take on Plosser's speech and more.

Jeff Frankel is blogging. Go. Read. Now.

Andrew Samwick is disappointed with congress over the stimulus package.

I considered appending this to the last post as an update, but decided it was already long enough. This will be brief.

Tomorrow's NY Times has an article on the disagreement among economists about how best to implement fiscal stimulus. The usual arguments against it have been hashed out already. But here's a defense of timely stimulus from John Taylor.

Stimulus packages of the less recent past are often cited as examples of how not to make policy. Economists say that in the recession of the mid-1970s, spending and tax cut measures were enacted too slowly, having an effect only after the economy had already picked up. In 1992 and 1993, partisan squabbling derailed plans for a stimulus package as the recession came and went.

The measures seven years ago sent a different lesson, according to John B. Taylor, a professor of economics at Stanford and a former Treasury official under Mr. Bush. “People look back at 2001 and are more positive about this kind of approach,” he added.

Taylor's point, which is present in his textbook and which he reiterated in a Bloomberg podcast with Tom Keene, is that timing is everything. However, in the podcast, Taylor reminds us that the 2001 rebate was actually an advance payment on the cut in tax rates (that are set to expire soon). In that way it was different from what is being proposed now.

In my opinion, that is a pretty big difference, and leads me to the view that the rebates being proposed now will be less effective than those in 2001.

Listen to the podcast with Taylor. He has some interesting comments on monetary policy as well. "Bloomberg On the Economy" is a good thing to have on in the background while you're blogging.

It did not take long for the stimulus/rebate discussion to take on a life of its own. Why it was just earlier this week that the presidential candidates were telling us how they would stimulate the economy. As if any of this would be timely or meaningful by the time they take office. As if green collar job programs are the way to help avoid recession. Well, the current president got the message and looks like he is going to try to steal at least a little bit of their thunder. Mr. Obama will have to either come up with something new or claim victory in that the president is proposing something similar to what he suggested.

Enter Mr. Bush... (NY Times)

WASHINGTON — President Bush called on Friday for about $145 billion worth of tax rebates for American families and incentives for businesses to provide “a shot in the arm to keep a fundamentally strong economy healthy” and avert a slide into recession.

The president said the package “must be big enough to make a difference” in an economy as large as that of the United States, meaning it should be worth about 1 percent of the gross domestic product, putting it at $140 billion to $150 billion, Treasury Secretary Henry M. Paulson Jr. said later.

“This growth package must be temporary and take effect right away,” Mr. Bush said. The president said Mr. Paulson would work with Congressional leaders to get a bipartisan relief package ready as soon as possible.

As soon as possible could be really soon. Over at CNN/Money the sub-headline was "Lawmakers are still working out final details on cutting checks to all Americans to fight recession." We're already on the final details? Considering how long it usually takes to get things done in congress, that is fast. Almost frighteningly fast. Back in the NY Times article, they quote Senator Reid,

The Senate majority leader, Harry Reid of Nevada, was low key and cautious in his initial reaction. “I am encouraged and share the president’s view that we need prompt bipartisan action to strengthen our economy,” he said. “I also agree that our focus must be on finding temporary measures that will do the job effectively. I look forward to working with the president to implement responsible solutions that revive our economy for the benefit of all Americans.”

Reid's "initial reaction" as lawmakers work out the "final details"? Like I said, this took on a life of its own this week. So can we quantify how fast this is rolling ahead? Apparently so. Back to CNN/Money:

On Friday afternoon, House Financial Services Chairman Barney Frank (D-Mass.) told CNN he believed lawmakers could pass a stimulus package, including a rebate, by March 1.

And that means money in your pocket by summertime.

But I ask again, as I asked the other day, is this this the way to go?

I'll stop short of calling it a 100% unmitigated bad thing. Sure, we all know that the link between the rebates and increased spending is tenuous. Shapiro and Slemrod find that only about 22% of households would spend the rebate (link via Angus at Kids Prefer Cheese). So the stimulus part is a little dubious. King Banaian repeats the skepticism he voiced the other day. Bill Thomas and Alex Brill express their displeasure with all the stimulus talk in this Wall Street Journal commentary. The Journal's editorial page also questions the need with a swipe at Nixon's famous line, "We're all Keynesians now." Andrew Samwick just calls it deficit spending. Everyone seems to be piling on, and it's hard to blame them. Still, in defense of the rebates, it's probably faster and, if targeted at low and middle income households, more effective than many other forms of fiscal stimulus.

Yet it's far from clear that fiscal stimulus is what is necessary to fight whatever recession, downturn, slowdown, or whatever you want to call it may be on the horizon. My main concern which I don't think I've seen mentioned elsewhere in the econ-blogosphere (but correct me if I'm wrong) is that politicians might become addicted to these rebate checks. There are all sorts of political games that can be played with them. The president doesn't have to worry about getting re-elected, but clearly the rebates could give him a small victory on the way out. Congress, however, is up for re-election in November, and wouldn't it be nice to be able to go back to their constituents after Labor Day and tell everyone how they are responsible for those checks. Not that the American voters can be bought, of course.

So despite the protests from many quarters, I'd say that the rebate checks (in some form) are just about a sure thing. Shapiro and Slemrod will have a chance at a sequel.

UPDATE: Bruce Bartlett pulls no punches.

Probably not.

But consider the following. Brad DeLong writes:

Bear in mind that I don't yet believe that the case for a fiscal stimulus is strong--although I may change my mind in a month or two, depending on how the data flow looks. The principal organization for successful stabilization policy is the Federal Reserve. Congress and the president have a role to play only in two situations: first, if monetary policy has shot its bolt and cannot do anything more--and we are far from that point--and second, if the Federal Reserve has been caught flat-footed in the wrong policy position, unemployment is rising rapidly, and it is important to get cash quickly into the hands of people who will spend it and so keep the rise in unemployment from being as large. We are not there yet--at least I don't think so--but we may be there in three months.

From this perspective Obama's plan looks pretty good:

Obama stimulus package emphasizes quick cash in hand: a $250 tax credit to 150 million workers to offset the payroll tax paid on the first $8,100 of earnings. He urged a further $250 tax credit per worker if employment declines three months in a row. He also would give a one-time, $250 payment to Social Security recipients who would not benefit from the tax credit, followed by another $250 payment if employment declines three months straight. The immediate relief would cost $45 billion, plus another $45 billion if the economy weakened...

...

John Edwards's and Hillary Rodham Clinton's plans look, to me, likely to be less effective. Consider Hillary Rodham Clinton's:

Talking Points Memo | Clinton offers economic stimulus plan: a $30 billion housing crisis fund to help states and localities deal with the fallout of foreclosures... ease the effects of vacant properties with anti-blight programs and helping local housing authorities buy and rent out vacant properties. Setting a 90-day moratorium on subprime mortgages of at least five years, or until housing lenders have converted mortgages into loans families can afford. The proposal also would increase the portfolio caps at Fannie Mae and Freddie Mac. Providing $25 billion in emergency energy assistance for families facing rising heating bills.... Providing $10 billion to extend unemployment insurance for those struggling to find work while supporting families. Providing $5 billion in energy efficiency by doing such things as giving tax credits to encourage purchases of low emission vehicles and efficient appliances windows and other clean technologies. She also proposes funds to train and put to work people making public buildings more energy efficient...

These are all worthy causes--things that the government should be spending more money on. But this is not a bill that can be passed quickly--the housing provisions, at least, are one of those things where the devil is in the details of the drafting and where quick, clean passage and implementation is almost impossible. Funds to train and put to work people making public buildings more energy efficient--well, those aren't timely. The proposal is not Obama's: we are going to stimulate demand by cutting a lot of identical checks via a refundable tax credit--a thing that the government can do well and quickly....

...

John Edwards and Hillary Rodham Clinton and their staffs--they don't seem to have grasped that governance is best when you ask congress to do things that are within its competence, and ask the administrative branch to do things that are within its competence. They might respond that these stimulus packages are political rather than policy documents--acts of campaigning rather than acts of governance--and they are right, up to a point.

And so my question: Is a rebate check the quickest and most effective fiscal stimulus? It would seem that there is an argument to be made that it is better than many other alternatives. This document from the CBO circulating through the blogosphere gives rebate checks a mixed review. Their report gives the best rating to extensions of unemployment insurance and increasing food stamp benefits. King Banaian is skeptical given that long term unemployment doesn't seem to be our biggest problem. I concur. If indeed we are turning toward recession, then I'd fire the first salvo from the monetary cannon rather than the fiscal one.

There are other problems with the idea of rebates as stimulus. Unless they are coupled with long term tax reductions there is a risk that they will be nothing more than an illustration of the permanent income hypothesis at work. It is unclear that the money would be spent, especially if the rebates are broad-based rather than targeted--and the broad-based ones are the most efficient put into play.

That said, the more complex proposals of Clinton and Edwards would certainly take longer to get through congress. And that's going to be the biggest problem of all.

Menzie Chinn has much more at Econbrowser.

There will be a lot more discussion of this in the next few weeks, but here's a start. From the NY Times:

Senator Hillary Rodham Clinton of New York has proposed $70 billion in emergency spending programs, with an additional $40 billion in tax rebates if the economy worsens. Senator Barack Obama of Illinois has a $75 billion plan based largely on immediate tax rebates of $250 to most workers to encourage consumer spending.

...

The Republican presidential candidates have been more skeptical about short-term stimulus measures than President Bush has been. Mr. Bush signaled last week that he would propose a package of measures, probably dominated by tax cuts, in his State of the Union address on Jan. 28.

The debate among candidates about stimulus measures is largely academic, because economic conditions are almost sure to be entirely different by the time a new president takes office a little more than a year from now.

You would be seeing those rebate checks in the summer of 2009 at the earliest, just like we got Bush's rebate checks in the summer of 2001. Depending on how things go this year, the timing might not be as fortuitous. I would be interested in hearing what my readers think about various plans floated by the candidates.

Also in the Wall Street Journal today is a piece by Martin Feldstein. Here are some excerpts.

Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral -- not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy. The Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.

Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. The current credit crunch reflects not only a lack of liquidity, but also a lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets. All of this implies that lower interest rates may not raise lending and economic activity to the same extent that they did in the past.

The latter paragraph is a good follow up to Greg Ip's piece. In old fashioned Keynesian terms, what we've got here by this reckoning, is the basis for a liquidity trap. Later in the article, Feldstein adds the second part of his strategy.

What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.

Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process.

You're probably familiar with the term "automatic stabilizers". Well this takes the concept to the next level. A tax cut conditional on economic data--that's an interesting suggestion. Unfortunately, the temporary nature of the cuts would tend to reduce their impact. Anyway, read on.

Even if the Fed decides that it should not cut rates further at the present time, it would not raise rates to offset the stimulus effect of the fiscal change. From the Fed's point of view, the tax cuts can provide a desirable short-run stimulus without the inflationary impact that would result from a lower interest rate and an increase in the stock of money.

Dust off your trusty old IS-LM model and let the fun begin.

Some reliance now on a fiscal stimulus rather than easier money would also take pressure off the exchange-rate adjustment. While further declines of the dollar are necessary to shrink the massive U.S. trade deficit, continued rapid declines might lead to counterproductive retaliatory actions by some of our trading partners.

Add a dash of Mundell-Fleming.

The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand.

But didn't we cut taxes in 2001 and 2003? Yes, however those cuts were aimed in large measure at increasing long run growth--the success of which is a fair topic of debate. That's not to say that the short-run stimulative effect was nil. But the question is: would a temporary tax cut with a similar order of magnitude to the 2001 and 2003 cuts have any more stimulative effect? Or would people just save it?

Mark Thoma also mentions the permanent income hypothesis, but doesn't mention the 2001 and 2003 tax cuts. Interestingly, a lot of prominent economists opposed the 2003 tax cut because they thought it should be temporary (contrary to Thoma) in order to provide stimulus without threatening the long term budget outlook and that it should include a spending component (in agreement with Thoma).

I think temporary tax cuts won't work very well (in agreement with Thoma) and I have my doubts about temporary spending increases (more bridges to nowhere?), contrary to Thoma. So where does that leave us?

With a lower funds rate in 2008, that's where.

Here's an article by James Pethokoukis, who writes at U.S. News:

How about a windfall profits tax on Google? It's an idea that came to me after watching a video of Sen. Hillary Clinton, speaking at the Democratic National Committee's winter wing-ding, apparently call for the confiscation of oil company profits. As the front-runner for the 2008 Democratic presidential nomination put it:

The other day the oil companies reported the highest profits in the history of the world. I want to take those profits, and I want to put them into a strategic energy fund that will begin to fund alternative smart energy ... technologies that will begin to actually move us toward the direction of independence.

Why stop there? Why not confiscate a portion of Google's fat annual profits–the company's 2006 earnings were some $3 billion on revenue of $10.6 billion–and use it for some relevant national goal? The search-engine company is, after all, profiting from technological infrastructure it didn't even build, an "information superhighway" (to use a quaint term) that came out of a government defense project. It's time to pay Uncle Sam back. When Sen. Barack Obama officially announced his own presidential bid last weekend, he called for a new Internet initiative. "Let's lay down broadband lines through the heart of inner cities and rural towns all across America," Obama said.

So there you go. A portion of Google's profits, as well as those perhaps from Amazon, Yahoo!, and eBay could be funneled into a government-managed fund to pay for laying down fatter pipe. Heck, it's too bad that some candidate missed an opportunity back in 2004 to advocate the confiscation of home builders' profits to help low-income renters buy their own McMansions. Of course, profits at Lennar, Centex, and Toll Brothers aren't what they used to be, thanks to the housing bust. And if oil prices drop, neither will those at ExxonMobil or Chevron. And if the economy sinks, Google's bottom line won't look so healthy, either.

As they say, read the whole thing. Pethokoukis gets a couple of things right. Windfall profits taxes are not good policy. They severely distort incentives and change the firms' attitude toward risk. The capricious nature with which these taxes could be imposed, removed, or changed just adds to the distortion. If the government needs revenue, there are better ways to get it. You want an alternative energy fund? There are more efficient ways to do fund it.

And as for taxing Google to pay for a broadband initiative, that too would be ill-advised for precisely the same reasons. But as long as we're on the subject, let's talk broadband for a minute. I would be wary of a government managed plan for universal broadband access. My fear would be that they would adopt a 20th century solution to a 21st century problem.

Broadband technology (particularly the new wireless broadband) is still evolving. Once you make it a government program, you introduce a lot of rigidity. Better to keep some flexibility until we see which technology is superior. We can, I believe, afford to do that in this case because wireless is a low fixed cost operation compared to high fixed cost utilities such as the electrical grid, the copper wire laid down by Ma Bell, and even cable TV. There will be competition just as there is for wireless phone service--speaking of an industry that went from high class luxury to practically universal access in about a decade.

Debates will rage about the best way to provide broadband to inner cities and rural areas. Let that debate happen. I won't say that there is no role for government. However, I would urge great caution. We'll have to live with the mistakes for a long time. But in any case, a targeted tax would not be the answer. Didn't we just get rid of one of those telecommunication taxes that was supposed to pay for the Spanish-American War?

UPDATE: PGL at Angry Bear doesn't take kindly to seeing the windfall profits tax bashed. Robert Lawson reports that the governor of Wisconsin wants to repeal the laws of tax incidence

MADISON, Wis. (AP) -- Gov. Jim Doyle proposes taxing big oil companies more than $270 million over the next two years to help pay for the state's transportation needs.

Doyle said the assessment will equate to $1.50 per barrel of oil sold in the state, and the companies would be prohibited from passing the tax on to customers at the pump. Violations carry a criminal penalty of up to six months in prison.

Safe to say that we'll be coming back to this topic.

UPDATE 2: Read the comments at the Angry Bear post (link above) for more of my thoughts as well as those of pgl and others.

The FY 2008 Budget of the United States was released today. If you're in a hurry, here are the summary tables.

My initial read is that there is a good bit of wishful thinking in there. PGL (three posts so far)and Menzie Chinn have various things to say. (Chinn is also quoted in the Wall Street Journal.) I'll just say that what the government actually spends in FY 2008 is likely to be a lot different from what you read today given the current composition of the Congress. Furthermore, the forecasts of the deficit contained in the initial February proposal are seldom very accurate. Perhaps that is a subject worth revisiting later.

PGL at Angry Bear picks up on my comments from last night, as I hoped someone would. He quotes extensively from the 10 point WIN proposal and notes that Ford also called for capital gains tax cuts and investment tax credits. So allow me to call attention to point number nine:

Number nine: Federal taxes and spending. To support programs, to increase production and share inflation-produced hardships, we need additional tax revenues.

I am aware that any proposal for new taxes just 4 weeks before a national election is, to put it mildly, considered politically unwise. And I am frank to say that I have been earnestly advised to wait and talk about taxes anytime after November 5. But I do say in sincerity that I will not play politics with America's future.

Our present inflation to a considerable degree comes from many years of enacting expensive programs without raising enough revenues to pay for them. The truth is that 19 out of the 25 years I had the honor and the privilege to serve in this Chamber, the Federal Government ended up with Federal deficits. That is not a very good batting average.

By now, almost everybody--almost everybody else, I should say--has stated my position on Federal gasoline taxes. This time I will do it myself. I am not-emphasizing not--asking you for any increase in gas taxes.

I am--I am asking you to approve a 1-year temporary tax surcharge of 5 percent on corporate and upper-level individual incomes. This would generally exclude from the surcharge those families with gross incomes below $15,000 a year. The estimated $5 billion in extra revenue to be raised by this inflation-fighting tax should pay for the new programs I have recommended in this message.

Ford was not a Pigouvian--that much is certain. However, one can see that his understanding of fiscal policy was probably more nuanced than that of many presidents due to his experience in the House. In point number five, he asked for spending to help provide public service employment during the time of recession (you might think he sounds like a quaint New Dealer at this point). But he realizes that this together with the investment tax credits would balloon the deficit if there wasn't some kind of offsetting tax increase. This is the point that I wanted to make earlier, and I thank PGL for the comment that gave me an excuse to refine the point.

This point number nine in the WIN proposal was, however, the only place I could find reference to Ford calling for tax increases, which is why in yesterdays post I was careful to state that he called for tax cuts as well. But, like PGL, I found this to be a rather curious thing. As PGL points out, Ford also calls for monetary restraint and lower interest rates as well. There were some contradictions there. After reading the whole proposal, I get the feeling that he was trying to be revenue neutral (increasing some taxes and decreasing others) while stimulating economic growth and reducing inflation. The cynic in me wonders why he didn't ask for a pony as well, since this was already an impossible list.

But the better part of me wants to cut him some slack. This was two months after taking office in a most undesirable way and one month after making a tough decision that cost him politically. Why not lay it all out on the line? WIN was an impossible dream. Anyone who thought it would whip inflation and bring back prosperity before the 1975 State of the Union Address was not being honest with himself. But Ford did start the ball rolling on some important initiatives that included tax reform and regulatory reform. And the WIN speech was where some of those ideas were rolled out. As usual, Gerald Ford was thinking beyond the next political cycle. Such thinking tends not to get one re-elected, but we could use a bit more of it. The biggest problem with WIN, as I see it, was that it was bound to fail as a short-run solution even though certain aspects of it would have carried long-term benefits. That is a familiar problem in political economy.

As the months wore on, it was the tax cuts that took center stage in Ford's economic policy, but his was not a policy of tax cuts for the wealthy alone. He vetoed a bill that didn't include enough tax relief for the middle class and that didn't include spending cuts.

PGL concludes:

By the time Gerald Ford made this speech, the unemployment rate had increased from 4.9% to 5.9%. By May 1975, the unemployment rate reached 9% and still at 7.7% when voters went to the polls to decide between Gerald Ford and Jimmy Carter. My problem with the WIN program was less its details and more with the fact that this President seemed to ignore the fact that we were on the verge of a rather significant recession.

Check that. By NBER dating, the economy had already been in recession for just short of a year when he made this speech and was only 5 months away from pulling out of it. The labor market is a lagging indicator, so while the unemployment rate was still high, it was trending downward as Carter took office. He was a victim of poor timing in that regard. That is, unless you are going to tell me that the continuation of that trend and a decline of 1% in the unemployment rate in Jimmy Carter's first 12 months in office was due to Carter's economic policies. If so, I would respectfully disagree. Remember also that Ford had to work with a heavily Democratic congress. The wheels turned slowly. The divided government, while perhaps slowing the recovery, also kept either side from pushing the pendulum too far to either side and led to a slow but sustained recovery until the oil crisis reared its head again in Carter's term.

President Ford was dealt a really bad hand. He restored a measure of respect to the office and kept a bad economy from deteriorating any further. He used the power of the veto pen to stand up for fiscal responsibility. He put the nation's interests ahead of his own more than once. He did all this with civility and grace that is becoming ever more rare. He is not the sort of person we tend to elect, but he was there when his country called. He leaves a meaningful legacy to American politics.

UPDATE: Macroblog has more discussion of WIN. David Altig writes:

Seen through contemporary eyes, it is clear that the President Ford's speech hopelessly entangled shocks to relative prices with ongoing inflation of monetary origins.

Indeed. It was, to be blunt, a rather confused attempt to set out inflation's cause and cure. It was a political attack on a monetary problem. It's more about taxes, spending, and conservation. Altig continues:

Are there are any kind words to be found about all of this? More thoughts to follow.

I have tried to find kind words. However, I want to be clear that my kind words are more about what Ford's longer term objectives may have been, and what some of the WIN proposals, and indeed Ford's proposals more generally, were designed to do. I still think that WIN was misleading advertising and a set-up for failure in the short-term. But it was better than Nixon's price controls. Are those the kindest words? I look forward to hearing David's additional thoughts.

UPDATE: Altig does have some nice words to say. James Hamilton, on the other hand, is less charitable. Hamilton says:

And, despite the clever arguments that Dave brings up in the WIN button's favor, I think one great disservice of that campaign was to cultivate the misperception that inflation is somehow the responsibility of ordinary U.S. citizens. In my view, maintaining the purchasing power of a dollar is instead exclusively the responsibility of the people who control how many dollars get printed.

In the long run, yes. In the short run, other things do affect measured inflation, and WIN tried to affect some of these. I still think that it was ill-advised and a set up for failure because it created expectations that could never be fulfilled in the short run (because of politics and policy lags) or the long run (because of Hamilton's argument). Though you must admit that Ford was between a rock and a hard place on this, and although the buttons may have been overkill, some of the policies were worth a shot.

In today's NY Times, Joseph Stiglitz takes on the topic of the hour. Most of it you have probably heard elsewhere. This part is not always mentioned:

Imagine that the Bush administration suddenly got religion (at least, the religion of fiscal responsibility) and cut expenditures. Assume that raising taxes is unlikely for an administration that has been arguing for further tax cuts. The expenditure cuts by themselves would lead to a weakening of the American and global economy. The Federal Reserve might try to offset this by lowering interest rates, and this might protect the American economy — by encouraging debt-ridden American households to try to take even more money out of their home-equity loans to pay for spending. But that would make America’s future even more precarious.

Yes, there is a tension between the fiscal and monetary authorities in cases like this. That is an important point to make, and is not always made. Stiglitz has a simple solution, however.

There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the “switch” in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.

"If appropriately designed...," is a deus ex machina. This paragraph, I think even the most adamant proponents of tax increases would admit, makes a number of assumptions. One important one would be that the increase in taxes at the high end of the distribution does not reduce saving even further (since he laments our lack of savings earlier in the piece). It also assumes that the tax change would cause enough new spending by "poor individuals" to offset whatever change in consumption and savings occurs at the high end. I suppose one could postulate a Keynesian model and mathematically determine how to change taxes at different income levels--thus the phrase "if appropriately designed". I am understandably skeptical of either party's ability to do the math and appropriately design the new policy. I would also apply the Lucas Critique to any proposed model.

So the title of the piece, "How to Fix the Global Economy," is perhaps too ambitious. It's not that simple, even at the textbook level. Unfortunately, it is hard to fix the global economy in 1000 words--harder still when you have to expend half of your word budget rehashing the yuan issue. He makes an excellent point on the fiscal vs. monetary conflict but reduces the solution to one paragraph that raises more questions than it answers and makes some rather heroic assumptions about our ability to model the effects of these policies as well as our ability to design and implement them. The debate continues.

UPDATE: The debate does indeed continue. Mark Thoma, Greg Mankiw, and "knzn" all weigh in. Thoma notes that it is the difference in maginal propensities to consume (for individuals with different levels of income) that matters. True. Mankiw argues that average propensities differ, but that "...the evidence for substantially different marginal propensities is much weaker." Being charitable and granting the benefit of the doubt that there may be some difference in MPCs, I'm still left with the feeling that those MPCs (and the differences between them) are not policy-invariant (my original objection invoking the Lucas Critique). I would be very wary of attempts to fine tune progressivity to this objective. If you want to argue for more progressivity for other purposes, that's one thing. But this argument doesn't convince me. (Greg Mankiw makes a similar statement.)

Postscript: In this post, I referred to posulating a Keynesian model. That is not to say that I think that a Keynesian model would be the one I would opt for in addressing this issue, but because it seemed to best fit the argument that Stiglitz was making (the focus on the MPC in formulating tax policy). Just wanted to clarify that.

Mark Thoma points us to this John Berry column (Bloomberg)

Feb. 23 (Bloomberg) -- The scary, totally unfunny debt ceiling farce is playing once again in Washington.

With the federal government debt about to hit the $8.18 trillion legal limit, the Treasury Department last week suspended sales of special securities bought by state and local governments so that regular auctions of Treasury bills and notes could continue.

More such steps undoubtedly will have to be taken in coming weeks until Congress screws up the courage to increase the debt limit. At some point next month, Treasury will run out of such stop-gap measures and regular securities auctions may have to be postponed.

F. Ward McCarthy of Stone & McCarthy noted that Treasury officials said they were confident Congress would act ``because it would be in `nobody's interest' to fail to do so.''

``Let's hope that this confidence is not misplaced, because it could be very disruptive,'' McCarthy told his clients on Feb. 17. ``While it was in nobody's good interest, prior debt ceiling impasses have resulted in Congress orchestrating intentional delays in passing increases in the debt ceiling, temporary increases in the debt ceiling, interruptions to the Treasury financing calendar, the threat of government shutdowns, and the attachment of questionable parasitic legislation to increases in the debt ceiling.''

The problem, of course, is that voting to increase the debt ceiling is approving profligate behavior, even though they have little choice because of earlier tax and spending decisions.

The rest of the article deals with the debate over making the tax cuts permanent. I'll save that for another day. Don't worry, the issue isn't going away. I want to take up this little game they are playing with the debt ceiling.

The appropriate analogy here is a credit card where you, the spender, also control the credit limit. So, after a big shopping spree, you think that you'll send yourself a message by deliberately not raising the credit limit--even though your next trip to the grocery store will surely put you over the limit. Serves you right, you say. Maybe a week of eating cold cereal instead of your usual breakfast, lunch, and dinner will teach you a lesson. Then, to complete the self-flagellation, you tell all your friends about the extreme sacrifice you have been forced to make and how this will steel your resolve to improve your spending habits. You want their pity. You want to be recognized for your "sacrifice."

Who wouldn't be able to see through that? It's silly, isn't it?

Eating cold cereal for a week is not going to teach you discipline, and it's not sustainable in the long run. The long run solution is to avoid the spending spree in the first place.

Choices have consequences. Playing games with the debt ceiling does not negate those consequences. The present value budget constraint must hold. You can vote either side of the constraint up or down as you please. The other side must rise or fall with it. Full stop.

But alas, who among us believes that this is the last time we'll be seeing this silliness play out?

Anyone?

That's what I thought.

Tyler Cowen and Max Sawicky debate in the latest Econoblog. It ends up being largely about the appropriate tax rate on capital. Enjoy!

UPDATE: See below.

Division of Labour links to this Wall St. Journal article on President Bush's plan for tax reform. The way they treat the mortgage interest deduction seems like a sensible compromise.

The panel suggests turning the deduction into a tax credit equal to 15% of eligible mortgage interest, which means the tax break for interest on a $100,000 mortgage would be the same for every taxpayer, regardless of income. It suggests lowering the $1 million ceiling to the size of an average mortgage, using Federal Housing Administration regional data.

In today's real-estate market, the ceiling would range from $172,632 in rural areas to $312,895 in the urban corridors of New York City, Boston, Washington, D.C., and parts of California. The FHA says about 81% of its loans are close to the lower end and about 2.5% of loans are in the ceiling range.

The change would mostly affect only taxpayers in higher brackets with above-average mortgages. Under current interest-deduction rules, a taxpayer in the 35% income bracket with a $500,000 mortgage at 6% in the country's pricier urban corridors can reduce his or her taxes by just over $10,000. By contrast, under the new proposal, that same individual could claim a credit of roughly $2,800, according to Goldman Sachs.

The commission also recommends ending tax breaks for second homes and home-equity loans. In its proposal, current homeowners would be able to keep their original mortgage-interest deductions, which would change only if the homeowners refinanced or purchased a new home.

Seems like a good place to start. The effect at the low end is going to be small, and that's where there would likely be any adverse impact on home ownership. So I don't worry that it would change the home ownership numbers that much. There might be some impact on prices at the high end. Using the numbers in the article, the present value of the stream of tax savings on a $500,000 house with a discount rate of 6% amounts to a bit over a bit under $100,000 (Footnote: That's before factoring in any expected appreciation, and the rate of appreciation isn't likely to change much with this policy--we're looking at a level effect here. So think of it as $100,000 in today's housing purchasing power. Update: It's actually a bit less because the interest deduction falls over time, but most of the action is up-front. I haven't incorporated all the details in the proposal, so this is very "back-of-the-envelope" see below for an update that contains the details). I think that's significant enough to make you want to think carefully about how to phase this in over time, but that's not an insurmountable problem. Of course, some people will never be swayed. Read on...

Nevertheless, the housing industry was quick to criticize the proposal. "The tax deductibility of interest paid on mortgages is both a powerful incentive for homeownership and one of the simplest provisions in the tax code," said Al Mansell, president of the National Association of Realtors. "It should not be targeted for change."

I'm shocked... shocked! Note that they [the panel] are recommending an elimination of the tax deduction for state and local taxes. Actually I find it more difficult to argue for a tax on a tax than to argue for the interest deduction. But rent seeking is a powerful thing.

UPDATE: I calculated the actual total present value difference in the tax breaks under the current system and the new proposal. For a $500,000 home in the highest price areas, the actual present value increase in taxes due to the change will be about $66,000. In the lowest price areas, the present value of the change would be about $83,500. Assumptions: 30 year mortgage, 6% interest, 35% tax bracket. By my calculations, having a 5 year phase-in, as they recommend, would reduce the cost in the neighborhood of 10 to 20 thousand dollars in this example.

Read the report, especially the appendix for details.

So I spent much of the last couple days working on a research question. I'm catching up on blog reading and I find PGL (Angry Bear) and Arnold Kling (EconLog) discussing Thomas Nugent's column at the NRO. Obviously, I sat up straight in my chair and took notice.

Nugent says,

How does the federal government pay for the damages caused by Katrina? Does anyone asking that question actually know how the government pays for anything? Essentially, the federal government pays for things in just one way — it credits a member bank account. Let’s review the process: The federal government writes a check to a construction company to pay for a bridge. The construction company deposits the check at a bank. When that check clears, the Fed credits the bank’s reserve account at the Fed, and then the bank credits the company’s bank account with “good funds.” Bottom line: Operationally, virtually all of the federal government’s spending per se consists of the Fed crediting an account — that’s all. The federal government doesn’t have any “box of money” that gets “filled” from tax collections and the proceeds from new Treasury securities and then gets “used up” by spending or lending. This is an operational reality. In today’s world of non-convertible currencies, spending is necessarily nothing more than “score keeping.” (If one football team scores a touchdown, and 6 points are added to its score, does anyone ask where the scorekeeper gets the points?)

Oh dear.

Likewise, tax payments simply reduce account balances in the private sector. Nothing “goes” anywhere; the government doesn’t “get anything.” To reinforce this point, if you pay your taxes in actual cash, or buy Treasury securities (government bonds) with actual cash, the Fed shreds the cash. Likewise, if you donate cash to the federal government for Katrina, it shreds it. In fact, if you take a $100 bill and burn it, you’ve donated that $100 to Katrina! Operationally, the entire spending process is not constrained by government “revenue.” Whether or not the government has collected taxes or borrowed is not a factor in the payment process. Any constraints on the process can only be “self imposed.”

Oh dear, again. Mr. Nugent, meet Mr. Ponzi. He has some land he'd like to sell you.

Gotta love Arnold Kling's response:

I'm sorry, but I've read the preceding paragraph several times, and it makes less sense each time.

Whether public or private in nature, spending allocation decisions involve real resources, not just scorekeeping. The Treasury and the Fed are not operationally equivalent. Nugent may be trying to get past the notion of a static budget constraint and asserting the most extreme form of Ricardian equivalence in an intertemporal budget constraint. But even the intertemporal constraint is subject to a transversality condition. At face value, Nugent's statement seems to ignore that. The transversality condition is not "self imposed". Ponzi schemes are simply not allowed. Hyperinflation is not an option.

Oh, I know. It's a rhetorical flourish. I can see that, and you can too. But still.

Continuing with Nugent:

Will private borrowers be crowded out? Impossible. The causation is “loans create deposits,” as taught on day one of every traditional money and banking class. The act of borrowing itself creates exactly that same amount of new liabilities (deposits). The process is “self funding” and circular, as a matter of accounting. The concept of a “pool of savings” that somehow gets “used up” by borrowers is a throwback to the time of fixed exchange rates and gold standards, and has no application in today’s floating-exchange-rate world.

Again, I yield the floor to Arnold Kling:

When I was in grad school, I somehow missed the lecture where they said that government deficits are self-funding in a flexible exchange-rate regime.

The savings curve is more elastic, but not perfectly elastic. There is a difference, and I'd hate to learn that the hard way.

Finally, Nugent says,

The true economic cost of Katrina is the real, physical resources committed to repairing the damage that otherwise could have been used elsewhere to expand productivity or improve overall standards of living. But with today’s excess capacity in everything but energy, there is not going to be much of an opportunity-cost to rebuilding, apart from temporary dislocations of building materials and energy production. In other words, shortages of goods and services due to rebuilding should be temporary and modest.

So the private sector faces real trade-offs (but they aren't bad, so don't worry). But the government faces no real trade-offs; its just scorekeeping.

Sorry, governments face real trade-offs too.

UPDATE: MaxSpeak also took notice.

Partly because I've been preoccupied with monetary policy, I've held off commenting much on the $200 billion bill for rebuilding after Katrina that President Bush outlined in his speech a few days ago. As I sit in front of a blank screen about to write this post, the words of Andrew Samwick ring loudly in my head:

Where to begin?

My first concern is the precision of the estimate of $200 billion. While Katrina was much more devastating (especially when you consider the damage to the levee system in NOLA) than any other hurricane in modern memory, the $200 billion is orders of magnitude higher than for any other rebuilding operation of its kind, at least according to information I've been able to scrounge up. Where will it go? The potential for waste and fraud is staggering. We already know that disaster aid is fraught with abuse. The thought of opening p the purse for an amount equal to about half of the annual defense budget is, well, unnerving.

But suppose we are in a perfect world where these early estimates are precise and fraud is not an issue. What then? The importance of New Orleans as a port is enough to make me sympathetic to plans to strengthen the levees and make it safe to live and conduct business there. People will return; they will rebuild. But it is incumbent on us (read, the government) to make sure it is done in a sensible way. I say this with some trepidation as a non-resident, but some parts of the city probably should not be rebuilt. There should be some care and thought put into this. I fear that with an open purse, care may not be exercised.

There is precedent for a flooded and burned out city rebuilding in a sensible way. Grand Forks, ND suffered a flood in 1997. They have since bought out over 600 properties in the flood plain. According to this document, $12.5 million in FEMA hazard mitigation grants were spent in the buyout. Sure, Grand Forks (pop. 52,000) is smaller than NOLA, and the number of affected properties in NOLA is much larger. But even multiplying the Grand Forks FEMA grants by a factor of 100 would give you a number that is less than 1% of the $200 billion now being requested. Do we need something on the scale of 10,000 Grand Forks disasters?

Rebuilding and strengthening the levee system is worthwhile and because of the value of NOLA as a port, we all benefit. In a perfect world, I'd say this is a good candidate for deficit financing. It's a capital expenditure--something that will hopefully last for generations if done right. Hence it may be appropriate to ask future generations to share in the burden. Perhaps an even better case could be made for this type of spending than on other spending in the budget. That's a topic for another day.

As for the Ricardian equivalence argument, I have some reservations. First, you might recall that I argued that when it comes to Social Security reform, a version of Ricardian equivalence might approximately hold. I'm more confident about a version of Ricardian equivalence applying when it comes to a trade-off between a tax financed and a private savings financed retirement system. The decision problem for the household is much more transparent. Portfolios will adjust. In general, however, when the political system introduces a huge amount of uncertainty as to the duration and amount of the spending on cleanup/war/homeland security, etc. I think it is at the very least marginally harder to argue Ricardian equivalence. Samwick puts it thusly,

There are circumstances under which a higher public deficit would be completely offset through higher saving in the private sector. I've never been convinced that these circumstances apply in practice, even though they closely approximate the behavior of the Samwick household (consumption is set at a level far below permanent income and is unaffected, so far, by changes in tax policy). There are simply too many people not saving enough in the present generation to meaningfully offset the debts we are passing along.

To the extent that for some four years now the lower taxes and higher deficits have not wreaked havoc with interest rates is at least partly attributable to open global capital markets. Of course, Brad Setser, for one, worries about the potential for adjustment somewhere down the road.

That adjustment has the potential to be non-trivial. To really argue Ricardian equivalence with a straight face at this fork in the road, you have to argue that consumer savings could turn on a dime in the event that other nations slow down their bond binge. I can't argue that right now. The adjustment in savings would not come overnight. We would need to be prodded by higher interest rates.

And that brings us full circle to monetary policy, the topic du jour given the FOMC meeting just hours away. The Fed must be looking at this situation and shaking their head as well. Ideally, there is a separation between monetary and fiscal policy, but if we are indeed stretching to our limits as The Eclectic Econoclast believes, there could be a real butting of heads. Something for the next Fed chair to deal with, and it has the potential to be a real trial by fire.

This is no small matter. The whole idea of a soft landing was predicated on the ability of the Fed to manage aggregate demand to smoothly meet up with potential GDP on the upswing. A jarring fiscal shock has the ability to upset that delicate balance, putting us at risk of overshooting or undershooting the goal as the differing fiscal and monetary policy lags worth through the system.

And is anyone else thinking that we might be one $200 billion disaster/war/terrorist attack, etc. away from even bigger problems?

No small matter indeed.