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Sunday, December 14, 2008


Today's Buggy Topic

It's found in a long thread at Economist's View, an unusually informative economic blog run by Professor Mark Thoma of the University of Oregon --- himself a moderate centrist, with Keynesian inclinations in macroeconomics.  Meaning?  In effect, there tends to be at times a systemic market-failure in the private economy, owing to a variety of influences, that prevents it from achieving full employment on its own . . . especially when there is mass uncertainty in financial markets about the near- and mid-term future of the economy's growth and price-performance.

The Keynesian Spectrum in Economics

Most Keynesians these days --- called New Keynesians --- locate the trouble in price and wage-rigidities in the face of rising unemployment.  One cause of these rigidities: what are called menu-costs, all sorts of contractual arrangements and transaction costs in changing them that make it difficult for business firms to reduce prices quickly in response to declining demand for their products, whether goods or services.

Another cause . . . in particular for the stickiness of money-wages in the face of declining business profits and rising unemployment?  It lies in what's called "efficiency wages:" specifically, business firms are reluctant to harm the morale of their more senior, better-trained workers by reducing their money wages --- even, as in the Great Depression, in the face of a falling general price-level and hence with reductions in money wages offset by reductions in the price falls that keep real wages at the same value as before.  Then, too, retraining new workers for specialized tasks --- even assembly-line production of, say, cars --- can be expensive and take time.  And finally, in case of inflation --- the opposite problem we now face, mind you --- workers who demand and get nominal (money) wage increases early on, before workers in other firms even in the same industry, actually experience an initial boost in their real wages.  New Keynesians call this a system-wide coordination problem.

The Outcome?

In the face of these market-failures that prevent the US economy, to stay with it, from achieving both full employment and price stability on its own --- exactly the opposite assumptions that enter into the New Classical theorists who have dominated economics for the last three decades --- New Keynesians emphasize the need for active and adaptable monetary and fiscal policies by the Federal Reserve for the former policies and, at times of serious recession like now, fiscal stimuli.

Enter the question: which stimuli are likely to be the most effective in enhancing GDP growth? Macro-economists, starting with Keynes (who drew on the work of some younger colleagues), call these multiplier-effects.  For which $1 spent by the government will you get the biggest bang in dollar-terms for increasing GDP?

The Controversies

It is the disputes among economists about these crowding-out effects that complicate the calculations of multiplier effects.  At the extreme, the dominant free-market theory about the business cycles these days --- especially the recessionary tendencies --- is that no government fiscal stimuli will work, and for that matter the same is true of expanding the money supply as Milton Friedman, the most influential free-market theorist of the last century, contended.  (Friedman regarded Keynes as the first modern monetarist.) 

That New Classical theory is called real business-cycle theory, its two pioneer theorists, Edward Prescott and Finn Kyland, shared a Nobel Prize a few years ago . . . Kyland, observe, now at UC Santa Barbara, Prof bug's former university.

The crux of real business-cycle theory?  Recessions and the inevitable upswing away from them into a boom phase are the result of "real" shocks to the economy, especially in the impact of technological  change and how it affects the marginal productivity of capital.  And since these are real shocks, neither fiscal nor monetary policies can offset them.  If anything, efforts to deal with nominal (money-supply changes) or fiscal stimuli will only prevent the US economy from recovering its long-term potential growth trend . . . the latter set, as even Keynesians fully agree with, by strictly supply-side influences: growth in capital investment, growth in the labor force and its quality, and technological progress.   

There Are Only So Many Spending Alternatives and the Problems of Crowding-Out

And all of them have to take into account, when considering multiplier effects, what their impact will be on private market consumption and investment, as well as on US exports and imports.  For instance, you don't want to "crowd out" private investment with the increased government spending being financed by the Federal Reserve selling the new US Treasury bills and bonds in financial markets that would divert those private savings (capital) from being used for private investment . . . as a result, say, of rising interest rates.  The latter, of course, is not a big concern now that we face a system-wide financial crash, the first time since the 1930s; but it will emerge as a consideration once the economy recovers again.  And --- as the Reagan and Bush-W eras have shown --- tax cuts that lead to large federal government deficits end up "crowding out" US exports, making them more expensive as foreign capital pours into the US to buy the new US Treasury bills being issued to finance the growing federal deficits.  And, if you're trying to target increased household consumption, you want to minimize leaks out of US economic growth into more and more expenditures on imported goods.

So What Are the Fiscal-Spending Alternatives and What Are the Predicted Multiplier-Effects of Each?

  • Tax cuts as happened earlier twice in this decade, financed by growing federal deficits (the opposite of what Bush and libertarian economists claimed would happen)
  • Tax cuts linked to promised and actual reductions in government spending . . . something that has never happened, even in the Reagan period when big government was supposed to be the problem, not the solution
  • Note that either of these tax cut policies can be implemented with promises to be temporary or permanent
  • Increased unemployment benefits: both in dollar terms and length, with the assumption that the unemployed will be able to help boost private-market consumption . . . quite apart, of course, for humanitarian motives behinds the benefits.
  • Increased poverty spending.
  • Federal government support for local and state governments, the latter's budgets badly strapped and most of them unable to run fiscal deficits legally (and the last thing you want in a serious recession is for them to raise taxes).
  • Increased military spending . . . which certainly ended the high unemployment levels that fast economic growth in the New Deal era didn't end until World War II.
  • And various kinds of infrastructure spending, with of course private construction firms and state-and-local employees who specialize in road-and-bridge construction, the electrical grid, dams and irrigation systems, airports and railway systems, public transportation, port-facilities, and for that matter --- depending on what you target --- education and health facilities.

Enter the Buggy Take on This

Professor Thoma began his thread with a lengthy and highly illuminating set of his comments, plus extensive quotes from other economists about the best way to increase fiscal spending --- to get the biggest bang for each buck spent.  The buggy prof joined the thread of posted-replies with a lengthy analysis of his own.  It's actually a revised version of an earlier analysis on the same subject that prof bug posted on December 5th, 2008 at the Marginal Revolution (a good and flexible libertarian web site).  When, please note, prof bug writes up his extensive analyses and comments an d posts them at other web sites, he bangs them out at bursting speed, and seldom does any revision except for running a spelling check.  This time, because he had some free time on his hands, he took the initial post and revised it with an eye to more coherence and sharpening the analysis. 

Click here for Professor Thoma's stimulating commentary and the extensive quoted materials and for prof bug's reply.