The Ongoing Problems of "Stimulust"

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It was not hard to predict that an Obama administration’s skeptical approach to
trade could cause international tension. But who ever would have thought we’d be
berating Europe over insufficient enthusiasm for domestic spending?

And yet that was at the heart of last week’s less-than-diplomatic lead up to
the weekend meeting of G-20 finance ministers in the United Kingdom. White House
aide Larry Summers, in a reprise of his past role as Treasury Secretary, called
for further European stimulus. The European reaction ranged from “significant
bewilderment” to outright rejection.

The U.S. theory is that we’re in a Keynesian world in which any federal
spending is worth its weight in economic activity and then some. There are at
least two big problems with this. First, there’s the most basic question: what
is fiscal stimulus? The answer might seem obvious: it’s an increase in
government deficit spending. That, though, would be the European answer. The
U.S. answer seems to be: fiscal stimulus is a new package that goes above and
beyond what you were planning to do anyway.

The difference is pretty big, as a recent IMF paper showed. Countries with
extensive social safety nets and high taxes see greater automatic deficit
increases as welfare payments rise and taxed activity falls. That reduces the
need for new legislative packages; the response is largely built-in. To take the
most extreme example, Britain’s stimulus package for 2010 actually shows a 0.1
percent decrease in net government spending relative to GDP under a narrow
definition. But Britain’s overall increase in deficit spending for 2010 is
predicted to be 5.4 percent of GDP, second only to that of the United States
among major nations. The difference is in the automatic stabilizers.

Why should it matter if a stimulus was built-in or delivered in a shiny new
package? One might argue that gloomy consumers already knew about the built-in
spending, whereas the shiny new package might surprise and stimulate them. Here
we come to the second big problem with the idea of fiscal stimulus as a panacea.
A big reason that fiscal stimulus had fallen out of favor in economics was that
it’s hard to tell a consistent story about how it will work. This problem is
particularly acute when we start worrying about people’s expectations.

The intellectual foundation for the administration’s claim that its fiscal
stimulus will create or save up to 3.5 million jobs is a short paper by
Christina Romer and Jared Bernstein. It is based on old-school theorizing (i.e.
don’t worry about expectations). It relies critically on assumptions such as a
zero interest rate in perpetuity. What if we revisit that assumption and apply
some of the macroeconomics learned over the last few decades? A recent paper by
former top Treasury official and Stanford economist John Taylor and colleagues
does just that. It finds that the U.S. stimulus package is likely to create or
save a total of about 500,000 jobs–roughly the level of recent monthly job
losses.

While the Obama administration deals with its fiscal stimulus fixation, the
financial sector lurks. Without a banking fix, even beguiling new fiscal
packages are unlikely to save the economy. The problem is that a financial
sector fix may cost dramatically more than the administration has acknowledged.
Holes in bank balance sheets have been estimated to be in the trillions. The
U.S. Treasury has decided to check how bad this problem really is by putting
major banks through “stress tests.” In Western Europe, they’re already stressed
as they grapple with weakened banks with major exposure to a faltering Eastern
Europe.

One European argument is that they don’t want to exhaust their credit lines
with this potential trouble on the horizon. The Obama administration has no such
worries, planning trillions of deficits for years to come in its new budget.
Perhaps it should listen to its creditor, though. Chinese Premier Wen Jiabao is
worried. He just called on the the United States to guarantee the security of
Chinese assets, a guarantee the United States can certainly not provide (it
would require perpetual low interest rates, a fixed exchange rate, price
stability, and fiscal responsibility).

While the Europeans may be more mature on fiscal discipline, they have their
own obsessions. In their view, the world will be set aright if only we could all
get together and regulate. The last great effort at global financial regulation
was to set standards to make sure banks had enough capital to avoid a financial
breakdown (the Basel II negotiations). Years of technical talks wrapped up in
2004, but the approach has not worked so well. Nor is it clear that tighter
financial regulation needs to be globally coordinated to be effective.

All of this should make for a fun set of G20 talks over the next few
weeks.

Philip I. Levy is a resident scholar at AEI.