Gary Becker poses an interesting question:
There appears to have been a huge conversion of economists toward Keynesian deficit spenders, but the evidence that produced such a “conversion” is not apparent (although maybe most economists were closet Keynesians all along). This is a serious recession, but Romer and Bernstein project a peak unemployment rate without the stimulus of about 9%. The 1981-82 recession had a peak unemployment rate of about 10.5%, but there was no apparent major “conversion” of economists at that time. What is so different about the present recession compared to that one, and to other recessions since then, that would greatly raise the estimated stimulating effects of government spending on various types of goods and services?
There are others better equipped than me to answer this question. But here’s my take:
1. Monetary policy isn’t enough this time.
Most Keynesians would still prefer monetary policy to be the first and main tool for stimulating demand in a recession. And no wonder; it did the trick in the recessions of the early 1980s, 1990s, and 2000s.
The 1981-82 downturn that Becker highlights differed from the ensuing ones, including the current one, in a key respect: the inflation rate in 1981 was 10%. The Fed Chair (Paul Volcker) and a growing number of economists viewed that as the central challenge initially, to be tackled via high interest rates. High unemployment was seen as a sacrifice necessary to wring inflation out of the system. Once that was achieved, monetary easing worked to end the recession.
But the Fed has now gone about as far as it can in lowering interest rates. As one of the apparent “converts,” Martin Feldstein, put it back in October, “With the Fed’s benchmark interest rate down to 1 percent, there is no scope for an easier monetary policy to stop the downward spiral in aggregate demand. ” The rate has been reduced further since then, and is now lower than at any point in the three prior recessions.
Also, Japan’s experience in the 1990s offers an empirical instance of drastic reductions in interest rates failing to revive demand effectively.
2. Getting credit flowing again — that is, restoring the normal functioning of the financial system — is critical. But doing so has proved difficult, and it probably won’t suffice in any case.
Despite various efforts by the Treasury Department and the Fed to encourage lending, including infusions of cash to banks, credit remains tight. Scarred by their mistakes of recent years, lenders appear to be very cautious about extending credit. Moreover, the problem isn’t just lack of access to credit; it’s also inadequate demand. This takes us back to fiscal stimulus.
3. Because of the steep drop in household assets due to the collapse of stock and housing prices, the shortfall in demand is likely a good bit larger this time than in other recent recessions. As Joseph Stiglitz puts it, “Americans confronted with debt, shrinking retirement accounts, houses worth less than mortgages, and a tough credit environment will save more of their money than in the past.”
4. None of this, however, answers Becker’s specific question: Why is there enhanced belief that fiscal stimulus will be effective? As best I can tell, most who favor a Keynesian response in fact are uncertain about its impact. The justification is closer to “this is very likely a wise strategy” than to “this will work.”
On the first page of their memo estimating the impact of various stimulus packages, Christina Romer and Jared Bernstein caution that
It should be understood that all of the estimates presented in this memo are subject to significant margins of error. There is the obvious uncertainty that comes from modeling a hypothetical package rather than the final legislation passed by the Congress. But there is the more fundamental uncertainty that comes with any estimate of the effects of a program. Our estimates of economic relationships and rules of thumb are derived from historical experience and so will not apply exactly to any given episode. Furthermore, the uncertainty is surely higher than normal now because the current recession is unusual both in its fundamental causes and its severity.
Mark Thoma is a bit more blunt:
We have very little U.S. historical data for time periods when the economy is in a depression, so … I don’t think we know much at all from the econometric evidence about the success of fiscal policy in deep downturns. We’ll know more in the future because we’ll be able to look back at this one, but for now policymakers are flying pretty blind. What we can examine is the experience of the Great Depression, and when you do, the case for fiscal policy is strong.
Did it work in Japan? Here’s Paul Krugman in the new edition of The Return of Depression Economics:
Some readers may object that providing a fiscal stimulus through public works spending is what Japan did in the 1990s — and it is. Even in Japan, however, public spending probably prevented a weak economy from plunging into an actual depression. There are, moreover, reasons to believe that stimulus through public spending would work better in the United States, if done promptly, than it did in Japan. For one thing, we aren’t yet stuck in the trap of deflationary expectations that Japan fell into after years of insufficiently forceful policies. And Japan waited far too long to recapitalize its banking system, a mistake we hopefully won’t repeat.
This touches on a final point: Why do many who advocate fiscal stimulus favor one that is immediate and large? Our experience in the 1930s and Japan’s in the 1990s suggest that moderate and sporadic stimulus efforts are unlikely to be sufficient in the case of a deep downturn. The Depression and Japan’s “lost decade” also teach that if early stimulus efforts are too modest, they create a political trap: concern about the government debt produced by the earlier stimulus packages grows, which heightens opposition to further stimulus.