Alesina and Zingales Caution on Public Works “Stimulus”

Professors Alberto Alesina and Luigi Zingales caution that the best way to help the poor weather the current economic crisis is to extended unemployment benefits vs. public works programs.

Many are concerned about what we can do to help the poor weather this crisis. Unlike during the Great Depression, we have an unemployment subsidy that protects the poor from the most severe consequences of this recession. If we want to further protect them, it is better to extend this unemployment subsidy than to invest in hasty public projects. Furthermore, tax cuts have a much better effect on job creation than highway rehabilitation.

Why? How about that lag I mentioned earlier in fiscal stimulus aimed at public works. If the CBO analysis is correct it is quite likely that much of that stimulus wont take effect until after the recession ends.

Alesina and Zingales also talk about how many economists, including some on Obama’s economic team don’t think well of Keynesian style fiscal stimulus,

In virtually all economics classes, including those taught by the many excellent economists on the Obama team, the idea of government spending as an engine for growth is not a popular topic. Yet despite their skepticism of Keynesianism in the classroom, when it comes to public policy, these economists happily endorse a large stimulus package that could bring our deficit to 10% of GDP. Why?

One explanation is that these economists think this recession is an extraordinary one. In normal recessions — the argument goes — an increase in discretionary government spending is unnecessary and even counterproductive. But in the event that a recession becomes a depression, a Keynesian stimulus package might work.

Alesina and Zingales are skeptical of this argument because they argue that the recession didn’t start in labor or manufacturing markets, but in financial markets.

But this particular recession is unique not in its dimensions, but in its sources. First, it is the result of a financial crisis that severely affected stock-market valuations. The bad equilibrium did not originate in the labor market, but in the credit market, where investors are reluctant to lend to risky firms. This reluctance is making it difficult for these firms to refinance their debt, forcing them to default on their credit, further validating investors’ fear. Thus, the problem is how to increase investors’ willingness to take risk. It’s unclear how the proposed stimulus package would help inspire investors to do so.

The second reason this recession is unusual is that it was caused in large part by a significant current-account imbalance due to the low savings rate of Americans (families and government). Even assuming that more public spending would increase private consumption — a big if — such a measure would cause even more imbalance.

So what is their proposed solution? They argue for a temporary elimination of the capital gains tax. The idea is to encourage people to become more willing to take on added risk. If the risk remains the same, but the tax rate goes down then people might decide that the added risk is worth it with lower taxes. Thus, moving people back into that portion of financial markets they have fled from. They also suggest allowing all capital and R&D expenditures be fully tax deductible for 2009.

A large temporary tax incentive may be just enough to jolt investors from their current paralysis to take action. Such a switch will also be fueled by the temporary capital-gains tax cut mentioned above, which will motivate people to move their savings from money-market funds to stocks, increasing valuations, investments and confidence.

Irrespective of the efficacy of this plan my guess is that it is not a viable option. There is almost no way that Obama will make a case for eliminating the capital gains tax and allowing full deductibility of capital and R&D expenditures even if it would end the recession next week. This really isn’t about doing the right thing, its about politics.

FILED UNDER: Economics and Business, Government, US Politics, ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Pete Burgess says:

    Fair Tax! It can work.

  2. Eliminate the federal withholding immediately would put money in the hands of the consumer immediately. Of course we would then find that in the following tax year people who didn’t plan ahead would not have enough to pay their taxes. The only difference would be the deficit spending would be spread across America rather than focused in DC.

  3. carpeicthus says:

    Are you f***ing kidding me? All this typing for the solution “If X, cut the capital gains tax” that’s already tattooed on wingnut foreheads? Just see past the ideology, it’s really pretty simple. The problem is that all of the massive capital gains people have made have been taxed too high? Really?

  4. Web Smith says:

    Right. It couldn’t be that the economy before and what is left of it now existed and exists on borrowed money.

    The borrowed money supply has increased by 70% since October, but the increase is mostly being held by the banks. When this borrowed money hits the economy, your dollar is going to be worth half of what it is now.

    We might be able to buy some time if they give us a tax holiday for a year and the government, instead of borrowing to replace the lost revenue, cuts its budget by a trillion, but that will cause the 70% the banks are holding to be released and it’s still a dead end street.

    The central banks know this and that is why they’ve been secretly meeting in Switzerland to discuss a new monetary policy along with a new currency.