The New New Deal (9 page)

And the worst market failure since the Depression was coming soon.

L
arry Summers liked to say that in economics, things take longer to happen than you think they will, and then happen faster than you thought they could.

By December 2007, bad things were starting to happen. The construction industry had stopped constructing. Lenders weren’t lending. The economy had slipped into recession, although no one knew that yet; the Blue Chip forecast, the conventional wisdom of the econometrics world, still expected modest growth in the coming year.
National Review
supply-sider Larry Kudlow was still crowing that “the Bush boom is alive and well,” ridiculing “the doom and gloom from the economic pessimistas.
⁶⁷
… These guys are going to end up with egg on their faces.” But Summers, a leading pessimista, was already warning of a “perfect storm,” perhaps the worst recession since the early 1980s. In a speech at Brookings, he suggested his own doom and gloom might even be overly optimistic: “History has cautioned that situations like the current one are likely to surprise on the downside for a considerable time.”
⁶⁸

In Washington, the conversation had turned to short-term stimulus, as it did whenever the economy turned sour. At the time, countercyclical Keynesian stimulus, a staple of introductory economics classes, was not overly controversial. Almost everyone seemed to agree that when
the goods-and-services engine known as aggregate demand stalled, government could help get it humming again by injecting money into the economy, either by taxing less or spending more. All the major presidential candidates were assembling fiscal stimulus plans. Republican Mitt Romney proposed the most aggressive plan, $250 billion worth of tax cuts; he also criticized McCain’s call for short-term spending cuts as the opposite of stimulus.
⁶⁹

Some economists thought “monetary stimulus” from Federal Reserve interest rate cuts would be enough to reverse this particular slump. Some conservatives opposed any new spending that would make the government a bigger player in the economy. And some deficit hawks fretted about further increases in the federal debt; Keynes had prescribed fiscal expansion during emergencies, but also fiscal responsibility during non-emergencies, which hadn’t happened under Bush.

Still, the general question of whether fiscal stimulus could help create jobs and revive output in the short term wasn’t much of a question back then. The question was how to do it properly, a question Keynes had never fully answered.

K
eynes wrote his masterpiece,
The General Theory of Employment, Interest and Money
, during the depths of the Depression.
⁷⁰
It’s full of revolutionary macroeconomic concepts, like the paradox of thrift, the marginal propensity to consume, and the Keynesian multiplier. But it’s mostly a book about depressions—how they happen, and how to prevent or end them. Summers thought it should have been titled
A Specific Theory of Collapsing Employment, Interest and Money
.
⁷¹

Before the Great Depression, most economists believed markets were automatically self-correcting. They assumed all downturns would eventually create a virtuous cycle: cheaper prices would spur consumption, cheaper money would spur investment, and lower wages would
spur hiring. It was an elegant theory, but after the crash of 1929, reality didn’t cooperate. President Hoover’s treasury secretary, Andrew Mellon, expressed the orthodoxy of the day when he described the Depression as a useful corrective to sloth and excess that would “purge the rottenness out of the system.” If you weren’t a Mellon, though, the Depression was pretty rotten.

Keynes saw recessions as simple failures of demand for goods and services, not as some kind of karmic retribution for moral turpitude. And he saw how a convulsive shock like Black Tuesday could create a vicious rather than virtuous cycle: lost income led to lost confidence, which led to hoarding of cash, which led to layoffs and cutbacks that left productive workers and equipment idle, which further depressed income as well as confidence, and so on down the drain. Part of the problem was a real deterioration of purchasing power. Workers without jobs couldn’t spend as much, even when prices were low, and businesses without customers couldn’t invest or hire as much, even when interest rates and wages were low. The other part of the problem was psychological, what Keynes dubbed “animal spirits.” Workers worried about losing their jobs and businesses worried about losing their customers would tighten their belts, too, perpetuating the paralyzing feedback loop. There’s a reason economic terms like “depression,” “panic,” “uncertainty,” and “demand” have psychological roots. Markets really can get jittery. The economy really is a confidence game.

Keynes concluded that the solution to both parts of the problem was an aggressive government effort to revive demand, an infusion of cash and confidence. Saving had always been considered a purely good thing, but Keynes saw that in a crisis what was needed was more spending. More saving would just deepen the crisis. (That’s the paradox of thrift.) And when consumers and businesses were too broke or too scared to spend, government would have to be the spender of last resort. Budget deficits had always been considered a purely bad thing, but Keynes saw that when the private sector hunkered down and demand dried up, the public sector needed to send more money into the economy than it took back in taxes. Once consumers started spending again, businesses
would hire more workers and make new investments, and the virtuous cycle could begin anew.

Keynes wasn’t rejecting capitalism, just the laissez-faire assumption that a shattered economy could always heal itself. He wasn’t recommending a new car, just a new “magneto,” or ignition system, a jump-start for a stalled economic engine. And he wasn’t too fussy about how that magneto was designed, as long as it got cash to flow from the government to the people. He suggested the Treasury could even “fill old bottles with bank notes, bury them at suitable depths in disused coal mines,” then watch an inevitable money-mining boom create jobs and economic activity.

“It would, indeed, be more sensible to build houses and the like, but … the above would be better than nothing,” he wrote.

B
ut not all magnetos are created equal. Burying cash was not an alluring option. After an epic real estate bust that left entire subdivisions vacant, “building houses and the like” didn’t seem so sensible, either.

So what was government to do? Traditionally, Republicans equated stimulus with tax cuts—and sure enough, the Bush White House, which would have prescribed tax cuts for a sore throat, was looking into new ones, while calling for a permanent extension of the original Bush tax cuts that were scheduled to expire in 2011. Generally, liberal Democrats preferred stimulus in the form of spending on liberal Democratic priorities—and true to form, Speaker Nancy Pelosi was pushing to cram extra cash into food stamps, public works, and renewable energy.

Summers, neither a Republican nor a liberal Democrat, did not think the question of how to stimulate the economy in the short term should be answered ideologically. He thought it should be answered correctly. At Brookings, he proposed a technocratic approach to Keynesian stimulus that has dominated the debate ever since. A stimulus package, he argued, should be
timely, targeted
, and
temporary
.

In other words, it should kick in fast enough to help cure the downturn; stimulus that isn’t timely can overheat an economy that’s already rebounding and unleash inflation. It should target the biggest economic
bang for each buck; fortuitously, the struggling families who need it most are the families most likely to spend it quickly. (That’s what Keynes meant by a high marginal propensity to consume.) Finally, stimulus should spur short-term growth without unnecessarily expanding long-term deficits, which could boost interest rates, slow down growth, and defeat the whole purpose of the exercise. Romney’s $250 billion plan would have amounted to nearly 2 percent of GDP, but Summers, worried about red ink, suggested that politicians should think “two digits, not three,” and let the Fed do most of the work.

The allure of fiscal stimulus from Congress was its ability to pump dollars quickly into the pockets of consumers and the coffers of businesses, as opposed to monetary stimulus from the Fed, which would pump dollars into the vaults of banks that were reluctant to lend at a time when businesses were reluctant to borrow. But fiscal stimulus had a downside, too. It would only work if a bitterly divided political system could pass timely, targeted, and temporary legislation in a hurry.

“Poorly designed fiscal stimulus,” Summers wrote in a column that would be quoted frequently a year later, “can have worse side effects than the disease that is to be cured.”
⁷²

I
n January 2008, Hillary Clinton released her plan to juice the weakening economy. To Obama’s economists, it looked like a textbook example of poorly designed stimulus. The centerpiece was $25 billion to help low-income families with heating bills, a tenfold expansion of an existing program, an administrative nightmare that made Jeffrey Liebman, yet another Harvard professor on Obama’s team, wonder if Hillary had misplaced a decimal point. The money wouldn’t go out until the next winter, which didn’t seem timely at all. Austan Goolsbee, a thirty-eight-year-old Obama adviser from the University of Chicago who was new to presidential politics, was shocked by the economic malpractice. “A year later is not stimulus!” he kept saying.

Goolsbee, who would later advise Obama in the White House, and Liebman, who would become a deputy in his budget office, had cooked up Making Work Pay over a weekend. Now they had two days to finalize a plan for real short-term stimulus—the first dress rehearsal for the Recovery Act. “It was my only true all-nighter of the campaign,” Liebman recalls. “But we knew we were going to blow Clinton’s plan away. We just stuck to the basics—timely, targeted, and temporary.”

The three T’s were suddenly the quasi-official test of the stimulus strategies flying around Washington. And some strategies flunked.

Regardless of the merits, making the Bush tax cuts permanent would be the opposite of timely, targeted, and temporary. It wouldn’t take effect until 2011; it would help well-off families with low propensities to spend; and it would explode the deficit. Permanent corporate tax cuts, a key plank of the McCain and Romney plans, also batted 0-for-3. A new Brookings stimulus analysis titled “If, When, How” rated both strategies “ineffective or counterproductive,” while a Moody’s Economy.com analysis of how much growth various policies would produce per dollar—the Keynesian multiplier—scored both below 50 cents.
⁷³
The Brookings report was written by two Clinton administration economists—Jason Furman, a Summers protégé who was running the Hamilton Project, and Doug Elmendorf, another former Summers student—but the Moody’s author, Mark Zandi, was a McCain campaign adviser.

By contrast, policies benefiting lower-income families provided much more bang for the buck, because the poor can’t afford to hoard. Increases in food stamps earned the highest multiplier from Moody’s, adding $1.73 in output for each dollar in cost. Extending unemployment benefits, which normally expire after six months, came in second. Those strategies batted 3-for-3: The benefits would go out instantly, target families likely to spend, and fade once the economy improved. One-time tax rebates also got decent marks, but only if those 35 million low-income workers who didn’t pay income tax were eligible. Many Republicans saw refundable tax cuts as glorified welfare—the
Wall Street Journal
editorial page referred to the low-income recipients as “lucky
duckies”—but a new CBO report noted that making rebates nonrefundable “substantially reduces the cost-effectiveness of the stimulus.”

Public works also had high bang for the buck, but economists didn’t think they were timely. Under Clinton, Summers had been a savage infrastructure critic, and while the new invest-in-America Larry was more sympathetic to moving dirt and pouring concrete, the old crunch-the-numbers Larry still doubted its value as stimulus. Peter Orszag’s CBO also dumped on infrastructure’s glacial pace in another little-noticed aside that would resurface a year later, noting that “public works involve long start-up lags,” and “even those that are ‘on the shelf’ generally cannot be undertaken quickly enough to provide timely stimulus.”

There was one more three-T idea: aid to states. As the downturn shriveled their revenues, state balanced budget requirements were poised to force austerity measures at the worst possible time, an “anti-stimulus” that would drain more money out of the economy. Bailing out cash-strapped states could provide a jolt of anti-anti-stimulus, preventing layoffs of public employees, cuts in services for the vulnerable, and tax hikes on everyone. But the politics were awful. Why would Congress want to help states close their fiscal gaps by expanding the nation’s? And why would a Democratic Congress want to help Republican governors fix their state deficits, so they could look virtuous while scolding Washington about national deficits? Senate majority leader Harry Reid of Nevada had little interest in bailing out scandal-ridden Nevada’s GOP governor Jim Gibbons, whose potential challengers included Reid’s son Rory, and Pelosi felt similarly disinclined to do favors for GOP governor Arnold Schwarzenegger of California.

But Obama’s economists focused on the three T’s. So their plan included state aid and unemployment benefits, while popular but slow infrastructure projects didn’t make the cut.
⁷⁴
The centerpiece was a refundable tax rebate for almost all workers, a one-time version of Making Work Pay. Overall, the plan cost $75 billion—two digits, not three—with a trigger to go to $120 billion if the economy didn’t rebound. It was somewhat bigger than Hillary’s plan, but the
Times
columnist and Nobel laureate economist Paul Krugman cautioned his
liberal readers that it “tilted to the right” by including tax cuts and leaving out alternative energy: “I know that Mr. Obama’s supporters hate to hear this, but he really is less progressive than his rivals on matters of domestic policy.”
⁷⁵