Aggressively targeting a full recovery is the least risky thing you can do: Back to Work Budget edition
A common theme has emerged in recent punditry and economic analysis: policymakers should begin withdrawing support for growth and jobs because the economy is rapidly improving. In recent months one can find several examples of commentators urging the Federal Reserve to abandon its efforts to boost activity and jobs and begin tightening to forestall (so far completely hypothetical) inflation. And any call for fiscal support for job creation on a real scale is greeted with hand-wringing about its riskiness—as can be seen in much reaction to the Congressional Progressive Caucus’s “Back to Work” fiscal 2014 budget alternative (BTWB, henceforth), which would invest $2.1 trillion in job creation measures over 2013-2015.
For example, David Brooks criticized the BTWB on the (incorrect) grounds that the economy “is finally beginning to take off…[as there is no longer] a large and growing gap between the economy’s current output and what it is capable of producing.” And a recent column by Ezra Klein contained concerns from Moody’s Analytics chief economist Mark Zandi that the BTWB targets job growth too aggressively, meaning that: (a) the overall economy has recovered enough (or surely will) that it doesn’t need this boost; and (b) that recovery has been and will be sufficiently fast that even the estimates of how much fiscal support will boost jobs and growth are overstated.
We strongly disagree. The economy remains deeply depressed, and the coming year will see a significant drag on already inadequate growth from further fiscal contraction (sequestration on top of deepening discretionary spending cuts and expiration of the payroll tax cut). Given this, there’s no reason at all to think that fiscal expansion would be less effective than in the past 3-4 years, and there is certainly no reason to gamble on a robust recovery without policy help.
On the first point, the economy’s improvement since the Great Recession’s freefall ended has been extraordinarily modest, and the pace of recovery has actually decelerated in the past year. Concretely, the output gap—the difference between actual GDP and what the economy could be producing with higher, non-inflationary resource utilization—grew from zero in 2007 to 7.5 percent of potential GDP by late 2009, and then shrank slightly to 6.0 percent in late 2010 (thanks largely to the Recovery Act). Since then, it has hardly budged and stands at 5.9 percent of GDP today. In short, if you thought the economy needed more support at the end of 2010, there is very little reason to have changed your mind since then.
On the second point, the effectiveness of fiscal expansion depends simply on the fact that the economy is stuck in a “liquidity trap”—the Federal Reserve has completely run out of room to cut the short-term policy interest rates that they control. This was true in 2009, 2010, 2011, 2012, and it remains true today. This really ends the argument – the only thing that reduces these large liquidity trap multipliers are countervailing effects stemming from interest rate increases (due to countervailing monetary policy and/or larger deficits) that “crowd-out” private investment and consumption. If no interest rate increases happen as deficits rise, there is no crowd-out and hence multipliers are not reduced.
On specific criticisms about multipliers used in developing the BTWB being too large, there is no reason to think either that they should be marked down, or that even a generalized marking-down of multipliers (presumably because of the economy’s “improved” health) should lead to markdowns of the GDP and job-creation estimates associated with the BTWB.
On the first issue (no reason for lower multipliers), estimated multipliers get lowered when expectations that rising interest rates generated by larger deficits will “crowd out” private activity rise. But to the degree that there is any empirical link between rising deficits and higher interest rates, it is future projected deficits that spur these increases. The BTWB would reduce deficits by FY15 and reduce public borrowing by at least $4.4 trillion over the decade relative to current policy. (“Fiscal clawback” effects from near-term job creation measures would likely save an additional $1 trillion.) Further, in the very near-term, deficit-financed stimulus would actually reduce the debt-GDP ratio. So, there’s little reason to expect crowd-out from this budget.
On the second issue (smaller multipliers won’t substantially hurt the BTWB estimates), our estimate of the BTWB’s economic boost is driven by increased government spending net of a drag from higher taxes. By 2015, the CPC budget would increase revenue by $617 billion and increase spending by $524 billion. Any across-the-board reductions in economic multipliers would mean that the smaller boost from spending would also face less of a headwind from tax increases.
Lastly, one should think about the real economic risk of the BWTB doing “too much” fiscal expansion. Let’s say the economy does indeed bounce back much faster than expected and the substantial public investment in the BTWB does, in the next couple of years, actually push up interest rates and crowd-out some private capital formation. Is that really such a disaster? Sure, private capital formation is valuable—but so is public capital formation. And research indicates that for the U.S., the rates of return on public investment are almost certainly above those for private investment. And we all know about the warnings of the infrastructure deficit. So, the worst-case scenario is that instead of a net addition to the nation’s overall (private plus public) capital stock, we instead get a swap that leaves it roughly unchanged (but like with higher rates of return) relative to the scenario where we’re complacent about the jobs crisis. This should be awfully hard to get scared about.
On the flip side, the downside risk of assuming a recovery that doesn’t materialize is enormous: sustained large output gaps, anemic growth, large cyclical budget deficits, high unemployment, and gradually squandered long-run potential—in the ballpark of another $8.3 trillion in forgone output and $3.1 trillion added to cyclical budget deficits over the next decade, both relative to Congressional Budget Office forecasts.
The economy clearly needs more help, and the risky move is to ignore these clear signals.