Credit Greg Uchrin

The U.S. has a temporary reprieve on the debt ceiling limit – tax revenues have come in higher than expected in the early part of the year, reducing the needed pace of borrowing by the U.S. government. While this has pushed the deadline for Congressional action back by a month or more, the rhetoric in Washington continues to be intense. As quick background…Congress periodically authorizes  new limits to borrowing to cover new debt. Public radio’s Planet Money has a good, short description of the ceiling. That ceiling needs to be adjusted upwards by Congress in order for the Treasury Department to sell more U.S. bonds (i.e. borrow more).

The coming vote on raising the debt ceiling is giving the Republicans a chance to push for a less-government/less-spending program. Speaker Boehner issued a challenge earlier this week, as reported in The New York Times,

‘Without significant spending cuts and changes to the way we spend the American people’s money, there will be no debt limit increase,’ Mr. Boehner told members of New York’s business and finance community. ‘And cuts should be greater than the accompanying increase in debt authority the president is given.’ Mr. Boehner said those cuts should be in the trillions of dollars, not billions.

So, what would happen if trillions, or even just $100 – $300 billion was cut from Federal spending? University of Oregon economics professor, Mark Thoma, was asked this question and wrote about it in MoneyWatch.

Thoma’s bottom line is

Even a much smaller cut, say $100 billion over the next year, would still wipe out 500,00 jobs over that time period — 2 months of job creation at present rates — and set the recovery back considerably.

For students in macroeconomics there are some good reminders of basic economic forces. I recommend reading the MoneyWatch posting. Look for these important uses of macroeconomic theory:

• The multiplier (AKA the Keynesian Multiplier). When the government spends money, that initial increase in spending adds directly to GDP. Government spending is one of the four main elements of GDP, along with Consumption, Investment, and Net Exports. Then, depending on how that money is used (spent vs. saved) those funds cascade through the economy, prompting more spending (usually personal consumption). That means the original government expenditure has an impact on GDP that is a multiple of the original amount. In theory that multiplier could be as high as 5, but applied research suggests figures between 1 and 2. Thoma makes a point that was new to me, that the multiplier can be different depending on the state of the economy – lower when the economy is closer to full employment, and higher during recessionary times. (Note to self – look this up.)
• Okun’s Law. Okun saw a relationship between changes in GDP and changes in unemployment. He observed empirically that a two percent drop in GDP was associated with a one percent rise in unemployment.

Putting it all together – Thoma estimates that a $600 billion drop in government spending over two years ($300 b in one year) will reduce GDP by two percentage points and raise unemployment by 1 percent. That is about 3 million workers losing their jobs. That would rip the guts out of our recovery.

[The] Washington stimulus has become the policy that dare not speak its name. This wouldn’t be surprising if we were talking about a failed program. But, by any reasonable measure, the $800-billion stimulus package that Congress passed in the winter of 2009 was a clear, if limited, success.

The Congressional Budget Office estimates that it reduced unemployment by somewhere between 0.8 and 1.7 per cent in recent months. Economists at various Wall Street houses suggest that it boosted G.D.P. by more than two per cent. And a recent study by Mark Zandi and Alan Blinder, economists from, respectively, Moody’s and Princeton, argues that, in the absence of the stimulus, unemployment would have risen above eleven per cent and that G.D.P. would have been almost half a trillion dollars lower.

This leads us to the fiscal (sometimes called the Keynesian) multiplier – where government stimulus funds (added spending or tax cuts) cascade through the economy and increase GDP by some factor that is hopefully greater than 1. The more we spend newly arriving money, the more cascades and increases the multiplier. The more we take that new money and use it to pay off debt, buy stocks, or save it, the lower the resulting multiplier.

This NPR piece gives a good overview of the issues and a glimpse of the man himself. I listened to it on the way home from teaching macroeconomics, and felt my day was complete.

Photo credit to: Walter Sanders/Time Life Pictures

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.