# The impact of the stimulus

The stimulus bill has been passed and it awaits the signature of the President. So what impact will it have?

The key question for understanding if the stimulus will work or not ((“work” in the improve welfare sense, not the improve GDP statistics sense)) is “what percentage of Americans are non-savers?” How many Americans act like Keynes’ hand-to-mouthers and how many act like Barro’s Ricardian savers?

Sarah at a great looking new blog called “Pensons” (not “pensions” as I first read it… talk about instantaneously going from boring to cool) finds evidence that a lower bound for the percent of Americans who are non-savers is 23%. If you believe this high estimate, the percent of “underbanked” Americans is a little less than 40%.

So how well will the stimulus work?

The CBO estimates there will be \$584.3B in deficit spending in the next two years. I’ll take this to be the stimulative part of the bill (the rest is just public investments, to be kind). Reading off this chart, the income multiplier will be 1.3 and the consumption multiplier will be 0.4 (and there will be negligible crowding out of investment). This suggests GDP will increase by about \$760B and consumption will increase by about \$230B relative to the baseline ((actually, I’m not sure what the baseline in Gali’s model is; potential income? How would the analysis change if we linearized that model around below the steady-state?)). Consumption last quarter \$450B in annualized terms, relative to the trend in the 10 quarter previous to 3rd quarter 2008.

If last quarter’s drop represents the total drop in consumption we’d see in this recession without the stimulus, the stimulus makes up for about 50% of lost consumption. On the other hand, the stimulus makes up for more than the drop GDP.

## 11 thoughts on “The impact of the stimulus”

1. Kevin Dick says:

That’s 584.3B of _additional_ deficit spending, right? That’s what the CBO document seems to indicate, but I wanted to make sure I understood.

2. Will, you shouldn’t require a login to post… i’m gonna strangle u thursday for making your poor blog posters jump thru so many gdamn hoops…

I’ve a couple comments: 1. I believe those CBO estimates are for a non-standard year ends, so the 585 billion covers about 18 months rather than two years. 2. Consensus estimates for this quarter’s GDP are -5%, which gives us an 8% output gap. Annualized, that’s \$1trillion. But the economy is tanking fast, so the output gap is, if anything, growing, and the stimulus is spread over three years, and next year we’re certain to face a large output gap as well. 3. In the next three years, state and local governments face shortfalls of \$400 billion plus! This may cut the effective size of the stimulus in half. For example, California has just cut \$15 billion in spending, and has also raised taxes by about \$15 billion. Indeed, 2/3rds of states have already cut their budgets for 2009. Local governments are doing the same — NYC is planning on laying off 23,000 workers. A lot of the aid money that goes to California will just reduce state debt. Hence, I think we can reasonably expect the stimulus to plug about a quarter of the output gap. 4. But this is all assuming things don’t get worse. What’s holding the economy up at this point? In most recessions, the Fed would be cutting interest rates like mad about now. Monetary policy, stuck at the zero lower bound, has not appeared to be effective as of yet. And the stimulus is just too small…

So tell me why we shouldn’t think that things are about to get very ugly? Because the bank bailout is going so well? Because Monetary policy — ineffective to-date — will suddenly start to bite?

3. “But the economy is tanking fast”

I went back and forth in my head about what the baseline should be in the calculations of this post. Are you sure we’re opening a gap between gdp and potential or is potential decreasing. The financial mess throws sand in the works (a real life negative technology shock) and people are realizing they aren’t as rich as they thought they were (a shock to value of installed capital?). These are “real” shocks. Real shocks are real shocks, there’s nothing government can do to get a more efficient outcome.

I’m glad you have such good forsight and are able to see how shitty things will get. I’m not as good with the crystal ball so I’m stuck anticapating the next statistics release. All I know is we need to help the worst hit and we need to fix the finance mess ASAP.

4. Lol… I realize not everyone has a crystal ball with which to see the future. That’s why Thorstein Veblen has returned Will, despite my old aching back, to help others who are stuck waiting for the smoking gun in the form of a mushroom cloud see the glory of the coming of the Lord! All I’m saying is this: my grandmother, who knows a great depression when she sees one, started buying gold bars last fall…

I’d also say that the idea of thinking about the bursting of the housing bubble and ensuing financial crisis as a “technology shock” is of limited usefulness. And, yes, these are real shocks, but the problem is that people tend to pull back too much. They may be behaving optimally from an individual perspective, but in a way which is actually increasing the risk to everyone. It’s as if someone yelled “fire” in a crowded hall, and now everyone, at the same instant, suddenly gets the urge to use the elevator. Stuffed with people, the jammed doors won’t budge. Everyone dies. Burns to death. Awful. Or, so it seems. But, *but*, the economist says, everyone was behaving optimally!

Other than that, love the blog and I look forward to sparring more with you in the future!

5. Re: Kevin Dick.

No, \$580 billion of spending will not increase the deficit by \$580 billion. Not even close. The workers who get that money will pay taxes on it, so perhaps 20% will immediately go right back in to government coffers. If those workers spend part of their paychecks, then they will pay sales tax, and that money will continue to get taxed as it continues to go around the system. The true debt cost is substantially less than that.

6. Kevin Dick says:

Thorstein: I think you misunderstand. I don’t care about the additional debt. I care about the stimulative effect. The 584.3B is apparently the additional amount the Federal government plans to spend, which is what you plug into the multiplier formula for fiscal policy, right?

7. Veblen, glad to have you and sparring is always fun, but “people are pulling back too much” is less helpful than throwing everything into technology shocks. You can invent any psychology you want. At least with technology shocks you have to settle on one stochastic form or another. There’s at least some discipline.

The whole point of the Gali model this post’s prognostications were based on was to give structure to the idea that some folks don’t optimize. They just eat everything they make in wages. It turns out you have to have a very large number of people not optimizing to get any action out of fiscal stimulus.

8. Re: “It turns out you have to have a very large number of people not optimizing to get any action out of fiscal stimulus.”

No, you don’t. With interest rates more-or-less fixed at the zero lower bound, any additional inflation/reduction in deflation that the stimulus bill provides will lower the real interest rate, which should help the economy. So, if the government spends a load of money, even if it failed to employ more people (and it really is silly to think that more government spending will have no effect on employment), government spending should be inflationary. To the extent that it is, well, that’s the whole goal of spending in a liquidity trap!

And, do we think that poor people don’t save b/c we do not behave optimally, or is it b/c we’re cash constrained and at a corner solution? OK, we’re also myopic…

Re: Kev– in that case, I wouldn’t plug \$580 billion into the multiplier formula for fiscal policy, I would plug in just \$400 billion in, b/c much of the federal stimulus merely reverses spending reductions at the state and local level… (Indeed, \$300 billion is probably the number you want to use.)

9. Veblen, you’re assuming the Fed’s policies aren’t affecting the real rate just because nominal rates are at their lower bound. This would be a problem for the Gali analysis because his model assumes Fed policies can put the real rates where it needs to be.

Yours is the same assumption Paul Krugman always makes.

I don’t think its a good assumption. Non-traditional monetary policy can work and, in terms of long term expectations of inflation, it is working.

However, I’d place bets against me that the Nobel prize winner is right and I’m wrong about assuming the binding constraint matters for the effectiveness of monetary policy. Fine. However, if nontraditional money policy doesn’t work at the lower bound to keep expectations of inflation up then its not clear to me how fiscal policy can work. Monetary policy (traditional or not) is explicitly about setting expectations of inflation whereas fiscal policy’s purpose is more diffuse. What is the magical mechanism that makes the latter work to form expectations but the former not?

10. Well, for the record, I hope you are correct. It would be great if the Fed still had a few arrows left in its quiver. This implies, of course, that the Fed has been grossly negligent to-date to leave said arrows in its quiver while the price level deflates and the economy burns. By mid-November, the Fed should have been in do-everything-possible mode, and, still, the economy shed jobs like crazy in December and January, and the CPI was also down in December, w/ the core rate unchanged. If monetary policy is starting to bite, then we should see a nice little pop in January’s core CPI when it comes out friday. If so, then the Obama stimulus combined w/ the infamous \$7 trillion in non-standard monetary policy may be enough to do the trick…