Plain Sense Economics

…we continue our look at the current economic recession and the various solutions proposed to turn things around…

As noted earlier, the general preference, among economists, is to let the Federal Reserve steer our economic ship, through its use of monetary policy tools. These days, however, the consensus seems to be that monetary policy alone will not fix our current situation, and that we must turn to fiscal policy – the use of government spending and tax policy to stimulate demand.

Output Gap

The first question on the table is how far “in the hole” are we? We can look at this in a number of different ways. We could take the current report of 7.5% unemployment and set a goal of reducing that to a natural rate of something like 4.5%. Instead, though, let us look at the output gap. Those of you who have taken Principles of Macroeconomics from me will recognize this as the “recessionary gap”. This gap is the difference in output (GDP) between what our country could do when all of our productive resources are fully used (potential GDP) and the actual output we are experiencing. A recessionary output gap means our actual output is less than our potential.

Recently the Congressional Budget Office issued an economic outlook, to help support their budget forecasting mandate. This chart shows the actual GDP when compared with potential GDP from 1949 to the present.

Look at the big drop in the line just after the vertical dotted line. This says that the CBO estimates our output gap at somewhere near 7 percent of potential GDP. They also predict that we will return to full productive output by 2015.

Obama Proposal

We’re all waiting to see the specifics of the plan being prepared by the incoming Obama administration. We know it includes some tax cuts and a lot of new government spending. The rough estimate of the total cost is in the area of $750 billion. This would take the current estimate for our Federal budget deficit this year from $1.2 trillion to close to $2.0 trillion.

The title for this blog posting, though, wonders whether this is enough.

Paul Krugman thinks not. He has calculated that the Obama plan will add about 3 percent to GDP – not enough to fill the 7% gap. There are more numbers in this earlier post from Krugman.

I can’t challenge Krugman’s math, and it is silly to spend too much time on it until we see the actual numbers proposed by the Obama team, and then see what Congress does to alter the proposal.

But… there are a couple of important principles concepts here – focused on what we call the multiplier (aka The Keynesian Multiplier). The related question is: Are tax cuts or increases in government spending the most effective ways to stimulate the economy?

The Multiplier

Midway through the term, in Macro, we see how an increase in government spending impacts GDP. First, there is a direct impact – $100 billion spent by the government on goods and services goes directly to GDP. (Remember that government spending – G – is a component of the spending definition of GDP.) The multiplier comes from the assumption that this new spending by the government will cascade through the economy, and spur other spending. A worker hired to build a new highway will save some of his new income, but will spend more of it – perhaps on a new fishing boat. This additional spending also gets tallied in GDP as personal consumption – C. In a perfect world, and on our classroom white board, this multiplier can get as high as a factor of 5. In the real world, the multiplier may be something less than 2. So, in real world terms, a $100 billion spending plan by the government translates into $200 billion increase in GDP. So far, so good. Government spending programs have some leverage through this multiplier.

Tax cuts also have a multiplier, but they are missing the first influx of money from the government, since a tax cut is not new spending – just allowing workers and businesses to keep more of their earnings. So the multiplier for tax cuts is lower than that for government spending – probably at least by a value of 1. A $100 billion tax cut may have a multiplier of 1, which means a $100 billion increase in GDP.

Politics and Public Opinion

President-Elect Obama has smart, savvy advisers on his economics team, and we under-estimate them at our peril. At the moment, it appears that the Obama plan is a little light for a couple of reasons. One is the psychological barrier of proposing a $1 trillion plan. All of the estimates floated these last couple of weeks stop short of that. The second issue is garnering enough support from Congressional Republicans. The Obama team probably wants overwhelmingly bi-partisan support for his proposal. To do that, they have to include tax cuts. Some of those cuts fit with Obama campaign promises – providing relief to lower and middle class workers. Some of the proposed cuts may be for business, though. Those seem designed to attract Republican support, and Krugman at least thinks that the multiplier for business tax cuts is very small.

Let’s all stay tuned. This is a terrific experiment in the impact of fiscal policy.

Post Script

On Sunday, Greg Mankiw weighed in on the size and appropriateness of fiscal policy in our current conditions. Read his New York Times essay.

WHEN the Obama administration finally unveils its proposal to get the economy on the road to recovery, the centerpiece is likely to be a huge increase in government spending. But there are ample reasons to doubt whether this is what the economy needs.