UPDATE on President Obama’s Jobs Proposal – Better, But Still Weak

First an update on a post I made a few days ago. When I commented last Monday on President Obama’s jobs proposal, I was less than excited. Having read more detail of the proposal, I should correct some statements I made.  I incorrectly left the impression that the payroll tax (Social Security/Medicare tax) cut that the President was proposing was only an extension of the present year cut that is scheduled to expire December 31, 2011.

In fact, the President is proposing not only a 1 year extension of this year’s temporary payroll tax cut, but an increase in the size of that tax cut.  Estimates are that for a median household income of near $50,000, it would result in a $1,500 reduction in payroll taxes compared to not having any payroll tax cut at all. However, the existing, this-year only, payroll tax cut had already cut payroll taxes by up to $500 per household.  So of the claimed $1,500 tax cut for next year for the median household, $500 is an extension of this year’s situation and  $1000 is new stimulus.  Today’s economy is weak even with the existing temporary $500 tax cut, so extending that cut won’t improve things. It will only prevent things from deteriorating further.  In my world, simply agreeing to not put on the brakes is not the same thing as actually hitting the accelerator.

But, the proposal does contain perhaps $1000 worth of tax cut stimulus to nearly all working households. That’s perhaps $150 billion of pure, new stimulus to economy.  It’s more than I estimated on Monday, so the plan will likely have some more stimulative effects than I thought.  But how much?  Let’s do a quick “back of the envelope” type calculation.  The proposal puts $150 billion in consumers’ hands that wouldn’t have been there without it.  But for this money to generate jobs, people have to spend the money.  Simply saving the money or paying down debt won’t cut it.  That improves individual household balance sheets but it doesn’t cause any firm out there to go “oh, more business! I need to hire people!”  In normal times like the 1960’s or 1970’s people would have spent 85-90% of the tax cut.  But these aren’t normal times. We live in high debt, high debt payments, and scared-of-the-future times.  More people save in these kind of times. (paying down debt is economically the same as savings – think of your debt as a negative balance in a savings account).  Let’s assume that people spend 2/3 of the money.  Both history and theory indicate that people save more of a tax cut when they know it’s temporary, but let’s be generous/optimistic and say 2/3 gets spent.  That’s $100 billion in new spending.

Now when it gets spent, it generates business demand and jobs.  Those people get paid and then they go spend the money again – the circular flow of money in the economy.  How much?  That’s a huge controversy in empirical macroeconomics.  This is the question of what the spending multiplier is.  Estimates vary widely, although often the studies are heavily biased by ideology to begin with.  Let’s be modestly optimistic and say the multiplier is 1.5 – 2.0.  This is a relatively high estimate given recent studies as far as I know, but let’s run with it.  That means that after some months, this initial $150 billion in tax cuts becomes $100 billion in new, initial spending which ultimately increases total spending by $150-$200 billion.  Total spending is another way of saying GDP.  This puts it in the range of 1.0% to 1.5% of GDP.

There’s a rule of thumb about the relationship between changes in GDP to changes in unemployment rate. It’s called Okun’s Law.  It’s not a law so much as a statistical regularity. There are many versions, but let’s use a real simple one: each 2 percentage point change in GDP equates to a 1 percentage point change in the unemployment rate.  So if we have GDP growth increasing by 1.5% points, we can count on unemployment rate going down by 0.75 to 1.0% points.

We’re currently over 9% unemployment rate and stuck there.  I’m not real excited about a proposal that aims to reduce the unemployment rate from over 9% to maybe 8%.  We know 4-5% unemployment is possible.  We did it in 2006 even with the slow-growth policies of the Bush administration.  We did better than that under Clinton. In the 1960’s we were even below 4%.   Why are we settling for tepid responses and setting goals of only getting to 8% unemployment and then calling this “bold”?  I don’t know.  But then maybe I’m just a grumpy old man.

What Happens If Government Debt Ceiling Isn’t Raised? 2 Things That Might, 1 That Will, and 1 That Won’t

Anybody who tells you they know exactly what’s going to happen if Congress doesn’t raise the government debt ceiling before next week is just making it up.  Reality is we don’t know for sure.  As Brad Delong notes (and Krugman and Nick Rowe), economists don’t even have nicely worked-out theoretical models of what happens if the government defaults.  It was just never considered.

Obviously, the devil is in the details. A lot depends on how the Congress deals with it  – the details of any “deal”. Many of the “plans” that have been floated on Capitol Hill to “deal” with the debt ceiling would most likely have consequences not much different from defaulting and not raising the ceiling at all.

And a lot depends on how millions of people think other millions of people will deal with it.  Another reason we have no good prediction of the consequences is because there are millions of investors worldwide involved. And each of them is making decisions based on what they think the other millions of investors will do.  It’s often tough to predict the behavior of 2-3 poker playing partners.  Predicting how millions of investors will place their bets is near impossible.

Most of the articles that have been peppering the news media speculating about the effects of default focus heavily on interest rates. Example: today’s NYTimes.  If you’re a banker, corporate treasurer, or hedge fund manager, that’s your biggest concern.  But there’s other more significant ways either default or any major spending cuts deal will affect everyday folks like you my readers.  There’s likely three ways either a default or a drastic cut in government spending (cut in deficit) will effect everyday folks.  So while we can’t predict exactly how things will play out, here’s a guide to where the possible dynamics are.  Here’s what we know:

  1. Interest Rates – Nobody knows for sure.  A majority of economists and bankers believe that a government default will raise interest rates on government bonds.  Accepted theories on interest rates then imply that all other interest rates would likely also go up a similar amount.  But this is far from certain.  Japan has had debt levels more than twice as high as the U.S. for well over decade.  Ratings agencies have down-graded Japanese debt.  But Japan still enjoys interest rates lower than the U.S.  I’ve read analyses by respectable economists and Wall Street types that pose plausible scenarios in which markets don’t raise interest rates at all, or that only government debt rates go up but private debt doesn’t.  I’ve even read scenarios wherein interest rates might slightly decline – although they are already so low there’s not much room to go lower.  Right now the markets aren’t showing any indication of higher rates. Anybody tells you they know what will happen to interest rates is telling you more than they know.  In fact, they’re telling more than what’s knowable now.
  2. Ratings on Government Debt – The bond ratings agencies, Moody’s, S&P, and Fitch, are threatening to downgrade US bonds from AAA to a lesser rating. Separate from any impact on interest rates, a downgrade might cause bond market turmoil and a lot of trading.  This would be because pension funds and other entities are often required by regulations and laws to keep a certain % of assets in AAA rated securities.  If US bonds are down-rated, then pension funds might have to sell their bonds and go into something else.  Nobody knows what that else might be or whether there’s enough of that something else to satisfy the demand.  As Krugman observed, when the bond ratings agencies speak, they have a lousy record.  They thought sub-prime mortgage securities were AAA because the banks said they were.  The agencies have been dead wrong about Japan.  Quoting Krugman: “when S&P or Moody’s speaks, that’s not the voice of “the market”. It’s just some guys with an agenda, and a very poor track record. And we have no idea how much effect their actions will have.”
  3. Government Spending Cuts & GDP. This one we know for sure.  If the government cuts it’s spending significantly at this time of high unemployment & low demand, it will slow the economy, depress GDP, and raise unemployment.    How much?  Here’s a quick rule-of-thumb, back-of-the-envelope calculation.  The GDP is now roughly $15 trillion.   Of that $15 trillion, $3.8 trillion comes from federal government spending.  $150 billion is 1% of GDP. So every $150 billion in spending cuts that the government does this year means a drop of 1% in GDP.  Right now, projections are that the government deficit in August alone will be close to $140 billion.  So, if the government has to suddenly cut it’s spending to match tax receipts (an instant balanced budget), it means the GDP shrinks by 1% every month.  In 2008-09, GDP only dropped by approximately 6% in total.  An instant balanced budget with no increase in borrowing will mean a recession more severe than 2008-09.  What will that do to unemployment?  According to estimates of Okun’s law, every 1% drop in GDP will bring a half percentage point increase in the unemployment rate.  So if we instantly balance the federal budget by cutting spending as many Tea Party members want, we will decrease GDP by 5% and unemployment will rise to around 11.5 – 12% by Christmas.
  4. Business Confidence.  Many Tea Party types and others are claiming that a balanced budget and no increase in the national debt will “restore business confidence” and unleash economic growth.  Hogwash.  Won’t happen.  Can’t happen. Hasn’t happened before.  This is the “growth from government austerity” pitch that has been made to Ireland in 2009.  Ireland did it and has only slowed further and had unemployment rise.  The Conservatives in the UK promised that budget cuts last year would stimulate the economy.  Hasn’t happened.  The UK economy slowed and is dead  in the water now.  In fact, we don’t have any recorded episodes of a major developed country stimulating it’s economy and reducing unemployment as a result. That’s because cutting spending is contractionary fiscal policy, which is, well, contractionary.  Government spending creates jobs and incomes just as much as private spending.  Right now, with high unemployment, we have too little aggregate spending in the economy.  Businesses are not spending because they fear the government’s budget.  They’re not spending because nobody’s buying – there’s no demand. Instead of wagering that government austerity will bring growth and employment, you’re better off betting on pigs flying.  The odds are better.