Ryan Avent writes about the possibility of an economic "placebo effect" from the stimulus.
But the underlying point is intriguing -- that much of the value of action may be psychological. Even if a government plan isn't directly contributing to public welfare, the idea that something is being done which will improve things will encourage people to spend, businesses to invest, banks to lend, and so on.
This gets at something that another participant, Robert Shiller, calls the "confidence multiplier," of which he says:
The focus has to get off of "what fraction of this stimulus will be spent" to "how does this stimulus affect confidence".
This is worth considering when we read that Americans are strongly in support of significant infrastructure investments. I know that I've been all over the map in terms of what the stimulus should include and how it should be structured, but it does occur to me that authorizing a plan to move forward on major infrastructure projects, even if we know those projects won't come online in the next year or two, could have strong, immediate beneficial effects for the economy (in additional to the long-term effects of the value added by the infrastructure). Critics may note that we'll wind up spending money after the economy has already recovered, but of course, that's less of an issue when you're building things that need to be built in any case.
The real question, I think, is how close the permanent income hypothesis is to being true. The basic idea is that people are forward looking, and they try to smooth their consumption over time. So if you give them a "temporary tax cut", they save most of it, knowing that eventually they will have to give the money back.
But of course, this should also be true of "temporary government spending"--if people think the money won't be there next year, they'll salt as much of the money away as possible. This is a topic very underexplored in the various estimates of the stimulus multiplier, even though consumers are massively overleveraged and will presumably save as much of their new income as they can.
Tax cuts give conservatives great confidence, of course, just as spending makes liberals with great faith in the power of the government feel all shiny and happy and optimistic. The question is how much faith others put in those nostrums.
If it's the placebo effect we're after, what we need is for Congress to pretend to spend the money. That would be much cheaper.
"eventually they will have to give the money back"
So what you earn is _not_ intrinsically yours?
Well, Rob, they're close: they're pretending they have the money to spend.
The real question is how much faith the Chinese et.al. will continue to have in our bonds.
Alan,
With inflation running at a negative 5.5% the gov't has the ability to print unlimited amounts of money. That is, until such time as prices begin to rise again. But for now, open the taps!
Another weird implication of the permanent income hypothesis could be: If people know that taxes will have to be raised in the future, in order to pay for this bill, then they will cut back on spending now.
I understand that people are in favor of infrastructure spending, as am I - but what does that have to do with this craptastic liberal shopping spree? The national electrical grid ALONE needs about $50billion of capital projects. How about spending some more cash on additional F-22 fighters? The production line is good to go, we need them and they are built in America. Also, since they will replace old F-15s one for one, they will not result in an expansion of the government. Most of this Pelosi garbage will result in a massive, expansion of the permanent civil service - this is not a one time spend, it will be the new baseline.
What we need is a great placebo undertaking like a placebo mission to mars to be paid for with trillions in placebo appropriations (and, of course, all shot in a studio in Van Nuys).
Might work...if you trusted the government. But trust has to be earned and it's getting in short supply.
Wish I could pretend to pay taxes.
The history of the Great Depression doesn't support this placebo hypothesis: FDR did lots and lots of things, and was seen to be doing lots of things, and was very popular, but the economy really didn't revive for seven years.
I think the "permanent income hypotheses" can be true and still cut both ways here. It just depends on what people *think* the effect of the stimulus will be: if they think it will keep their income steady, then the we're good. If people think their income will fall anyway, we're not. The effectiveness of the stimulus is irrelevant in this part of the calculus.
Yancey Ward:
Well, the Secretary of the Treasury has already announced that he takes a quite expansive view of what might be considered an innocent mistake.
Psittakos,
You know, I just thought of the most brilliant stimulus plan of all- government buys TurboTax for everyone! You get a free Geithner signature to boot!
Seems like we tried managing perception of the economy with a tissue of lies for, oh, I don't know, the past ten years ("the fundamentals of our economy are strong," "irrational exuberance.")
How well did that all work out? Oh, right.
The basic idea is that people are forward looking, and they try to smooth their consumption over time.
Maybe, then, we should figure out a way to structure the economy such that it doesn't fall to a shambles the second Americans start acting with responsible prudence.
Two out of three isn't bad, HoldFast. We don't really need the F-22, unless we're planning a war against another world power with a modern air force (China, Russia, etc.). Its true that the F-22 replaces the F-15, but you presume we need large numbers of F-15 replacements to begin with. As I recall, the F-15 was built specifically to engage and destroy Soviet air superiority fighters so that our ground attack aircraft would have a clear shot at attacking Soviet armored columns. Since we're no longer facing the imminent threat of a significant air-to-air engagement in the near future, I don't see why we need "pure" air superiority fighters in large numbers any more.
That's not to say that I'm wholly against defense spending. I just think that there are better uses for the money. The F-35 project is a good one, since it replaces the F-16 and the VTOL variant replaces the aging Harriers of the Marine Corps. More spending on modernizing the Army's helicopter fleet would also be helpful. The Navy could certainly use a new class of small boats for "brown-water" anti-pirate activity (like around Somalia). All of these things are probably more important to our national security than a fighter jet designed for a war that never was.
much of the value of action may be psychological
Along the lines of what KJM said, the harm of action may also be psychological. If, like me, you're convinced that the bill the House passed is incredibly awful, actively harmful to the economy, and actually worse than putting the money in a pile and torching it -- then your response is to spend absolutely nothing because another ten-year depression is becoming increasingly likely.
The "placebo effect" only gets politicians re-elected on the idea that they're doing something. FDR ruined an economy and got elected 4 times. Sleight of hand...
Looks like Not My President is taking a page out of that book.
There is a real problem with this analysis.
Government spending isn't a placebo. It has real effects in the marketplace.
1. When government is borrowing close to a trillion dollars, they are competing for capital. They get it, others don't. I thought the problem behind this mess was difficulty in getting credit.
2. If they aren't borrowing, they are taxing. Taxing and then spending has a very poor multiplier in the economy. Some is required of course, but it is a fixed cost, a negative. The cheaper the better.
3. Government projects and hiring set wages and benefit levels in the economy. Also firms bidding on government work require a different set of skills that doesn't translate into the larger economy. Not only don't translate, but those skills are profoundly useless and probably harmful to the economy as a whole.
4. There is a real problem here, which took decades to create, and enormous care and attention to maintain. It isn't a 'lack of confidence'. It is hard lessons learned by hard knocks. Give your money to Wall Street and they will lose it. Or take it. Real estate investment is tough, always has been, always will, and you can lose surprising amounts of money. Borrowing large sums of money personally or as a corporation may seem fine in the short term but will severely restrict your options if the inevitable slowdown happens. As always having a pool of cash allows you to thrive in good or bad times. No government action can help here. In fact, they have actively encouraged people to ignore those hard lessons.
And the very hard reality here is the growth and prosperity of the last decade or two will not reoccur under these conditions. You can't have a bounding and leaping economy which is 70% consumption if people are saving and being conservative with their finances.
No amount of government spending is going to recreate the real estate boom. No stimulus package is going to get people to borrow money to put into dodgy investment vehicles. In my area, there has been a grocery store construction frenzy for the last years. The costs are extraordinarily high, low credit costs and easy availability created a situation where they are competing not by low prices or attractive display, but spending $25 million on a store in an area that would support maybe a $5 million investment. In my town there is probably 100% surplus retail capacity. No government spending is going to fix that. Store chains are going to go bankrupt, construction workers laid off.
Placebo. Bah. Maybe a hard hallucinogenic drug.
Derek
the "FDR effect"....
"If it's the placebo effect we're after, what we need is for Congress to pretend to spend the money. That would be much cheaper."
you go Rob Lyman!!!
Wouldn't this placebo effect also require that it somehow remain a secret that very little of this stimulus is going to anything that could sensibly be called "infrastructure"?
y81 got it right. It failed for FDR. So, is there any time and place where we know it worked? Because 1 known failure, and 0 known successes, translate into: bad idea.
Dan: The media are hard at work not digging into the details of the plan. That approach worked in November, and its prospects are good now.
Greg Q: There's at least one more data point, Japan in the '90s. So 2 known failures.
We don't really need the F-22, unless we're planning a war against another world power with a modern air force (China, Russia, etc.).
That kind of hardware takes far longer to get into production than an "incident" takes to become a full-blown war. Truer words were never spoken (by Rumsfeld, no less): You go to war with what you have. The F-15 is hopelessly overmatched by the latest European and Russian equipment, and both parties will sell to whomever has hard currency.
We don't need the F-22 today. But if we don't build it we won't have it when we do need it.
T'aint difficult. If you are confident, you do something with most of the money. If you are worried sick, you squirrel it away.
A government that looks as though it has a good idea of what it is doing makes you a bit more confident than one that is either paralysed or flailing about. So people do something with a bit more of the money; find the economy has looked up a bit as a result; and do something with a bit more of the money.
That sort of placebo can do a lot of good in an economy that is only short of demand. We also have to deal with shortages of bank capital, a horrible overseas defict and financial regulation which seems to need drastic repair. If the government drops the ball on those, the 'placebo' effect will vanish away.
This has been another episode of Economics Is a Con Game. Con referring to confidence as we all know. I'm not willing to say the economy is a con game but there can be no doubt that finance is a confidence game
A game that demands absolutely an ever increasing amount of money. Since money today is credit the severe impairment of the credit market guarantees the Con is over for now.
The products of modern finance especially it's non bank originated credit instruments and the derivatives of them did not create money but they were as liquid as money. Having a property that Doug Noland calls Moneiness. Upon this foundation the great fortunes of the age were based. This was a Con game in its purest form. If some or many of the players didn't see it that way or intend it that way matters not. What matters and what is revealing is that they all now long for a return of "confidence".
Re: So if you give them a "temporary tax cut", they save most of it, knowing that eventually they will have to give the money back.
In what way do you have give tax cut money back? That's a rather odd (and untrue) way of phrasing it.
Also human beings (and their institutions) have fairly limited time horizons; for most of us anything much beyond a couple years (if that) simply is not real. Which explains why people engage in habits with long term adverse health consequences, why so many fail to save for retirement, why firms focus on next quarter's results not long term profits, etc. Put in a "temporary" tax cut for a long enough period an it will treated as if permnanent, at least until it expiry date approaches.
In what way do you have give tax cut money back?
"Give it back" is not the right way of putting it. It would be accurate to say that your net income is increasing this year, then decreasing next year. To people who base their lifestyles on their income stream rather than their current bank balance (and I think that describes most people), that has the impact of having to "give money back". If you improve your lifestyle with the money this year, next year you have to tighten your belt and worsen your lifestyle.
Take two scenarios, one in which your taxes are permanently lowered by $1000 per year and one in which you get a one-time $1000 tax break that then goes away. In the latter case, you receive $1000 and have no reason to expect any more money. But in the former case, you expect to make an extra $30,000 over the next thirty years. You're less inclined to sock away that $1000 for a rainy day because your anticipated wealth is uch greater than the $1000 you've got in your pocket.
We gave tax incentives to speculation and surprise surprise, we got speculation.
The only time the purchase of stock results in capital being put into a companies hands for investment in the economy is when it is first issued. At the IPO or later issues. Every other trade of a stock is a pure speculation. The purchase of stocks otherwise is a speculation not an investment. They buyer may say they are an investor and maybe it's just semantics but I say they are a speculator. The more important point however is the purchase of the stocks provides no net capital to the system. It does provide income to the stock trading industry, and usually profits.
Next stop. S&P 600
Oh, rapier, you incorrigible optimist.
rapier:
Not exactly. Many companies secure their lines of credit at least in part through their ability to issue new shares at a specified price (or higher). This is why lenders to corporations sometimes call their loans when the shares slip below that price. Demand for those shares thus directly affects the company's access to credit.
Secondarily, few people (Warren Buffet, maybe) would buy shares of companies upon first issuance if they couldn't later sell them. If you want that first sale, you have to facilitate later ones.
So if you give them a "temporary tax cut", they save most of it, knowing that eventually they will have to give the money back.
Doesn't this also imply that if the government imposes a "temporary tax hike," people will go out and spend more, in anticipation of a future windfall? Do we really think that correctly models taxpayer behavior?
Every other trade of a stock is a pure speculation.
Earth to Clueless Person: companies issue stock more than once. The price at which they issue new stock offerings is determined by the market price of their stock.
It isn't just speculation. It determines the market value of the company's stock, which determines (a) how much more money the company can raise through stock offerings and (b) how much development capital they can borrow against the value of the company.
Keynes told Roosevelt that if we printed money the economy would recover.
In World War II we finally printed money and the economy recovered.
That won't work today because if we print money the Chinese economy recovers...
The real question, I think, is how close the permanent income hypothesis is to being true. The basic idea is that people are forward looking, and they try to smooth their consumption over time. So if you give them a "temporary tax cut", they save most of it, knowing that eventually they will have to give the money back.
It sounds like you're saying the stimulus can work AND the permanent income hypothesis can be true. Right now people think their lifetime incomes are going to be crap. If they see some massive projects like major infrastructure or a major green offensive like a huge fleet of high mpg cars with lots of solar panels they may feel like they are entering 'the future'. If this makes them feel good they will raise their estimates of lifetime income which generates economic recovery and wel all live happily ever after.
My jihad against stocks is in relation to the tax advantage given to stock trading profits. There should be no tax advantage for just trading. Stocks do serve various purposes for companies and the system but short term speculation doesn't.
I went over the top with my rhetoric to make people think. It is just a given in peoples minds that trading stocks is investment. In some senses it is and some it isn't, on either a personal or systematic basis. A huge portion of all stock trading is speculation and speculation should not get a tax advantage.
When the history of the age is written historians will puzzle over the broad public support for giving tax advantages to speculators over workers. For the public's and their representatives inability to see the rising prices of financial instruments for what it was, inflation.
One conceptual framework that should have been used for the bailouts would have been to aim them all at incomes and aim nothing at asset prices. The attempts to stabilize or reinflate assets is probably hopeless and terribly misguided.
Glassman was wrong. It's going to be DOW 3600.
Hey, Megan, didn't know know that the PIH doesn't apply when rational agents are borrowing-constrained?
Modigliani would be proud, but unfortunately, I don't think we can completely apply PIH to the scenario you're referring to about temporary tax relief. The question about PIH is a long going debate; however, more importantly here is whether or not stimulus will lead banks back to lending, as opposed to firms just saving their funds back to prevent another era of volatility. With that said, also, I do think we'll see some of the trends you talk about, which could be glimpses of PIH, because saving rates have to come up before spending will. This is the key reason our crisis is so different from Japan's.
My jihad against stocks is in relation to the tax advantage given to stock trading profits.
Do you also object to the massive tax DISADVANTAGE of stock trading losses?
My net income last year was negative -- my investments declined enormously over the course of the year. But the government will only let me "recognize" $3000 of that loss, so as far as they're concerned I had a positive income last year and still owe them taxes.
If you want to treat the gains as normal income, fine. But let me cash out all my stocks, put the money into something more stable, and inform the government that I made negative $30,000 last year and want my earned income tax credit. :)
I think McArdle has the permanent income hypothesis confused with the so-called Ricardian equivalence hypothesis, a pet notion with elbow patch conservatives.
All PIH states is that consumption behaviour is sluggish, determined by what consumers perceive as their permanent income based on past experience, and practically unaffected by sudden temporary swings in either direction. Hence last years' tax rebates only resulted in a 15 cent on the dollar spending effect.
The permanent income hypothesis thus argues against tax cuts (especially temporary tax cuts) and in favour of public spending as a means of stimulating aggregate demand.
After all public spending is, well, spending. And that's what you're looking for in a stimulus.
Before commenting on this thread, people should check out Krugman's comments on McArdle's sloppy throwaway here.
stostoto has a point but even Robert Barro's Ricardian Equivalence proposition says Megan has this al backwards:
econospeak.blogspot.com/2009/02/milton-friedman-and-paul-krugman-on.html
"But of course, this should also be true of "temporary government spending"--"
Not according to Paul Krugman:
http://krugman.blogs.nytimes.com/2009/01/31/another-temporary-misunderstanding/
But, I'm sure Megan will just dismiss him like she always does. After all, she knows SOOOOOOO much more about economics than he does.
From this blog's "About" blurb:
Megan holds a bachelor's degree in English literature from the University of Pennsylvania, and an MBA from the University of Chicago
In short, Megan is just a blissful amateur when it comes to economics. I guess this part is an attempt at humorous tongue-in-cheek:
She may or may not have been the first major economics blogger, depending on whether we are allowed to throw outlying variables such as Brad Delong out of the set.
as noted, probably more Ricardian equivalence (you'll have to pay a tax cut which is not accompanied by a spending cut back at some point in the future, so might as well save the cut so you have the resources to pay it back when time comes) than Permanent Income (I recall the empirics offer little thorough support, at best, to this idea - there's an 'element' of truth, but not truth itself). Ricardian Equivalence (IF true!) would suggest spending increases will necessitate tax increases at some point- so a bigger tax bill is coming due, what will an agent do with their share of the extra spending to make sure they're able to pay the larger bill when time comes? But the extra spending isn't just a pot of money (which is how 'tax cuts' are treated). It's cash in exchange for a good or service. The first thing you do with that receipt is pay along your supply chain - possible side discussion here re: whether or not any of those products would have been purchased absent the spending - but REH certainly says that wouldn't be the case after tax cuts. It's only the profit slice which looks to be eligible for Ricardian logic.
I know the economics of publishing push quantity over quality, but that doesn't preclude anyone from aiming for quality... try harder, please?
Appreciate the clear and concise argument for how PIH applies to the stimulus offered by stostosto.
a) No I am not talking about Ricardian equivalence; I'm talking about the PIH.
b) I don't have it backwards; I'm not arguing about the difference between spending and taxes. I'm asking what the PIH means for spending.
c) Noah: Since our expectations about future income are contracting, not expanding, no, this is not a good critique. Everyone in America has available credit in the relevant direction, which is to say they can save more or pay down debt. I presume that at very low income levels, they *won't*--which is one of the reasons I assume the multiplier will not be arbitraged away.
4) As I used to say in my tech days, RTFM. If people will read the whole post, rather than reading DeLong's gloss, they will see that commenters and other bloggers are "refuting" claims I haven't made. My modest claim is that people will probably worry somewhat about future taxes to pay for all this spending, and save some of the income thus obtained, lowering the multiplier. I have nothing to say about the exciting virtues of spending over taxation, debt finance over taxation, or any of the other very interesting points that have been elucidated.