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Paul Krugman is wrong; Obama DOES need to discuss Keynesian economics in his State of the Union address. Here’s why.

Paul Krugman is my hero.  I credit him–him alone, really–with ending, finally, the Peterson Foundation’s capture of almost all of the mainstream news media as their PR outfit.  Just as I credit Occupy Wall Street, also alone, with finally ending the decades-long political prohibition of class warfare by any group but the hedge fund/CEO crowd. Krugman, unlike other liberal economists, thanks to his New York Times column and blog, is not relegated by the news and political worlds to tree-falling-in-a-forest status.  His writings penetrate the barriers–consciousness–that no other liberal economist can.  And he has, single-handledly, removed from the big-name propogandists the freedom to sell their snake oil, unrebutted in any broadly-read forum, as news and fact-based commentary. Krugman bats down this stuff, daily.

The economic/fiscal right is similar to the conservative-legal-movement right, best as I can tell, in its perversion– its Orwellian redefinition–of common language terms and its out-of-the-blue proclamations of false fact. In law, it is words, phrases and concepts such as freedom, liberty, viewpoint coercion, matters of public concern, First Amendment rights to free speech and free association and to petition the government for a redress of grievances, that are now regularly removed from their ordinary meaning to strip or fabricate constitutional rights, depending upon which outcome advances what is at bottom the Reagan-era-right’s legislative agenda.  There is, it is by now clear, no redefinition or fabrication of fact too shamelessly politically opportunistic, or too whiplash-inducing in light of their own recent aggressive rulings to the contrary, that four or five justices won’t adopt, and certainly no limit to the bald silliness that their legal-movement apparatus won’t offer with a straight face.

Freedom means imprisonment.  Or, more precisely, it means being denied access to the federal habeas corpus process after conviction of felonies and sentenced to a long prison term, however rampant the violations of federal constitutional rights, as long as the conviction was in state court, because states, or more accurately, state judicial branches are sovereigns whose dignity must not be offended by the shackles of having to comply with the Constitution’s dictates and prohibitions.  Yes, and work will make you free, as long as the work occurs inside a concentration camp, within a sovereign state.  Or at least it will if you’re a public-sector employee in a unionized job and you are ideologically opposed to big government but not so strongly against it that you will quit your job and ask that your position not be filled upon your departure.  Or if you’re a physician who accepts Medicare patients.  But not if you’re a prosecutor whose discovered bald misconduct on the part of the part of the police in a prosecution, and your own office looks the other way and you complain, since the phrase “big government” does not include within its meaning police misconduct and therefore is not a matter of public concern.

I wish there were a Krugman-equivalent for legal issues.  Without one, these folks dramatically rewrite the Constitution and federal statutes, with rare exceptions entirely off the public’s radar screen.  But there’s not.

But I digress.  I come not just to praise Paul Krugman but also to refute him.  Well, actually to refute his argument today that it’s okay if Obama doesn’t address Keynesian economics in his State of the Union address next week, as long as he addresses, at length, issues of dramatically unequal income and wealth distribution and access to the means of economic mobility.  Krugman recognizes, of course, the relationship between the two, but concludes, citing FDR’s inability to do so in 1937, that the former is almost impossible to accomplish while the latter is easy to do because the public is now very aware of the basic facts and, by large majorities, concerned about it.

Krugman’s purpose is largely to dispute the claim by some liberals that a focus on inequality distracts from an argument for a jobs-creation agenda–that is, an argument for a new economic-stimulus fiscal policy.  He’s right that that is wrong; issues of inequality of income and wealth are anything but a distraction from the sluggish economy.  And, separately, they’re of essential concern.

But a threshold to progress on either of these fronts is victory in this year’s congressional and state-government elections. And therefore, a refutation of the Republican “Obama economy” mantra.

Two weeks ago, in a post I titled “Yes, Speaker Boehner, But WHOSE Policies of the Present Are to Blame?”, I expressed my deep desire to see Obama use his State of the Union Address to point out the dramatic decline in government employment at every level of government–federal, state, local–throughout his presidency, and to show, using charts, how that differs from every economic downturn since the early 1930s.  This is different than a Keynesian argument for economic stimulus. This is easy to explain–both the facts and the economic effects.  If a teacher, firefighter or police officer is laid off, he or she and his or family is spending far less money in the community and the larger economy.  And the layoff may mean the loss of the family’s home.  Federal funds to states and localities has been dramatically reduced since the Tea Party gained control of Congress–a majority in the House, a veto-by-filibuster in the Senate. Compare that to, say, the recession in the early 2000s.

It’s their fiscal policy–and their economy.  And by no means just because of a failure to enact further stimulus programs.  The public needs to be told–and shown–this.  I think it’s important not to conflate stimulus with dramatic reductions in spending. And, with all the respect that Krugman is due notwithstanding, I think that’s what he’s doing.

As for FDR, it seems to me likely that he reversed fiscal course in 1937 not because of public opinion poll results but instead because he, like the public, bought into deficit fears.  But the experience of the 1930s’ double-dip depression, along with the current experience here and in Europe, is not that hard to explain to the public.  FDR’s problem was that Keynesian economics was pretty new territory then, and he wasn’t clairvoyant.  He made the same mistake that Obama made.  He bought the wrong sales pitch.  Understandable in 1937, but not so much these days.

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Finally … The Change We’ve Been Waiting For

This was a throw-down-the-gauntlet speech.  

We have ourselves a leader.  

—-
UPDATE: E.J. Dionne equates this speech with FDR’s second inaugural speech and Reagan’s first one, in its importance. I hadn’t thought of Reagan’s–and of course the substance of today’s speech was the mirror image, the opposite, of Reagan’s–and I wasn’t alive for any of FDR’s speeches. But my very first reaction to the speech today was to think that it probably was similar in its essence to FDR’s 1937 inaugural speech. Just an instinct, but apparently I was right.

PS: Also, be sure not to miss Greg Sargent’s specific comparison of the speech to FDR’s second inaugural one.

It’s happening, folks. It’s finally happening. It’s finally our turn.

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How Keynesian Policy Led Economic Growth In the New Deal Era: Three Simple Graphs

by Mike Kimel

In this post, I will show that during the New Deal era, changes in the real economic growth rate can be explained almost entirely by the earlier changes in federal government’s non-defense spending. There are going to be a lot of words at first – but if you’re the impatient type, feel free to jump ahead to the graphs. There are three of them.

The story I’m going to tell is a very Keynesian story. In broad strokes, when the Great Depression began in 1929, aggregate demand dropped a lot. People stopped buying things leading companies to reduce production and stop hiring, which in turn reduced how much people could buy and so on and so forth in a vicious cycle. Keynes’ approach, and one that FDR bought into, was that somebody had to step in and start buying stuff, and if nobody else would do it, the government would.

So an increase in this federal government spending would lead to an increase in economic growth. Even a relatively small boost in government spending, in theory, could have a big consequences through the multiplier effect – the government hires some construction companies to build a road, those companies in turn purchase material from third parties and hire people, and in the end, if the government spent X, that could lead to an effect on the economy exceeding X.

This increased spending by the Federal government typically came in the form of roads and dams, the CCC and the WPA and the Tennessee Valley Authority, in the Bureau of Economic Analysis’ National Income and Product Accounts (NIPA) tables it falls under the category of nondefense federal spending.

Now, in a time and place like the US in the early 1930s, it could take a while for such nondefense spending by the federal government to work its way through the economy. Commerce moved more slowly back in the day. It was more difficult to spend money at the time than it is now, particularly if you were employed on building a road or a dam out in the boondocks. You might be able to spend some of your earnings at a company store, but presumably the bulk of what you made wouldn’t get spent until you get somewhere close to civilization again.

So let’s make a simple assumption – let’s say that according to this Keynesian theory we’re looking at, growth in any given year a function of nondefense spending in that year and the year before. Let’s keep it very simple and say the effect of nondefense spending in the current year is exactly twice the effect of nondefense spending in the previous year. Thus, restated,

(1) change in economic growth, t =
f[(2/3)*change in nondefense spending t,
(1/3)*change in nondefense spending t-1]

For the change in economic growth, we can simply use Growth Rate of Real GDP at time t less Growth Rate of Real GDP at time t-1. The growth rate of real GDP is provided by the BEA in an easy to use spreadsheet here.

Now, it would seem to make sense that nondefense spending could simply be adjusted for inflation as well. But it isn’t that simple. Our little Keynesian story assumes a multiplier, but we’re not going to estimate that multiplier or this is going to get too complicated very quickly, particularly given the large swing from deflation to inflation that occurred in the period. What we can say is that from the point of view of companies that have gotten a federal contract, or the point of view of people hired to work on that contract who saved what they didn’t spend in their workboots, or storekeepers serving those people, they would have spent more of their discretionary income if they felt richer and would have spent less if they felt poorer.

And an extra 100 million in nondefense spending (i.e., contracts coming down the pike) will seem like more money if its a larger percentage of the most recently observed GDP than if its a smaller percentage of the most recently observed GDP. Put another way, context for nondefense spending in a period of rapid swings in deflation and inflation can be provided by comparing it to last year’s GDP.

So let’s rewrite equation (1) as follows:

(2) Growth in Real GDP t – Growth in Real GDP t-1
f[(2/3)*change in {nondefense spending t / GDP t-1},
(1/3)*change in {nondefense spending t-1 / GDP t-2}]

Put another way… this simple story assumes that changes in the Growth Rate in Real GDP (i.e., the degree to which the growth rate accelerated or decelerated) can be explained by the rate at which nondefense spending as a perceived share of the economy accelerated or decelerated. Thus, when the government increased nondefense spending (as a percent of how big the people viewed the economy) quickly, that translated a rapid increase in real GDP growth rates. Conversely, when the government slowed down or shrunk nondefense spending, real GDP growth rates slowed down or even went negative.

Note that GDP and nondefense spending figures are “midyear” figures. Note also that at the time, the fiscal year ran from July to June… so the amount of nondefense spending that showed up in any given calendar year would have been almost completely determined through the budget process a year earlier.

As an example… nondefense spending figures for 1935 were made up of nondefense spending through the first half of the year, which in turn were determined by the budget which had been drawn up in the first half of 1934. In other words, equation (2) explains changes in real GDP growth rates based on spending determined one and two years earlier. If there is any causality, it isn’t that growth rates in real GDP are moving the budget.

Since there stories are cheap, the question of relevance is this: how well does equation (2) fit the data? Well, I’ll start with a couple graphs. And then I’ll ramp things up a notch (below the fold).

Figure 1 below shows the right hand side of equation (2) on the left axis, and the left hand side of equation (2) on the right axis. (Sorry for reversing axes, but since the right hand side of the equation (2) leads it made sense to put it on the primary axis.)

Notice that the changes in nondefense spending growth and the changes in the rate of real GDP growth correlate very strongly, despite the fact that the former is essentially determined a year and two years in advance of the latter.

Here’s the same information with a scatterplot:

So far, it would seem that either the government’s changes to nondefense spending growth were a big determinant of real economic growth, or there’s one heck of a coincidence, particularly since I didn’t exactly “fit” the nondefense function.

But as I noted earlier in this post, after the first two graphs, I would step things up a notch. That means I’m going to show that the fit is even tighter than it looks based on the two graphs above. And I’m going to do so with a comment and a third graph.

Here’s the comment: 1933 figures do not provide information about how the New Deal programs worked. After all, the figures are midyear – so the real GDP growth would be growth from midyear 1932 to midyear 1933. But FDR didn’t become President until March of 1933.

So… here’s Figure 2 redrawn, to include only data from 1934 to 1938.

While I’m a firm believer in the importance of monetary policy, for a number of reasons I don’t believe it made much of a difference in the New Deal era. As Figure 3 shows, changes in nondefense spending – hiring people to build roads, dams, and the like, explain subsequent changes in real GDP growth rates exceptionally well from 1934 to 1938. This simple model explains more than 90% of the change in real GDP growth rates over that period.

Of course, after 1938, the relationship breaks down… but by then the economy was on the mend (despite the big downturn in 1938). More importantly (I believe – haven’t checked this yet!), defense spending began to become increasingly important. People who might have been employed building roads in 1935 might have found employment refurbishing ships going to the Great Britain in 1939.

As always, if you want my spreadsheet, drop me a line. I’m at my first name (mike) period my last name (kimel – note only one “m”) at gmail.com.

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Scott Sumner Digs Deeper

by Mike Kimel

Scott Sumner Digs Deeper

Scott Sumner criticizes my most recent post in which I indicate that Keynesian theory explains growth rates during the New Deal era better than theories proposed by monetarists.

He starts by criticizing this, which I wrote in my earlier post.

Aggregate demand was very slack when FDR took office.

FDR showed up in Washington with a plan to start spending a lot of money and thus boost aggregate demand.

The immediate effect was to convince factories they’d be running down their inventories. That boosted producer prices. It had a much smaller effect on consumer prices because everyone knew the gubmint was going to buy a heck of a lot more producer goods than consumer goods. (The government did buy some consumer goods for the various programs, plus there was a spillover effect, but as the graph clearly shows, the action was on the producer side.)

After a bit of time, the public realized FDR wasn’t planning just a one-off, but rather a sustained program of purchases of industrial items. That led them to start using some of their idle capacity, which meant not just selling the fixed amount that was in inventory. The rate of price increases thus dropped.

GDP increased the fastest rate in the United States peacetime history since data has been kept. There was a big hiccup, of course, in 1937 when the government cut back on spending for a while.

Sumner’s most important point:

Prices didn’t start rising when FDR came to Washington with spending plans; they started rising when he began depreciating the dollar. Furthermore, the weekly rise in the WPI index was highly correlated with weekly increases in the dollar price of gold (i.e. currency depreciation.) And those changes (in gold prices) were caused by explicit statements and actions by FDR. Not by fiscal stimulus, which would be expected to appreciate the dollar.

OK. Using the cool graphical tool from FRED, the Federal Reserve Economic Database, I generated this graph of the series that from what I can tell seems to be Sumner’s favorite price index when discussing the period:

Figure 1.

Now, take a gander at the graph. And bear in mind, FDR was inaugurated in March 1933. But everyone knew what he was going to do, spending-wise, once he showed up. You can see the decline in prices halt and start reversing even before he took office.

Additionally, I’m not sure what Sumner means when he refers to the period when he says FDR “began depreciating the dollar.” There was a gold standard in place going back a long time. That means the value of the dollar was its price in gold. The price of gold was $20.67 an ounce for decades before FDR took office. It was $20.67 an ounce until the Gold Reserve Act of January 30, 1934, when the price of gold was changed to $35 an ounce. (To be precise, the government devalued the dollar on January 31, the day after the Act passed.)

The peak in the curve came in February 1934, days or at most weeks (the index isn’t that precise) after the Gold Reserve Act. Put another way… price inflation using Sumner’s measure peaked when the currency was devalued. That is precisely 100% the opposite of what Sumner wrote.

But there are some extenuating circumstances for Sumner.

(The next paragraph summarizes this story, from the memoirs of Jesse Jones.)

It seems that on October 22, 1933, Jones, the head of the Reconstruction Finance Corporation and Henry Morgenthau, then Farm Credit Administrator but soon to be Treasury Secretary, were told by FDR to come by on October 23 to devaluing the dollar by changing its relationship with gold. The three men – FDR, Morgenthau, and Jones, then went about raising the price of gold by fiat between then and January 31, 1934, when prices came to rest at $35 an ounce, a price where they stayed through 1971.

I assume that’s what Sumner is talking about. So let me modify Figure 1 to only show the period from January to October 1933.

Figure 2.

Now, recall, Sumner’s evidence that the Keynesian view is wrong and the monetary view is right is: “Prices didn’t start rising when FDR came to Washington with spending plans; they started rising when he began depreciating the dollar.”

And yet… the graph shows very clearly that prices started to rise when FDR came to Washington with spending plans, not at the end of October when he began depreciating the dollar. As is very evident from the graph, by that time prices had already been increasing for quite a while. Wholesale prices, by October 1, were up 17% from the beginning of the year. If you started in October of 1933, it wasn’t until December of 1936 before prices increased another 17%.

The point is, Sumner is wrong. He is very wrong about when prices started to rise. He is also very wrong about why prices started to rise. And since “when” and “why” are assumptions in his model, his model is very wrong.

Now, for completeness I’m going to tackle the other thing Sumner mentioned in his post. Sumner’s critique of me includes this:

There are all sorts of the problems with the argument that the inflation of 1933-34 was caused by expectations of fiscal stimulus. First of all, it’s completely at variance with Keynesian theory, which Kimel seems to be trying to defend. Keynesian theory says demand stimulus doesn’t raise prices when there is “slack,” and there has never been more slack in all of American history than in 1933.

The problem for Sumner is that Keynesian theory is merely an extension of good old fashioned Adam Smith. Prices depend on supply and demand. You can have a good or service go up in price locally even as it goes down everywhere else.

As I noted in my earlier post, and he quoted:

The immediate effect was to convince factories they’d be running down their inventories… After a bit of time, the public realized FDR wasn’t planning just a one-off, but rather a sustained program of purchases of industrial items. That led them to start using some of their idle capacity, which meant not just selling the fixed amount that was in inventory. The rate of price increases thus dropped.

Which of course, is very consistent with the timing of events.

None of this is to pick on Sumner. There’s a whole cottage industry dedicated to advancing a story that government spending cannot have a positive effect on the economy during recessions or depressions. The problem for those trying to advance that story is that government spending does seem to correlate with positive effects during those periods. So alternate theories are proposed, and have been proposed for decades. And those theories often make a lot of sense… until you take a close look at the data.

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