http://krugman.blogs.nytimes.com/2008/11/10/stimulus-math-wonkish/
November 10, 2008, 4:38 pm
Stimulus math (wonkish)
I wrote this morning's column partly because I had a hunch that the
Obama people might be thinking too small on stimulus. Now I have more
than a hunch - I've heard an unreliable rumor! So let's talk about
stimulus math, as I see it.
Actually, before I get to the math, some concepts. 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.
Wait, there's more. Ben Bernanke can't push on a string - but he can
pull, if necessary. Suppose fiscal policy ends up being too
expansionary, so that real GDP "wants" to come in 2 percent above
potential. In that case the Fed can tighten a bit, and no harm is done.
But if fiscal policy is too contractionary, and real GDP comes in below
potential, there's no potential monetary offset. That means that fiscal
policy should take risks in the direction of boldness.
So what kinds of numbers are we talking about? 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.
That's twice what the unreliable rumor says. So if there's any truth to
the rumor, my advice to the powers that be (or more accurately will be
in a couple of months) is to think hard - you really, really don't want
to lowball this.