Diagnosis is correct, but the prescription needs work

Posted by Alberto Alesina on 30 January 2009

Editors’ note: Oliver Blanchard’s “Economics Focus” on fixing the crisis asserts that eliminating uncertainty is the key to ending the crisis – an argument advanced in more detail by his colleague Ricardo Caballero on Vox last week. The Economist’s blog, Free Exchange, has invited a number of comments from eminent economists; GCD reproduces them here (with permission). The full thread of Blanchard posts can be followed here.

Olivier Blanchard's piece is absolutely on the mark regarding the analysis of the crisis. I was a bit disappointed, however, by the suggested policy prescriptions.

The fear (or perhaps panic) affecting investors is clear. Nobody wants to take risks. The enormous spread between Treasury bill rates and corporate bonds is an obvious indication of this. This fear is understandable given what has happened in financial markets over the past year, but I fully agree with Mr Blanchard that the world is panicking above and beyond what is reasonable. (And incidentally, the comments of pundits who have seized on the crisis as an opportunity to criticise the market economy and spread fear of the Great Depression are adding unnecessarily to the panic.)

I have three comments.
Need to worry about sustainability

The piece seems to suggest that we should act without regard for the implications for current and future deficits -- whether the issue is public infrastructure investment or bank recapitalisation. However the prospect of future tax burdens may create more fear today. Worries about the American deficit are increasing in frequency in the press. To be clear, I fully endorse increasing the deficit during recessions, but one cannot simply ignore the budget constraint altogether. Should we forget about expectations of future conditions? We do not ignore it when we teach fiscal policy to our students.

Need priorities

Secondly, the role of the economic advisor is to suggest priorities, even in a crisis, and this piece does not do that. Is the marginal tax dollar better spent on building roads or on recapitalising banks? "Do everything" is not sufficient as policy advice. And such an approach -- throw everything you have at the economy -- may actually increase panic rather than reduce it. Frankly, after finishing the piece by Mr Blanchard, and despite the well-written optimism of the last sentence, I was more worried than before.

Need to focus on financial markets

The panic originated in the financial markets. There is where the focus of policy should then be. In addition to recapitalisation, there should be public insurance against defaulting borrowers for banks who lend. Fiscal incentives should be extended to encourage private investors to invest this year rather than next (easily done with depreciation allowances). Fiscal protection against stock market losses, using temporal variation in capital-gains taxes and loss deductions, is another potential solution. In other words, a package of temporary incentives for banks to lend, and for investors to borrow and invest.

On the effectiveness of fiscal stimulus

I would assume that Mr Blanchard may agree with much of the above, but then he also endorses the old-fashioned Keynesian strategy of spending more on infrastructure to get the multiplier working, and he applauds the Obama plan.

First of all, even assuming that spending multipliers work, remember that American consumers are indebted to the roof. They may indeed want to save more. Haven’t we blamed them for saving too little until recently? And now we want them to consume even more? It is a bit tricky.

Secondly all the recent academic literature I have read suggests that tax cuts work better than spending increases to stimulate demand -- including a paper by Christina Romer and David Romer -- but suddenly this message seems to be lost in the panic of doing everything we can on the spending side of the government budget. Obviously a surge of demand from China and Europe might help the American economy, but this is beyond the direct control of the government's authority.

It may very well be the case that in a major crisis like this Keynesian multipliers work differently, favouring the spending rather than the tax side. Maybe, but I am not familiar with any evidence to this effect, so the almost universal belief that this is an essential part of a rescue package is not very reassuring.

Final proviso

Finally, I applaud the author for reminding us that there are many things we do not know and that there is much uncertainty, but I am not sure that “do a lot” is necessarily the logical implication of this situation. The first reaction of the American government to the financial crisis was to do a lot of things. Did it help?