I was just thinking. Imagine you are Barack Obama. Larry Summers is the economist you respect most, and he's telling you that the stimulus is large enough. Pitched against him are many conservatives whining about how the stimulus is so large it's going to bankrupt America, and that what we really need is a large permanent tax cut. So then, Barack talks to the very well-respected economists at the CBO, who say, that if the stimulus goes well, we'll see a dramatic reduction in unemployment by year's end of just 7.7% (a reduction, that is, over where we'll be in two months when the stimulus spending starts), Elmendorf forecasts, under the rosy scenario, and, if not, if the stimulus goes poorly, we'll still only be at 8.5%, just a touch above where we are now. Elmendorf predicts a "A marked contraction in the U.S. economy in calendar year 2009, with real (inflation-adjusted) gross domestic product (GDP) falling by 2.2 percent, a steep decline from a historical perspective." The thing is, the economy will drop at 5% in quarter one, that much looks clear. The stimulus spending in the six months thereafter comes only to $188 billion, or about 2.5% of GDP. So, let's assume that GDP contracts at only 2.5%, and then, magically, stages a recovery in quarter 4 to have flat GDP growth. This strikes me as an utterly fanciful scenario, and yet it yields a reduction in GDP for the year of 2.5%, higher than the CBOs prediction of 2.2%.
The problem is that, with monetary policy at a zero lower bound, any deflation we experience now will only increase the real interest rate, which should reduce economic activity. The CBO seems to believe that things will just magically turn around. They haven't said where the supposed recovery is going to come from. It looks like we've put all our chips into nonstandard monetary policy suddenly roaring to life and working, even though it has not been effective so far.
If Obama wants to hear an alternative to this rosy, magical recovery scenario, he basically has to read Krugman's blog, talk to stiglitz on the phone, or talk to Biden's economist Jared Bernstein, who has a much lower profile than Summers, Geithner, Orszag, or Romer. Point is, Obama can't exactly pick up the NYT and WaPo and find people blasting his stimulus as irresponsibly small. Criticism is pretty much limited to a few liberal cranks. (Although, with the bank bailout, there are no shortage of critics...)
Let's envision a disaster scenario. Last quarter, excluding the rise in inventories (which was an ominous sign), GDP lost 5.1%. Let's say things continue to get worse. Why might they get worse? Well, the labor market did shed 600,000 jobs in January, vs. an average of -520,000 in Q4 2008. The rise in inventories tells me that firms should want to cut back production even more, so they can reduce their costly inventory. There are still problems in the credit market, the banking crisis hasn't been sorted out yet, and the rise in unemployment means that consumer confidence should continue to be bad. So let's say GDP drops 6% in Q1 2009, which does not seem unreasonable given the January job loss numbers. Now let's say there is an increased crisis of confidence, consumers pull back even more than they are, and so too does state government spending (who's hands are often tied by balanced budget amendments), and so let's use a baseline of -7% for Q2 and Q3 of 2009, which doesn't seem too unreasonable. Why should we assume that, absent any government intervention, things won't just keep getting worse? In this case, the Obama stimulus gets us back to just -4.5%, and perhaps just -4% for Q4.
Here's the thing: If the economy does that poorly, state and local governments are going to be that much more in the hole, and will have to pull back even more in 2010. Previous estimates were that state governments forecasted revenue shortfalls of $350 billion thru 2011, but those estimates were almost certainly based on, at worst, the CBOs rosy predictions of -2.2% GDP reductions. With -4% GDP, those state government shortfalls could be more like $500 billion over three years, which has the effect of eating away at even more of the meat of the Obama stimulus plan. If local shortfalls (including cities but not states) come to $150 billion over the next three years, which does not seem unreasonable, then practically all of the Obama stimulus will be gobbled up by actions at the state and local level.
So, the question is, how long until Obama Stimulus II?
And, once the specter of Obama Stimulus II comes out, how many milliseconds will it take Congressional Republicans to jeer that, if the stimulus didn't work the first time, why on Earth would it work a second time? How long will it take them to deplore throwing good money after bad?
Schedule for Week of January 26, 2020
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