Thursday, February 12, 2009

Positively stimulating

Matthew Yglesias is right. Spending can be perfectly good "stimulus," even if it doesn't produce anything else of value:
In other words, when the primary point of spending money on something is to get the thing you need to worry a lot about efficiency. You don’t want “wasteful” procurement wherein you overpay for stuff, or spending on stuff that doesn’t work. For the purposes of fiscal stimulus, however, while it’s better to spend the money in an efficient way on useful items, it’s not essential to do so. Which doesn’t mean we should totally throw caution to the wind and pay people to dig holes. But it does mean that it makes perfect sense to relax our criteria for what counts as useful and what counts as efficient. The efficacy of stimulus as stimulus just has to do with how quickly the funds cycle into private hands and then out into the wider economy and has relatively little to do with “efficiency” in an ordinary sense.
Unfortunately, this doesn't contradict Kevin Murphy's argument. Murphy would agree, I think, that the efficiency of stimulus "as stimulus" isn't determined by its inherent value as spending. He's saying, however, that our decision to commit stimulus money -- not where to allocate it, but whether to spend it at all -- should be influenced by whether we're getting anything more than stimulus in return. There are many plausible models where a stimulus package isn't optimal if its only effect is stimulus, but where the combined benefits of stimulus and public investment together push it over the top. While Yglesias is definitely on the right track when he talks about "relaxing" our criteria for what counts as efficient or useful, he's wrong to think that this is some kind of blow to Murphy's framework, or something that Murphy doesn't consider.

One place where Murphy is genuinely off-base, however, is in his 'λ' parameter. This measures the value people place on their free time: the idea is that using lost income to estimate the impact of unemployment is an overestimate, because people can do other productive or enjoyable things in their newly free workweek. He argues that λ is "nonzero and likely to be substantial," which contributes to the conclusion that overall, stimulus probably doesn't pass a cost-benefit analysis.

Brad Delong demurs, estimating λ at 1/5 and noting that "the cyclically unemployed are not having much fun." Yes, but 1/5 is still too high, and to accurately capture the relevant issues within Murphy's framework, we'd have to make λ negative. This is because the gap between actual and potential output understates the pain of a recession, where the losses are concentrated among the unemployed. Intuitively, this is simple: $20,000 is more useful in the hands of an unemployed person, who may desperately need the money, than spread out evenly through everyone in the economy. This is why, although naive economic analyses might conclude that the welfare effect of business cycles is minor, recessions so thoroughly dominate the political landscape.

(For the economists out there, note that the fundamental problem is that Murphy's stylized model implicitly assumes linear utility of income, which is obviously an inaccurate assumption when dealing with the massive income swings induced by unemployment.)


Plamen said...

Matt, you say "$20,000 is more useful in the hands of an unemployed person, who may desperately need the money, than spread out evenly through everyone in the economy."

That sounds very "intuitive" indeed, but does not make it right. Academics do not run small businesses, and the small businesses are the ones that end up funding such re-distributions, and then making decisions on the margin about whether to employ or let go of people.

Yglesias and DeLong do not view the game as one with multiple rounds, and thus severely underestimate the deadweight loss of taxation, and the incentive distortions a stimulus causes, such as welfare traps. They view stimuluses (stimuli?) as one-time events, and expect economic agents to foolishly assume that once a stimulus is over, it's over, which is not how in reality things work - because stimuluses are not initiated and discontinued by economists, but by politicians.

Plamen said...

To be a little more specific, note DeLong's assumption of α = 0 and f = 1.5. In this world, the government would be wise to run permanent "stimuluses" - music to the ears of any politician out there.

Also, why view λ as only describing the unemployed? Remember the Friends episode where Rachel gets her first paycheck and discovers that someone named FICA took a lot of her earnings? In a different post, you claim "A 100% drop in income for one person, obviously, is a lot worse than a 1% drop for 100 people". Worse for whom? Economic history shows over and over that reducing inequality comes hand in hand with a shrinking pie.

I hope you are familiar with the Austrian school in economics - it does not get much attention these days in universities. Use it to evaluate critically many of the wisdom DeLong, Yglesias, etc. pass off as self-evident, obvious, axiomatic...