More on the likelihood of a recession (and its causes if it happens)

If everybody was predicting a recession before the employment numbers last Friday,* now it has become an unanimity. The story is of course the uncertainty caused by the tariffs and the collapse of investment (a second story, far behind in popularity, is that profit squeeze, also caused by tariffs to some extent, caused the decline in investment). I should note that most stories in the press are vague about the mechanism for the recession. But when pressed most people fall into the uncertainty story.

First, let me discuss briefly the numbers. GDP grew significantly in the second quarter, if one looks at the BEA Report, also released last week, at 3% (see figure below). Of course, as noted before, when the numbers of the first quarter come out, the whole story was in the import numbers. Huge increase in the first quarter (imports subtract from GDP, making growth negative), and large decline now, explaining the growth spurt. As noted before, in that same post, GDP is simply slowing down. Ray Fair has suggested that in the last forecast of his model, before the election last year. No surprises there.

 

A better way of looking this is that growth is slowing down after a spurt that was caused by the rapid -- and I must add, bipartisan -- increase in spending after the pandemic, and the infamous (worst mistake in 40 years, according to Larry Summers) US$ 1.9 trillion fiscal package. The economy is sliding into lower rates of growth, now a little below 2% (see below).

Why was GDP slowing down, and even Fair forecasts suggested that before Trump's election victory, one might ask. The reason is that the fiscal expansion had basically given way to a less expansionist stance, and monetary policy had been tightening over the last two years. In fact, the most troublesome part of the two BEA reports this year is the slowdown in the government spending contributions to economic growth (negative in the first quarter, and only slightly positive in the second; and consistently negative at the federal level), with a large fall on non-defense spending in the second quarter (see this table).

Again, whether this would eventually continue is to be seen. It seems that the DOGE/libertarian wing of the GOP has lost internally, but the Big Beautiful Bill was more about cutting taxes (for the wealthy; and spending for the poor) than about expanding spending (even defense spending). This is not exactly Reaganomics (I'm not even talking about the tariffs).

The other thing is the effects of interests rates, which the Fed had also kept in place a couple of weeks ago, prompting lots of insults from Trump, and a renewed defense of the central bank by many progressives (I need to write about the new breed of Free Trade/Central Bank Independence progressives). As I have discussed before, a key variable here is Private Residential Fixed Investment, shown below. As I noted before, only four times this variable became rate of change was negative and a recession did not follow (In the early 50s, because of the Korean War, the late 60s, because of Vietnam, the early 90s, with the dot.com bubble, and in 2023, as a result of Biden's fiscal package, only possible in the post-pandemic context). Now this is again moving dangerously close to the negative space. This is where the big risk of a recession comes from. High interests that affect the ability of households to consume, that is tied to mortgage interest rates (which depend on the Fed policy rates). not surprisingly consumption has also grow sluggishly after an initial decline (even with wages at the bottom still growing more than inflation).

Interestingly enough, on this (and only on this), Trump seems to be right, and Powell wrong, even if you think that Powell is a decent man (I'm not sure anyone would be confused about Epstein... I mean, Trump). Lower interest rates would be important to avoid a recession. So it would be the case with a more robust round of spending on social transfers like we did during the pandemic. But that is certainly not happening. The mood has turned against fiscal policy, even among progressives. Not that there is any risk of a fiscal crisis. On this the MMT crowd is correct.

But as a conclusion: it is NOT the uncertainty of tariffs, or its effect on profits and investment (which is merely reactive to the level of activity). It is macroeconomic policy, or the mismanagement of the macro policy to be more precise, that might cause a recession.

* And yes, before anyone says anything, it was nuts to fire the BLS head. I doubt, however, that he will be able to cook the numbers, and think that even with a crony (I hope not) the BLS is a strong institution that will basically report the numbers, as it has done so far. 

Alan Blinder on Fiscal Adjustment

Alan Blinder published recently two columns on the WSJ (here and here) on the need to exercise fiscal restraint. In both cases he complains that the fiscal deficit is too large. Note that he is not saying that this is always the case, he emphasizes that in the second and most recent piece. The reason, as always, is that we are close to full employment. In his words:

"... today we are back at full employment, or perhaps beyond it, ad economic growth kooks solid. The economy doesn't need fiscal stimulus."

Blinder one must note was strongly for hiking rates in the mid to late 1990s, when he was the vice chairperson at the Fed, exactly for the same reasons (see this old piece in The American Prospect).  So at least he is coherent. We cannot grow too fast, since that would cause inflation. And we have a tendency to be at full employment (note that a few years back almost everybody said full employment, the natural rate, was about 6%, not the 4% or so we have). But if he is coherent, he has also been almost always wrong.

And we are not at full employment. The employment-population ratio (seen below) has finally started to recover in the last three years, but it is still well below the peak before the recession, and the participation rate (not shown but available here) has been stagnant.

That means that too many people remain discouraged about the situation in the labor market, and that when we look at broader measures of unemployment that look at those marginally attached to the labor market the level of unemployment is closer to 8% (see here). And let's not forget that the last two decades saw an impressive decline in manufacturing jobs that reduced the availability of good jobs. So the issue is not just the number of jobs, but the quality of those. It should NOT be a surprise that Trump won in some Rust Belt states.

Dems, and their economists (like Blinder), should be more sensible about the need to create more jobs, and particularly good jobs if they want to regain the White House and Congress. I would suggest that austerity is a terrible strategy. This is what you should expect from the Progressive-Neoliberal branch of the party, as it was aptly called by Nancy Fraser.

The IMF and fiscal policy

This is a topic I discussed several times here (for example, here, here, here, here or here). Now there is a paper by Marc Lavoie (with co-author) in Intervention, on the same topic. The paper notes that: "There is a paper by Vernengo/Ford (2014) that covers some of the same ground. Their conclusion is that the 2008 crisis prompted only some cautious change in the views being entertained at the IMF" (my paper with Kirsten is here). Just to clarify, that's not exactly our point. The point we make is that while the research department has changed some of their views, without discarding the crucial concept of the natural rate of unemployment in their analytical framework, the policies pursued by the IMF changed very little indeed. So that there is a kind of double discourse. I referred to something like that within the mainstream of the profession as organized hypocrisy. Double discourse in theory, with no significant change in the theories that underlie the policy, and almost no change in policy.* At any rate, as anything that Marc writes this paper is worth your time and attention.

* In our intro we say: "It is concluded that even a most optimistic reading of IMF reports and country arrangements disappoints. The power structure ultimately remains the same: the Fund continues to be the mechanism through which creditor countries enforce contractionary policy on indebted countries." So, in our view, nothing really changed. more window dressing than anything else going on.

Trump's budget

The figure from the New York Times shows the changes in spending by category. More defense and less social spending. Not a surprise there. Schumpeter long ago (in his The Crisis of the Tax State) suggested that it is the fiscal history of a society that explains the spirit of the people and the character of the government, since it is there plain to see by those that can read it what they are trying to achieve.

The surprise to me, at least so far, is that the increase in defense seems to be more or less cancelled by the cuts in social spending. I suppose the stimulus part of his fiscal plan will come just from the tax cuts. If that is the case, I would not be too optimistic about the Trump boom.

Will Trumponomics be expansionary?

Deficit vultures

A few days ago, Trump announced South Carolina Rep. Mick Mulvaney to be the director of the Office of Management and Budget. He is a Tea Party nut (he was for Rand Paul, and might have libertarian tendencies), and more importantly a fiscal hawk, and for a balanced budget amendment. Mulvaney is really for cutting spending, including, somewhat surprisingly, military spending, even if he thinks that defense is the first priority of the federal government.

So this has created a certain uncertainty about what direction fiscal policy will take in the next administration. Tyler Durden at Zero Hedge has said that: "it is difficult to reconcile this appointment, with the market's increasingly conventional view of Trump as an "out of control" spender." I may be wrong, but I think Mulvaney would be as adept to balanced budget, and strict debt-ceiling limits as a budget director, as an old fashioned tax and spend Democrat. But without the taxes, of course. So I still believe that there will be an increase in deficits, and it's likely that defense and infrastructure spending increase, while taxes, for corporations and the wealthy go down.

Trumponomics is Reaganomics. And as much as fiscal hawks preach the advantages of low deficits, and reduced spending (on entitlements), they do increase both once in power. By the way, I do expect an assault on entitlements. I don't believe that the deep convictions about debt management are in general. It's basically strict fiscal rules for Dems, and loose rules and pork barrel spending for the right wingers. It's predatory capitalism, as Jamie Galbraith would call it. Another interesting nugget in the Durden post, is that Mulvaney is in favor of full privatization of Freddy and Fannie, something that I'm sure would be okay with real state broker in chief.

Interest rates are up, and what is the real problem with that

Not by much. To 0.75%, and yes it wasn't necessary because we're not at full employment yet (Krugman thinks we're; his point is that wages are increasing again, but not that much and participation rates remain low). Two things worth mentioning. One is that Yellen agrees with Krugman, and that signals that the Fed doesn't get what's the current state of the economy. She said:

"I believe my predecessor and I called for fiscal stimulus when the unemployment rate was substantially higher than it is now. With a 4.6% unemployment and a solid labor market, there may be some additional slack in labor markets but I would judge that the degree of slack has diminished. I would say at this point that fiscal policy is not obviously needed to provide stimulus to get back to full employment."

Again, fiscal policy was needed to get a healthy recovery according to Clinton's plans, and it is also true under Trump. I know Trump won't expand the welfare net, quite the opposite, and some of his spending will help his businesses and his cronies. But some infrastructure spending will do some good. And it's needed.

The other important misconception is that Trump's possible fiscal stimulus won't work. Krugman says:

"Meanwhile, Trump deficits won’t actually do much to boost growth, because rates will rise and there will be lots of crowding out. Also a strong dollar and bigger trade deficit, like Reagan’s morning after Morning in America."

First, that's not crowding out per se. In other words, it's not that the use of funds by the government crowds out private investors. It's more like monetary policy will be used to counter the fiscal expansion. But the previous experience with contractionary monetary and expansionary fiscal (militaristic and welfare cutting and full of cronyism too), yeah the Reagan era, led to significant growth, with increasing income inequality.

I'm skeptical that interest rates will go up by a lot. But let's say I'm wrong and Yellen decides to do that, and Trump does expand military and infrastructure spending. That danger is not an overheating economy and too much inflation. It's increasing income inequality. Higher rates will make the life of workers and debtors (consumers, kids in college, etc.) considerably harder. The stimulus will create jobs, but not good manufacturing jobs with high pay. More McJobs. And yes, economic growth, which might help in a reelection campaign in 2020.

Trumponomics might just be Reaganomics on steroids, but Krugman misreads the main danger. The trade deficits didn't stop growth (and won't this time either). Besides the manufacturing jobs wouldn't come back even with a very large depreciation (we're not about to pay Chinese salaries in the US). It's inequality stupid!

Lord Eatwell in the Financial Times

A short Letter to the Editor, but worth reading. He clearly explains the policy failure since the global crisis and the reasons for the current problems in financial markets in developed and developing countries. He says:

The adage that, in the absence of the prospect of growing demand, cheap money amounts to “pushing on a string” has been once again confirmed in advanced economies by the slowest recovery from any modern recession. Instead of funding real investment, monetary expansion has resulted in a boom in asset prices — not just in real estate and equity markets, but in the flow of funds into emerging market corporate bonds in the search for higher return. All these asset markets are extremely unstable, as is now all too evident. And, as has been once again demonstrated in the last 7 years, financial instability leads to substantial real economic loss.

Yet in the face of evident policy failure, and of severe asset market distortions that can only lead to further financial instability, the response seems to be “more of the same”, or even, in the case of negative interest rates, “very much more of the same”. There was a significant fiscal expansion in the US in 2009 that had a clear positive impact. But the federal government lost its nerve and reined back on the expansion just as it was gathering pace. The quiet abandonment of severe austerity by the UK government in 2012 at least enabled something of a recovery, albeit fuelled by growing household debt. Fiscal policy works. 

Given that the cost of funds to most governments is today negative in real terms (and sometimes in money terms too) it is difficult to understand the failure to initiate a major expansion of investment in infrastructure and the other major components of “supply-side” strength. This failure is resulting not just in a loss of output today, but a long-term loss of competitive productive capacity (a particularly severe problem for the UK). Fiscal policy can provide the pull on the string required to validate the monetary push.

Read the full letter here (subscription required). Pushing on a string as an explanation for the inefficiency of monetary policy in a crisis was a term popularized by Marriner Eccles, by the way.

Scalia, Partisanship bias, and Long Term Stagnation

So a student asked me if the nomination for the Scalia vacancy at the Supreme Court would have any macroeconomic impact. Can't imagine what kind of effect he was thinking about, but there is a relevant question on what are the effects of the inability of the legislative to get things done. The most obvious is the inability to pass a budget that deals with the slow recovery.

It used to be the case that both parties had a a very different fiscal agenda, with Democrats being for tax and spend, in particular spend on social welfare, while the GOP was for, at least nominally, for small government. And up to the Vietnam War, hawks tended to be Democrats (certainly before World War-II, most isolationists were Republicans). But as I noted before, there has been a switch in both parties, with the GOP being since Gerald Ford the party of Big Government.

In part, the switch is explained by the fact that the GOP has become the party of the neocons, and of the shadow government that requires contracts for the Military-Industrial Complex. Big Government for corporations so to speak. And low taxes for the wealthy, hopefully allowing debt to accumulate, and creating the conditions for cutting welfare programs and spending. Democrats too have accepted some of this logic, as the speaking fees of Hillary Clinton seem to indicate (but that's another story).

At any rate, it used to be that even though the parties had different priorities, at least it was agreed that certain things were necessary (like appointing Supreme Court justices). That included, for example, spending in infrastructure. And the inability to have a healthy fiscal package after the crisis, in my view, and not a long term problem with the technologies associated with the third industrial revolution, as Robert Gordon thinks, is what is behind the new normal, the lower growth in output and productivity.

I've deal with demand driven views of labor productivity before, here and here, but there are more if you search the archive.

Austerity, class warfare and weak labor markets

Labor market still weak. New BLS report says that: "total nonfarm payroll employment increased by 142,000 in September, and the unemployment rate was unchanged at 5.1 percent." Also: "average hourly earnings of private-sector production and nonsupervisory employees were unchanged" and revisions meant that "employment gains in July and August combined were 59,000 less than previously reported." Not enough job creation, labor participation falling, and wages stagnant. Secretary of Labor said, correctly, that an infrastructure bill would be needed to get us out of the slow recovery. That used to be a bipartisan policy. Nobody was against fixing roads and bridges.

But the chances for expansionary fiscal policy are nil. The US has adopted, basically since 2011, a contractionary stance. This basically results from the politics of hostage taking in Congress, and while we narrowly avoided a government shutdown this week, it is very likely that the budget and the debt ceiling limit would lead to one before the end of the year. Class warfare, and attack on labor, is at the end of the day the basis for this irrational fiscal policy, as I discussed a couple years back after another shutdown was in the news.

PS: I'll be discussing some of these issues later today (4pm Eastern time) at the Rick Smith Show.

Smithin on Endogenous Money, Fiscal Policy, Interest and Exchange Rates

New Working Paper by John Smithin. From the Introduction:

One of the main collective contributions of the various heterodox schools of monetary thought, such as circuit theory, Post Keynesian theory, in both its horizontalist and structuralist versions, modern money theory (now known simply by its acronym MMT), and others, has been to stress the importance of the endogeneity of money via bank credit creation. This issue was hardly discussed at all in the economics mainstream after Keynes’s death, not until the very end of twentieth century and the beginning of the twenty-first.

Read rest here.

Austerity Sucks: Mark Blyth on the follies of US budget policy

The following is from a presentation before the US Senate by Mark Blyth, author of “Austerity: The History of a Dangerous Idea” It is a scholarly rebuke of mainstream notions about public debt and investment in social welfare that are driving domestic economic policy.

My name is Mark Blyth and I am the Eastman Professor of Political Economy at the Watson Institute for International Studies and Brown University in Providence RI. I am also the author of a book entitled Austerity: The History of a Dangerous Idea (Oxford University Press 2013) a book, which oddly just received a national award in Germany, the country most associated with budgetary austerity. Given that irony is not a German national trait, it might be the case that even the Germans are re-thinking their stance on balanced budgets. As I shall show you today, it’s really not working out so well in Europe and it would be a disaster if it were tried here too.

And yet balancing the budget as a matter of principle is intuitive. After all, you can’t spend more than you earn. It is also appealing. After all, people want more money in their pockets rather than less, so spending ‘other people’s money’ now so that they would have less in the future because of debt interest repayments seems to be the height of folly. But balancing the budget because of these arguments is also folly. While they are intuitive, these arguments are systematically wrong, because they are based upon two faulty analogies: one drawn between households firms and states and another between savings always being good and spending always being bad. I begin by taking each in turn before giving more specific examples.

Read rest here. Blyth’s presentation is viewable here, starting at the 46:20 mark.

US Interstate Transfers and the Euro Crisis

by Nathaniel Cline and David Fields

It is recognized among heterodox economists that the fiscal crisis some Eurozone countries faced (and are facing) is the result not of internal fiscal excess but of fundamental imbalances made worse by the adoption of a common currency. Indeed, as Wynne Godley pointed out (in several pieces) long ago, European structural payment imbalances will not be automatically corrected by market forces. In this case a common currency without centralized fiscal powers will potentially exacerbate the balance of payments problems of member countries. Some countries will be permanently outsold, and under the current arrangements, are forced to make large income adjustments to resolve their balance of payments.

As a result, many (even in the mainstream) have suggested that a common fiscal union would resolve the problems these countries face. Comparisons have been made to the US whose member states enjoy a common currency with a substantial federal fiscal system that redistributes funds among the states. Residents of states pay taxes to the federal government and states receive government expenditures (through federal programs, grants, salaries, and other means). However the payments states receive are decided upon different ground than the taxes they pay. Thus a state like Mississippi pays very little in taxes, but receives a substantial amount of government spending. In contrast, states like Minnesota pay in to the system much more than they receive.

In normal times this prevents large balance of payments crises from emerging between states. Mississippi is thus permitted a higher average growth rate than would otherwise be implied by their balance of payments.

It is misleading however to assume from these large transfers that simple fiscal transfers between states would resolve Europe's fiscal problems. In a recent presentation to the Eastern Economic Association, Dave Fields and I argued that in fact, the US did not respond to the crisis by transferring large amounts of money between states as it does in normal times.

The key point was that US federal government went into deficit to transfer money to states as a whole. The relevant transfer in the crisis was then not among states, but between states and the federal government. What is needed then is a Euro deficit which would finance all member states, and not necessarily transfers between say Germany and Greece in the middle of a crisis.

The degree of interstate transfers in the US is shown below. Note that between 2004 and 2007 it appears that the federal government is actually a net drag on the states. This is likely not quite correct because the expenditures in the chart do not count expenditures which cannot easily be allocated among states (like for instance federal interest payments).

The Degree of Interstate Transfers 2004-1013

Source: Expenditures provided by the Pew Fiscal Federalism Initiative, tax data from the IRS, author's calculations

The issue can be seen clearly too if the transfers are broken down by state as is done in the chart below. One can see that by 2009, only a few states remained net contributors to the system while the others all became net recipients (including by the way both California and Texas). 

Fiscal Transfers Between the States 2008-2009

Source: Expenditures provided by the Pew Fiscal Federalism Initiative, tax data from the IRS, author's calculations

How Stimulative Has Fiscal Policy Been Around the World?

So a student asked me if I wrote something about how fiscal policy should have been more stimulative after the crisis. The paper written in 2010 with Esteban Pérez seems to hold well after more than 4 years. From Challenge Magazine's short intro:

The current credit crisis and worldwide policy response have resurrected the reputation of fiscal policy. But the authors contend that it is still widely misunderstood. Many of those who now support fiscal stimulus—such as more government spending—have a limited view of its usefulness, one advocated by the pre-Friedmanite economists of the University of Chicago. It stands in contrast to the more thorough Keynesian revolution, which they argue now more than ever needs to be understood. The result has been far smaller fiscal stimulus packages than are necessary to return nations to rapid growth.

I still like more the original title: All is quiet on the fiscal front. We were worried that fiscal stimulus was not big enough, and concerned that the IMF and governments were overly optimistic about the economy's tendency to full employment. Sounds about right. The Keynesian moment was short lived indeed.

Keynes is all you need

From BusinessWeek:

Is there a doctor in the house? The global economy is failing to thrive, and its caretakers are fumbling. Greece took its medicine as instructed and was rewarded with an unemployment rate of 26 percent. Portugal obeyed the budget rules; its citizens are looking for jobs in Angola and Mozambique because there are so few at home. Germans are feeling anemic despite their massive trade surplus. In the U.S., the income of a median household adjusted for inflation is 3 percent lower than at the worst point of the 2007-09 recession, according to Sentier Research. Whatever medicine is being doled out isn’t working. Citigroup (C) Chief Economist Willem Buiter recently described the Bank of England’s policy as “an intellectual potpourri of factoids, partial theories, empirical regularities without firm theoretical foundations, hunches, intuitions, and half-developed insights.” And that, he said, is better than things countries are trying elsewhere.

Read rest here.

The L-word

Lowflation is the new dirty word now. The Economist says that deflation, not lowflation, in Europe is the world's biggest economic problem. But they also suggest that low inflation (lowflation is the neologism; some suggest that the term was coined by Reza Moghadam from the IMF) is as bad as deflation. In a recent article they note that most countries are undershooting their official or unofficial inflation targets. The Economist says:

"In America, Britain and the euro zone central banks have a 2% target for inflation. In all three, it is below that target. In Italy, Spain and Greece, which have experienced wrenching crises and recessions, it is below zero (as it also is in Sweden and Israel). Japan, which finally escaped from deflation in 2013 after more than a decade of struggle, is battling not to return. Leave out the effects of a consumption-tax increase and inflation there is barely half way to its 2% target. Even in China inflation is below 2%, compared with a 4% central government target (see chart 1)."

They also suggest that the: "the catalyst for the latest deflation scare is ... [the fall in] the price of a barrel of oil ... from $115 at the end of June to about $85 today, prompting a sharp drop in headline inflation." Yes lower commodity prices might play a role, but it is the weak recovery and the excessively contractionary policies in developed countries that are to blame for lowflation.

The Economist at least gets the dangers of lowflation/deflation right, and it's pure Keynes. They say that: "The belief that money made tomorrow will be worth less than money today stymies investment; the belief that goods bought tomorrow will be cheaper than goods bought today chokes consumption." Keynes version of debt-deflation emphasized more the effects of falling prices on debt and investment that consumption, but is essentially the same point. He said: "if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment."

Also, The Economist reports that even Wall Street economists (admittedly Buiter is an Old Keynesian with ties to Jim Tobin) like:

"Willem Buiter of Citigroup thinks this [fiscal expansion] would be a 'no-brainer' for America, which badly needs better public infrastructure and which can issue virtually unlimited volumes of treasury bills thanks to the dollar’s reserve currency status. In Europe, Mr Buiter says, the equivalent would be for the EU to permit peripheral countries to run larger deficits with the ECB independently initiating QE to buy the resulting bonds."

This is relevant, since today many expect the Fed to announce the end of QE. 

Josh Bivens With Another Reminder About the Stupidity of Austerity

By Josh Bivens

[...] there are multiplier effects, so if actual federal government spending was $118 billion higher today (that’s the gap between actual and “should be” spending identified), then overall GDP would be roughly $180 billion higher. So, the policy decision to pursue austerity is costlier (in GDP terms) than just the difference between government spending levels [...] Government transfers—Social Security, unemployment insurance, food stamps, Medicaid, Medicare—are not classified as government consumption and investment spending in the GDP accounts. Instead, they show up as increased consumption spending [...] Most of the political argument has centered on the recovery phase of this cycle, simply because the actual recession began before the Obama administration took office. Further, it’s really only been since 2011 that government spending has been a truly significant drag on growth. Before then, between the Recovery Act and what we have called “ad hoc stimulus measures” (like the payroll tax cut in 2010), we didn’t have real austerity until the fallout from 2011’s Budget Control Act (passed in the wake of Republican debt ceiling brinksmanship in summer 2011) began.

Read rest here.

Mark Blyth's book Austerity: The History of a Dangerous Idea is highly recommended.

CEPR | Stimulus and Fiscal Consolidation: The Evidence and Implications

In a previous post, see here, Matias provided a graph that displayed the fiscal results for the US as a share of GDP from 1993-2014, along with a discussion of the misconception that democrats are nothing but tax/spend liberals. I thought it would be pertinent to post this paper by Dean Baker and David Rosnick providing conclusive evidence on the effects of stimulus packages and fiscal consolidation during the recent economic crisis.

From the abstract:

The first part deals with the most important literature on the subject, the consensus in the research of the past decade attests a clear counter-cyclical effect of stimulus packages during a prolonged recession. The second part deals with the impact of changes in government consumption and investment to growth. For this data for developed countries in 1980 are analyzed. Consistent with much of the previous literature have increased government spending during a crisis has a positive effect on economic growth. In addition, the period is simulated after the crisis, the multiplier effect is around 1.5. The third part focuses on the production potential, which has declined sharply due to the economic crisis. This would have to include a comprehensive model that analyzes the effects of an economic stimulus package with, since the effect could turn out relative to the size of the stimulus package as significant.

Read rest here.

Overall federal fiscal results for the US, 1993-2014

Prompted by my post on Brazil yesterday. Graph below shows fiscal results for the US as a share of GDP.

For more go to the original post here.

PS: On the switch between Democrats and Republicans regarding deficits and the 'size' of government see this debate.

Big government, functional finance and debt sustainability

Teaching the fiscal policy classes of my intermediate macro course. One of the few things that is still not well understood and discussed in manuals is functional finance. Froyen's manual, which is otherwise an old textbook similar to Dornbusch and Fischer or Gordon or any 1970s manual (meaning with short run ISLM and Phillips curve first, and then growth), includes in the policy discussion Partisan Theory and Public Choice, but not Functional Finance or any heterodox approach.

Partisan Theory, developed by Douglas Hibbs, builds on an old idea by Kalecki that political and ideological elements would affect the business cycle. Left of center governments would lead to higher government spending and lower unemployment, and conservative governments would be concerned with inflation, and tend to promote fiscal adjustment. Public choice, more dramatically, suggested that politicians would be guided by selfish desire for re-election, which would lead to a permanent bias for deficits, and accumulation of debt. Big government, and Keynesian ideas, that had unleashed the monster, or so thought James Buchanan, one of the leaders of the Public Choice School, had to be constrained by balanced budget amendments.

When one looks at the data for the United States it is fairly clear that over the last forty something years it has been Republicans that have expanded deficits.

Deficit (% GDP)

In the graph you can see that with Carter (1977-1980), Clinton (1993-2000) and Obama (2009 to 2012 in the graph) the deficit as a share of GDP has fallen, while it did increase with all Republicans [note that with Reagan they increase, and then fall after taxes were raised]. Also, if you have any doubts, Republicans are the party of big government when it comes to spending.

Government Spending (% GDP)

The graph above shows that also spending actually falls with the three Democrats, and increases with the four Republicans (Ford, Reagan, Bush I, and Bush II). This switch on Democratic and Republican views on fiscal issues was discussed here. Obviously there are important differences between the old Democrats, from the New Deal and Kennedy/Johnson era, that wanted big government for social purposes, and the kind of big government promoted by the GOP.

Also, the political economy of why the GOP is for big government, has less to do with Partisan Theory or Public Choice, and more with the starve-the-beast theory, according to which if you cut taxes, then government will eventually be forced to cut spending.

Functional finance, an idea introduced by Abba Lerner, that could be seen as the extension of Keynesian ideas to fiscal policy (Keynes actually had little to say in the General Theory, were he refers vaguely to the socialization of investment rather than fiscal deficits), suggests that deficits should be judged on the basis of their function in the economy. Deficits that promote growth, and take place in an environment of low rates of interest, not only would be sustainable, but would be necessary to promote full employment.

By the way, by historical standards the US net debt (held by the public, i.e. not in the hands of the Fed or the Social Security Trust Fund) is not high at around 70% of GDP, below the peak at the end of the Great Depression and World-War II.

Net Public Debt (% GDP)

The debt-to-GDP ratio did increase after the 1980s, basically as a result of higher deficits on average (both the starve the beast, and more recently the massive recession), but also because until the collapse of the housing bubble rates of interest were on average higher than rates of growth of the economy. The debt-to-GDP ratio did fall in the late 1990s, as a result of the Clinton surpluses.

Mind you, two important points must be noted. First, historically the period in which rates of interest were consistently below growth rates was during the so-called Golden Age of Capitalism, roughly the post-war period up to the 1970s. In other words, in normal times the economy is in the wrong side of Domar's sustainability condition [that the rate of growth of the ability to repay, economic growth, should be higher than the growth of debt, that is, the rate of interest]. That didn't preclude governments to run deficits and accumulate debt. Note that governments have one advantage over private agents, when it comes to spending, namely: government spending is sufficiently large that by increasing general income it leads to higher tax revenue and an increase of its own income.

The second point, for those concerned with the size of the debt, is that the recession, and the collapse of the bubble have created the political conditions for a low rate of interest, which would be very hard to reverse in the medium term. That is, the Fed is unlikely to hike rates while unemployment remains high. Which basically provides space for fiscal deficits and debt on a relatively cheap basis. Of course chances of that happening are a completely different question.

Krugman and the Fear of Wages

Although Krugman is a New Keynesian, who, by definition, oftentimes implicitly assumes a natural rate, he is quite on point:

Four years ago, some of us watched with a mixture of incredulity and horror as elite discussion of economic policy went completely off the rails. Over the course of just a few months, influential people all over the Western world convinced themselves and each other that budget deficits were an existential threat, trumping any and all concern about mass unemployment. The result was a turn to fiscal austerity that deepened and prolonged the economic crisis, inflicting immense suffering.

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