State/Local Fiscal Policy During the Great Depression

When I discussed government purchases during FDR’s first two terms as President, I opened with something from Paul Krugman. Alex Tabarrok graced our blog with this comment:

Here from HSUS is Federal Spending by year - note by 1934 spending had more than doubled in nominal terms.

Maybe I should acknowledge something else Paul had to say:

So I caught Governor Schwarzenegger on TV, talking fiscal crisis, and found myself thinking about fiscal stupidity. Economists may remember that the president of the European Commission once called the eurozone’s “stability pact,” which was supposed to set a rigid limit on budget deficits, the “stupidity pact” - because it would have forced tax hikes and spending cuts in the middle of a recession. Well, we’ve got our own stupidity pact: state and local governments operate under fiscal rules that lead to booming spending and tax cuts when the economy is strong and the reverse when the economy is weak. This is bad governance: services are cut precisely when people need them most. It’s also bad macroeconomics: it exacerbates the business cycle. Right now, we’re seeing a sharp drop in state revenues, which is going to lead to big cutbacks in spending and tax increases at exactly the wrong time.

While Alex is focused on Federal expenditures and revenues, my original graph looked at total government purchases. Expenditures include both purchases and transfer payments but looking at Federal figures omits what was happening at the state & local level. But let me give even more credit to Marmico who sent us to a series of Federal expenditures and revenues as percentages of GDP, which our first graph depicts for the 1930 to 1941 period. Expenditures (outlays) rose relative to GDP from 1930 to 1934 but this was more due to a drop in real GDP than skyrocketing real spending. Federal receipts (taxes) did rise as a share of GDP from 1932 to 1938 while outlays as a share of GDP fell from 1934 to 1938. Federal fiscal policy wasn’t exactly doing what Keynes would recommend in his 1936 General Theory until after the 1938 recession.

Our second graph – which represents the reason for this post – shows a historical example of what currently concerns Paul – falling state & local revenues (as a share of GDP) combined with the tendency for state & local governments to annually balance their budgets, which translates into reduced expenditures (as a share of GDP). And given the fact that state & local expenditures were often greater than Federal expenditures before World War II, the pro-cyclical nature of state & local fiscal policy could have easily dominated any timid attempt at countercyclical fiscal policy from the Federal government – even if FDR had more wisdom and courage to try what Keynes came to recommend.

Missing: the strange disappearance of S. J. Chapman’s theory of the hours of labour (8)

The eclipse of work in neoclassical economics. Part II

Pencavel (1986) concluded that, considering the consistency with which empirical research produces values that violate the model's predictions, "the scientific procedure is surely to regard the theory as it has been formulated and applied to date as having been refuted by the evidence" (p.95). Other criticisms point out that the income-leisure choice model "cannot provide any substantive analytical predictions on the course of labor supply by an individual or a group" (Altman, 2001, 199) and takes no account of the non-pecuniary benefits of working (Farzin and Akao, 2006).

Derobert (2001) questioned the pedigree of the model, noting the paradoxical disappearance of labour, documenting bibliographical anomalies in the model's transmission and finding that the model's formal consecration by Tibor Scitovsky (1952) was accompanied by a warning about its pitfalls – specifically, that regarding leisure as a commodity may lead us to mistakenly assume there is a "conflict between the efficient specialization among workers and the efficient distribution of leisure" (p. 107). "It is much safer," Scitovsky went on to explain,

as well as more natural, to look at the face of the medal and concentrate our attention on work and the burden it involves, rather than on freedom from work and the satisfaction this yields. We can, if we like, think of work as a negative commodity, of its burden as a disutility or negative satisfaction, and of the earnings received for work as a negative price... (p. 107).

Scitovsky's 'safer' and 'more natural' approach, however, would require abandoning the opportunity-cost value theory at the foundation of the income-leisure choice model, without which the model itself would cease to have any meaning.

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Abstract: Sidney Chapman's theory of the hours of labour, published in 1909 in The Economic Journal, was acknowledged as authoritative by the leading economists of the day. It provided important insights into the prospects for market rationality with respect to work time arrangements and hinted at a profound immanent critique of economists' excessive concern with external wealth. Chapman's theory was consigned to obscurity by mathematical analyses that reverted heedlessly to outdated and naïve assumptions about the connection between hours and output. The Sandwichman is serializing "Missing: the strange disappearance of S. J. Chapman's theory of the hours of labour" on EconoSpeak in celebration of the centenary of publication of Chapman's theory. (To download the entire article in a pdf file, click on the article title.)

Why Markets Fail

Markets fail for many reasons. With all the attention to the current financial crisis, the time has come to look at another part of market failure -- the reluctance to invest in long-lived plant and equipment. I'm not merely thinking about the deindustrialization of the US economy, but a more general reluctance.

The commitment of funds for fixed capital entails taking a risk. In the words of John Hicks, one of the earliest economists to win a so-called Nobel Prize, pointed to the obvious problem: "an entrepreneur by investing in fixed capital gives hostages to the future" (Hicks 1932, p. 183). Unfortunately, neither Hicks nor virtually any other economist has explored this fear of investment.

The most popular response to this reluctance to invest came from a very conservative Austrian economist, who once served as a socialist minister of finance, before landing at Harvard. Joseph Schumpeter was indeed one of the giants of 20th century economics. Here his reputation to his personal brilliance, as well as a willingness to learn from Karl Marx.

I have posted the rest of the piece as a pdf at

schumpeter

It was written to help me focus my thoughts for my talk in San Francisco tomorrow. Any comments will be appreciated.

Government Purchases: 1932 to 1941

Let’s return to the discussion of New Deal economics, that is the role of fiscal policy during the first two FDR administrations and look at the discussion from Alex Tabarrok:

Thus, an accurate portrayal of fiscal policy during the Great Depression - entirely consistent with Krugman - is that we had much greater spending, much greater taxes and not much economic stimulus.

Raising tax rates during a period when aggregate demand falls far short of potential GDP does seem silly but I have to challenge this notion that we tried a massive increase in government purchases. Using BEA data, I have provided graphs of real government purchases (G/Prices in terms of 2000$) and the ratio of government purchases to GDP (G/GDP). Before 1941, the increase in government purchases roughly mirrored the increase in GDP so this claim of “much greater spending” sounds a bit suspicious. Of course, government purchases did increase substantially starting in 1941 but then as the graph of output to potential output provided by Paul Krugman notes – that is when fiscal stimulus did restore full employment.

Update: Marginal Revolution reader Marmico challenges the notion that tax collections rose substantially during FDR’s first two terms providing us with this link. As Marmico notes:

Conflating high individual marginal tax rates with much greater taxes is bunk.

To be fair, Marmico’s graph shows only a subset of Federal tax revenues as a share of GDP so I have added a graph of total government revenue (Rev) relative to GDP.

Missing: the strange disappearance of S. J. Chapman’s theory of the hours of labour (7)

The eclipse of work in neoclassical economics, Part I

The approach to the analysis of individual labour supply that replaced Chapman's theory took no notice of the effects of technological change on fatigue or on the subjective experience of the worker. It treated labour itself as a residual of the individual's consumption preferences. According to the new orthodoxy of income-leisure choice, leisure is assumed to be a normal good. Work is something featureless that takes place in the weeds behind the billboard of consumption and disposable time. Because this commodity-leisure itself lacks any definitive quality other than not being work, work is reduced to the hollow double negative of 'not not-working'. There is no pain in this hollowed-out work, neither is there joy.

A chorus of criticism surrounds the income-leisure choice model. Spencer (2003, 2004) objected that the model ignores the qualitative dimension of both work and leisure, a dimension that was specifically addressed in the approaches of Jevons and Marshall. Philp, Slater and Harvie (2005) disputed the epistemological coherence of the model's microfoundations, concluding that, "the indifference curves which underpin labour-leisure preferences are themselves founded on axioms which have been shown to be problematic elsewhere in neoclassical economics" (p. 80). Jennings (2004) analyzed the dead metaphors that signify measurement in the labour supply model, pointing out that measurement already requires a metaphor but that unmeasurable homogenous units of labour are a metaphor for a metaphor – a catachresis (literally "wrong use"). She cited Barthes's criticism of such speech forms as foundational for mythologies that "falsely universalize by removing the historical referents of signifiers" (p. 137) and noted his warning about the disingenuous "depoliticization" inherent in such speech.

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Abstract: Sidney Chapman's theory of the hours of labour, published in 1909 in The Economic Journal, was acknowledged as authoritative by the leading economists of the day. It provided important insights into the prospects for market rationality with respect to work time arrangements and hinted at a profound immanent critique of economists' excessive concern with external wealth. Chapman's theory was consigned to obscurity by mathematical analyses that reverted heedlessly to outdated and naïve assumptions about the connection between hours and output. The Sandwichman is serializing "Missing: the strange disappearance of S. J. Chapman's theory of the hours of labour" on EconoSpeak in celebration of the centenary of publication of Chapman's theory. (To download the entire article in a pdf file, click on the article title.)

How to Deal with Housing: Speaking for Galbraith IV

Finally, I have a few suggestions regarding dealing with the current crisis associated with the decline of the housing bubble and the distress this is causing to individuals, especially those facing foreclosures or difficulties in paying their mortgages. I would support two proposals that have been floating around.

The first is that of foreclosure vouchers, a proposal due to David Colander. The idea is to have the government (Treasury? HUD?) distribute to taxpayers mortgage foreclosure vouchers, based on income, with lower income persons receiving larger vouchers. These can either be used to pay off a mortgage for those facing foreclosure or to buy a house that has been foreclosed. Otherwise, they can be sold in a secondary market. This will help those in most danger and may help to stabilize the housing market as well, although there will probably need to be some further declines in housing prices as they continue to remain some 10-30% above historical norms, if the Case-Shiller index is to be believed. While falling housing prices are creating many problems, ultimately lower housing prices will make it easier for younger and poorer people to buy houses without relying on exotic mortgages, which should be sharply limited.

Another idea is that of a shared appreciation mortgage (SAM), which have been used in the past as well as in the UK. In this case, a borrower gets a lower mortgage rate, but must share any appreciation of the value of their house with the lender. This may provide a way for renegotiating mortgages to make them easier to pay, while preserving the stability of the lending institutions as well. Apparently this sort of mortgage is technically available for use right now, but has been not used in recent years due to an IRS ruling against them because of problems keeping debt and equity separate for tax purposes. As has been noted by proponents, this rule could be changed "by the stroke of a pen" used by the Treasury Secretary.

As a final note, I point out that Canadian banks are currently rated the safest in the world and have been relatively unharmed during this current crisis. Their regulations are clear and straightforward, with the Canadians having a nationwide, branch banking system. So, it is possible to improve how the financial system works through appropriate rules and regulations.

Relax the Mark to Marketing Accounting Rule: Speaking for Galbraith III

The real source of the problem with mark-to-marketing accounting rules has been international, coming out of the Basel II rules that have only recently been fully adopted in the world's banks. In any case, banks must revalue their assets according to current market conditions, which in itself is not such a bad thing. However, the minimum capitalization rules in conjunction with this method of accounting aggravate downward spirals. If a bank's assets decline in value, it may be forced to sell some to raise its capitalization, which has a clearly negative multiplier effect on the markets in general.

The SEC has reportedly been considering some variation of this rule. I would suport a change that has been reported to have been adopted in Germany. Banks that declare a willingness to hold onto an asset to maturity, may value it at its original face value. Thus, promises to hold certain assets to maturity takes them out of being subject to the mark to marketing rule and stabilizes their capitalization, and hopefully, the financial markets more broadly.

Battling Bubbles: Speaking for Galbraith II

Probably the most difficult proposal I shall make will be to advocate a much more vigorous role by the government in preventing bubbles from getting too large. I understand that the Fed is thinking about this, but I think this is a function that should be spread across various agencies, with perhaps the CEA being the one to try to advocate for something being done. Different bubbles may require different tools, with very precise ones that influence the relevant markets the best. Thus, for an oil bubble, use selling oil from the Strategic Petroleum Reserve. Paul Davidson has long advocated using buffer stocks of commodities to regulate excess price volatility in some markets. This can be done for some agricultural commodities as well, presumably by the USDA. In housing markets, limits on certain kinds of mortgages can be imposed, perhaps by the Fed, no interest only or other mortgages that encourage prices of housing too high for most buyers. In broader financial markets, the SEC or the Fed can use margin requirements to slow the rush to buy and push up prices, and clearly various derivatives not now under such regulations should be brought under them. So, a flexible policy not focused on one tool or approach should be used.

In this regard, let me issue a warning. While many have sneered at Alan Greenspan for his reluctance to do anything about bubbles, it should be kept in mind that, aside from margin requirements, the main tools available or the Fed are probably too blunt. Thus, no one should forget that the overly tight monetary policy of 1929-30 was substantially driven by a desire to squeeze down the stock market bubble of the late 1920s. Clearly a tool can be overused. And, while many also sneer, it is also not always that easy to know when a bubble is going on, although I think this can be done. In this regard, Greenspan himself jumped the gun with his famous remarks in 1996 cautioning against "irrational exuberance," which caused the stock market to drop the next day, but then to start climbing again, with the main market indices not ever getting down that low again (although I think the NASDAQ has, which was the bubbliest).

No New Bureaucracies: Speaking for Galbraith I

This Friday, November 14, I shall be participating in a public forum at the Theresa Lang Student Center, New School University, 55 West 13th Street, Room 1202, 1203, that has been organized by James K. Galbraith, a senior Obama economics adviser, under the sponsorship of the Economists for Peace and Security, and entitled, "Financial Crisis, the US Economy, and International Security in the New Administration." Besides Galbraith and myself, a few of the other participants will include Joseph Stiglitz, Lord John Eatwell, Allen Sinai, Paul Davidson, Perry Mehrling, Ping Chen, and Dimitri Papadimitriou, among others. I will be on a panel devoted to proposing new regulations for the domestic financial system. I shall discuss what I intend to talk about in four postings here, this the first one.

So, my first remark will be to urge that there be no new regulatory bodies or other bureaucracies created. What is needed are better rules and better people in the relevant positions. There may be (and already have been) changes in the powers of particular bodies, but any effort to create some new, grand oversight body will be just a waste of time and effort. Unfortunately, Democrats sometimes like to d0 this. So, in the wake of 9/11 they were stronger advocates than most Republicans of creating the Department of Homeland Security to combat terrorism. This was supposed to centralize and simplify decisionmaking, but it simply made things more confused and worse. Burying FEMA in this body did not help with its ability to fight against hurricane disasters and damages. I see no reason for Obama to revive Clinton's National Economic Council either. What did it ever do that the CEA cannot do? And for that matter, do we really need the Comptroller of the Currency? Cannot its functions be taken over by the Fed? In this time in which government will necessarily be increasing its role in the economy, let us at least hold back on increasing its overblown bureaucracy. Keep it lean and clean and mean.

Cutting Defense Department Pork

Conservatives wanted to paint Barack Obama as a big spending liberal but maybe he will propose reducing DoD spending says Bryan Bender:

A senior Pentagon advisory group, in a series of bluntly worded briefings, is warning President-elect Barack Obama that the Defense Department's current budget is "not sustainable," and he must scale back or eliminate some of the military's most prized weapons programs. The briefings were prepared by the Defense Business Board, an internal management oversight body. It contends that the nation's recent financial crisis makes it imperative that the Pentagon and Congress slash some of the nation's most costly and troubled weapons to ensure they can finance the military's most pressing priorities.

I’m all in favor of a strong military but there has always been room to make our Defense Department leaner without sacrificing national security. According to this source, overall Federal spending rose from 18.99% of GDP in 2000 to 20.86% of GDP in 2007 with defense spending leading the way as it rose from 3.77% of GDP in 2000 to 4.8% of GDP in 2007. Defense spending represents 23% of the total Federal budget even if we include Social Security benefits. Defense spending is also more than double nondefense Federal spending. While you may her talk among Republican circles that we can balance the budget without raising taxes, this talk is pure fantasy unless one is willing to curb DoD spending. Yet – Republican support for the type of proposals outlined by this advisory group has historically been quite rare. Let’s hope things change over the next few years.

Fiscal Policy and the 1938 Recession

Paul Krugman has a few economic history lessons for the President-elect and the rest of us:

Everybody’s talking new New Deal these days - and, predictably, the FDR-haters are out in force, with all the usual claims about FDR having actually made the Great Depression worse.

These rightwing FDR-haters also seem to think that the General Theory written by Lord Keynes is one of the most evil books of all time. Paul notes, however, that real GDP rose impressively relative to potential GDP from 1933 to 1941. But wasn’t there a recession in 1938? Paul continues:

you might say that the incomplete recovery shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump.

Today Paul adds this:

there’s a whole intellectual industry, mainly operating out of right-wing think tanks, devoted to propagating the idea that F.D.R. actually made the Depression worse. So it’s important to know that most of what you hear along those lines is based on deliberate misrepresentation of the facts. The New Deal brought real relief to most Americans. That said, F.D.R. did not, in fact, manage to engineer a full economic recovery during his first two terms. This failure is often cited as evidence against Keynesian economics, which says that increased public spending can get a stalled economy moving. But the definitive study of fiscal policy in the ’30s, by the M.I.T. economist E. Cary Brown, reached a very different conclusion: fiscal stimulus was unsuccessful “not because it does not work, but because it was not tried.” ... F.D.R. wasn’t just reluctant to pursue an all-out fiscal expansion - he was eager to return to conservative budget principles. That eagerness almost destroyed his legacy. After winning a smashing election victory in 1936, the Roosevelt administration cut spending and raised taxes, precipitating an economic relapse that drove the unemployment rate back into double digits and led to a major defeat in the 1938 midterm elections. What saved the economy, and the New Deal, was the enormous public works project known as World War II, which finally provided a fiscal stimulus adequate to the economy’s needs.

In other words, that 1938 recession cited by rightwingers as evidence that fiscal stimulus is bad, bad is actually evidence that we should not turn to fiscal discipline just now. Let’s just hope the 2009 fiscal stimulus package does not come at the point of a gun – just as another idiotic invasion of a Middle East nation.

The Financial Meltdown and the “Meltdown Meltdown”

Bill McKibben reminds us that we can’t put climate change on hold until we think it’s economically convenient; the natural world has its own priorities, and we don’t get to vote. If you understand why putting a lid on carbon emissions is urgent, you know why it can’t be pushed back to the middle of the to-do list.

But there is another point to be made, crucially. In the end, there is only one resource constraint the government faces in its effort to contain the financial crisis and prevent recession from morphing into depression: the requirement that external deficits be financed. The Fed can wave its wand and create finance out of thin air—so long as this doesn’t lead to a panicked flight from the dollar. As it was in the beginning of the crisis, so it shall be in its long unfolding: dollars going out must find their way back in.

This constraint is invisible at the moment, because treasuries are seen as the safest asset in an unsafe world. In fact, money is flowing in at such a pace that the Fed has had to set up a network of currency swaps to make sure other central banks have enough dollars. But that sentiment will change at some point, perhaps suddenly, and when it does the feasibility of the current free-spending bailout will be in question.

There is no single solution to this problem (although I’ve argued in the past that bailing out the private sector’s old losses to generate new finance makes it worse). One significant step, however, is to push down the US oil import bill as far as it can go. A carbon cap along the lines Obama the candidate advocated last winter would be just the ticket. If we jack up the price of oil through a hard-nosed cap, imports will fall. And, as I also argued in an earlier post, households would benefit if the auction revenues were returned to them more or less in full. Rather than paying out to oil companies and petrostates and never seeing their money again, their payments would be captured by the auctions and handed back to them. Importance for the financial crisis: less oil imports mean a lower current account deficit, and therefore less reliance on external financing. It pushes the resource constraint out.

Missing: the strange disappearance of S. J. Chapman’s theory of the hours of labour (6)

...now you don't? Part IV

For Hicks, then, thinking back his argument to a "more cumbrous but more realistic form" involved making an unexplained leap from the observation in Chapter V, consistent with Chapman's theory and historical evidence, that "[p]robably it had never entered the heads of most employers that it was at all conceivable that hours could be shortened and output maintained" (p. 107) to the claim in Chapter XI that, "[a] very moderate degree of rationality on the part of employers will thus lead them to reduce hours to the output optimum as soon as Trade Unionism has to be reckoned with at all seriously" (p. 218). It is not a question of whether Hicks's assertion was right or wrong. His claim simply didn't follow from his own premises and, in key respects, contradicted them.


Although Hicks's non sequitur feat of "realism" may be one element in the disappearance of Chapman's theory, surely it can't be held solely responsible for its eclipse. For an explanation of that, we need to turn to a subsequent general shift in formal economic analysis (in which Hicks was deeply involved) that took place in the 1930s. This shift inherited some of its fundamental premises from the thought of Leon Walras, Vilfredo Pareto and Enrico Barone, proponents of the Lausanne school of economics.

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Abstract: Sidney Chapman's theory of the hours of labour, published in 1909 in The Economic Journal, was acknowledged as authoritative by the leading economists of the day. It provided important insights into the prospects for market rationality with respect to work time arrangements and hinted at a profound immanent critique of economists' excessive concern with external wealth. Chapman's theory was consigned to obscurity by mathematical analyses that reverted heedlessly to outdated and naïve assumptions about the connection between hours and output. The Sandwichman is serializing "Missing: the strange disappearance of S. J. Chapman's theory of the hours of labour" on EconoSpeak in celebration of the centenary of publication of Chapman's theory. (To download the entire article in a pdf file, click on the article title.)

Johnathan Swift on The Bubble

No commentary needed:

The Bubble
Ye wise Philosophers explain
What Magick makes our Money rise,
When dropt into the Southern Main;
Or do these Juglers cheat our Eyes?

Angels and Pins

Sandwichman asks Dr. Reich: So, just how many stimulus angels can dance on the head of a fiscal pin?