Stimulus: Cure-all or bloodletting?

interns Contributor
Font Size:

On a wet and cold December day in 1799, George Washington went out for a five hour horseback ride. At 67 years of age, the former president was in robust good health. It was a Thursday.

On Friday, Washington did not feel very well.

On Saturday, Washington grew feverish, had a very sore throat, and experienced difficulty breathing. Doctors were called. As was the practice at the time, a bloodletting was performed, but Washington’s condition did not improve. More blood was taken, and the patient’s condition worsened. So doctors took even more blood. All told, physicians drained an estimated five-to-seven pints of blood from George Washington in five separate bloodlettings—about one-third of his total blood volume in a single day.

On Sunday, Washington died.

The physicians attending to Washington were among the best of their day. With nothing but good intentions, they essentially drained his body dry.

In early 2009, the American economy, like Washington, had taken ill. The incoming Obama administration predicted that without a massive stimulus package, unemployment could go as high as 8.8 percent. The stimulus was administered, and unemployment spiked to 10 percent. The patient got worse.

The economy clearly failed to respond in the manner predicted by Obama’s advisors. But why? There are two popular explanations. The first is that the stimulus spending simply did not work.

The other explanation is that the stimulus actually did work and that without it, unemployment would be even higher than it is today. This is the argument being made by President Obama.

“Part of the challenge in delivering this message about all that the Recovery Act accomplished is that things are still tough. They just aren’t as bad as they could have been. They could have been a catastrophe,” Obama told a Wisconsin audience in June 2010. “So people kind of say, ‘Yeah, but unemployment is still at 9.6 [percent].’ Yes, but it’s not at 12, or 13, or 15 [percent].”

The Obama administration claims they misjudged the severity of the economic situation they inherited. The stimulus was the right medicine, they say, but the economy was much sicker than they realized.

It is possible that the administration’s explanation is correct. If that is the case, then even more deficit spending is just what the doctor ordered. Indeed, some prominent voices are making just such an argument.

The New York Times editorialized that “slashing budgets is the wrong thing to do.” Nobel laureate economist Paul Krugman writes, “Spend now, while the economy remains depressed; save later, once it has recovered. How hard is that to understand?”

It’s not difficult to understand, just hard to swallow. For these arguments all depend on the assumption that the model used by Obama’s economic advisors was essentially sound. But what if it wasn’t?

Obama’s Model: Confident, precise, wrong

The key force behind Obama’s economic model is Christina Romer, Chair of the President’s Council of Economic Advisors. In January 2009, she co-authored the report that laid out the rationale for passing the American Recovery and Reinvestment Act, the $787 billion stimulus package signed into law in February 2009.

Ms. Romer’s report firmly ensconced John Maynard Keynes as the official defunct economist of the Obama administration. Romer embraced a Keynesian response to the economic downturn, whereby government would support recovery by boosting demand through a combination of deficit spending, tax cuts, and aid to states. The report relied on economic modeling to predict what would happen if the stimulus bill passed. Working off forecasts, Ms. Romer explained, you “then put them into the computer and simulate.”

Key to the model is a variety of “multipliers” to assess the direct and indirect impact of the various types of spending. As Romer explains: “When you invest money in infrastructure, that makes jobs directly as you hire people. But it also makes some more jobs as they get wages and start spending it, and then the things they are buying, those create jobs.” These multipliers, which are a source of great debate among economists, vary depending on the type of stimulus involved—for example, government spending is given a multiplier of 1.57 while a tax-cut is given only 0.99. These multipliers were, in the authors’ words, developed by “averaging the multipliers for increases in government spending and tax cuts from a leading private forecasting firm and the Federal Reserve’s FRB/US model.” Though quantified with scientific precision, these multipliers represent highly disputed guesswork.

The report was precise in its projections, however. By Q4 2010, the stimulus package would increase jobs by 3,675,000 and hold the unemployment rate to “approximately 7.0%, which is well below the approximately 8.8% that would result in the absence of a plan.” The report predicted that the stimulus would allow 2.7 million workers to move from part-time to full-time work, and reduce the “underemployment rate by more than three percentage points compared to its level in the absence of a recovery package.”

It’s one thing to be wrong. It’s another to be precisely, spectacularly wrong.

As Harvard economist N. Gregory Mankiw noted in a recent National Affairs article, precisely modeling the complex interrelationships is a daunting task, one that calls for a great deal of humility on the part of macroeconomists. “When we talk about the impact of government purchases on aggregate demand, and therefore on job creation, we must take into account an enormous number of “general equilibrium effects” — that is, the indirect effects that occur as one economic variable influences another, which in turn influences yet another, and so on.” Mankiw continues:

These general equilibrium effects are tremendously important to the economy — sometimes in positive ways, sometimes in negative… The negative effects are even more challenging to trace. For example, if people observe the government issuing substantial debt (required to finance a stimulus), they may anticipate higher future taxes and therefore cut back on their current consumption. Increased government borrowing may also drive up long-term interest rates, which could make it difficult for people to borrow money and could therefore reduce spending today… In other words, in certain conditions stimulus spending can have a depressive effect. Without the luxury of a ‘control universe’ it’s impossible to know with complete certainty the impact of the $787 stimulus package. But the question is critical to the economic health of our nation. Did the stimulus work? Should we do more of it?

The Obama administration wants more of it, even if they now call it by a different name. In June 2010, Christina Romer was asked if she would push for more deficit spending. Her answer: “We are in favor of responsible targeted actions,” including tax incentives for green manufacturing jobs, extending unemployment insurance benefits, and aid to state and local government.

The abandonment of the language of stimulus is a sure sign that the people have moved on. Economists may disagree, but regular people have made up their mind.

Doctors still debate whether George Washington would have recovered if left on his own. There is universal agreement, however, that the repeated bloodletting weakened the former president and made recovery less likely. Economically, we have already drained our coffers dry, and more stimulus spending could hurt, not help, our ailing economy.

John O’Leary is a Research Felow at the Ash Center at Harvard’s Kennedy School of Government, editor of the Better, Faster, Cheaper blog, and the co-author with Bill Eggers of If We Can Put a Man on the Moon (Harvard Business Press).