Krugman tells how large the stimulus should be

There is now little doubt that the federal government has to conduct a stimulus program. But how large should it be?

Krugman thinks Obama should act boldly and think big. He should take lessons from FDR, both what FDR did that succeeded and what he did that did not succeed. Consider the successes.

Imagine how much worse the financial crisis would be if the New Deal hadn’t insured most bank deposits. Imagine how insecure older Americans would feel right now if Republicans had managed to dismantle Social Security. [Snip]

Progressives hope that the Obama administration, like the New Deal, will respond to the current economic and financial crisis by creating institutions, especially a universal health care system, that will change the shape of American society for generations to come.

But not everything FDR tried succeeded.

F.D.R. did not, in fact, manage to engineer a full economic recovery during his first two terms. This failure is often cited as evidence against Keynesian economics, which says that increased public spending can get a stalled economy moving. But the definitive study of fiscal policy in the ’30s, by the M.I.T. economist E. Cary Brown, reached a very different conclusion: fiscal stimulus was unsuccessful “not because it does not work, but because it was not tried.”

The problem was not that Keynesian economics failed as some argue. It's that it wasn't tried. Krugman points out that in fact Keynes' book was not published until 1936. And FDR himself was not a strong proponent of government stimulus.

F.D.R. wasn’t just reluctant to pursue an all-out fiscal expansion — he was eager to return to conservative budget principles. That eagerness almost destroyed his legacy. After winning a smashing election victory in 1936, the Roosevelt administration cut spending and raised taxes, precipitating an economic relapse that drove the unemployment rate back into double digits and led to a major defeat in the 1938 midterm elections.

Late Monday Krugman made his point even more strongly on his NY Times blog.

Nearly every forecast now says that, in the absence of strong policy action, real GDP will fall far below potential output in the near future. In normal times, that would be a reason to cut interest rates. But interest rates can’t be cut in any meaningful sense. Fiscal policy is the only game in town.

But while the Federal Reserve cannot contribute to the expansion of the economy because lowering the interest rates no longer have an effect, the Fed can still prevent inflation if any stimulus is too effective. So the risks of stimulus are all on the side of not having enough of it. Here are the numbers Krugman published.

GDP next year will be about $15 trillion, so 1% of GDP is $150 billion. The natural rate of unemployment is, say, 5% — maybe lower. Given Okun’s law, every excess point of unemployment above 5 means a 2% output gap.

Right now, we’re at 6.5% unemployment and a 3% output gap – but those numbers are heading higher fast. Goldman predicts 8.5% unemployment, meaning a 7% output gap. That sounds reasonable to me.

So we need a fiscal stimulus big enough to close a 7% output gap. Remember, if the stimulus is too big, it does much less harm than if it’s too small. What’s the multiplier? Better, we hope, than on the early-2008 package. But you’d be hard pressed to argue for an overall multiplier as high as 2.

When I put all this together, I conclude that the stimulus package should be at least 4% of GDP, or $600 billion.

So Paul Krugman recommends that the federal government conduct a very strong stimulus to try to hold off the worst of the recession.

This view begins to look like the common wisdom of the inside the beltway pundits and experts, E. J. Dionne and Fareed Zacharia for example. The wisdom of smart economists is beginning to leak into the political realm. That means it has a possibility of actually being acted on. Now Krugman has put some numbers onto the "Act Boldly" idea. politically it will have two hurdles. First, will the incoming Obama administration buy it? Second, how much will the conservative troglodytes in Congress be able to do to prevent it?

We will all be watching to see how this plays out.