Wednesday, October 24, 2012

Romer's Case is Fundamentally Flawed

Copyright, The New York Times Company

A fundamental flaw in much of the advocacy for government spending to “jump-start the economy” has been a failure to adequately distinguish government transfers to individuals from government spending on goods and services.

When the Obama administration designed the American Reinvestment and Recovery Act in early 2009, its chief economic adviser and one of the act’s enthusiastic advocates was Prof. Christina Romer of the University of California, Berkeley. Ever since, Professor Romer has insisted that opposition to the act’s purported stimulus value is largely motivated by ideology, contrary to empirical evidence, and is getting in the way of the even bigger stimulus that is needed.

The recovery act had three basic components: government purchases, transfers to the poor and unemployed, and so-called tax cuts. (Parts of the act gave resources to state and local governments, which they could devote to the same three components.)

I agree with Professor Romer that plenty of historical episodes featured surges in government purchases of goods and services, especially but not exclusively purchases by the Defense Department. Moreover, I agree with her that historical episodes can be informative about the modern-day effects of government purchases.

The fatal flaw in Professor Romer’s evaluation of recovery act’s effects occurs when she assumes that transfers to the poor and unemployed have the same employment and output effects as government spending on goods and services.

Economic theory and common sense tell us that paying someone to build a tank or pave a highway – as government purchases often do – has a very different effect than paying them for not working or paying them for earning less rather than more – as the law’s transfers did.

Professor Romer calls herself “an empirical economist” and might therefore eschew economic theory and common sense until it is supported by empirical evidence. But she fails to mention that dozens, if not hundreds, of empirical studies have found that safety-net programs discourage people from working and discourage employers from hiring (there are so many studies that there are now studies of studies, summaries of meta-analyses and so on).

That literature offers a range of estimates, and sometimes passionate arguments among its authors, but certainly does not support the idea that incentives are negligible, especially when the government obtains the large majority of the proceeds of a person’s work.

Understandably the law was put together hastily in early 2009 as people feared that the recession was getting out of control, and some bases were momentarily left uncovered. But almost four years later, an empirical economist should have noticed that the legislation eroded incentives to work and eroded incentives for employers to hire or avoid layoffs, and that these parts of the act by themselves are likely to have reduced employment and certainly did not expand it as much as government purchases would.

An empirical economist would also notice that the demographic groups whose work incentives were eroded the most by the law, like unmarried people, were remarkably the same groups whose employment and work hours fell the most. By further expanding safety-net programs, a bigger stimulus would only have created more groups with labor-market outcomes like the unmarried and enlarged the ranks of people for whom government help permitted them to spend more by working less.

Professor Romer might point to a study the President’s Council of Economic Advisers released shortly after she left in 2010, contending that extending the duration of unemployment insurance increased national employment. But that study suffers from the same flaw, because its estimates are based on the backward assumption that the historical “multipliers” for government purchases apply to transfer-program spending too.

In my new book, I explain how the American Reinvestment and Recovery Act did not erode work incentives by extending unemployment benefits (those extensions, examined in the White House study, were put in place by other legislation), but rather by giving unemployed people bonuses, paying for most of an unemployed person’s health insurance and expanding the food stamp program, to name just a few provisions.

Throughout the time Professor Romer has been trying to convince us that the law expanded our economy, she has failed to mention that it eroded work incentives, and she has not explained how its transfers could possibly have the expansionary effects of historical military buildups and the like.

One might expect that the tax credits part of the law would have enhanced incentives and thereby help offset the incentives that were eroded by its transfers. However, many of the tax credits were withheld from people from high incomes. Regardless of whether redistribution is achieved by collecting more taxes from families with high incomes, providing more subsidies to families with low incomes, or both, an essential consequence is the same: a reduction in the reward to activities and efforts that raise incomes.

Studies suggest that the American Reinvestment and Recovery Act helped keep living standards out of poverty, a great benefit that may be worth depressing the labor market. But empirical evidence, economic theory and common sense all contradict Professor Romer’s assumption that transfers to the poor and the unemployed raise employment about as much as the same amount of government spending on goods and services.

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