Monday, June 21, 2010

Economic Known Unknowns

Stimulus is dangerous. The second-order costs of government spending are real, and we are very far from being able to understand or estimate them. Here are some second order costs:

  1. Transfers of relative purchasing power from other citizens to the beneficiaries of government spending may call into question the legitimacy of the distribution of opportunity, wealth, and influence and of the government itself. Perceptions of make-work or corrupt contracting are deeply corrosive. Deficit spending commits government to future transfers that may come to seem undesirable or illegitimate.

  2. Government spending choices may lead to lower quality uses of real resources than would have occurred if the government had not acted. Since economic activity is habit forming and temporary interventions become permanent, the cost of poor government choices can be high. It matters very much what work the government is paying for. Work must be well-tailored to the talents, interests, and future prospects of individuals. Employing people badly is much worse than just giving them money.

  3. If funds are spent, directly or indirectly, on resources in scarce supply, prices may be harmfully propped or bid up. That might take the form of a general inflation, or a narrower effect on the prices of specific commodities or assets.

  4. High levels of government debt may have a destabilizing effect on prices, increasing price volatility and impairing economic calculation even in the absence of a general inflation, or even in a deflation. Government obligations are liquid and hypothecable, and the availability of good collateral increases the degree to which subjective changes in relative valuation translate to changes in nominal pricing.

  5. There exist theories of government solvency which suggest that the safety and value of currency is related to the indebtedness of the issuing government. Those theories may or may not be reasonable. They may or may not find support in the historical record. Regardless, to the degree they are widespread, they may be self-fulfilling. Whether sensible or sunspot, loss of confidence in a currency is possible. Currency crises represent a “tail risk” whose likelihood and cost are difficult to estimate.

There are second order benefits to stimulus as well as costs: multipliers, consumer confidence, etc. But these are also difficult to estimate.

This is from an author who affirms there are things the government should be doing, and describes his own view as skewing "activist". Not exactly the un-thinking deficit-hawk that Krugman and others like to hold up for scrutiny just so they can knock them down.

Posted via web from rhymeswithclown's posterous


D said...

Pretty good post. One issue of contention, however.
"Government spending choices may lead to lower quality uses of real resources than would have occurred if the government had not acted."
By definition, this is necessarily true, not a mere possibility. Utility is subject to each and every individual, with people tending to care for their highest valued uses first, and dealing with marginal cares later.
By definition, if the government is taking money from people against their will and spending on what THEY think is valuable, the money cannot be going towards its highest valued use. It is therefore, by definition, less productive than the situation that would occur otherwise.
In addition, government emergency spending tends to always come in the form of bonded or printed money, further robbing the hapless taxpayer and redistributing wealth.
"There exist theories of government solvency which suggest that the safety and value of currency is related to the indebtedness of the issuing government"
I had to smile when I noticed the refusal to use the term 'money' when speaking about fiat currency.

J. Strupp said...

Obviously, I can't speak for Krugman but I don't think that there is anything on the list that he would disagree with. There's no question that there are pitfalls. Expectations matter, deficits matter.

The questions is whether or not we're capable of constructing a targeted, short-term stimulus large enough to substantially boost GDP and, therefor, employment, without doing any significant damage to long run inflation expectations.

It can be done. We just haven't done it.

Also quickly, government spending choices do not (by definition) lead to lower quality uses of real resources if the utility of those resources is near zero (as is the case right now in many areas) This is another crowding out argument and it was wrong in the 30's and it's wrong today.

Jeremy R. Shown said...

Krugman may well acknowledge these propositions if asked to, but I'm not sure you'll find any hint of them in his blogging lately.

To hear him (and you) tell it, the case for additional fiscal stimulus is obvious, but I'm not convinced that it is.

J. Strupp said...

Oh the case for additional stimulus is very obvious. Definately. All I'm saying is that at some point we'll reach a debt level that erodes confidence which could cause a spike in inflation expectations and all of those items on that list become a reality. If history is any indicator, we aren't even close to these levels.

So far, the long run costs of stimulus have been negligible, long term treasury yields remain low and disinflation continues to be tilting towards deflation.

The risk of keeping the status quo far outweighs the risk of action at present. My guess is that's why guys like Krugman aren't emphasizing the risks of additional spending these days.