Keynesianism

With the stimulus signed into law, Barack Obama got the dramatic, unprecedented jolt to the economy that he wanted -- the yearly budgetary impact of the stimulus is about 3 times what the 2001 Bush tax cuts were -- and now we'll have a chance to see if it works. Today was the day Barack Obama took ownership of the economy. A President could traditionally expect an 18 to 24 month honeymoon -- but with this dramatic action that honeymoon period shortened to 6 to 12 months. For Obama's stake -- and for liberalism's -- it had better work. 

Let's lay down some markers on what success means, and hold the Democrats accountable for meeting them. Start with their own words. Advocates of the stimulus have taken one of two tacks to describe its impact: 

• The President's contention that the stimulus will save or create 4 million new jobs
• The fact that the stimulus needed to be be at least $775 billion since this was the projected difference between the economy's actual and potential capacity. 

President Obama is on the record stating that employment will be 4 million higher than if we did nothing by the end of 2010, and that economic growth will be about 2.8% higher (over two years, the stimulus represents about 2.8% of GDP) -- if you assume every dollar of stimulus is a dollar of economic growth, as is strongly implied by the second bullet. 

What does this mean in terms of actual levels of economic activity? 

First, we have to establish some baselines. Last week, Nate Silver posted an insightful chart forecasting the unemployment rate based on postwar recessions. If job growth continues along the average trajectory of the postwar period, unemployment will peak at about 8.1% this summer and begin declining. Most economists would say this is getting off relatively easy. However, if the trajectory continues along the lines predicted by recessions in the modern period marked by the Fed chairmanship of Alan Greenspan, unemployment will top out at 9.6% in June 2010 before beginning a steeper decline. 

This is if we "do nothing."

Obama's projected four million jobs saved translates to a projected 2.8% off the unemployment rate by the end of 2010. My reading of the post-1987 chart suggests that unemployment if we do nothing would be at 9.1% in January 2011 and 6.3% post-stimulus. This is the worst case scenario. Looking at the postwar curve, 6.8% unemployment pre-stimulus would be converted into an astonishing 4.0% post-stimulus. This is highly unlikely, but it's the best case scenario. 

Split the difference between these scenarios and you get an unemployment rate of 5.15% at the end of 2010. Either way, we should expect an unemployment rate no worse than 6.3% at the appointed date if Obama's economic theory proves correct. 

The economic growth targets are a bit more nebulous, but the implicit promise is that the economy will get no worse than it is when the stimulus first kicks in. So we should expect zero economic growth at a minimum over the next two years if what we are promised actually occurs -- and likely more, since even 1-2% percent declines in economic activity are rarely sustained over four quarters or more (Obama has seven economic quarters to make it happen). 

This is a terrific interview and should be read by everyone on both sides of the stimulus debate.  Barro has actually done work in Keynesian economics (Krugman did not, incidentally) and he is skeptical of the stimulus.  And, he lucidly explains why tax cuts are to be preferred over spending when it comes to economic stimulus:

...when you cut taxes there are two different effects. One is that you cut tax rates, and therefore give people incentives to do things like work and produce more and pay more -- maybe, depending on what kind of taxes. And then you also maybe give people more income. This income effect is the one that's related to this Keynesian multiplier argument, where it's usually argued that government spending should have a bigger effect. So that's the income effect. But the tax-rate effect, inducing people to do things like work and produce more and invest more, is a whole separate effect, and that could easily be much bigger than the multiplier thing, than the income thing.