Kerry Stirton, a New York-based investment manager formerly of Goldman Sachs, is a long-time student of macroeconomic trends and financial public policy. Each week he will examine a facet of the current economic situation, reviewing the best thinking on the topic, filtered by his own. Today, he begins by reviewing the matter of stimulus, central to the debate in Washington and Ottawa.
Milton Friedman would not approve.
The U.S. free-markets economist and Nobel recipient once famously said: "If you put the federal government in charge of the Sahara Desert, in five years there'd be a shortage of sand."
But he's no longer around to condemn the current enthusiasm for government stimulus, which suddenly enjoys a remarkably broad consensus. The current basic approach in Washington and in New York proceeds this way: "What's Plan A? Answer: Massive fiscal stimulus. What if it doesn't work; what's Plan B? Answer: More massive stimulus."
The questions that economists and politicians are really grappling with right now are occurring at a different level of emphasis:
How much stimulus is enough?
How much of a multiplier on spending can we expect?
Are direct spending programs more or less effective than tax cuts?
At precisely what should the direct spending be targeted?
When will we see the benefits?
This is where the differences start to emerge, in both economic theory and in political practice.
The Democrats - with Barack Obama and the director of the National Economic Council, Lawrence Summers, in the lead - tend to favour large-scale direct spending programs on projects they conceive as multiplier-rich public goods: hospital and school infrastructure, clean energy technology, highway and transmission line construction. These are areas where they think the private sector would not be stepping up, especially in this under-capacity economy.
The main arguments are that direct spending can target long-term, strategically beneficial priorities, yet get three to four million people back to work quickly, according to the president-elect. The programs cannot be hijacked into savings accounts or stuck under mattresses as tax credits can be. Invoked as supportive authority for this approach are John Maynard Keynes and the reinvestment programs of the Thirties and the period around the Second World War spawned by Keynes's thinking. That said, the proposed program is a real political compromise that throws together a large tax cut of about $300-billion with nearly $500-billion in direct spending.
Republican economists tend to agree that a sizable stimulus is needed, but prefer monetary tools and tax cuts. They think direct spending is misdirected and slow. They see such spending as inevitably wasteful because it comes in a pressured and artificial manner, and is not allocated by pricing mechanisms in the market; with lower multiplier effects than tax cuts. They prefer tax cuts, because in theory they could start going to work as soon as they are passed into law, as people should know they have more take-home income.
But regardless of left-right balance, most economists will acknowledge that even if a spending program's multiplier effects are reasonably positive, the effect unavoidably lags. Promises of millions of created jobs in the very short term are probably not well grounded. As Anthony Karydakis, former chief U.S. economist for JP Morgan Asset Management, now teaching at Columbia University, states:
"The potential of such a package to turn the economy around in any meaningful way in 2009 is actually quite limited. In fact, it is nearly impossible to alter the trajectory of economic activity over the next two to three quarters, fiscal stimulus or not. ... Over that time frame, the economy will simply do what it is already on track to do, which is essentially to experience additional contraction."
So, more specific and nuanced arguments are now coming into the discussion, and presumably there will be more in the next few weeks. A group of 49 Nobel recipients has recently weighed in with their support for the Obama program, with their own twist. Citing the high state of readiness of thousands of already approved scientific research programs that are just waiting to find some money and hire staff, they contend that the "science multiplier" is higher than other multipliers and argue that well-paid jobs will arise, virtually immediately, in ways that will induce private capital to be invested in the eventual commercial applications, while the resulting discoveries improve the competitive advantage of the nation in all sorts of unseen ways. As two of them have written: "Money could be spent within weeks of passage of a stimulus to fund the many highly rated applications that have been waiting for support in 2008 and to restore dollars from funded grants in recent years." That a dollar spent on a new asphalt covering is worth the same as a dollar spent on scientific research does seem a stretch. Still, there are many views on multiplier coefficients out there. Harvard professor Greg Mankiw cites as authority on this issue a recent study by Valerie A. Ramey, an economist at the University of California. Looking at U.S. history, Prof. Ramey estimates that each dollar of government spending boosts GDP by only 1.4 dollars. You get 40 cents extra in private-sector spinoff activity for every dollar spent by government, whereas Prof. Ramey sees tax cuts having more than twice that kind of multiplier outcome over time. Others on the other side of the spectrum have this relative effectiveness assessment reversed. It turns out, however, that last year's Nobel laureate in economics, Paul Krugman, does not see the multiplier much differently, at 1.5 times. But the challenges of direct-spending efficacy have him arguing for even more aggressive use of the public purse. In his strongly worded opinion, and not without its basic logic:
"Given sufficient demand for its output, America would produce more than $30-trillion worth of goods and services over the next two years. But with both consumer spending and business investment plunging, a huge gap is opening up between what the American economy can produce and what it's able to sell. And the Obama plan is nowhere near big enough to fill this "output gap" .... Even the CBO [Congressional Budget Office] says that 'economic output over the next two years will average 6.8 per cent below its potential.' This translates into $2.1-trillion of lost production. ... to close a gap of more than $2-trillion - possibly a lot more, if the budget office projections turn out to be too optimistic. ... The bottom line is that the Obama plan is unlikely to close more than half of the looming output gap, and could easily end up doing less than a third of the job."
Against this backdrop, the methods and the magnitudes of the stimulus are the key issues, and have become more controversial with each passing day. Lobbyists for often-conflicting special interests have been marching hard through Congress this week. And with the TARP bailout a fresh sore spot, temperatures are rising again. Congress balked last fall in the first vote for the financial rescue. It seems increasingly conceivable that a snag might occur to forestall quick passage of Mr. Obama's American Recovery and Reinvestment Plan.