Thursday, April 02, 2009

Thoughts on the Recession and Stimulus

This is an expanded version of a short article I was asked to write for the college newspaper.

We are currently in a recession. Why? How do we make it end sooner? The causes are complicated, and there is some disagreement over them. A bubble appeared in housing. A bubble occurs when people wrongly believe that the price of an asset will keep going up, so they buy now in order to sell later and make a profit. Eventually bubbles pop—everyone realizes that housing can’t go up at such a rapid rate forever, so they scramble to sell before everyone else does (According to Larry Lindsey, there are about 3 million surplus empty housing units on the market, for a total of around 18.5 million--and that was as of last June. The numbers have surely climbed since then). As the supply of houses on the market increases, prices drop rapidly. People who own these assets (some of whom did so in lieu of saving) experience a decline in their real wealth. When this happens, they are poorer, so they spend less and save more. In some macroeconomic models, this reduced spending results in recession due to the inability of prices to fully adjust downward in the short run.

When businesses begin to close down on a large scale (for example, many financial businesses closing down, or many homebuilding companies closing down), many people lose their jobs. If wages were fully flexible, employers could just offer these workers a pay cut to stay on, but this doesn’t seem to be the case. As a result, unemployed workers are poorer, so they reduce their consumption, which affects other people who depend on that expenditure for their own livelihood. The overall reduction in confidence, combined with sticky wages, and reduced expenditure, results in a general economic slowdown. It turns out that the biggest reductions come from investment, not from consumption. That is, consumption is somewhat smooth over the business cycle. Investment is very unstable, dropping dramatically during slowdowns, both because lenders are unwilling to lend, and because borrowers are afraid to borrow for expensive investments when times look bad.

Why did the housing bubble happen? Some blame the Community Reinvestment Act, although that is probably not to blame. It has too small an impact, and happened too far back in time. Some blame changes in regulation, or deregulation, although that is also not clear. Mark Jickling has a great list of possible causes and criticisms of those causes here. The sad truth is that we do not really know why bubbles happen at some times, and not at others. That may be the very nature of bubbles—that they are unpredictable and inexplicable.

In addition to the housing bubble collapse, there is a related credit crunch. As a result of some strange financial dealings, many companies bought financial instruments—such as credit default swaps—that turned out not to be a good idea. Again it is unclear why they took off at this time (but not earlier), and it is unclear if regulation could have stopped this from happening (remember regulators aren’t perfect either). So now many companies hold financial assets that are dangerous—toxic assets, they are sometimes called. That is, some companies hold bundles of “securitized mortgages” which may be worthless, because the mortgagees are likely to default. Companies are reluctant to reveal whether or not they are holding such mortgages, because they do not want to frighten their business partners and potential lenders. This has at least partially frozen some credit markets, however—because lenders are worried that they may be lending to people holding toxic assets, they are reluctant to lend to anyone. Why didn’t stockholders restrain companies from engaging in this risky behavior? We don’t know; they seemed to be asleep at the wheel. Why didn’t these assets blow up earlier? We don’t know.

All of this leads me to a general complaint about macroeconomics: We lack data. Yes, we have years of data, but we only observe the world as it existed. We do not get to run back the clock, try something else, and see what would have happened. In microeconomics we often have a wealth of tiny natural experiments, as different counties or states do different things, or as different firms do different things. Not so at the federal level. To put it another way, we’re trying to do statistical work on depressions with only one observation: The Great Depression. It is very difficult to conclude much from this. Perhaps in a few years we will have another depression to look back upon (let us hope not), giving us two data points.

As a result there are many economists providing many different explanations for how we got here, and how to get out of this mess. There is a lack of consensus on basic macroeconomic variables. Which ones are endogenous? Which are exogenous? What direction does causation flow? I do not think I am exaggerating. Read the various reputable economics blogs—Paul Krugman, Brad Delong, James Hamilton, Arnold Kling, Greg Mankiw—and you will come away bewildered. Are there aspects of macroeconomics on which economists agree?

Most economists prefer to rely on the Federal Reserve to stimulate the economy. The Fed’s preferred method for doing this is to increase the money supply in order to drive down interest rates. As the Fed reduces interest rates, some businesses are encouraged to borrow to build factories, invest in new equipment, tools, training, etc. Ideally this increase in investment and employment would restore consumer confidence and get us out of recession. At the moment, however, the Fed has effectively reduced its target interest rate to zero. There is little more it can do on this front. The Fed has some other tools available, and is trying new tools, but it may have reached the limits of its influence.

Because of this, many economists turn to fiscal policy. Fiscal policy consists of changing government spending and taxes to stimulate or slow down the economy. The goal is to spend money in ways that put currently unemployed resources—workers—back to work. It may be necessary to borrow money to fund this sort of stimulus (tax receipts are down in recessions, and government spending goes up), but it might be worth it to get out of the recession. After all, once the economy speeds up again, the borrowing can be paid back with higher taxes.

Now two problems appear. First, in the real world, governments spend money according to who has political influence, and not necessarily according to what will stimulate the economy. So there has been a great deal of effort by lobbyists to get pieces of the stimulus bill. Politicians want to send money back to their home states to get votes to help them get reelected. Spending on many of the projects—such as green energy—will probably not put to work those workers who are currently unemployed. That is, an unemployed Wall Street guy is not going to become an environmental or electrical engineer building a new clean power plant (not fast enough to stimulate the economy, anyway). Other areas of spending, such as road construction and bridge repair, may indeed re-employ currently unemployed workers (so construction workers who are currently idle may go work on building roads and bridges instead). A portion of the money won’t provide a stimulus now because it won’t take effect until next year. Even the money spent now will not have an immediate effect because these things take time. It is prudent to be skeptical regarding the effectiveness of the stimulus program.

The second problem is that resources devoted to uses dictated by this government spending are not available for alternative uses. That is, there is no free lunch. If we spend $2 billion on building a green power plant today, some of that $2 billion represents resources that will not be available in the future. It depends, again, on which of those resources are currently idle and which are not, and on which resources are finite, like concrete (once used, it’s not available for other uses), or not finite, like labor (that is, using it for one thing now doesn’t mean it can’t be used for other things later, and if it’s idle now, it’s probably better to use it than not). In this sense, dollars are really irrelevant; what matters are resources. Government spending either moves money around from one person to another (like social security) or consumes real resources (like building a dam). It may be worth it to build this power plant, or it might not, but if it is not going to put to work currently out-of-work workers, then the criteria we should use for deciding whether or not to expend resources on it is cost-benefit analysis, and it’s not stimulus.

Bob Higgs has argued that the Great Depression’s duration and end were caused by “regime uncertainty”—businesses were unsure about how much Roosevelt would change the rules of the game. This made long-term investments risky. The same may be true today. Businesses may be holding off on investment spending because they are unsure of what the government will be doing. Will the stimulus package help them or their competitors? Will regulation in their industry increase or decrease? Will health care reform reduce their costs or raise them? This can lengthen the adjustment process, as firms wait to find out how this uncertainty is resolved. For this reason it might be best for Congress and the administration to hurry up and do something, however bad, and stick with it in a predictable way.

A further, more subtle point: Arnold Kling points out that the finance industry (and I would suggest the construction industry) got too big during the bubble. It needs to shrink. Trying to reinflate them by bailing out banks and trying to keep them operating, by encouraging people to take on more debt and buy houses, and generally act the way they did three years ago is simply trying to reinflate the bubble. This is a bad idea. It may be the case that the only way to readjust our resources is to suffer a recession for a year or two. We need to recognize that we built too many houses, and spent too much time and effort trading pieces of paper, and stop doing that, not try to do more of it.

Other proposals have included more income tax rebates or cuts in income taxes. Based on recent evidence, these do not seem to work, because workers save most of the money (often by paying off debt), rather than spending it.

A more interesting recent proposal is the elimination of the payroll tax. Payroll taxes are taxes taken out of everyone’s paycheck up to the first $102,000. Income over that amount is not subject to payroll tax. Payroll taxes are essentially a tax on employment; they are a disincentive for workers to work, and a disincentive for employers to hire. Getting rid of the payroll tax would instantly put money in the pockets of both workers and employers, encouraging the former to spend (although they might just save most of it) and, more importantly, encouraging the latter to hire. Several economists, including Greg Mankiw, suggested eventually replacing payroll taxes with a higher gasoline tax, or a carbon tax, in order to reduce pollution. I think this sounds like a much better idea than a messy spending bill, which may do very little. Or maybe it will do a lot. I’m not a macroeconomist, and my opinion on this may not be very valuable. On the other hand, I’m not convinced that the real macroeconomists know, either.