An Economic Exercise in Wishful Thinking

Warning: Do NOT use before making economic policy.

In today’s NY Times, David Leonhardt is very clear about the role of hope and wishful thinking among the Obama economics team. They got the unemployment numbers very, very wrong and as a result, we got a stimulus package that was underdesigned and oversold. If you read me or for that matter, Paul Krugman or Joseph Stiglitz, you were warned about the likely result. While this m.o. among Obama and his minions comes as no surprise to folks here, we’re beginning to see the resulting shock and awe as every one else awakens to policy based on the empty rhetoric of hope and no real change. Precious time, political majorities and capital are being wasted on an enhanced status quo.

In the weeks just before President Obama took office, his economic advisers made a mistake. They got a little carried away with hope.

To make the case for a big stimulus package, they released their economic forecast for the next few years. Without the stimulus, they saw the unemployment rate — then 7.2 percent — rising above 8 percent in 2009 and peaking at 9 percent next year. With the stimulus, the advisers said, unemployment would probably peak at 8 percent late this year.

We now know that this forecast was terribly optimistic. The jobless rate has already reached 9.4 percent. On Thursday, the Labor Department will announce the latest number, for June, and forecasters are expecting it to rise further. In concrete terms, the difference between the situation that the Obama advisers predicted and the one that has come to pass is about 2.5 million jobs. It’s as if every worker in the city of Los Angeles received an unexpected layoff notice.

There are some fundamental things in the labor market that the Obama Team somehow overlooked. The first is the unwinding of the automobile network and all the supporting infrastructure around the supply and sales chain. The second is the impact on the states of low tax revenues and high unemployment insurance payouts. Some how, in focusing on the impact of the financial crisis, they appeared to haven forgotten some basic underlying macroeconomic dynamics. At least, that is my take. They may have kept their eye on the ball, but they failed to look around the bigger field of play.

Leonhardt points to two possible explanations as to why so many very bright people got it so wrong. He argues that because the stimulus package was designed poorly and hurried through with the rosy scenario coloring the numbers, that it is possible that the stimulus package has done nothing and that as a result, things are getting worse. That’s hypothesis number one. His second hypothesis is the more likely one in both his and my opinion. That is that the economy is deteriorating further and this is despite of the stimulus. Again, this would be due to a bad forecast and an even worse policy prescription. So he’s laid out the ground work for the big question while giving a slight nod to some potential for the stimulus plan.

The stimulus package does seem to have helped. But its impact has been minor — so far — compared with the harshness of the Great Recession.

Unfortunately, the administration’s rose-colored forecast has muddied this picture. So if at some point this year or next the White House decides that the economy needs more stimulus, skeptics will surely brandish that old forecast.

Worst of all, the economy really may need more help.

Well, you know, on the one hand, on the other hand. However, whichever hand you choose, this is a policy failure we couldn’t afford.

Leonhard does try to put the impact of the stimulus into perspective.

There is no ironclad way to judge the stimulus, because we can’t rerun the last six months in an alternate universe. But you can get a pretty good sense by looking at the size of the gap between where the economy is today and where the administration thought it would be: those 2.5 million jobs that would still exist if the forecast had been right.

This gap is just far too large to be explained by the stimulus. The plan that Mr. Obama signed definitely has its flaws. It spends money more slowly than is ideal and spends some of it on projects of little long-term value. But no stimulus package could have come close to preventing 2.5 million job losses over six months.

For starters, a stimulus package doesn’t affect the job market immediately because most employers don’t hire or fire workers as soon as they sense their business shifting. That’s why economists refer to employment as a lagging indicator.

When private economists began analyzing various stimulus proposals in January, they said that none would have a major effect on the jobless rate until the end of the year. By June, the effect would be only a few tenths of a percentage point, which translates into several hundred thousand jobs.

The stimulus that passed may in fact be having an impact of roughly this scale. Consumer spending, after plummeting late last year, is up slightly this year, despite a continuing rise in the savings rate. This combination suggests that spending would still be falling if not for the tax cuts in the stimulus.

So again, this means we’ve seen a moderation but no real change. I’m again, going to use the term enhanced status quo, because that appears to be what we are seeing in this analysis. There are still some major shifts happening in the underlying economy and these folks can no longer ignore them.

First, there is a serious movement away from the high, debt-funded consumption of yesteryear. The marginal propensity to consume is falling, the marginal propensity to save is increasing and this will undoubtedly impact the policy multipliers from now on. Fiscal policy will have to be bigger. You can also discount the multiplier by our still increasing marginal propensity to import. Unless we suddenly start buying American, Fiscal policy will have to be a lot more bigger because we export a portion of it with this scenario.

Again, two major U.S. industries–finance and automobiles–are unwinding. Every population center with the presence of those industry is going to experience an impact and that will impact the tax revenues for the State and Local Governments (SLGs). Given we now have states with balanced budget amendments, SLGs cannot stimulate their own economies. They must grow their budgets because the economy that demands it. But they can’t because of the straight jacket of those balanced budget amendments. They must act as agents of recession-creation by law. This makes it even more imperative that big fiscal policy comes from the Feds. Witness this headline today for California, the state that is typically the canary in the coal mine for the U.S.

California misses budget deadline, readies “IOUs”

SAN FRANCISCO (Reuters) – California’s lawmakers failed to agree on a balanced budget by the start of its new fiscal year on Wednesday morning, clearing the way to suspend payments owed to the state’s vendors and local agencies, who instead will get “IOU” notes promising payment.

The notes will mark the first time in 17 years the most populous U.S. state’s government will have to resort to the unusual and dramatic measure.

Democrats who control the legislature could not convince Republicans late on Tuesday night to back their plans to tackle a $24.3 billion budget shortfall or a stopgap effort to ward off the IOUs. The two sides agree on the need for spending cuts but are split over whether to raise taxes.

Democrats have pushed for new revenues while Republican lawmakers and Governor Arnold Schwarzenegger, also a Republican, have ruled out tax increases. They instead see deep spending cuts as the solution to balancing the budget, but Democrats say that would slash the state’s safety net for the needy to the bone.

Tempers flared in the state Senate as the midnight start of the new fiscal year neared.

“There is no excuse to hold this whole state hostage,” state Senate President Pro Tem Darrell Steinberg told Republicans during a floor debate.

Senate Republican Leader Dennis Hollingsworth countered that major cuts are urgently needed. Otherwise, “There will be entire programs that will have to be lopped off,” he said.

Economic policy during a time of crisis should not be based on empty rhetoric. Change is not a quantifiable variable in the abstract. Massive unemployment is a quantifiable variable and extremely real. Step away from the hope bong and get real. There is no reason why stimulus packages in times of trouble and huge democratic majorities in congress need be simple moderation unless you really don’t know what it takes to make real change.

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Update: How some other economists have framed this:

Brad deLong: Forecasting the Obama Economy

Henry Blodget: How Obama Blew his Credibility on the Economy

Noam Scheiber: How Did the White House By 2.5 Million?