Thursday, October 11, 2012

2001 Bush Tax Cut and Keynesianism

I just read a brief article by Jonathan Chait for The New Republic called "When Conservatives Loved Keynes". I immediately thought that I was seeing the same thing as Mr. Chait, but I'm not so sure after thinking about what was actually said. In 2001, in discussion about the 2001 Tax Cuts, Dr. Kevin "Dow 36,000" Hassett and Paul Ryan appear to stand up for a Keynesian argument about fiscal stimulus:
  
Dr. HASSETT. I would just like to add, Mr. Ryan, that the economists who studied this were quite surprised to find that fiscal policy in recessions was reasonably effective. It is just that folks tried  a first punch that was too light and that generally we didn't get big measures until well into the recession. So the reason that in the past fiscal policy hasn't pushed us out of recession is that we delayed. 

So I think that Mr. Greenstein agrees, and he is saying it is not likely that we would pass it soon but I would argue this is why we should. 

Mr. RYAN. That is precisely my point. That is why I like my porridge hot. I think we ought to have this income tax cut fast, deeper, retroactive to January 1st, to make sure we get a good punch into the economy, juice the economy to make sure that we can avoid a hard landing. 

The concern I have around here is that everybody is talking about let's wait and see, let's see if they materialize. Well, $1.5 trillion have already materialized in the surplus since then-Governor Bush proposed this tax cut in the first place. The economy has soured. The growth of the projections of the surpluses are higher. So we have waited and we do see, and it is my concern that if we keep waiting and seeing we won't give the economy the boost it needs right now.

As you see, Dr. Dow 36,000 said that fiscal policy in recessions are reasonably effective. He seems to say that often the "first punch" is too light and by the time it is phased in, it's too late because the economy is doing better already. He doesn't say that there is a reason to believe that the 2001 recession would be long-lasting, so shouldn't his logic push us to the conclusion that the fiscal policy wasn't needed at that time? So what he's really suggesting if I read him right is that if the Bush Tax Cuts are not enacted quickly, they would not push the economy out of recession. But he doesn't actually suggest that a strong recovery isn't in the offing. If a recovery could be coming anyway, perhaps by monetary policy (like cutting interest rates repeatedly as the Fed was doing at the time), then there wouldn't be a need for the Bush Tax Cut to be enacted to fight a recession.

Mr. Ryan sounds a little better, since he says that he wants the income taxes cut fast, deep and retroactive to January 1st, so they can prevent the economy from having a "hard landing". He said, "if we keep waiting and seeing we won't give the economy the boost it needs right now." So Paul Ryan believed the tax cuts would help the economy recover.

I think there is a way to take Paul Ryan at his word that he's not a Keynesian. If he doesn't believe that tax cuts give the economy a boost because of a spending multiplier, then he may believe that lower marginal tax rates have big supply side effects. I wouldn't deny that tax rates matter, but I think a fair part of the power of tax cuts in a recession are because of a multiplier that is higher than 1 (the IMF seems to agree).

These statements should not be seen in isolation, so I present the following graph (and bear in mind that hindsight is 20/20).


It may look confusing because I'm including a lot of things in this graph.  The orange line shows the extent to which GDP exceeds the CBO's estimate of potential (the scale is on the right). So we see that GDP dipped below its potential in mid-2001 and didn't fully recover until mid-2004. The green line shows the amount of annual growth that would be needed to maintain a stable level of output relative to potential and the red line shows the actual annual growth (both scaled on the left). There was pretty bad growth from mid-2000 to early 2003. The average monthly effective funds rate is shown by the blue line (scaled on the left), which shows big cuts in the interest rate until 2002, then a further cut or so in late 2002 and a further cut in mid-2003. If we use the simple, "The proof of the pudding is in the eating" (Wicksellian) assessment of policy throughout this period, the federal funds rate should probably have been cut further, earlier. Perhaps part of the problem was that interest rates were not cut before 2001, despite steeply declining rates of real GDP growth. I'm a big reluctant to say we really needed the Bush Tax Cuts, although they certainly didn't hurt the prospects for recovery (because of the multiplier, primarily, not reduced rates leading to big supply side effects).

In general, I'm inclined to agree with Milton Friedman in most cases about the problems with fiscal policy. There are "long and variable lags" that make it hard to enact expansionary/contractionary fiscal policy at the right time. Some of that can be eased with institutional fixes, but going through the normal legislative process for tax cuts or stimulus can really slow things down. In some cases, this doesn't matter so much, like when there is a big hit to aggregate demand, as we've experienced during the current depression. During the standard recessions we are all used to, monetary policy can usually do the heavy lifting. Monetary policy can change more quickly, although even it is imperfect. In normal times, like when your nominal interest rates aren't 0 (at the zero lower bound/in a liquidity trap), monetary policy is the way to go and that was the situation back in 2001.

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