Economic InsightsAN IDEA PUBLICATION June 2010 Volume 4 Number 2

Questions about Fiscal Policy: Implications from the Financial Crisis of 2008-2009 N. Gregory Mankiw

Evaluating Fiscal Policy sick. Then you choose the medicine that you WWW.CCEE.NET hope will make the patient better. My objective here is to offer some reflec- Economic Insights is tions about recent fiscal policy. But I want to What you would prefer to do is run a con- an idea publication of begin with an example, and I hope a useful trolled experiment. You’d like to assemble the Colorado Council analogy, about medicine. 100 patients with similar conditions, give for Economic Educa- 50 of them the medicine you think might tion, a not-for-profit Imagine you are a physician, and a patient work and 50 of them a placebo, and then see 501(c)(3) organization comes to you with some adverse symptoms. whether the patients receiving the medicine founded in 1971 to He’s in pretty bad shape. You have never recover. But you do not have 100 patients; promote and improve economic literacy in treated a condition quite like this before, you have only one. What do you do? Colorado schools. and the causes of his ailments are not at all clear. You remember reading about a similar Well, you take your best shot. You decide We feel that an un- case in medical school, and so you try to what you believe to be the most likely cause derstanding of key recall as much as possible and come up with of the patient’s trouble and the most likely economic concepts a theory as to what is making this patient remedy to improve his health. Then you is vital for all citi- zens in order to live, work and make in- About the Author formed decisions in N. Gregory Mankiw is Professor of Economics at Harvard our modern econo- University. As a student, he studied economics at Princeton my. We present high- University and MIT. Professor Mankiw is a prolific writer quality graduate-level and a regular participant in academic and policy debates. His courses designed to published articles have appeared in academic journals and in provide an under- more widely accessible forums, such as The New York Times, standing of important The Washington Post, The Wall Street Journal, and Fortune. He economic concepts to has written two popular textbooks, and his Principles of Eco- Colorado K–12 teach- nomics has sold over a million copies and has been translated ers, so they can then into 20 languages. In addition to his teaching, research, and bring these concepts writing, Professor Mankiw has been a research associate of the to their classrooms. National Bureau of Economic Research, an adviser to the Federal Reserve Bank of Boston and the CCEE also presents Congressional Budget Office, a member of the ETS test development committee for the advanced The Stock Market placement exam in economics, and Chief Economist to the Council for Economic Education. From Game™ in Colorado. 2003 to 2005 he served as Chairman of the President’s Council of Economic Advisers. Colorado’s New Personal Financial Literacy Standards are Embedded in the Revised Economics and Mathematics Standards As required by legislation enacted in 2008, new Personal Financial Literacy (PFL) standards were adopted by the Colo- rado State Board of Education in December 2009. These comprehensive PFL standards, which are distinct for each P-12 grade-level, are required to be implemented in all public schools for the 2011-12 school year. These PFL standards (Economics) and Evidence Outcomes (Math) are embedded in the revised Economics and Mathematics standards.

As included in economics, PFL is designed to enable students to: design, analyze and apply a financial plan based on short and long-term financial goals (standard 4), analyze strategic spending, saving and investment options (standard 5), establish personal credit and manage debt (standard 6), identify, develop and evaluate risk management strategies (standard 7). Ways CCEE is Helping Teachers and School Districts n CCEE began last January by offering a one-day training for 40 teachers representing each of Denver’s 10 high schools, and by distributing to them 1,200 Financial Fitness for Life student workbooks and teacher guides. n CCEE will continue to help meet the need for teacher training by offering a five-day Methods for Teaching Financial Literacy class, July 12-16, with an economics professor and master teachers for each level — elementary, middle and high school. n CCEE has made new PFL standards easily accessible so everyone can see what they look like for each grade level: www.ccee.net/PDFS/PFL.pdf. n The Stock Market Game (SMG), which CCEE offers each semester, aligns perfectly with several of the new PFL standards. Find all of CCEE’s exciting new summer and fall economics classes by visiting: www.ccee.net. administer the medicine. lem facing the Obama administra- that, because of the credit crisis, tion. They entered office when our people were not able to obtain loans; But the patient returns a few weeks economy was very sick. They con- and, because people were not able later, and his symptoms are worse. cluded that if they did nothing, the to obtain loans, there was insuf- What do you conclude? You might unemployment rate would reach 9 ficient aggregate demand. Looking decide that you gave him the wrong percent. (That was their forecast in to the standard textbook theory that medicine. Or you might decide that the documents they released shortly fiscal policy can prop up aggregate the patient is even sicker than you after the election.) But they had a plan demand, they implemented their thought he was when he first came to stimulate the economy by spend- stimulus plan. in and that you should increase the ing a great deal of money, and with dosage. that stimulus—according to their In the forecast the administration estimates—the unemployment rate used to describe the effects of the If you consider the epistemological would not exceed 8 percent. stimulus, they provided the multipli- question, you realize that either of ers which guided their actions. Their those conclusions is possible. The In late 2009, unemployment rose government-purchases multiplier patient could have been sicker than above 10 percent. So what do we was 1.57, and their tax multiplier you realized, and maybe you do have make of that? The Administration was 0.99. Because 1.57 is larger than the right medicine. Or maybe you’re concluded that the patient was sicker 0.99, they concluded it was better to on the wrong track completely. And, than they thought. spend money than to cut taxes. They because you have only one patient, obtained those numbers through a you don’t have any way to conduct I should emphasize that the Obama simulation from a standard mac- that controlled experiment. So, you administration has been guided by roeconometric model, the kind of can’t be sure. a standard theory in the economics model people have been building profession—textbook Keynesian for years. This analogy describes the prob- theory, to be specific. They thought

Economic Insights, Colorado Council for Economic Education, www.ccee.net — Page 2 The question, ultimately, is whether Taxing Less versus thing they wanted in a school. They the model is right, whether it accu- Spending More spent many more months selecting rately describes how the world works. the site to build on and which houses If you could be sure the model was The larger question for me is this: to take over to obtain the land. It was right—if God told you, “Yes. This Would we have been better off focus- a years-long process. model of the economy that you’re ing on the tax side of fiscal policy simulating, it is truth”—then, when rather than on the government spend- Now, what if someone had provided your stimulus plan was followed by ing side? I think there are several all the funds for a new Wellesley 10 percent unemployment, you would issues here to consider. high school but demanded that it know what to conclude: The patient be built immediately? Presumably, was sicker than you thought, because, The first question is whether the quality would have been sacrificed after all, the stimulus worked; my government can spend large sums of for speed. It would have been built model said so. And if the stimulus money quickly and wisely. To consid- more quickly because, presumably, worked, then unemployment would er the question, I’ll offer a personal if people are told they have to spend surely have been 11 percent if not for story. I live in a suburb of Boston money immediately, they will find the stimulus. That is the position the called Wellesley. Coincidentally, my some way to do it. But in such an administration has taken. environment—town planning or national fiscal policy—you wonder Of course, we do not know if it is the Leave A Legacy® whether money can be spent both right model. Macroeconomists have to CCEE quickly and wisely. to be extremely humble. There is a lot we do not know. Please join the late Bob The second question, which is more and Babe Arnold, whose academic in nature, is about the size I teach the Principles of Economics legacy contribution was of the relevant multipliers. The text- course at Harvard. It is a full-year received by CCEE in 2009. book Keynesian model tells us that course, and I start with what we By making a gift to CCEE government purchases multipliers economists are confident is true and in your will, trust, or are larger than tax multipliers. And, then move on to material that is less beneficiary designation, again, the Obama Administration’s and less certain as the year goes on. you will be helping to economic team consulted these stan- We look first at supply and demand, ensure the long-term dard models in reaching their conclu- the theory of comparative advan- success of CCEE’s valuable sions. However, there is a variety of tage, profit maximization, marginal economic education evidence that calls those conclusions revenue equals marginal cost—the programs. into question. premises we agree on. Eventually, as the course goes on, we move to Somewhat ironically, one of the piec- macroeconomics. We examine clas- town has been debating building a es of evidence against this preference sical monetary theory, growth theory, new high school, which is now being for government spending over cutting and at the very end of the course, the constructed just a few blocks from taxes comes from Christina Romer, theory of business cycles, which is where I live. The project is creating the current chair of the Council of the topic we understand least of all. many jobs and, in fact, seems to have Economic Advisors for President been planned and implemented in an Obama. About six months before she I am actually a believer in Keynesian intelligent and prudent way. Partici- took that job, she wrote a paper with theory; much of my research is in pating in such a process makes you her husband David Romer about the that field. But even as a believer in realize how much time it takes to impact of tax policy on the economy many aspects of Keynesian theory, I accomplish something this substan- (Romer and Romer, 2009). appreciate that you cannot approach tial. The town spent many months this subject matter without showing debating whether to build a new Their conclusion was that the tax some humility about what we, as high school or renovate the old high multiplier was 3—that is, every dol- economists, can truly be confident school. Once they decided that, they lar spent on tax cuts will raise GDP about. spent many months designing the by $3. That is roughly three times the new school and determining every- size that the Obama Administration

Economic Insights, Colorado Council for Economic Education, www.ccee.net — Page 3 assumed with their policy simula- other recent work using U.S. data. What Teachers are tions. To be clear, I don’t blame the There appears to be a growing body Saying about CCEE’s Obama Administration for relying of evidence suggesting that taxes may on more conventional multiplier esti- be a better tool for fiscal stimulus than Classes mates. Nor is it reasonable to assume conventional models have indicated. “I have attended four CCEE that simply because they appointed classes over two years and they Christina Romer to chair the Coun- Taxes as Fiscal Policy Tool have been the best professional cil that they must use her research development I have ever in measuring the multiplier. But the What, then, is behind these conclu- experienced. The information Romers’ research does suggest that sions that taxes have a more potent presented is interesting and conventional results about tax policy effect on the economy than spend- for every topic, there is a hands- on GDP are understated. ing? The answer is not clear-cut, on lesson provided that I can but it is easy to speculate why this take back to my classroom and Of course, it could be the case—and could be true. Most obviously, there this is in fact the Obama administra- are effects on the supply side. Tax teach to my 6th graders. My tion’s interpretation—that all multi- rates influence work incentives, for time is never wasted and I like pliers may be larger than previously instance. But even if you believe the challenge and rigor of the measured. Fiscal policy may be so that aggregate demand drives the classes.” potent that, if the tax multiplier is 3, economy in the short run, as many - Carla Rainone, Century Middle the government’s spending multiplier Keynesians do, you might consider School, Adams 12 School District might be 4 or 5. The Romers did not that taxes affect aggregate demand analyze government spending multi- in ways that are not included in the “My first economic class ever. pliers in their recent study, but only textbook Keynesian model. Extremely enlightening, tax multipliers. Clearly, it is still an interesting and informative. open question. When we change taxes, we typically Although I teach history, I can do not just write checks to taxpayers. definitely use some of these The piece of evidence I want to draw Usually, we change marginal tax activities, ideas, etc. with my your attention to is some very recent rates: We change corporate income classes.” work by my colleagues Alberto Ale- taxes, change personal income taxes, - Angela Selman, Palmer High sina and Silvia Ardagna at Harvard. and maybe even institute an invest- School, Colorado Springs School They used data from the Organisa- ment tax credit. These measures have District 11 tion for Economic Cooperation and more complicated and nuanced effects “CCEE has provided useful Development (OECD) to identify on aggregate demand than what the instructors with valuable every major fiscal stimulus in those textbook Keynesian model assumes. countries (Alesina and Ardagna, It is not simply a change in cash flow; materials I have used in the 2009). They then separated out the it is actually a change in marginal classroom and I always look successful polices—those that in fact incentives and can even be direct en- forward to the new classes were followed by robust economic couragement to spend. One example each year and the wealth of growth—from the unsuccessful ones is creating tax incentives to invest. knowledge the instructors and compared their characteristics. bring. My all-time favorite They found that the successful stimu- The “Cash for Clunkers” program was the class about Lewis and lus packages cut business and income involved that type of incentive. I was Clark. I have also shared this taxes and the unsuccessful stimulus not much in favor of that specific one with my colleagues. The packages increased government micromanagement of how people classes are always informative spending and transfer payments. should spend their money. Nonethe- and engaging, and I love less, the fact that people responded to meeting teachers from other The data in the Alesina-Ardagna a tax incentive like Cash for Clunkers districts with new ideas.” study are mostly European, with does suggest that a more comprehen- - Carmen Jackson, Martin Luther only a small portion from the United sive program (such as an investment King Jr. Early College High School, States. But they lead to conclusions tax credit) might have stimulated Denver Public Schools that are very similar to those from spending even more broadly.

Economic Insights, Colorado Council for Economic Education, www.ccee.net — Page 4 The Long-Run Fiscal Situation and the Colorado Council for Economic Education’s Healthcare Challenge Colorado Any discussion of fiscal policy has to be couched in terms of the long-run fiscal picture. I know that some econ- An on-line classroom simulation for students in grades 4-12 omists have made the argument that we should not be concerned about the long-run fiscal picture when we consider short-run fiscal policy: Once the economy begins to grow again, they contend, tax revenue will flow in and the longer-term fiscal picture will be improved. That would be true if these policy multipliers were very large, but they are probably not so 2010 FALL Game: large, in my judgment, that we can ignore the long-run problems created September 27 - December 3 by short-run policies. Register Online to Play the Game http://colorado.smgww.org We now face a very dire long-run fis- Presenting sponsor: cal picture, which is being driven by a couple of factors. One is the aging of the population, with the first wave of Baby Boomers beginning to retire. I explain this scenario to my students at Harvard this way: “My generation has promised ourselves generous retirement benefits in the form of Social Security and Medicare, and For more than 20 years, Colorado’s premiere stock market we promise you’re going to pay for it. education experience for students in grades 4-12 How do you feel about that?” A memorable opportunity for the next generation to engage in learning about financial and economic literacy The bills for those benefits are large partly because of aging and partly * * * * * * * * * * * * * * because of higher healthcare costs. Sponsors needed! Parents! The latter is one of the motivations, Contact CCEE today about Talk to your schools about allegedly, for the current healthcare Sponsorship Opportunities participating in the SMG! legislation. I am personally skepti- 303-832-4764 / [email protected] www.stockmarketgame.org cal that the proposed legislation will reduce healthcare spending substan- Additional support provided by: tially—if at all. So on that score, we are not making true progress on the long-run fiscal picture. To address the issue, I would raise the age of eligibil- ity for Social Security and Medicare. Economists seem to like this idea, In-kind support: but in polls of the general public it is much less popular, so I don’t expect this idea to be implemented.

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I should note that I am not opti- technology continually improving workforce differs from the American mistic that any proposed measure but also becoming more and more workforce—specifically, why Euro- will reduce healthcare costs signifi- expensive. As a society, we have peans enjoy spending more time at cantly. People talk about “bending not figured out how we are going to the café than Americans do and why the curve” and squeezing out waste, eventually say no to people or have we work harder than they do. There fraud, abuse, and so on. My read- people say no for themselves. are many hypotheses out there: (i) ing of the evidence brings me to the Europeans have more joie de vivre conclusion that healthcare costs are The Coming than Americans, and therefore, they growing more expensive over time Value-Added Tax? want to enjoy their high productiv- mainly because technologies are im- ity by spending more time enjoying proving. That is a good thing, but it is I have my own normative conclusions leisure, (ii) that it is the presence and also expensive, and so we must find a about addressing some of these prob- scope of powerful labor unions in way to pay for it. I am not sure what lems, such as raising the retirement Europe that have negotiated shorter the right answer is, but I don’t think age. What I believe is more likely to work weeks, more vacation days, that rooting out waste, fraud, and occur, however, is that taxes will be and so on, and (iii) it is the high tax abuse is going to save much money. raised to very high levels. rates in Europe. I actually find this I am sure there is some waste, fraud, last argument the most compelling. and abuse—there is in all systems— A value-added tax (VAT) is an ef- What that means is, if we are heading but it is not likely a primary driver of ficient tax from an economic stand- toward higher tax rates, my children healthcare costs. point. It is basically a flat consump- will enjoy a lot more leisure than I tion tax, so it tends to be an efficient do. One of the classic hypothetical ques- way to raise revenue. But it is also a tions economists ask when referring fairly well hidden tax, and there is [Editor’s Note: This article is to healthcare costs is, “Would you some debate among proponents and based on Dr. Mankiw’s remarks rather go back to 1950s medical care opponents about that aspect. delivered at the Federal Reserve and 1950s prices?” If that option Bank of Philadelphia’s policy forum were offered at your place of work, In particular, people look at Euro- “Policy Lessons from the Economic my guess is that you would not take pean countries and see the connec- and Financial Crisis,” December 4, it. What that means is, in some real tion between their large governments 2009, and published in the Federal sense, healthcare is cheaper today if and their VATs and conclude that the Reserve Bank of St. Louis Review, you adjust prices properly to account problem with the VAT is that it makes May/June 2010, 92(3), pp. 177 – 83. for quality improvements. A dollar government grow too much. That is It has been edited for length and is of healthcare today has more value one possibility. Another possibil- reprinted with permission from the than a dollar of healthcare in 1950. ity is that governments grow, and, author and the Federal Reserve Bank I posed this hypothetical question in when they do so, they look for ways of St. Louis.] a New York Times column in mid- to raise revenue efficiently. In many 2009: Imagine a Dorian Gray pill has cases, they turn to a VAT. My guess REFERENCES been invented and that taking the pill is that the latter is probably the cor- every day will keep you the same age rect direction of causation and that Alesina, Alberto and Ardagna, Sil- for as long as you take the pill. It is it is also probably the direction in via. “Large Changes in Fiscal Policy: perfect healthcare: You would not age which we’re heading: larger govern- Taxes versus Spending.” or become sick or die. The problem is ment and higher taxes. If we use the Working paper, Harvard University, that these pills are expensive—let’s tax system we have now, though, the October 2009. say, it costs $1,000 to manufacture revenue raised will likely fall short; each daily dose. Again, it is perfect hence, we are probably going to move Romer, Christina D. and Romer, Da- healthcare but at a very, very ex- in the direction of a VAT. vid H. “The Macroeconomic Effects pensive price. How would we, as a of Tax Changes: Estimates Based on society, deal with that? I don’t think Such a large change in our tax policy a New Measure of Fiscal Shocks.” we have the answer to that question, would inevitably incite comparisons Working paper, University of Cali- but in some sense we are moving in with Europe. There is a literature fornia, at Berkeley, April 2009. that direction already, with health about how and why the European

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