Why Obama’s Stimulus Won’t Work and What Might

February 13, 2009

by Mario Rizzo

 

The fiscal stimulus package has passed. But the argument is not over. I gave a talk at the Club for Growth-Heritage Foundation conference, “Economic Recovery: Free Markets vs. Big Government” this past Tuesday just as the bill passed the Senate. I have linked the text of my remarks here. My four key points are:

 

1. The central cause of the current economic state of affairs is bad monetary policy from 2002 through early 2006.

 

2. Stimulus should not stimulate or reinforce the misallocation of resources.

 

3. Stimulus should create economic value and not destroy it.

 

4. The best stimulus consists of incentive-relevant tax reductions.

 

I could say that we’ll see what happens with the actual stimulus package. However, there is no clearly defined standard for whether it will “work” or not. President Obama has made the standard partly counterfactual – it will save jobs that otherwise would have been lost. Let that pass. Suppose we all agree by some date that it didn’t work, there is no easy way to determine whether that is because it wasn’t large enough – as Paul Krugman and others are already claiming – or because it was an inherently bad idea.  

 

 

I am not saying that, in principle, we cannot decide these things with some reasonable confidence. That would be science, not politics. There is no “rational” political standard or test to apply ex post. It is a matter of “simple” rhetoric and exploiting events and mood. As my late colleague Ludwig Lachmann used to say: There is no doubt that people learn from experience, but – what do they learn?

 

Additional link: Peter Kein has a very interesting post at Organizations and Markets called, “Demand for Commodities in Not Demand for Labor.” The historian of economic thought will note that this is one of John Stuart Mill’s tests of an (real) economist.  

Update: The entire Club for Growth-Heritage Foundation conference is available on video. I recommend it. My own talk is on the second panel — the first talk after the introductory remarks.

 

Further link:  The Mises Institute has kindly posted my talk in its entirety. Here.

 

 

 

14 Responses to “Why Obama’s Stimulus Won’t Work and What Might”


  1. Will the stimulus bill compromise lower your tax rebate to $8 per week? That appears to be true. The final version has not been passed, but reports indicate the $500 per year in reduced tax withholding has been reduced to $400 per individual and $800 per couple. That only comes to $8 per week for an individual and $16 for a couple. If they start the payments in June and make it retroactive to the beginning of the year, you will get $13 per week until next January. Then, your rebate would drop to the $8 per week level. Are you felling stimulated yet? In a stimulus bill of almost $1 trillion dollars, you would think President Obama would have more for the working class.

  2. Bogdan Enache Says:

    Basically, instead of a counter-cyclical fiscal policy, a structural supplly side approach should be adopted. I wonder however – if I understood correctly the argument – if you think there is any room in a downturn for counter-cyclical fiscal policy as it’s traditional understood, i.e. doing something to bring the economy back to its pre-slump potential output?

  3. Bob Says:

    Professor Rizzo,

    In the text of your remarks you said:

    1. We must remember that the current economic state of affairs was caused by the excessively low interest-rate policy followed by the Federal Reserve from about mid-2002 through the third quarter of 2006. This policy resulted in significant economic distortions or imbalances.

    According to the Fed, the intended federal funds rate was rising throughout this period. Source:

    http://www.federalreserve.gov/fomc/fundsrate.htm

    Is it your contention that the Fed should have increased the intended fed funds rate even more during this period?

  4. Mario Rizzo Says:

    Bogdan,

    I think cut in marginal tax rates might help offset the general problem of lack of confidence and fear. It is not a cure-all.
    —-
    Bob,

    Yes, my contention is that they should have raised rates. This is the implication of the Taylor Rule. There is no such thing as “absolutely” low (or high) but only low relative to economic conditions.

  5. Bill Stepp Says:

    Bob,

    According to the chart, the Fed-funds rate hit its all-time high in May 2000, then began its long slide, bottoming at around 1% in the summer of 2003, where it stayed for about a year. The effect of this worked with a lag–”a long and variable lag,” in the words of Milton Friedman. Housing starts peaked in the first half of 2006, and the stock prices of home builders peaked in August 2005 (see a five-year chart of the XHB).
    Prof. Rizzo is right that the absolute level of rates is less important than where they stand in relation to other economic variables. Throughout this period, the Fed-funds rate was considerably lower than it should have been based on the supply and demand for investible resources in the economy. That’s what drove the boom and led to the malinvestments that only started to be revealed, again with a lag, first in the residential real estate market, including subprime mortgages, then alt-A mortgages (see last week’s issue of The Economist), and, later, in other markets, including private equity and leveraged buy outs.
    The partially Fed-driven commodities boom also peaked in the summer of 2007.

    The Economist’s article raised the strong possibility that even prime mortgage loans, which were underwritten with more traditional conservative standards, could come a cropper next. Given the magnitude of the credit expansion and the fact that sub-market interest rates undergirded even prime loans, that is likely to be in the cards.

    Easy Al did a lot more damage to the world’s economy than bin Laden ever dreamed of doing. It’s a crime that he’s walking around spending the millions he got from writing a guilt-free memoir.
    When he flogged his book in NYC, I shouted out from the back of the room that he should be under arrest, and that he should stop calling himself a libertarian. A lot of people agreed.

  6. Bob Says:

    Professor Rizzo and Bill,

    Thanks for the responses. I think I understand what you’re saying. I’ll go look into the Taylor Rule some more.

  7. Bob Murphy Says:

    Mario wrote:

    There is no “rational” political standard or test to apply ex post.

    I think the test the Reps and Dems will apply is the net gain or loss of seats in the 2010 elections. Except for the three senators Who Shall Not Be Named, every Republican opposed this thing. It is Obama’s baby, for good or ill.

  8. Bob Murphy Says:

    Bob,

    I try to flesh out the empirical claims linking the housing boom to the Fed here and then here.

  9. Joe Calhoun Says:

    While I agree that a supply side approach would be better, I think there is another piece of the puzzle that needs to be addressed – the dollar.

    The value of the dollar affects investment decisions and the fact is that when the value of the dollar is falling, housing prices rise as do commodity prices. Faced with a loss of purchasing power, investors rush to the real.

    Furthermore, tax cuts will be somewhat ineffective in the absence of a stable dollar. I think we have some real world evidence of that from recent policy when we got tax cuts in combination with a weak dollar policy. Malinvestments are not caused solely by interest rate policy but are also influenced by the course of the dollar.

    One could argue that the Fed caused this mess and they certainly had a hand, but Treasury holds the dollar portfolio and has to take their share of the blame as well.

    One can also argue that a rising dollar has ill effects. I would argue that the large rise in the dollar in the late 90s had a role in the internet bubble. If the Fed had initially met the demand for dollars and stablized its value, we wouldn’t have seen the huge inflow of investment into the internet sector.

    It seems to me that what we should be concentrating on is policy directly aimed at first strengthening and then stabilizing the value of the dollar. Policies that do that will result in better economic performance.


  10. Mario,

    Didn’t the monetary policy mistakes start much earlier than that?

    Just as in the 20s we had strong productivity growth masking the impact of credit inflation on the PCE. The 90s also saw an improvement in the terms of trade which had a similar impact.

    (So the Fed created inflation in the domestic sector to offset falling prices in traded goods and high-tech sectors. This is also the driver of deindustrialisation as bubble sectors bid resources away).

    So there was little concern about the build-up of credit following the loosening of reserve requirements in the early 90s and their effective abolition in 1995. Instead it was welcomed as ‘financial innovation’.

    Excessively loose monetary policy from 2002-2005 was, after all, a deliberate policy mistake in response to the unpleasant aftermath of the tech bubble. Bill Gross and others called at the time for the inflation of a new bubble in housing, and evidently Greenspan had the same idea.

    Joe Calhoun,

    I am really not sure that the rising dollar to come over the next couple of years is something that should or will be welcomed.

    It reflects a credit growth drought as people scramble to sell assets and repay their fixed dollar notional liabilities.

    It might be instructive to plot a chart of the SPX against the inverted DXY (dollar index).


  11. [...] Why Obama’s Stimulus Won’t Work [...]

  12. Andrew Says:

    The only ‘stimulus’ that will ever be effective is of the nature of the stimulus of WW2 expenditure. That is – consumption replacing investment expenditure.

    What many seem to overlook or forget, is that WW2 policy wasn’t about jacking up consumption expenditure, it was about enormously increased investment expenditure, financed, in affect, by cutting consumption, not by increasing it.

    Consumption replacing investment is the way to go (if any), as opposed to those awful ‘Keynesian’ AS-AD models that imply that we can ‘spend’ our way (back) to prosperity. The WW2 model was the very antithesis of these modern models, as were the results. Namely, a return to high output and full employment that set up the 1st-world economies for a generation, but falsely claimed by the Keynesians’ as being a result of their own ideas.

  13. Andrew Says:

    The only ‘stimulus’ that will ever be effective is of the nature of the stimulus of WW2 expenditure. That is – consumption replacing investment expenditure.

    What many seem to overlook or forget, is that WW2 policy wasn’t about jacking up consumption expenditure, it was about enormously increased investment expenditure, financed, in affect, by cutting consumption, not by increasing it.

    Consumption replacing investment is the way to go (if any), as opposed to those awful ‘Keynesian’ AS-AD models that imply that we can ‘spend’ our way (back) to prosperity. The WW2 model was the very antithesis of these modern models, as were the results. Namely, a return to high output and full employment that set up the 1st-world economies for a generation, but falsely claimed by the Keynesians’ as being a result of their own ideas.

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