Myron Scholes Global Markets Forum
January 16, 2009
Evaluating Obama's Proposed Stimulus Package
A Panel Discussion featuring John Huizinga, Robert Lucas, and Kevin Murphy
A few days before Barack Obama’s inauguration, the IGM gathered three of the university’s distinguished service professors to discuss the economic stimulus package proposed by the president-elect (and signed into law in a somewhat amended form a month later). John Huizinga started by sharing what he used to tell students: it was the predominant view among macroeconomists that fighting recessions with fiscal policy was a bad idea. “I still think in general that it is a bad idea,” he told the audience, “but I’m less convinced than I used to be that that’s the predominant view…. I’ve been surprised by how many economists have come out in support of this.” He then listed possibilities that may have led many economists to change their views. The main reason, he said, was that many believed we were in extraordinary times. So Huizinga tried to compare this recession with previous postwar downturns.
One important factor he noted was the fall in employment. Although the drop through the end of 2008 did not look out of line with other postwar recessions, Huizinga said, proponents of the stimulus in the Obama camp were forecasting a long period—perhaps 36 months—of falling employment, which would be more than the length of time that employment had fallen in any previous postwar recession. Still, he said, it was important to think about benefits and costs when evaluating stimulus plans.
A big cost to consider is the effect on future economic activity. The same models that predict fiscal policy will increase output also imply that national savings must fall. If the stimulus “works” by boosting output in the short term, a consequence will either be lower investment or a larger current account deficit in the future. “Budget deficits aren’t free. You pay for them,” Huizinga said.
Kevin Murphy sketched out a simple equation—into which anyone could easily plug their own assumptions—to compare the benefits and costs of stimulus spending. The advantage, he argued, is the equation helps everyone to be clear about exactly what they are assuming and why it supports their approach to the stimulus. According to Murphy, the main items everyone should be clear about are: the fraction of the economy’s resources that are idle; the value of keeping those resources idle (e.g., most people value their time, and will not work without compensation); the deadweight loss from raising taxes in the future to pay for the spending; and the cost of allocating spending through government, if it is allocated less efficiently as a result (this can be negative —i.e., a benefit—if government is better than the private sector at allocating resources).
Murphy did not consider the stimulus a good proposal, but he explained how his assumptions about each element of his framework differed from those of president-elect Obama’s team. “It’s easy to see what you have to assume in order to make the stimulus make sense,” Murphy said.
Regarding the tax cut measures in the stimulus plan, Murphy thought they were designed in an especially inefficient way. Since marginal tax rates are what matter for incentives, he argued, it was not helpful that the Obama plan would give tax cuts in the form of direct credits to certain taxpayers without lowering rates. That the president would likely address the resulting deficit by raising rates in the future would exacerbate the problem.
Robert Lucas pointed out that the U.S. economy was already four percent below its long-term trend level in January 2008. In addition, consensus forecasts - which “mean a lot” over short horizons such as a year - suggested the economy would be eight percent below after another year. This would be larger than any other postwar recession, though nowhere near as bad as the 30 percent gap in the 1930s. “It’s not the worst in my lifetime, but it’s the worst in Obama’s,” Lucas said, “and it would be foolish not to take some actions to deal with it.”
Monetary measures to deal with the recession make a lot of sense, said Lucas, who added that many of the Fed’s actions were beneficial. The trouble was the fiscal stimulus did not seem designed to deal with the real problem. A good approach, Lucas said, would be to use the fiscal stimulus “as another way of getting cash into circulation in the private sector.” He mentioned hypothetical examples that Milton Friedman - dropping money from helicopters - and John Maynard Keynes - paying people to dig and refill ditches - had posed as ways of achieving this. “If fiscal stimuli are designed to be effective, they’re going to be effective because they carry along a monetary policy of the sort that raises the dollar spending level,” Lucas said.
Based on the plans and information he had seen from president-elect Obama’s advisors, however, Lucas said that this did not seem to be what the new administration was planning. Instead, he said, “all they’re talking about is transferring resources, additional levels of spending, from one use to another,” which, he argued, would have no substantial effect on the average level of spending and thus would not help fight the recession.
Walter David "Bud" Fackler Distinguished Service Professor of Economics
John Dewey Distinguished Service Professor of Economics
Kevin M. Murphy
George J. Stigler Distinguished Service Professor of Economics
This event was part of the Initiative on Global Markets and is generously sponsored by Myron Scholes.
The Initiative also receives financial support from the Chicago Mercantile Exchange (CME) Group Foundation and our corporate partners: AQR Capital Management, Barclays Bank PLC, John Deere, and Northern Trust Corporation.