A Specter is Haunting America

…The specter of fiscal mindlessness

I’m just back from two weeks in Europe. During that time, growth indicators have signaled a slowdown [0] in the midst of a massive negative output gap [1], while a substantial bloc in the Congress refuses to think in a sensible fashion about fiscal policy. This point is most forcefully illustrated by the inability of the Senate to move forward on extending unemployment insurance. (It makes me wonder if some were asking the question, “Are there no poorhouses?”)

Slack in the Economy  

First, a recap of the output gap, as estimated by the Congressional Budget Office, and the projected gap using the latest available Macroeconomic Advisers’ forecast. In log terms, the output gap for 2010Q2 is 5.57% (5.42% in level terms).

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Figure 1: Log GDP, in bn. Ch.2005$ (blue line), Macroeconomic Advisers’ forecasted GDP as of 2 July (red line), and potential GDP as estimated by CBO in January 2010 (bold gray line). Gray shaded area indicates recession, assuming trough at 2009Q2. Sources: BEA, 2010Q1 3rd release, Macroeconomic Advisers, CBO, NBER, and author’s calculations.Consistent with the Administration’s forecasts as well as CBO’s, considerable slack will exist in the economy for at least another year. And yet, I often hear calls for monetary restraint because of incipient inflationary pressures, which I haven’t seen any evidence of (see also Figure 3 in Rudebusch’s discussion). Fiscal restraint makes a lot of sense, and in fact in my 2005 Council on Foreign Relations report, I made strenuous argument for fiscal restraint to pull output back to potential — that is, getting the cyclically-adjusted budget deficit close to zero. But cutting back on fiscal stimulus at a time of substantial slack is pro-cyclical fiscal policy, something that makes little sense. (Note that the actual and cyclically adjusted budget deficit differ substantially, according to the CBO [2])

What If the Forecasts Are too Optimistic?

The recent employment situation release for June suggests that we should err on the side of caution, and worry more about deficient aggregate demand than inflation.

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Figure 2: Log nonfarm payroll employment, seasonally adjusted (blue line), private sector employment (red line), private sector aggregate weekly hours index (green line), all seasonally adjusted, normalized to 0 at 2007M12. Gray shaded area indicates recession, assuming trough at 2009Q2. Source: BLS via FRED, NBER and authors calculations.Figure 2 makes clear that private sector employment is growing, but growing slowly. Even (private sector) aggregate hours are no longer rebounding strongly. Figure 2, rebased to 2007M12 levels, highlights the fact that hours remain more than 8% below peak. As a consequence of the June release, I suspect that forecasters are revising downward at least their short term forecasts (see WSJ RTE).

Overall Government Spending

The failure to implement more transfers to the states as part of an additional stabilization package seems extremely foolhardy to me, given that the estimated multiplier for such transfers is quite high. [3] We know that spending is now declining in real terms, and hence exerting a negative impact on GDP growth.

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Figure 3: State and local government consumption contribution to GDP growth in percentage points, SAAR (blue line, left scale), and state and local government consumption in billions of Ch.2005$, SAAR, in logs (red line, right scale). Gray shaded areas indicate recession, assumes trough for last recession at 2009Q2. Source: BEA, 2010Q1 3rd release, NBER, and author’s calculations.Moreover, state and local government employment is now decreasing. See also WSJ RTE, and Aizenman and Pasricha (2010).

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Figure 4: Total government employment, in thousands, seasonally adjusted (blue line), excluding temporary Census workers (red line), state and local government employment including education (green squares). Gray shaded area indicates recession, assuming trough at 2009Q2. Source: BLS via FRED, BLS, NBER and author’s calculations.The Fiscal Situation, Misunderstood

I think a certain self-flagellating approach to fiscal policy has taken hold in policy circles, both here and in the euro area (see the Economist‘s discussion; see also WSJ RTE). Sometimes, fiscal restraint in a downturn is unavoidable; for instance Southern European countries that have investors fleeing their debt do need fiscal consolidation, augmented by other measures.

But in the case of the United States, we have faced a long term fiscal challenge for a long time. The biggest portion of the challenge comes not from provisions of the stimulus package, or TARP, but rather from our refusal to deal with long term cost trajectories in the entitlement programs, and our refusal to tax ourselves, as exemplified by the tax cuts of 2001 and 2003.[4]

Spending cuts in the short run, and the refusal to fund unemployment insurance and transfers to the states, is certainly counterproductive to the extent that they throw the economy into another downturn, or condemn us to stagnant growth. Such cuts provide the patina of “fiscal responsibility”, while failing to address the core budget busting problems, as laid out in CBO’s recent Long Term Budget Outlook. Much better to pin down long term expectations regarding the debt by dealing with entitlements, and maintain current aggregate demand by avoiding ill advised cuts that will do little to impact long term debt sustainability. (See Giavazzi (2010) for more).

The International Dimension

There are additional reasons to consider additional stimulus. In my presentation at a Euro50 Group/Reinventing Bretton Woods Committee conference, discussing the implications for the rest of the world of the euro area’s debt-related travails, I did not see a big impact from the euro’s depreciation. However, I did worry that excessive fiscal retrenchment on the part of the Northern euro area countries could have a large negative impact on the US, insofar as euro area growth suffered from the contractionary fiscal policy.

The international connection is also important in terms of context, especially in reference to discussion of “expansionary fiscal contraction” a la Giavazzi-Pagano (1990). Fiscal contraction might or might not have a positive impact on output; much depends on the initial conditions, how the policy is effected, and so forth. One supportive factor that is missing in this case is a buoyant international economy. To the extent that the rest of the G-20 — particularly the advanced countries — is not expanding rapidly, the prerequisites for expansionary fiscal contraction in the US are less applicable to the current situation (see Krugman for a discussion).

Update: 6 July, 7:15am

Jeff Frankel has more details on the issue of addressing the deficit over the long term.

J. Calmes/NYT describes the internal WH debate on further stimulus.


Originally published at Econbrowser and reproduced here with the author’s permission.
 
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