Obama and Key’s responses to the financial crisis

Gordon Campbell

Stung by comments that his government has been on holiday for nearly a third of its first 100 days of action, Prime Minister John Key called back several of his senior Ministers this week for a Treasury briefing and planning session on the state of the economy. Key has also announced a “Jobs Summit” to be held on February 27 to canvass ideas for keeping New Zealanders in employment. In both cases, the initiatives looked more like a response to media criticism than a confident team on top of its game. Damage control, after all, is not actually a plan.

The early rationale for the government going AWOL in the face of the biggest financial crisis since the 1930s Depression could hardly have been weaker. 2008 had been “a big year for National,” a Key spokesman told the NZ Herald when first pressed about the holiday inertia, and having a break was therefore “very important.” Well, Barack Obama also had a big year during 2008 and he managed, just like Key, to fit a Hawaiian holiday into his schedule. Yet while Key was still in snooze mode, Obama also released a comprehensive public document available here outlining his policy response to the financial crisis.

The Obama report contains everything that is missing to date from Key’s response to the crisis. Such as – evaluations of the available policy options, and an informed ‘who will benefit’ analysis of their likely outcomes. First up, the Obama report addresses – with research to back it up – why government spending will have a bigger stimulative impact on the economy than tax cuts. The report considers which industries have more job creation potential than others, and asks what those jobs will look like – full time or part time ? – and which age, gender and ethnic groups in society are likely to most benefit from the package.

In her Youtube discussion of the Obama report that she largely wrote, the Berkeley economist Christina Romer acknowledges that the stimulus package co-exists with the existing pressures towards part-time employment. As she says, questions are being raised as to whether a stimulus package based on building roads and bridges will end up mainly creating jobs for ‘burly men’ in the construction industry – unless there is not a corresponding investment in the health and education service areas in which women workers stand to gain more directly from the injection of taxpayer funds. Such questions, Romer concedes, trouble her. They should also be troubling women voters in New Zealand, as they consider who stands to gain (and retain) employment from the stimulus spending that the Key government has in mind.

So far, Key and English have yet to produce a detailed breakdown of the components of their stimulus package – a list of infrastructure projects is promised soon – let alone lead a public debate about the priorities. To be fair, the limits on what any government can do to alleviate the looming crisis do need to be acknowledged. We are experiencing the worst slide in business confidence since 1970. The unemployment rate could well double to around 7 per cent this year, and stay there for the foreseeable, peaking at 7.5 per cent in 2011. The Standard and Poors agency has just reduced our credit rating from stable to negative. The declining value of the dollar has begun to push up fuel prices. We already have a huge current account deficit of eight pet cent of GDP. The level of government debt – hitherto the only bright spot on the economic horizon at 17% of GDP – is now being estimated to reach 40% of GDP by 2013.

In these conditions, the stimulus package is more of a political document than an economic one. It is likely to serve more as a figleaf for the government’s impotence – message : we’re doing something, however ineffectual – than be a real game changer for consumer confidence. Infrastructure projects, after all, can only do so much (at great expense) for a few people. As one commentator on the Obama package pointed out, “It is not clear that building bridges and roads stimulates consumer confidence, which is the short term issue at play here – and most people worrying about their jobs will not be suddenly working on road construction.”

Moreover, a small tax cut in April (which is what most of will get, if anything at all, from government during the first quarter of this year) will hardly do much to over-ride the fear of losing one’s job and/or defaulting on the mortgage – much less instill sufficient confidence so that large numbers of New Zealanders will feel emboldened to go out and buy a new fridge, start dining out again on a regular basis and do all the other things that make an economy tick over normally.

It is precisely because the Key government stimulus package is likely to be so puny that its thrust needs to be well directed. A fresh and convincing rationale will need to be tabled, for instance, as to why the $1.5 billion spend-up on providing faster broadband is the best use of scarce resources in the current crisis. It looks more like a piece of frippery from a bygone era of prosperity. Given the way the private sector has got us into this mess, it now seems obvious – to the rest of the world at least – that government spending will have to lead the way out of it. This week, the Obama report made this salient point in its summary, about the government spending vs tax cuts option:

The tax cuts, especially temporary ones, and fiscal relief to the states are likely to create fewer jobs than direct increases in government purchases. However, because there is a limit on how much government investment can be carried out efficiently in a short time frame, and because tax cuts and state relief can be implemented quickly, they are crucial elements of any package aimed at easing economic distress quickly.

Within Obama’s $825 billion stimulus package, tax cuts are currently expected to comprise around $275 billion of the full picture.

Not surprisingly, a lot of liberal Democrats think that ratio is wrong, wrong, wrong – given the relatively weak stimulative effect that tax cuts can deliver. In the US, the fact these relatively inefficient (in terms of multiplier effects) tax cuts are there at all is largely political. They are meant to sweeten the deal among Republicans who might otherwise baulk at the huge injection of government spending. Another factor, as the above quote indicates, is the relative speed at which tax cuts produce their stimulus effect compared to say, infrastructural spending. Essentially, tax cuts are a short term sugar fix for the economy. Ideologically though, Obama wants to include the tax cuts sweetener in order to encourage bi-partisan support by the Republicans for his crisis package – and one can only contrast this approach with the petty-minded way that Key has excluded Labour from his own Jobs Summit on February 27.

Obama’s tax cuts research

On the evidence, tax cuts are a particularly poor tool for stimulating an economy during a recession. The Obama research evidence on this point should be of particular interest to New Zealand. Over recent years, the National Party, its Act Party partner in government and much of the business community in New Zealand have held an almost mystical faith in the transformative power of tax cuts. Perhaps it is now time to grow up, and stop believing in the tax cuts tooth fairy. As the New York Times said yesterday about this aspect of the stimulus package :

Every dollar spent on a politically expedient tax cut is money that is not spent where it could do more good. It also perpetuates the corrosive debate in which taxes are portrayed as basically evil and tax cuts as unmitigated good. That is not a debate that Mr. Obama should engage.

When the economy recovers, the nation will face a far more difficult task than deciding how to spend its way out of a slump. As a nation, we will have to right the country’s severe long-term budget imbalance. That will require reforming health care and cutting spending, and — yes — tax increases.

Mr. Obama will need to lead that fight too. Planting the idea that tax cuts are not an overarching solution to serious problems is a good place to start.

The New Zealand Herald:

In the face of deficits for the foreseeable future, a credit rating headed south this week, and the rising health care costs that are an inevitable part of an ageing population, New Zealand will need to revisit the need for tax increases at some time in the future. Right now, it has to get the tax cut/government spending balance right in its stimulus package.

A complicating feature is that the Key government has Rodney Hide, a sworn foe of government spending, in its ranks as associate Commerce Minister. Hide still seems wedded to the largely discredited Friedmanite religion of less regulation and small government, and one of Key’s management tasks will be to make Hide a busy part of his government, but not a central part. Because the political risk for Key is that Hide will use the crisis as an excuse to slash and privatize public services – largely for ideological reasons likely to harm the bulk of New Zealanders, while benefiting the Act Party’s predator cronies.

Key could begin by making a clear statement on the optimum balance he sees between tax cuts and government spending in the stimulus package. As a spokesperson in Bill English’s office told me, ‘about a third’ of the $9 billion stimulus package running from June 2008 to June 2011 will consist of tax cuts. Much of the planning for those tax cuts preceded the financial crisis – and therefore, they cannot honestly be portrayed as a response to it. On principle, it would be interesting to know whether Key believes that tax cuts – or government spending – are a superior form of stimulus for the economy during this particular crisis.

“Both” is not an answer. What the Obama economic team did was compare the multiplier effects of a permanent government spending increase equivalent to 1% of GDP with a permanent tax cut also equal to 1% of GDP. The answer? Government spending proved to be more productive than tax cuts, with a multiplier gain in GDP of $1.57 dollar for every dollar spent, as opposed to only a 99 cents gain for every dollar of tax cuts.

Not only did the Obama team find that tax cuts provide less bang for the buck, their report also didn’t see much evidence of government spending ‘crowding out’ private sector investment. Mainly because the recession already has caused the private sector to already shrink into its shell. As Nate Silver says :

In this case, the [Obama] administration figures that most [is] money the private sector either can’t spend — private companies don’t build their own highways — or won’t spend during a recession because it’s become too risk-averse or because capital is too difficult to obtain.

That’s exactly the situation in New Zealand, where private sector risk aversion and the high cost of capital for major infrastructure construction projects will almost certainly rule out the extent of private public partnerships (PPPs) that the Key/English team were rosily envisaging only 12 months ago. Again, it would be really helpful if Key could say clearly whether he thinks the financial crisis now renders PPPs a less – or more – central aspect of his economic planning. Obviously, there will be dangers involved if Key and English now plan on lavishly using taxpayer funds as risk capital to entice gunshy private investors into the stimulus programme. As Silver goes on :

To summarize, people who are arguing that tax cuts are liable to be more effective than government spending in the long-run are arguing in effect that:
a) A significant fraction of tax cuts will be spent rather than saved;
b) Public spending significantly crowds out private spending;
c) Private spending is significantly more efficient than public spending.

And people who are arguing that government spending that is liable to be more effective than tax cuts are arguing just the opposite:
a) A significant fraction of tax cuts will be saved rather than spent;
b) Public spending does not significantly crowd out private spending;
c) Private spending is only marginally more efficient than public spending.

The point is, right now, Obama’s economists find the arguments for spending more persuasive than the arguments for tax cuts — as do most (although hardly all) private and academic economists.

Going by their past track record, Treasury is likely to be out of step with the global neo-Keynesian consensus that is now emerging among the US private sector and academic economists that Nate Silver is talking about. To convince it to shed its fixation on Chicago School economics, Treasury may need to be pointed towards the seminal paper in the Obama team’s approach, which is by Christina Romer and David Romer, and can be found here.

This is not the easiest paper in the world to read, so good luck. One minor distraction about it should also be noted beforehand. Earlier this month, the economist Greg Mankiw – who, under George Bush had the same job as chief of the President’s Council of Economic Advisers that Christina Romer will now hold under Obama – wrote a NYT op ed piece that badly mis-stated the multiplier effects in the Romer and Romer paper. The Mankiw column is here, and the error in the piece is critiqued here by Berkeley economist Brad DeLong and by Nate Silver here as well.

What the Romer and Romer paper does do is measure the multiplier effects from different types of tax cut stimulus. Usefully, it distinguishes between the effects of what the Romers call ‘exogeneous’ tax cuts enacted in healthy economic circumstances, and compares them with two types of ‘endogenous’ tax cuts that are enacted as a counter-cyclical stimulative measure. What the Romers found is that the endogenous tax cuts in a recession tend to have a lower stimulative effect than the ‘healthy economy’ kind. Arguably, what New Zealand now sits astride is a tax cut regime launched by Michael Cullen during the dying days of an ‘exogeneous’ period, but which are now being firmly deployed in ‘endogenous’ conditions to re-stimulate economic activity – a situation in which Romer and Romer find the stimulative benefits to be far less substantial.

In fact, as Silver indicates, the Romers don’t seem all that that keen on stimulative tax cuts during a recession at all :

What is being contemplated is a countercyclical action in an unhealthy economy designed to return the economy to normal growth. Romer and Romer are not all that keen on this type of tax cut; in fact, they argue that such “countercyclical fiscal policy is not achieving its intended purpose,” and that “policymakers’ efforts to adjust taxes to offset anticipated changes in private economic activity have been largely unsuccessful”.

Again, perhaps Key and English can share with us what multiplier effect Treasury has told them will accrue for each of the four tranches of tax cuts due between October 2008 and June 2011. That would be a useful initial window on the advice that Treasury is currently giving to its new political masters.

As the current cliché goes, we are all in unknown waters. Few economists know very much about how economies extract themselves from frozen credit markets, year-long global recessions, and collapsing housing markets. Yet if, in Bill English’s words, we’re all paddling in the same waka, maybe the captains at the macroeconomic helm could start sharing the details of their stimulus plans, the options on the table and the reasoning and research evidence for the choices they are making. When an open economy goes south, open government becomes a necessity.