Woodward and Hall Analyze the Financial Crisis and the Recession

I’ve been arguing that government spending is preferable to tax cuts as a means of stimulating the economy. Via an email from Bob Hall, an argument against that position from a paper described below:

General Stimulus

Current forecasts have real GDP reach its lowest value in the second quarter of 2009,… the total shortfall [is] $855 billion. This figure provides a way to think about the magnitude of a stimulus. Trying to push spending and output up to its trend level in a short time, would probably be unwise, for fear of overshooting. Eventually, the corrective forces of the economy would bring spending and output back to its long-run growth path. Policy fits in somewhere between, hastening the return to normal.

The case for stimulus is particularly strong with deflation hanging over the economy. But the Fed has a small amount of room left to stimulate through reductions in the fed funds rate—its target is currently one percent.

Fiscal stimulus will provide most of the needed boost. Fiscal actions take two forms, tax cuts and spending increases. Tax cuts raise consumer spending and business investment and thereby raise output and employment. When we speak of tax cuts, we include rebates paid to families who pay no income tax and we also include increase in social benefits, such as unemployment compensation. Spending increases go directly into higher output. Rebuilding a bridge produces output included in GDP and raises employment. The spending we are talking about here involves the government buying goods and services, not paying subsidies or benefits to families or businesses. Those go in the tax cut bucket. 25

Commentators apart from economists often compare the two types of policies in terms of bang for the buck. Bang is the amount added to GDP and thus to employment and buck is the amount of government money involved, or, equivalently, the addition to the government deficit. By this measure, spending stimulus comes out ahead of tax-cut stimulus. The spending automatically enters GDP and may have some second-round effects as well. Some part of a tax cut goes into saving, so the immediate increase in GDP is probably smaller. (John Taylor’s evidence) Earlier this year, the federal government used a tax-cut stimulus that helped delay the recession. Now advocates of spending stimulus are using the bang-for-the-buck criterion to argue that it is time to crank up spending.

Bang for the buck is not the right way to score stimulus measures. The nation is not limited to any particular level of government outlay or deficit level. The U.S. federal government has the best credit rating in the world because its current debt is small in relation to its ability to tax in the future. If consumers save half of a tax cut, the cut can be made twice as large as the desired increase in immediate spending.

Instead, the choice between tax cuts and spending increases should depend on the tradeoff between the value of the increased spending, which favors tax cuts, and precision of timing, which favors spending increases. Consumers respond to improved resources, from a tax cut or any other source, by adding the most valuable spending that they were unable to afford prior to the improvement. They are bound to spend a tax cut on something they want. By contrast, the government is not notably successful in picking good spending projects. Way too much money goes to inefficient operations like Amtrak and to build multilane interstates in Montana. Unlike the consumer, the government does not reliably spend extra resources on valuable purchases.

On the other hand, the government can, in principle, concentrate a spending stimulus in the time when it is most desirable, namely in the next few months. The government cannot concentrate the spending that consumers choose to make from a tax cut—part of that spending may occur way too late. Unfortunately, it is hard for the government to crank up spending quickly. Even if the government hires contractors quickly to fix creaky bridges, the stimulus only takes effect when the contractor hires the workers and puts them to work, a process that takes up to a year.

The government could concentrate the spending from a tax cut into a brief period with a novel kind of fiscal stimulus, a general consumption subsidy. Here consumers would receive, say, four percent back from the government, for consumption purchases in the first three months of 2009. The credit would be refundable to low-income families and phased out, as the current income tax does for deductions, for high-income families. The stimulus from this policy would be concentrated at the time when stimulus is most needed, sooner than any practical government spending increase. One way to generate the subsidy is to eliminate state sales taxes for a period. (Kotlikoff-Leamer proposal)

A second way to concentrate the stimulus is to cut the payroll tax for a period of a year or two. Half of the immediate benefit would go to employers and would encourage hiring and retaining workers while the other half would increase the take-home pay of workers. The employer effect would be in place only during the tax cut, so it is highly concentrated. The worker half would be more like a standard tax cut, subject to the problem of consumption deferral. Cutting only the employer part of the tax would be most effective at targeting the stimulus when most needed.

The text quoted above is from a website maintained by Susan Woodward and Bob Hall. The goal is to provide analysis of the financial crisis and to recommend policy responses, i.e. to “update this description of what has happened in the U.S. economy since the crisis began in 2007 and to give a commentary on the events and on actual and recommended policies to deal with financial stress and recession”:

Woodward and Hall analyze the financial crisis and the recession: Susan Woodward is a financial economist with a specialty in the mortgage market. She served as the Chief Economist of the Department of Housing and Urban Development. Recently, she prepared a study of mortgage closing costs for HUD. Robert Hall is a macroeconomist at Stanford: his website. We are maintaining a 30-page document on the crisis and recession, with a good deal of data and many source references. Some of the ideas we promote in the document are:

  • Low interest rates in the early part of the decade were responsible monetary policy to head off deflation, not an irresponsible contribution to a housing price bubble
  • The most important fact about the economy today is the collapse of spending on home building and the resulting recession
  • The aggressive response of financial policy seems to have contained the effects of the financial crisis on some key elements of spending, especially plant and equipment investment, through the third quarter this year
  • The government is wasting money by not stating a formal guarantee of Fannie Mae’s and Freddie Mac’s debt
  • Proposed and active programs for helping beleaguered homeowners reach only a small fraction of those in trouble and focus on the wrong goals
  • The top policy priority is a large stimulus to the overall economy rather than actions aimed just at housing

Click here for the pdf containing the analysis with graphs, sources, and bibliography. Click here for the Excel file containing the relevant data.

Back to the fiscal policy versus tax cuts question, according to the argument above, one reason government spending dominates tax cuts is that the private sector will allocate the money more efficiently than government. Government “is not notably successful in picking good spending projects,” while the private sector recipients of tax cuts devote the money to “the most valuable spending.”

Like purchasing stocks and houses in a bubble, things like that? The private sector isn’t perfect either, some businesses will fail miserably, the resources are wasted, not every private sector employee is the model of efficiency, and some consumers will come home with magic beans (you can find roads to nowhere in the private sector too – they go to housing developments where the streets are in place, but there’s little or nothing built there). So we mean relative efficiency. I’m not saying the government is just as efficient as the private sector, only that the relative levels of wasted resources may not be quite as stark as we sometimes think.

But here’s the main question. Suppose we ask, “should we tax consumers and build a bridge, or should we let consumers keep the money?” If every time we ask that question the answer is “consumers should keep the money because they are more efficient,” how does infrastructure ever get built? There must be times when there are public goods – goods the private sector will not build on its own – that have a net positive value to society. If that’s the case, then there is a role for government to step in and provide those goods. So why not build what we need now? Tax cuts cannot be aggregated into large sums – the large amounts of money needed to build major infrastructure projects – but government can act as an intermediary by pooling the money into sums large enough to get the job done. This is a time when such pools of money will be available, so we should take advantage of the opportunity.

To be fair, the question in the previous paragraph is not quite the question Woodward and Hall are asking since it is also desirable to time the policy so as to optimally offset swings in GDP and employment. But I think that objection can be overcome with a combination policy that uses tax cuts to provide an immediate boost with infrastructure spending that maintains the boost over a longer time period.

A combination policy can also help with another problem. It is no easy task to find $700 billion dollars worth of infrastructure projects that clearly fit into the category of having net positive value to society. Spending the money just to spend it is wasteful, and it is detrimental to policymakers in the future who will have to live with precedent set by actions taken now. So we should invest the money where we get the most value, and also where it has the best chance of lifting us out of the recession.

Because of that, I would break up the stimulus into pieces, with part of it going to provide an immediate boost through targeted tax cuts of some sort, another part would be devoted to providing an ongoing stimulus through infrastructure spending – those projects with clear positive societal value – and the remainder would go to backfill shortages at the state and local level, enhance food stamp programs, extend unemployment insurance, fill lapses in health care coverage due to layoffs, and other such needs.