Whacking Nonlinear Systems: The Stimulus Package

It is easy to secure agreement that national and world economies are strongly nonlinear systems. We can probably make reasonable predictions about the net effect of small policy shifts. But when we whack the system with large perturbations like the current stimulus pack, there are undoubtedly effects that are essentially unpredictable. It is for this reason it is a prideful and unjustifiably arrogant to exhibit too much confidence in asserting what the cumulative effect of the current stimulus package. That’s is what why making policy is so difficult.

Should we emphasize tax cuts or spending increases to stimulate the economy?  The current stimulus package is weighted toward spending increases. Should we emphasize policies that will have an immediate effect or spread the stimulus over a long period of time? These are all good questions that have not yet received sufficient attention.

There are were many on Left who argued that we did not devote sufficient deliberation or time to consider the liberation of Iraq and that the president was fear mongering to force an ill-considered decision. However, the Iraq decision was spread over many months and included long debates in Congress supported hearings and has until this point cost about $630 billion over nearly six years.

We are now about to decide whether to spend over $800 billion over a shorter period of time with little Congressional deliberation and no hearings in less than a month with President Obama warning of economic “catastrophe” if we do not act immediately.

Let it be respectfully suggested that we are acting too hastily. There is no reason we cannot provide an immediate and more modest stimulus to the economy with tax cuts that can be implemented immediately coupled with increasing unemployment benefits to put money quickly in the economy. The remainder of the package can be considered deliberately with hearings over the next few months. Regardless of the particular stimulus we end up choosing, we should try to achieve the greatest effect for the cost.

One question of particular interest is should a stimulus focus more on tax decreases or spending increases. It is certainly the case the that the question is more complex that this. Surely all spending increases do not have equal stimulative impact and all tax decreases do not have an equal salutary effect on the economy. Nonetheless, can some relative weight of the effects between spending increases and tax decreases be estimated?

Economists often speak of the the “multiplier effect.” If the government spends an amount equal to x% of the Gross National Product (GDP) and net GDP increases y% then y/x is the multiplier. As Nobel Prize-winning economist Krugman explained:

“Consider an increase in government spending; assume that the interest rate is fixed (a good assumption right now, because interest rates are up against the zero lower bound). Then textbook analysis says that if the stimulus is dG, the increase in GDP is 1/(1 – c(1-t)) where c is the marginal propensity to consume out of income and t is the marginal tax rate. Suppose c is 0.5 and t is 1/3; then the multiplier is 1.5, which is more or less the conventional wisdom right now.”

So Krugman claims the conventional wisdom is that spending multiplier is 1.5. However, there is some suggestion that the multiplier for tax decreases is larger. Christina Romer, Garff B. Wilson Professor of Economics at the University of California Berkeley, was recently selected by Obama as  Chair of the Council of Economic Advisers. She and David Romer have recently published an analysis that suggests that the multiplier for taxes is from 2 to 3. This would argue strongly  in favor of tax cuts for stimulation.

This is not to argue that the above analysis is conclusive, but it does argue for more careful consideration because these are non-trivial differences. The Congressional Budget Office has scored the current stimulus package and found that in the long run it will reduced GDP. Decade-long predictions from any economic analysis have to be consider extremely provisional. But it does suggestion that we should do what is necessary in the short term and tread carefully in with such a large package.

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