Tuesday, 27 January 2009

How economists analyse the stimulus

Arnold Kling writes on How economists analyze the stimulus in the Atlantic magazine. Kling writes
Two economists on opposite sides of the stimulus debate recently expressed their opinions in terms of algebra. The opponent, Kevin Murphy of the University of Chicago, laid out the basic framework at a panel where he was the second speaker. The proponent, Brad DeLong of Berkeley, reacted by reprinting Murphy's framework and using it to articulate his disagreement with Murphy.
A summary of the differences between Murphy and DeLong is given in the table below:

$100 of Government SpendingMurphy's EstimatesDeLong's Estimates
Keynes Effect$50$150
Housework Effect-$25-$30
Galbraith Effect-$25$0
Feldstein Effect-$80-$33
The Bottom Line-$80$87

The Keynes Effect is the use of unemployed resources to produce useful output. The Housework Effect reflects the fact that we count the output people produce in the market but not the value of leisure or unpaid work that they can produce when not on a paying job. The Galbraith Effect is the additional value of government output over private output. The Feldstein Effect is the fact that government output eventually must be paid for with taxes, and most taxes cause supply-side distortions to the economy. Taxes tend to penalize work, thrift, and investment, which are the sources of prosperity. The Kling Atlantic piece explains in more detail.

Kling comments on the framework used above:
First, it assumes that the four parameters are constants. That is, they assume that what is true of $100 of government spending is proportionately true for $800 billion of government spending or for $100 trillion of government spending. However, the more the government spends, the less likely it is that the additional dollars will soak up unemployed resources and the more likely it is that instead additional dollars will draw resources away from private output. Furthermore, there probably are diminishing returns to the Galbraith effect--as you get beyond the "low-hanging fruit," the usefulness of additional government projects will decline.

Second, I think that the spending plan will pass because politicians, particularly Democrats, assume a huge Galbraith effect. They value government output much more highly than private output. Larry Summers famously said that in order to be effective, fiscal stimulus must be "timely, targeted, and temporary." The Democrats' plan is none of those things. Instead, it is an enormous Galbraithian transfer from the private sector to the public sector. While I can understand their enthusiasm for this transfer, I cannot share in their glee.
Personally I'm more in the Murphy camp than the DeLong camp.


Lee Clark said...

A more accessible title might have been 'How Economists Stimulate the Analysts"

eye thenkyu

Unknown said...

NotPC's blog has just alerted me to the fact your blog is back.

Looking forward to catching up.