Greg Mankiw makes a good point about the investment tax credit

An investment tax credit is probably less effective when interest rates are very low, as they are now, than in normal times. As Greg Mankiw explains:

However, the impact will be relatively modest. Notice that expensing merely accelerates deductions. Thus, the value to the firm depends on interest rates. With interest rates near zero, the impetus to investment is small. Put another way, this policy can be seen as giving firms a zero-interest loan if they invest in equipment. But with interest rates near zero anyway, the value of the loan is not that great.

David Leonhardt on tax cuts

David Leonhardt makes the point in yesterday's NY Times that I have been thinking about for awhile. If President Obama is smart (and I know he is) and if he hasn't given up on trying to save the economy from a double dip and save Congress from falling to the Republicans (of that I'm not so sure), here's what he does: propose legislation to extend the Bush tax cuts for all but the highest income earners; let the tax cuts for the top earners expire, but take the proceeds for the next two years and use them to fund a set of tax cuts that moderate Democrat, Republican and independent voters will understand and approve. These include a payroll tax holiday and investment tax credit. I'd toss in the support for community banks to finance loans to small businesses if we can all avoid calling it TARP for small banks. It's good for the economy, and it's good politics.

There's a lot of disagreement out there as to whether tax cuts of any kind, but especially tax cuts for the rich, have a stimulative effect on the economy. Leonhardt presents a very strong argument that tax cuts for the rich have very little effect: we've tried that twice in the past (1981 and 2001) and each time the tax cuts were followed by many months of continued declines in employment. Not an airtight case, but certainly if you do something twice and it doesn't work, you might want to think again about doing it a third time.

The tragic fate of a slow-footed, dim-witted macroeconomist with a heavy teaching load

The paper I planned on writing eventually, "Monetary Policy Rules, Fiscal Policy Drools," has already been written, by Eric Leeper, under the title "Monetary Science, Fiscal Alchemy". His paper is excellent but I like my title better.

A fiscal stimulus allegory

A guy walks into the doctor's office with a splitting headache. The doctor prescribes him some painkillers, but wanting to save some money, the guy takes only half the dose. He goes back a week later and says "Doc, I've still got this splitting headache." The Doc says, well why don't you just take the full dose this time. "The painkillers didn't work last time around," the guy responds, "why don't you just hit me over the head with a hammer instead?"

A plan to reinvigorate the economy

I approve of Joe Gagnon's approach:



- The Fed launches a new $2 trillion round of quantitative easing with a commitment to further action if the economy remains weak



- The Fed lowers the interest paid on reserves to zero



- The Obama Administration instructs Fannie Mae and Freddie Mac to allow all homeowners current on their mortgage payments to refinance regardless of loan-to-value ratio



- The Obama Administration makes a strong effort for mortgage modifications for distressed mortgage borrowers



- The Treasury renounces its "strong dollar" policy, allowing a broad-based depreciation.



I endorse Paul Krugman's caveat: the Fed should not reassure markets that it will switch course if inflation rises above 3 percent. In fact, the Fed should promise that it will continue to make purchases as long as inflation is below 3 percent for a few years.



I also support the establishment of an infrastructure bank in legislation attached to the highway bill that is under consideration in Congress, and an extension of the payroll tax holiday and unemployment compensation.



Everything but the last three proposals can be done by the Obama Administration and Fed alone, without having to go through Congress. For the last three, Obama needs to be much more specific and forceful than he was in his speech yesterday. The message ought to be, if Congress does not act on jobs, it - not he - will be held responsible for continued high unemployment in 2012. If you can't get the legislation, take the issue.

Better than nothing

Nothing is what Ben Bernanke is offering in terms of additional stimulus from the Federal Reserve. Joe Gagnon suggests three things the Fed could do:

- Lower the interest rate the Fed pays banks on reserves from 0.25 percent to zero
- Purchase three year Treasury securities in sufficient quantity to achieve a target rate of 0.25 percent (versus 0.90 percent now)
- Establish a facility to allow banks to borrow for terms up to 24 months at an interest rate of 0.25 percent

He claims that

These measures are all within the Federal Reserve's established powers. They pose essentially no risk to the Fed's balance sheet. They would reduce unemployment roughly as much as a 2-year $600 billion fiscal package and yet they would actually reduce the federal budget deficit. And they can be reversed quickly should the balance of risks shift from deflation to inflation.

I'd be interested to know where he got the $600 billion figure - it seems wildly optimistic. Nevertheless, if the Fed did those things it would be better than nothing. I'd add that the Fed could begin charging banks for holding reserves (does anything in the legislation authorizing the Fed to pay interest on reserves require that that interest rate be positive?) as a way of encouraging banks to lend rather than hold idle reserves.

But even so, I think the Fed's ability to influence the economy is very constrained at this point. The Fed's quantitative easing has brought long-term interest rates to historically low levels. Specific intervention in the mortgage and commercial paper markets has brought spreads in those markets down dramatically. Corporate bond spreads are also at normal recession (not normal recovery) levels, but unless the Fed starts buying up corporate bonds in massive quantities there's not much it can do there.

The biggest obstacles to strong recovery now are consumer spending, the housing sector, lack of availability of credit for small businesses, state and local government finances, and employment. This is the job for fiscal policy, not monetary policy.

I'm getting very tired of Ben Nelson

Ben Nelson on aid to states, loans to small business, and other stimulus measures:

The Congressional Budget Office estimated that the original bill to reauthorize long-term unemployment benefits, a broad domestic aid package that also included business tax breaks and state Medicaid money, would have added $134 billion to the deficit over 10 years. When Senate Majority Leader Harry Reid (D-Nev.) first brought it to the floor in June, it failed with a whopping dozen Democrats voting nay. Over the next several weeks, Reid and Senate Finance Committee Chairman Max Baucus (D-Mont.) reduced the bill's deficit impact by adding revenue raisers and doing things like cutting $25 per week from every unemployment check. They got closer and closer in a series of votes, but Nelson joined moderate Republicans in saying the bill was moving in the "right direction" while still voting no.

Ben Nelson on extending unemployment benefits:

In this week's votes, Nelson insisted that Democrats find a way to pay for the extension of benefits. He said there are some stimulus funds that could be used -- an idea that Republicans back..."The question is the level of emergency versus the initial point: I'm not trying to say it's [unemployment] not important. Obviously it's very important. If it's that important, it's important enough to be paid for."

Ben Nelson on extending the Bush tax cuts for top income earners:

Two more Senate Democrats called for extending tax cuts for all earners—including those with the highest incomes—in what appears to be a breakdown of the party's consensus on the how to handle the expiration of Bush-era tax cuts. Sen. Kent Conrad (D., N.D.) said in an interview Wednesday that Congress shouldn't allow taxes on the wealthy to rise until the economy is on a sounder footing. Sen. Ben Nelson (D., Neb.) said through a spokesman that he also supported extending all the expiring tax cuts for now, adding that he wanted to offset the impact on federal deficits as much as possible.

Offset the impact on the deficit how? By cutting spending on things like aid to states and the unemployed? Has anyone suggested the opposite approach to Senator Nelson, paying for aid to states and the unemployed by allowing the Bush tax cuts to expire? More generally, I think that every time Senator Nelson says we can't undertake some stimulus measure unless it is paid for somewhere else in the deficit, the response should be to offer massive cuts in agriculture subsidies, directed specifically at Nebraska farmers if possible.

The macroeconomic effect of the stimulus

Bruce Bartlett has collected some recent research on the effects of the 2009 fiscal stimulus (ARRA). John Taylor in Congressional testimony makes the following arguments:

1. Fiscal stimulus was not effective

- models suggesting it was have conclusions "baked in" from the beginning

- other models show small effects

- the 2008 tax cut and cash-for-clunkers had very little effect on consumption, consistent with the permanent income hypothesis

- most of the turnaround in GDP growth can be explained by inventory growth, not government purchases

2. The main reason growth is slowing is lack of confidence resulting from a scary fiscal situation

- CBO projects that debt will rise to 947% of GDP by 2084

- there's a lot of uncertainty about financial reform, effects of health reform, future taxes

3. Therefore what we need is fiscal consolidation. Reversing the stimulus will not hurt because it has had such a small effect anyway.

I will agree with Taylor on his very first point, that models suggesting a large impact from the stimulus are not terribly convincing because their conclusions are baked in. What we need is to rerun the world economy with no stimulus and compare it to what we have now. We can't do that literally, but we can do it using theoretical models. But the theoretical models will by necessity assume the conclusions one way or another, so the exercise is of limited utility. I'll also agree with his claim that the 2008 tax cuts (and maybe cash-for-clunkers) had relatively small effects.

The rest of his argument strikes me as very sloppy reasoning. Take the inventory vs. government purchases argument. Inventory investment turned positive because inventories had been drawn down to a very low level and businesses were anticipating an increase in sales. Where did that expectation come from? It is inconceivable that a significant part of that expectation did not arise from the fact that the government had just committed to spending $787 billion over a three year period.

The challenge that stimulus pessimists face is coming up with another theory to explain the effects of fiscal policy. The Keynesian story is simple: in conditions of deep recession, if someone in the economy (consumers, business, government) spends, that creates demand for goods and services, which is met by new production and employment. How could it be otherwise? Taylor and others have dug through pre-Keynesian business cycle theories and hit upon the problem of "confidence". Government spending creates uncertainty, which spooks investors and keeps them from spending. Let me enumerate the problems with this line of argument:

1. There is no evidence, none, that the uncertainty created by government deficits has a greater impact than uncertainty concerning the length and severity of the recession. I don't know of any studies that show that the fear of budget deficits has any effect on investment at all, except through long-term interest rates (which are now at extremely low levels). Proponents of this theory I think are engaged in projection: budget deficits make me uncomfortable, so they must make businesses uncomfortable, which must explain why they're not investing.

2. The idea that anyone is worried enough about the debt-GDP ratio in 2084 under the CBO's alternate fiscal scenario to put off investment spending is ludicrous. As we speak the stock market is lurching to and fro in response to company earnings reports for 2010Q2. Consumers are worried about whether they can pay their bills this month. We've seen how ridiculously short-sighted businesses have been, from the financial sector to BP to GM. They're not investing because of what they fear the fiscal situation will look like when my grandchildren are old and gray? Please.

3. There was going to be uncertainty about the health and financial sectors regardless of whether or not reform bills passed. Arguably the passage of comprehensive reform bills has reduced uncertainty rather than increased it. Furthermore, the health reform legislation was the most serious attempt ever to control costs in Medicare over the long haul; you would think that people like Taylor who are concerned about the deficit (and any businesspeople out there who are hinging their investment decisions on fiscal policy) would give the Democrats some credit for that. But noooooo.

So the truth is that we do not know what the effect of fiscal stimulus was. But the Keynesian logic suggesting a substantial positive effect is far more compelling than any alternative that has been proposed.

What do we do about a slowing economy?

My rosy forecasts for economic growth coming out of this recession are not looking so good right now. Employment growth in March and April suggested a strong recovery. May and June's numbers, however, provide unmistakable evidence that the economy is slowing down. Private sector employment increased by 33,000 in May and 83,000 in June, well below the pace needed to make a dent in unemployment. Hours worked increased by only a tiny bit in June, so that total growth in hours in the second quarter is only 2.4 percent, the same as in the first quarter. Hence my best guess is that GDP grew no better in the second quarter than the first (3-3.5 percent, versus my guess of 4.5-5 percent based on April-May's data). What's going on out there?

Well, it seems as if in the race between the forces of recovery (pent up demand, expansionary monetary and fiscal policy) and the forces of contraction (consumer debt, oversupply of housing, pressure on state and local budgets, general lack of confidence) the forces of contraction have taken the lead. Awhile ago I thought that the prudent course of action was a "small" (on the order of $100 billion or so) stimulus focused on aid to the unemployed and state governments to guard against a slowdown. Now the slowdown seems to be upon us, anyone with a brain would agree that a stimulus package of that size or larger is the way to go. Unfortunately, people with brains seem to be very scarce in the policymaking and opinion-forming communities.

Paul Krugman and Brad DeLong have written several pieces lately asking how it is that Keynesians seem to have lost the argument on policy to the deficit hawks. The best answer seems to me to be the attractiveness of false prudence in times of crisis. We got into this mess because of over-indulgence. The cure must be to tighten our belts and accept our punishment. Reduce the budget deficit, put a halt to the rise in debt, take our lumps, and things will be all right. Well, that is clearly nonsense: the problem we face right now is that people and businesses prefer to hoard money rather than spend it. The solution must be to stimulate spending, which means that the government needs to borrow more, not less. But something about calling for more "irresponsibility" on the part of government at this time is deeply unattractive to an important segment of our polity (largely, though I suppose not exclusively, that segment that is securely employed such as politicians and journalists). And so here we sit, unable to do the obvious things like extend benefits to the unemployed and states that might get us out of this mess.

When people try to come up with a logical argument for austerity they focus on the effects of austerity on "confidence". David Brooks's column in today's NY Times is a particularly asinine version of this line of reasoning. First he paints an absurd caricature of proponents of stimulus (without naming anyone or citing specifics, of course) as arrogant and overly confident in their theoretical models. Nothing could be further from the truth: we all admit that we're in uncharted territory here (well, territory that has been charted only a couple of times in history) and allow for a wide range of uncertainty in our prescriptions). Then he idolizes the non-egghead, commonsense man on the street who somehow has accumulated more wisdom about the workings of the macroeconomy than the so-called "experts". And he summarizes their wisdom thusly:

You can't read models, but you do talk to entrepreneurs in Racine and Yakima. Higher deficits will make them more insecure and more risk-averse, not less. They're afraid of a fiscal crisis. They're afraid of future tax increases. They don't believe government-stimulated growth is real and lasting. Maybe they are wrong to feel this way, but they do. And they are the ones who invest and hire, not the theorists.

Is there a word for arrogant anti-elitism, the flaunting of ignorance as a badge of honor? Brooks is bathing in this, whatever it is. Would it do any good to point out that there is no evidence that business people are not investing or hiring because of fear of deficits or future tax increases (as opposed to the fear that no one is going to buy their stuff)? Probably not, because reliance on "facts" and "evidence" is too eggheady for the likes of Brooks. But for the record, if people with money were really afraid of a fiscal crisis, they would hesitate to buy government debt. The government would have to pay a premium to borrow - we'd see a big spike in interest rates. The truth? The interest rate on 10-year government bonds is 3.2 percent, which is ridiculously low. The expected inflation rate implied by the difference between the interest rate on regular government bonds and bonds that are indexed to inflation (TIPS) is about 2 percent, the same as it's been for decades.

Even renowned economists are capable of spouting nonsense about the advisability of stimulus. Ed Glaeser counseled in today's Times (the link has disappeared - perhaps he had second thoughts) against the government spending money on infrastructure and other things that we don't need. A waste of resources, he says, echoing the austere gentlemen who ran the British Treasury in the early 1930s as the British economy descended into a death spiral. What is a greater waste of resources - millions of people unemployed, or using some of those unemployed to build highways?

Government spending, either directly or through aid to states and the unemployed, is an essential part of the answer to the problem we face. The Obama Administration needs to make this its number one priority this summer. The Senate has to be convinced to take action now - otherwise the Democrats are doomed, and a Republican dominated legislature is bound to pursue the wrongheaded (but strangely morally satisfying) policies next year that will extend our economic misery for years to come.

I don't understand Gillian Tett's article in the Financial Times

She writes:

Reality of America’s fiscal mess starting to bite

By Gillian Tett

Published: June 17 2010 16:15 | Last updated: June 17 2010 16:58

If you pop into a toilet on the Seattle waterfront this summer, you might see over-flowing bins. The reason? A polite notice explains that “because of 2010 budget reductions”, the Seattle government can no longer afford to “service this comfort station” each day. Hence the dirt.

Investors would do well to take note. In recent months, America’s fiscal mess has assumed a rather surreal air. On paper, the country’s federal-level deficit and debt numbers certainly look very scary. But in practical terms, the impact of those ever-swelling zeroes still seems distinctly abstract.

After all, so far the federal government has not been slashing spending; on the contrary, there was a stimulus bill last year. And, as my colleague John Plender pointed out this week, Treasury bond yields have been falling as investors flee the eurozone woes. As a result, those scary numbers still seem to be a problem primarily concocted in the world of cyber finance.

But there is one place where reality is already starting to bite in America and that is in terms of state finances. Just look at the statistics. A report from the US Center on Budget and Policy Priorities issued last month estimates that in fiscal 2010 the US states collectively posted a $200bn-odd budget shortfall, equivalent to 30 per cent of all state budgets.

Last year, that pain was partly eased by Barack Obama’s stimulus package(s). But that spending splurge is now fading away. And in fiscal 2011 and 2012, the states are expected to face another combined budget deficit of $260bn, with the 2011 shortfall in places such as New Jersey, Illinois, Nevada and Arizona projected to be more than 35 per cent of last year’s budget.

So far, the municipal bond market has been dangerously complacent about all this, with yields on 10-year municipal bonds hovering just above 3 per cent. But even if markets seem relatively relaxed, the key point is that the state statistics are already having a very real world impact – in contrast to the federal debt.

Never mind the trivial matter of Seattle’s comfort stations; as it happens, Washington State’s finances are better than most. In New Jersey schools, classes are being cut. In California, public sector employees are not getting paid. In New York, a subway extension has just been cancelled. And in places such as Illinois and San Diego, pension benefits are being renegotiated altogether, breaking numerous taboos.

This, in turn, begs a bigger question: what will be the wider economic and psychologal impact? One obvious, immediate consequence of these cuts is that they appear to be undermining consumer confidence, over and above the damage already being inflicted by the stubbornly high unemployment rate. The pattern may also be fuelling some subtle shifts in terms of how investors view the future.

In Seattle, for example, local insurance companies have recently changed the message they are giving to customers. For though financial planners used to steer households into tax-deferred products (such as 401K), since they assumed that employees would pay lower taxes when they retired, the new mantra is “tax diversification”. That is based around the idea that households should not defer tax payments, since taxes wll inevitably rise in the future, as the fiscal squeeze takes hold. And that, in turn, raises another question: namely what all of this real-world squeeze in Seattle (and eslewhere) might - or might not - do to the bigger debate about the federal debt.

It is a fair bet that eventually the debate about state spending cuts will encourage investors and voters to start paying more attention to the seemingly abstract federal fiscal numbers.

That might spark more market upheaval. it might also create more political upheaval. Just look at the rise of the Tea Party for signs of that.

But if you want to be optimistic, it is also possible to put a more upbeat spin on this. For all the gloomy statistics about state deficits and spending cuts, what has not received as much attention is that some states are now trying proactively to tackle their woes. Illinois, for example, is facing a big crunch due to credit downgrades; but it is also doing some imaginative things, such as raising the retirement age for local state employees.

That may not please voters. Nor will it necessarily save Illinois from further downgrades to its debt. But this is the type of step that needs to embraced at the federal level, too. So if places such as Illinois can actually break these taboos, it could be a reason for cheer; conversely, if it sparks too much social unrest, it will be a powerful warning sign. Either way, holders of US Treasury bonds had better keep a close watch on what happens to state budgets this year; even in the all-too-tangible world of the Seattle waterfront.

She seems to be saying that large deficits and debt are a problem at the state level and this signals that trouble may be brewing over federal debt as well. She takes some comfort in the fact that states like Illinois are making some tough budget cuts, and hopes that the federal government can do this too. She is warning us, I think, that although standard indicators like interest rates on Treasury bonds do not suggest that bond markets think there's a problem with the federal debt right now, trouble is right around the corner.

But her article actually provides strong anecdotal evidence that it is not large deficits and soaring debt that are a problem, but efforts to cut those deficits and debt during a recession. It is the spending cuts that are having an impact on consumer confidence, not the deficits. This is an excellent argument for another round of federal government support for state budgets; why doesn't she come right out and say that?

This would be pretty ok, if true

Matt Yglesias reports that the Obama Administration is considering pushing for a payroll tax cut to address the apparent slowdown in the economy. That's a step in the right direction relative to what seems to be an attitude at both the Fed and the Administration that they've done quite enough to fight the recession thank you very much, and now have to pivot to the "problems" of inflation and government debt. But at this point - almost two years into the recovery with unemployment still at 9.1 percent and the economy slowing down, I think much more drastic measures are in order. How about:

1) A bounty for firms to hire long-term unemployed workers. If a company hires a worker who can document having been on unemployment compensation for 26 weeks or more, and can document that this worker represents a net addition to payrolls, it receives an amount of money representing say half of that worker's compensation paid in monthly installments for the next 12 months.

2) Obama makes a deal with Republicans: present to me your list of the most onerous regulations that are impeding small business hiring and I will offer a temporary waiver. In exchange, Republicans agree to some element of the Democrats' stimulus agenda: more spending on infrastructure, aid to state and local governments, whatever.

3) An open-ended commitment by the Fed to a program of quantitative easing that does not stop until we have solid economic growth and inflation in the three to four percent range. Increasing expectations of inflation can help stimulate the economy by reducing real interest rates (i.e. if a business can borrow at four percent but believes the price of its product is going to rise at four percent, it's borrowing at a zero percent expected real rate of interest - free money!).

4) Restrictions on bank and non-bank lending to hedge funds and other institutions for speculative purposes and a strong swift kick in the backside to banks to get them to make more conventional business, mortgage and personal loans.

5) A bold program to resolve the foreclosure mess. I still don't understand this issue well enough, but I do know that the relentless slump in the housing market is killing the economy. If what is required is for Freddie Mac and Fannie Mae to buy up every outstanding mortgage under say $500,000 at face value and then work out debt restructuring agreements with the borrowers, then go ahead and do that.

I don't for a minute believe we're going to get that aggressive an array of policies, however. It looks, for reasons that are really unfathomable, as if the Administration is spurred to action only when economic growth threatens to fall close to zero, but is content to see us muddle through at a 2-3 percent growth rate. At that rate we will never, and I mean never, see a complete recovery from this recession.

More analysis of Obama's hostage crisis

Good God, I think I agree more with Charles Krauthammer than Paul Krugman. One reason is that much of the political costs that Krugman mentions disappears if Obama takes up tax reform next year.

That said, if the revolt of the House Democrats succeeds in squeezing more out of Republicans (as opposed to scuttling the deal entirely) I'm all for it. It would be great if the Democrats could get the Republicans to accept a lower threshold or higher marginal rate on the estate tax, but I doubt it. Money for infrastructure investment maybe? At a minimum I'd like to see the debt ceiling lifted now rather than risk a showdown over this issue in February.

Shwing!

I predicted +167,000 private sector employment, +134,000 overall because of a drop in government workers. Actual numbers: +159,000 private sector, +151,000 overall because of basically flat government employment. I declare victory!

Most forecasts were much more pessimistic. Calculated Risk says the consensus was +60,000. In fact, the establishment survey side of the BLS employment report was stronger than the headline number indicates because they revised August's and September's numbers upward by 56,000 and 54,000 respectively. The BLS now estimates that 1.1 million jobs have been created since December 2009. This is not sufficient - a good number would be closer to 3 million - but it is a far cry from the "jobless recovery" following the 2001 recession.

Another good piece of news is average weekly hours, up from 34.2 to 34.3 hours. Pre-recession average was around 34.6. As we approach 34.6, more and more of the increased labor demand will show up as an increase in jobs rather than hours, and the jobs numbers will look better and better.

On the other hand, the household survey indicates a loss in employment of 330,000 workers, most of whom left the labor force (labor force fell by 254,000). This number is very volatile however so you don't want to make too much of one month's data. Since December 1.3 million more people are working according to this measure.

What does all this mean for policy in the months to come? Briefly: we still need QE2. The positive news does not mean that it is now time to contract fiscal policy - we need to extend the middle class portion of the Bush tax cuts, we need more aid to state and local governments, we need extended unemployment insurance. Republicans will nip this recovery in the bud if they insist on slashing the deficit or shutting down the government.

Keynes vs Hayek

Circulating in the attention economy of the "internets" is this Austrian appropriation of the hiphop vernacular.



Moralist tone of the Hayekian critique of excessive borrowing aside, I find it quite interesting how the liberatory tinge of Hayek's "I want to free the markets!" is made to contrast with Keynes' "I want to steer the market". In a sense, hiphop (an erstwhile element of alternative youth culture) and discourses of freedom are mobilized to support a particular economic ideology (and I am not using ideology in a merely pejorative sense). No doubt, underlying this freedom versus planning dichotomy is the ultimate normative bedrock of neoliberal creed: freedom of choice. Nevertheless in this particular context, it seems that our choices are truncated; they are limited to either steering the economy or freeing the economy. As if these two are our only choices. What about embedding the economy, or socialising the economy, or ecologising the economy? The implicit common denominator that brings Keynes and Hayek together is that both place their bets on economic growth as the ultimate aim of social evolution and that they are both blind to the systemic nature of class and ecological injustices of these creatively destructive but also destructively creative cycles of boom and bust.

Circular firing squad department - commander in chief division

So apparently President Obama is going to propose a spending freeze starting 2011 on the $447 billion dollar part of the budget that funds nondefense discretionary programs. Brad DeLong calls it "dingbat kabuki"; Mark Thoma echoes the sentiment. One could defend the plan in a few ways:

- It's really a small amount of money, amounting to $25 billion less spending than currently planned in 2011, which will hit the economy (hopefully) at a time when the recovery is well underway.

- Some programs, like agriculture subsidies, deserve to be cut, and doing so is easier if put in the context of a spending freeze.

Well, I'm not going to dismiss those arguments out of hand. But what we really need now is not a weak-kneed concession to the anti-deficit crazies but an impassioned defense of the economic policies, including fiscal policies, that Obama pursued in the last year. Obama's policies have worked: TARP kept the financial system afloat and most of the money (outside AIG) has been repaid; the bank tax Obama proposes will recoup the rest. Helping GM and Chrysler through bankruptcy saved hundreds of thousands of jobs. Obama can point to plausible studies that estimate a million or more jobs have been "created or saved" because of ARRA. Reducing spending now when the unemployment rate is ten percent, as the Republicans want to do, would be insane. It would cost jobs. Where would they cut? Reduce road construction? How many construction workers would be thrown out of work? Aid to states? How many teachers, police officers, firefighters? Lay it out for us, Barack!

Deficits are a problem in general. But right now, a large budget deficit is doing a great deal to stimulate recovery. The deficit needs to be reduced in the medium- to long-term, and the key to doing this is to get control of health spending. The health care reform bills that the Senate and House passed are the most substantial attempt at reining in health spending ever attempted. Obama needs to call the Republicans and blue dogs out on this: you've been professing to care about the budget deficit, but you have a piece of legislation before you that reduces the growth of Medicare by $500 billion over the next ten years and puts mechanisms in place that have a shot at reducing the growth rate of spending for decades. If you oppose this bill while at the same time denouncing the deficit, you are a hypocrite.

Obama has been accused of letting his attention wander from the needs of Americans to his "pet project" of health care reform. Explain why this isn't the case. Millions of Americans are out of work or fear for their jobs - they need access to the health care system, and the bills before Congress do this. The high cost of health care is strangling businesses, increasing costs and reducing employment; the reforms are directed at this problem. Health reform is not a diversion, it's an attempt to help Americans with one of the most basic of human needs in these very difficult times. Make the case!

I was very happy with Obama's leadership up until about a week ago. Now it seems that his response to political difficulties is being pulled right out of the traditional Democratic triangulation playbook: rather than defend what you believe, capitulate on every philosophical argument. Back away from ambitious policies that might help people, substitute for these policies a watered-down version of what a Republican administration would offer. Offer targeted programs for the "middle class" that poll well but make no real impact (direct deposit for retirement accounts? are you kidding me?). Then watch Republicans roll over you in the midterm elections.

How much trouble are we in?

All the real economy indicators are currently headed in the right direction toward a reasonably strong recovery, as I've noted in previous posts. The patterns in the data, that is to say historical precedent, suggest that we are on the verge of a meaningful recovery in employment, and so I have taken an optimistic view of the economy in 2010.

But I didn't count on the bizarre political events of the last week. The Democrats lose the Massachusetts Senate seat, so health care seems to be a lost cause, so Obama switches gears to attacking the banks while Democratic senators threaten not to reappoint Bernanke to the Fed, so financial markets get spooked and stock markets plummet. Further turmoil in financial markets could undue much of the good that has been accomplished in the last year.

What good? Well, in November 2008 the yield on Baa corporate bonds was 9.2 percent. Thanks to the heroic efforts of the Fed and Treasury - the provision of massive amounts of liquidity, restoration of confidence in the banking system - the rate is 6.3 percent today. This is about where the Baa rate was at the end of 2004, when the economy started to finally grow at a healthy pace. Using the rule of thumb that a one percentage point drop in the federal funds rate causes about a quarter percent drop in long-term bond rates, the 300 basis point drop in the Baa yield through extraordinary policies is the equivalent of a 1200 basis point cut in the federal funds rate. That's a lot of stimulus, and it's the main reason (ARRA being important but secondary) the economy is recovery.

But this latest sequence of events - yikes. The Obama Administration needs to right the ship and restore order and confidence fast, or the recovery could be scuttled. Four things: (1) Pass the Senate health reform bill through the House, pass some fixes through reconciliation, but get the stink of this whole issue behind you. (2) Go down to the Senate and tell them they must confirm Bernanke now. There's no upside to replacing him, and a huge downside to just the uncertainty of the reappointment. (3) We need financial reform with teeth, and I'm glad to see the Administration is finally listening to Paul Volcker. But Obama has to convince the financial sector that he's not going to go all Huey Long on them for the rest of 2010. (4) Get behind the House's jobs bill. States need relief, though I'm not wild about the tax credit for new jobs (seems there are too many ways that could be gamed). Some kind of stimulus for business investment would be a nice addition. The package doesn't have to be huge, but there should be something.

Please Barack, don't screw this up.