Economist’s have a phrase ‘omitted variable bias,’ that refers to studies that draw conclusions from data without also considering other variables that may be part of the dynamics influencing events.
The best example we can use here is the claim that President Reagan’s initial tax cuts were responsible for the subsequent economic recovery from a severe recession that began just before Reagan took office. The variable omitted here was the fact that the recession itself was brought on by Federal Reserve Chairman Paul Volcker who hiked the fed funds rate into the mid-teens in order to bludgeon inflation. Doing this cratered the economy as well as inflation. Once Volcker believed inflation was sufficiently subdued (the economy was certainly subdued) he dropped the Fed funds rate as quickly as he had raised it before. Once Volcker’s brakes were relaxed and he stepped on the gas pedal, the economy rebounded smartly and almost immediately.
In brief, Volcker created the recession and he also created the recovery. The Reagan tax cuts were merely happy bystanders. Reagan, by the way, spent the next seven years of his Presidency reversing most of his initial tax cuts.
The reason we bring up omitted variable bias is because of disagreement over the impact, good or bad, of stimulus. Former economic advisor to President Obama, economist Christine Romer, discussed this issue in a speech delivered November 7, 2011 at Hamilton College. You can read the entire speech here.
Romer concludes that the $787 billion American Recovery Act passed by Congress early in President Obama’s first term resulted in 3 million more jobs being available compared to what would have been available without any stimulus. She asserts that studies concluding the stimulus had no positive impact made the mistake of omitted variable bias–of ignoring variables such as the depth of the housing collapse, for one example cited by Romer–in concluding the stimulus had no net positive impact.
Romer also concludes that government spending, as opposed to tax cuts, had more positive impact than economists expected, greater than that of the tax cuts. These findings, made in more recent studies, came after researchers carefully designed their research to avoid the mistake of omitted variable bias.
Despite all of the claims and protestations, the evidence is that fiscal stimulus does raise output and employment significantly. Now, it would take another bold move—probably substantially larger than the $450 billion program President Obama has proposed—to really create a lot of jobs. But the evidence says it would work.
We could do the near-term fiscal expansion in a more cost-effective way by listening to what studies say about the types of stimulus that work best. For example, larger temporary tax cuts may not be the best way to go. State fiscal relief and government infrastructure spending are two measures with particularly high bang for the buck.
And if you want to see how austerity is working out in Great Britain, economist Paul Krugman offers the following chart depicting recent economic performance now that the austerity measures are taking hold.
Beezer here. And why, pray tell, would state fiscal relief and infrastructure spending be the most effective? Because they guarantee jobs, not just promise them. Near term that's what the doctor is ordering, but Congress, at least the Tea Party which controls the House, isn't listening. So we remain stuck with a weak, tenuous recovery that keeps millions of able bodied men and women sitting on their duffs for far too long. Long term fiscal reform is also needed, of course. The nation does need to better balance it's revenues and spending. A major reform of health care that reduces the current growth path of spending in that industry will be necessary. But for right now, austerity policies will only make matters worse, not better.