Friday, January 23, 2009

Barro on Obama-nomics

From Robert Barro in the WSJ...

Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called "multiplier" effect of government spending on economic output is greater than one -- Team Obama is reportedly using a number around 1.5.

I've blogged on the Laffer Curve previously. The difference is that supply-side is logically a given; the only question is the extent. The demand-side requires significant idle resources which will be effectively harnessed by the govt-- two difficult assumptions.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment.

The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful....Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system....

One of the ironies of the Great Depression is that the govt itself was a prime cause of prices not working-- through wage/price floors, moral suasion to keep wages higher, lots of legislation that strengthened labor market cartels (unions), and so on.

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports. In other words, the social cost of one unit of additional government purchases is one.

This approach is the one usually applied to cost-benefit analyses of public projects. In particular, the value of the project (counting, say, the whole flow of future benefits from a bridge or a road) has to justify the social cost. I think this perspective, not the supposed macroeconomic benefits from fiscal stimulus, is the right one to apply to the many new and expanded government programs that we are likely to see this year and next....

What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II....the multiplier was 0.8 (430/540)....Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.

We can consider similarly three other U.S. wartime experiences -- World War I, the Korean War, and the Vietnam War...yields an overall estimate of the multiplier of 0.8 -- the same value as before....

There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases....


At January 24, 2009 at 10:55 AM , Blogger Bryce Raley said...

Even if these Keynesian theories worked, which I don't believe they do; then I would like to see the affects analyzed in context. Today we have a huge national debt and budget deficit. Our money is no longer backed by a real asset like it was in all the war times mentioned in the article. In the context of current deficits, a fiat currency and a new global economy, how does this change Keynesian macro policies. I think it would make them even worse.

If government intervention into the Great Depression lengthened the depression from 5 years to 10, which seems to be an idea gaining traction; then what would massive government intervention do to this current recession. Turn it into a depression instead of a 3-4 recession?

It seems to me people are doing smart things. It seems we are spending less, saving more and living simpler for example. Companies are going out of business or reorganizing. Lots of things that are tough to stomach but necessary to bust this bubble. Now if right when we're getting through the dip or over the hump, the government flips the switch and says spend again, how will it set us back. Not to mention the massive increase in regulation that this stimulus would require. Also, the trickle affect of socialization of more industries. Banking happened right before our eyes and the majority of Americans said nothing.


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