Fiscal Stimulus: "Why One Percent of GDP?"

I have a great deal of respect for people who take the time to do real analysis, and Menzie Chinn is one of them.

In his current post at Econbrowser, “Why One Percent of GDP? Opportunity Cost Illustrated (Part III),” Menzie looks into where that arbitrary-seeming figure came from. He first goes through the history of various pronouncements and suggestions and then gets to the meat of his argument. The number is not at all random, but in fact dictated by fear of pushing our luck too far with our so-far-indulgent funding sources, namely, foreign central banks.

One element that Menzie does not mention, perhaps assuming that it is understood, is that much of our Iraq-related deficit spending is a complete waste as far as the domestic economy is concerned. It is going to grossly inflated contracts to multiple layers of contractors in Iraq, and thus providing no economic boost at home.

Chinn tends to adopt an anodyne voice and save his punch line for the end, so be sure to read his closing paragraph. Also, apologies that the chart herein is blurry. I tried it at quite a few different sizes and none worked well.

From Econbrowser:

I wonder — where did that presciption of a one percentage point of GDP fiscal stimulus come from?…

As far as I know, there’s no measured threshold effect in fiscal policy. And if there is, why not 1.5 percentage points of GDP? Why not 2 percentage points?…

To put matters in perspective, consider where the debate has moved over just the past few weeks. Larry Summers writes an op ed in the January 6th FT, advocating: “…a $50bn-$75bn package implemented over two to three quarters [which] would provide about 1 per cent of gross domestic product in stimulus over the period of its implementation.”. On January 10th, the Hamilton Project and Brookings held a conference on fiscal stimulus; a number of around $100 billion is kicked around. Even on the 17th, Bernanke is quoted as noting the possible usefulness of a $70 billion stimulus (although he did not rule out smaller or larger stimuli) (Bloomberg). Now the number being cited as of the 18th is around $140 billion. All this has happened so fast that the White House “Fact Sheet” accessed on January 18th still lauded the the strong growth in the economy (it’s been changed since then):….

It’s been a quick turnaround from zero to 1 ppt. of GDP. The question I now want to pose is — if matters deteriorate further as the rest of the world sinks into slowdown — why not more? (Note — I’m not advocating more stimulus; rather I’m trying to highlight the constraints that have been imposed by the ill-conceived policy decisions of the past seven years.

I think the answer resides in the fact that we have been running deficits for the past seven years, and even at the top of the expansion, we were still running a deficit in excess of 1 percentage point of GDP. It’s also useful to consider what 1 percentage points of fiscal stimulus is now going — expenditures in the Iraq theater of operations.

As I’ve noted in previous posts (here, and here) costs of the troop level surge in Iraq were likely to push current costs (and future refurbishment and equipment replacement costs) further higher. My burn rate estimate for FY 2007 was on the order of $11 to $12 billion per month. In October 2007, the Congressional Budget Office estimated Fiscal Year 2007 expenditures at about $122 billion (see Table 2, below).

Table 2 from CBO, Statement of Peter Orszag, Director, “Estimated Costs of U.S. Operations in Iraq and Afghanistan and of Other Activities Related to the War on Terrorism,” before the Committee on the Budget U.S. House of Representatives (October 24, 2007).

The fiscal year ended in September; the elevated level of troops can be dated around June. This means FY2007 figures incorporate only about 3 to 4 months of elevated expenditures associated with the surge, while FY2008 expenditures will incorporate about 8 to 9 months of surge-related expenditures. This suggests to me that FY2008 expenditures in the Iraq theater of operations will exceed $122 billion recorded in FY2007.

So, if the economy softens even more than it has, one could certainly contemplate more tax cuts and government transfers and expenditures. But I think one has to carefully consider (1) how much more Treasuries the rest-of-the-world will want to purchase, given their bloated stocks of Treasury securities (2) and at what interest rate, and relatedly (3) how many more dollar assets (both private and government) they want at current yield/default risk characteristics, especially given likely trends in the dollar’s value in the next few quarters. (See Brad Setser on what it takes to get continued financing)

Hence, in my mind, 1 pct. comes from the fact that we embarked upon a reckless path of long-lived tax cuts (especially in 2003) aimed at the highest income deciles at a time when the economy was growing, and expanding discretionary spending rapidly, as demographic and health care cost challenges loomed (or were exacerbated by Medicare Part D). Now when we need the maximal policy flexibility, we are, truly, facing the situation with (at least) one hand tied behind our back.

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  1. Anonymous

    Ok it works…hey, I think the size of the stimulas was pulled out of Bush’s anus…but that isn’t what I want to comment about. I was alive in the 90s when Saddam H. was a Great Military Leader who would Bring Us Down unless we crushed him…but Slick Willie never quite got around to that. Come Y2k and here’s shrub…squish! Yep it was spendy but problem solved. Now picking up the pieces is expensive too and much hand-wringing goes on. But this was like cancer that about everyone in Washington thought had to be dealt with…now that it has been-he has been-dealt with everyone regrets the cost. Not a shocker but this is like chemotherapy to kill a malignant likely fatal tumor that brings huge medical bills and much time lost from productive labor. Now that it is done people wonder maybe we didn’t need chemo maybe it would have healed on its own. But I doubt it.

  2. Anonymous

    Look at how much economic value has been destroyed in the last year with subprime fraud and then banking fraud and now the resulting market correction. We have a multi trillion dollar meltdown,but a 1% solution. Its comic!

  3. Anonymous

    The stimulus plan is all about Iraq and the reality of playing pea and shell games with the us economy. I just read this as a reference: President Bush will propose on Monday spending nearly $300 billion more through 2009 for the war on terror, which is dominated by the war in Iraq, a senior administration official said today.
    The funding, sure to be closely scrutinized by Congress, will include:

    •$100 billion for the 2007 fiscal year ending Sept. 30, which when added to spending already in the pipeline would bring the year’s total to $170 billion.

    •$145 billion for 2008, a figure derived from this year’s troop levels and expenditures.

    •$50 billion to get started on 2009. More funds likely will be needed.

    Does the $150 Billion stimulus jump start plan look like a mirror of what gets wasted in iraq?

  4. Anonymous

    One issue seldom discussed is property taxes which probably added to the amount of debt which people were in denial about.

    I often wondered if The Fed didnt shift the tax burden of Iraq to states that were able to increase property taxes in the Fed promoted housing bubble, the ownership society, where people would take on opportunities. I think a lot of unqualified and under-qualified people that were able to take advantage of no-doc subprime fraud probably forget to factor in property taxes, and thus The Fed also forgot to factor in the default of these people that never should have been given keys to homes that didnt have supporting collateral or evidence which would support sustainable cash flow.

    Anyone think the Fed looked the other way on the housing bubble just to help fund Iraq costs?

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