The ongoing problems of “stimulust”

By Phil Levy

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.