Lecture 26

Macroeconomic Analysis and Economic Policy

(Spring 1996)
Brad DeLong

May 1, 1996

Associate Professor of Economics University of California at Berkeley

Berkeley, CA 94720-3880
phone: (510) 643-4027
fax: (510) 642-6615
e-mail: [email protected]
www: http://www.j-bradford-delong.net/

Introduction
How the Government Got Into the Macroeconomic Management Business
Making Macroeconomic Policy in Early 1993
The Trade Deficit and "Competitiveness" in the 1980s and 1990s
Conclusion

Introduction

Announcements:

 Anyone who has a serious and significant conflict on May 18, the final exam date,
and wishes to take the slightly harder final to be given on May 8 should have
talked to me already, and should certainly have talked to me by the end of my
office hours today.

 Time and place of early alternative final (for those with conflicts on May 18); 3
Evans; Wednesday May 8, 1-4 PM

 Time and place of real final

 
  We will try very hard to have the grades out and posted by student ID number by
early in the week of May 20th.

Last time I finished discussing deficit prospects, and took a too-brief look at the current
macroeconomic situation. This Friday I am going to go over the practice final exam that I
handed out on Monday. And next Monday, the last day of class, I am going to answer
questions that you ask, and--if we have time--ask questions for you to answer. It looks
like I am going to be teaching this course for quite a few years, and I urge you to provide
feedback if you have any feelings of mercy toward your successors who are going to be
taking this course in the future. The most valuable feedback will be on areas of the course
where I should spend more time and effort, and areas where I should spend less.

I started thinking about how to do this lecture when David Romer asked me to give a
guest lecture to his Econ 101b class. I had been a macroeconomist. Then at the end of
1992 I had become what journalists call a "senior treasury official," working for the
federal government as Deputy Assistant Secretary for Economic Policy. And now I am
trying to become an academic macroeconomist again.
It seemed that I probably had things to say about how macroeconomic analysis is--or is
not--of use in the making of macroeconomic policy in the United States today. And I
thought about it. And I agreed that I probably did have things to say. And as I tought
about it it seemed to me that he was right. And it seemed to me that the topic of the
usefulness or non-usefulness of Econ 100b-level courses for thinking about--and
making--macroeconomic policy would make a very good topic for the final substantive
lecture in this course.

And I have decided that I have five things to say that you should hear.

Let me begin by running through all five of them very quickly, in brief and abbreviated
form. And then let me circle back around to consider each of them in more depth:

 First, the federal government is deeply engaged in the macroeconomic

management business. Thus macroeconomic analysis ought to be useful for the
government because it is highly relevant to one of the tasks that the government
has taken on. They government has been deeply engaged in this business ever
since the Great Depression. There is no sign that it will ever (and no particular
reason why it should) abandon this line of business. So macroeconomists ought to
have things to say that are highly relevant for government policy and politics.

 Second, as far as the amount of macroeconomic analysis useful for understanding,

and even for making, macroeconomic policy is concerned, all of you now have--
or will have, if you finish the semester and do well on the exam--90 percent of the
tools that you would ever need. The aspects of macroeconomic analysis that are
the most useful in making economic policy are the fundamentals: the basics.
When I think about this, sometimes I am heartened: we must be very good
 teachers if we can so quickly bring you up to speed on what is relevant for politics
and policy. Sometimes I am depressed: we must be really lousy technicians, and
not have all that much to teach, if we can bring you more-or-less up to speed in
less than two semesters.

 Third, the fact that the issues and principles that are useful are the simple, basic,
fundamental ones does not mean that the job is easy. Uncertainty is enormous.
Neither the present state of the economy, nor its future course, nor the effects of
policies on the future course of the economy is known with any confidence. To a
juggler, the principles involved in juggling three items are pretty simple--but the
task of juggling priceless eggs in variable gravity remains very, very hard. (Flying
Karamazov Brothers.)

 Fourth, the fact that the issues and principles are basic does not mean that
everyone understands them. Most do not. Some cannot afford to understand them:
if they did understand them, and act on them, their paychecks would dry up. Some
genuinely do not understand them because they do not believe that that is the way
the world works.

 Thus, fifth, we do a lot less well than we could do, or in some sense should do.
When we do the right thing, it is just by the skin of our teeth. And we have an
immense capacity to do the wrong thing in economic policy and cause enormous
damage.

Let me expand on these points in several stages.

First, let me talk about why the government is in the macroeconomic management
business. Second, let me use the early 1993 debate about Clinton Administration
economic policy-as relayed not completely inaccurately in Robert Woodward's book, The
Agenda, to expand on the second and third points: that the issues and principles that are
useful are the simple ones, yet the task remains very, very hard. Third, let me detour into
the international macroeconomics of the trade and budget deficits in the 1980s to expand
on the fourth point-that the principal obstacle is ignorance, some of it involuntary and
some of it voluntary and willed.

And then at the end, I will quickly tell you what I have told you, thus making this lecture
fit the classic rhetorical pattern: "tell 'em what you're going to tell 'em, tell 'em, and then
tell 'em what you told 'em."
How the Government Got Into the Macroeconomic Management Business

Back before World War I it no more crossed people's minds that the government ought to
be in the macroeconomic management business--the business of avoiding and shortening
recessions and depressions--than that it ought to be in the hurricane-prevention business.
The business cycle had its origins outside the government, in fluctuations of demand for
investment goods and in foreign demand for America's agricultural exports. Local
governments had a duty and a responsibility to alleviate the human cost of the business
cycle by helping to provide relief and charity. But the national government? A
responsibility to manage the economy to avoid or shorten recessions and depressions?
Simply not thought of.

By the end of the 1920s things had changed. President Herbert Hoover, for example,
liked to draw a distinction between his brand of Republicanism--which wanted to use the
government as a powerful tool to advance public purposes, including economic
prosperity--and the Neanderthal Republican "old guard," which included some members
of Hoover's own cabinet. Hoover denounced the:

leave-it-alone-liquidationists headed by Secretary of the Treasury Andrew Mellon, who

felt that government must keep its hands off [the economy] and let the [Great Depression
continue until it ended by]... itself. Mr. Mellon had only one formula: "Liquidate labor,
liquidate stocks, liquidate the farmers, liquidate real estate." [Mellon] insisted that, when
the people get an inflation brainstorm, the only way to get it out of their blood is to let it
collapse... even a panic was not altogether a bad thing...

Hoover thus set a new standard for Washington infighting and backstabbing--denouncing
the Secretary of the Treasury whom he had appointed and whom he retained throughout
his presidency.

Unfortunately for America, Hoover's view of what the government needed to do in order
to cut short the Great Depression was almost exactly the opposite of what we would now
see as desirable. Hoover believed that the way to bring the Great Depression to a rapid
end was to restore business confidence and business investment--and that the best road to
restoring business confidence and business investment was to balance the federal budget
through spending cuts and tax increases.

Now as Herbert Stein observes in his Fiscal Revolution in America, it is not crazy to
worry about the depressing effects of government deficits on investment. Keynes
included this channel--that a government that runs a high cyclical deficit in recession may
find its lack of balance either increasing consumers' preference for liquidity or
discouraging investment--in his General Theory as one factor making the net positive
impact of a fiscal stimulus smaller than one would calculate based on the size of the fiscal
stimulus and a naive multiplier derived from the marginal propensity to consume:

If, for example, a Government employs 100,000 additional men on public works, and if
the multiplier (as defined above) is 4, it is not safe to assume that aggregate employment
will increase by 400,000. For the new policy may have adverse reactions on investment
in other directions.

It would seem... that the following are likely in a modern community to be the factors
which it is most important not to overlook...

(ii) With the confused psychology... the Government programme may through its effects
on "confidence," increase liquidity-preference or diminish the marginal efficiency of
capital... (John Maynard Keynes, General Theory of Employment, Interest and Money,
pp. 119-120.)

Nevertheless, we would have to live in a very strange world indeed for Herbert Hoover's
policy of fighting recession by raising taxes and cutting spending to be preferable to our
current instincts to let the economy's fiscal automatic stabilizers operate to damp down
business cycle swings in demand and employment.

The commitment Herbert Hoover had enunciated--that the government would rescue the
macroeconomy--was never abandoned. It was codified, in a sense, in the 1946
Employment Act. We hope that current principles of macroeconomic management make
more sense than did Hoover's attempt to cure a Great Depression through fiscal
contraction.

Why did the government take on this role of macroeconomic management in the interwar
years? Before WWI, the most any government did was to try to guarantee the value of the
currency: gold standard.

Political scientists' answer #1: the expansion of the franchise--not satisfactory. Answer
#2: governments that would not promise to perform the task of macroeconomic
management--or that did not deliver--fell apart and vanished in the interwar period.

Answer #3: Hitler and Stalin. Promising full employment was a necessary step in making
liberalism more attractive than communism (or fascism).

I don't know which of these is correct...

Making Macroeconomic Policy in Early 1993

Second, as far as the amount of macroeconomic analysis useful for understanding, and
even for making, macroeconomic policy is concerned, all of you now have--or will have,
if you finish the semester and do well on the exam--90 percent of the tools that you
would ever need. The aspects of macroeconomic analysis that are the most useful in
making economic policy are the fundamentals: the basics.

When I think about this, sometimes I am heartened: we must be very good teachers if we
can so quickly bring you up to speed on what is relevant for politics and policy.
Sometimes I am depressed: we must be really lousy technicians, and not have all that
much to teach, if we can bring you more-or-less up to speed in less than two semesters.

Let me illustrate this by quoting a passage from Robert Woodward's 1994 book about the
making of Clinton administration economic policy. The book is called The Agenda. In it
Woodward describes the first meeting of Clinton's cabinet level policy council, the
National Economic Council.

 Assume that Robert Woodward's account of the National Economic Council

meeting he describes is correct (even though I know of places--particularly where
Woodward claims to get inside people's heads--where it is not).

 This is closely connected to the fact that Woodward's standard payoff to sources
is for him to paint flattering portraits of them--and the standard punishment for
not being a source is to be portrayed as heartless and incompetent. So if you go
and read the book, watch out for this as well.

At one point during the meeting, CEA Vice Chairman-Designate Alan Blinder is making
a presentation on the economic consequences of adopting a particular deficit-reduction
program. According to Woodward:

Blinder flashed his...chart, which summarized the costs and benefits of a $60 billion
annual deficit cut. The costs would be immediate: a sharp 1.5 percent[age point] drop in
[the first year's] economic growth from the 2.8 [percent per year growth from 1993 to
1994]... that was projected.

The benefits, on the other hand, lay far off: perhaps a 1 percent increase in growth [sic; a
mistake: a 1 percent increase in the level of output; and not in four years] after four years,
perhaps 2 percent after 20 years, and a 2.7 percent increase at "infinity"...

Where did these numbers come from? Well you--each of you--could have generated these
numbers. To generate the first, Alan Blinder took his favorite estimate of the Keynesian
multiplier, fed it the degree of reduction in government spending relative to taxes, and
calculated the resulting shift in GDP. To get the second, Alan Blinder took the effect of a
$60 billion increase in national savings and fed it to the Solow growth model in Mankiw's
chapter four--and had a staff person hanging around the Democratic Transition Team
(me) calculate the speed of convergence to the new, 2.7 percent higher GDP steady state
growth path.

Blinder did a bunch of calculations, a lot of work for this presentation: considering
alternative scenarios and assumptions about how the economy really works, investigating
the sensitivity of his conclusions to small changes in assumptions, and so forth. But the
guts of the calculation are made up of exercises that you have carried out--and that may
well be on the final exam.
And the challenges that other people made to Blinder's analysis also all used concepts
with which you are very familiar. To quote Woodward again:

Larry Summers interjected some optimism. A favorable response on long-term rates from
a good deficit reduction plan, he said, was not so unlikely. The inflation premium [in
bond interest rates] was abnormally high now, he noted, and a good plan would convince
the markets that inflation was not that much of a problem and long-term rates should fall.

In the language of Econ 100b, Larry was saying that Blinder's analysis was incomplete
because Blinder had only thought about what happens to the IS curve when the deficit is
reduced. Larry thought that the inward shift in the IS curve would be matched by an
outward shift in the LM curve--as the Federal Reserve lowered short-term interest rates,
and as investors expected the lowering of interest rates to continue into the future.

So, in short, you have very smart people who have devoted their lives to managing the
intricacies of macroeconomics debating issues of vital importance to economic policy--
and do they use concepts from Econ 137? Do they use concepts from Econ 202? Do they
use concepts from Econ 236?

No. They use concepts from Econ 100b. And I would go a step further and say that that
was the level at which the debate ought to have been conducted.

The Trade Deficit and "Competitiveness" in the 1980s and 1990s

But the fact that the issues and principles that are useful are the simple, basic,
fundamental ones does not mean that the job is easy.

Uncertainty is enormous.

Neither the present state of the economy, nor its future course, nor the effects of policies
on the future course of the economy is known with any confidence.

To a juggler, the principles involved in juggling three items are pretty simple--but the
task of juggling priceless eggs in variable gravity remains very, very hard. (Flying
Karamazov Brothers story at the Microsoft company picnic, perhaps: things that they had
done thousands of time suddenly became very very difficult and very very nervewracking
because of the variable winds.)

So people age very quickly in these jobs. Insomnia is rife. Stakes are very high--and for
real. (How much has Bob Rubin aged in the past four years.

 My mistake--a group mistake, but still my mistake--Mexico. A million more

Mexicans out of work today than in some alternative world where we did a better
job...
  

 Still, things could be much, much, much worse. A large number of judgments
made--especially about the benefits of deficit reduction--appear to have been very
sound.

To make things worse, even if you have correctly spotted the proper policy and analyzed
the proper consequences, you have to convince lots of people who are not economists
that it is in fact correct. This is hard:

 Some people dislike economists and economic reasoning on principle.

 Some people dislike economic reasoning because they generalize incorrectly from
their own experience.
 Some people cannot afford to listen to economists.

Let me give you an example of the second and third. I got to my Treasury office one
morning to find a memo in my inbox, stating that:

The NEC and the NSC are convening a team to produce an analysis for the President of
the nation's structural current account deficit. The project will analyze the underlying
causes and composition of our deficit and the economic problems it may cause for current
and future living standards. The study will be global in scope, with particular emphasis
on our economic relations with Asian nations.

...The effort will be coordinated by Ira C. Magaziner...

Translation: Ira Magaziner needs something to do after making a catastrophic mess of

health care reform. Ira thinks that he can make a contribution by identifying barriers to
America's exports that cause a "structural" trade deficit. And some Japan-bashing thown
in.

The problem is that we know that the U.S. trade deficit grew from zero in 1992 to $150
billion this year because of the balance of national savings and investment--memos
written in early 1993 predicting it.

Yet if Ira acknowledges this, he is out of a job--and few people ever leave the OEOB
until their hands are ripped by force from the ornamental stone geegaws of the building.

And Ira generalizes from his experience as a consultant, in which a firm that fails to
export (or that sees its markets stolen by imports) is probably failing to be
"competitive"--and he cannot make the conceptual jump necessary to notice that what is
true about an individual firm is not true for the economy as a whole. Potential foreign
customers of a business can always decide that its products are not worth buying, and go
buy the products of some other firm.
But once you have sold your imports in America and gotten paid in dollars, you must buy
something American (or trade your dollars to someone who wants them to buy something
American)--either an export or make an investment. There is no "alternative" place to
spend your dollars. Thus whether America's businesses are competitive or uncompetitive,
the international accounts balance--with the trade deficit equal to net investment by
foreigners in the U.S.

Ira's response: I have a friend trapped in the OEOB who has to deal with him
occasionally: "I don't think economists have much to say that is useful about modern
international trade."

 He doesn't like economists (because they make claims to expertise that he can't
evaluate or debate)
 He incorrectly thinks his own experience generalizes to the world
 And he loses his job if he understands the determinants of the trade balance

All in all, a pretty powerful set of reasons insulating one against any kind of rational
argument.

Conclusion

Economists know a lot of stuff...

A lot of what they know is pretty useful...

You now know a lot of what economists know...

Yet we do much less well than we in some sense should...