Tuesday, October 4, 2011

Analysis Of Government Intervention Incorporating Welfare Economics Lowers Value Of Government Actions

Welfare Economics Demotes Government Stimulus Spending To The Bottom Of The Policy Heap

Harvard Professor N. Gregory Mankiw in his latest paper, "An Exploration of Optimal Stabilization Policy" with co-author Assistant Harvard Professor Matthew Weinzierl, adds welfare economics to an analysis of Keynesian stimulus spending:
The goal of this paper is to address this set of issues in light of modern macroeconomic theory. Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and firms and builds from there. This feature of modern theory is not a mere fetish for microeconomic foundations. Instead, it allows policy prescriptions to be founded on the basic principles of welfare economics. This feature seems particularly important for the case at hand, because the Keynesian recommendation is to have the government undo the actions that private citizens are taking on their own behalf. Figuring out whether such a policy can improve the well-being of those citizens is the key issue, and a task that seems impossible to address without some reliable measure of welfare.
By adding Welfare Economics, the constraints faced by households and firms, Mankiw and Weinzierl find a hierarchy of policy instruments for dealing with recessions and a drop in aggregate demand. They find that stimulus spending, increased government spending, is at the bottom of policy options. Stimulus spending should be used when targeted tax policy is unavailable. The order of policy options is:
  1. conventional monetary policy
  2. unconventional monetary policy
  3. fiscal policy that incentivizes interest-sensitive components of spending, such as investment
  4. increasing government spending, as well as cutting the overall level of taxation to encourage consumption.
Mankiw and Weinzierl state:
The goal of this paper has been to explore optimal monetary and fiscal policy for an economy experiencing a shortfall in aggregate demand. The model we have used is in many ways conventional. It includes short-run sticky prices, long-run flexible prices, and intertemporal optimization and forward-looking behavior on the part of firms and households. It is simple enough to be tractable yet rich enough to offer some useful guidelines for policymakers. These guidelines are tentative because, after all, our model is only a model. Yet with this caveat in mind, it will be useful to state the model’s conclusions as clearly and starkly as possible. One unambiguous implication of the analysis is that whether and how any policy instrument is used depends on which other instruments are available. To summarize the results, it is fair to say that there is a hierarchy of instruments for policymakers to take off the shelf when the economy has insufficient aggregate demand to maintain full employment of its productive resources.

The first level of the hierarchy applies when the zero lower bound on the short-term interest rate is not binding. In this case, conventional monetary policy is sufficient to restore the economy to full employment. That is, all that is needed is for the central bank to cut the short-term interest rate. Fiscal policy should be set based on classical principles of cost-benefit analysis, rather than Keynesian principles of demand management. Government consumption should be set to equate its marginal utility with the marginal utility of private consumption. Government investment should be set to equate its marginal product with the marginal product of private investment.

The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound. In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment. A reduction in long-term interest rates may be sufficient when a cut in the short-term interest rate is not. And an increase in the long-term nominal anchor is, in this model, always sufficient to put the economy back on track. This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth. With this monetary policy in place, fiscal policy remains classically determined.

The third level of the hierarchy is reached when monetary policy is severely constrained. In particular, the short-term interest rate has hit the zero bound, and the central bank is unable to commit to future monetary policy actions. In this case, fiscal policy may play a role. The model, however, does not point toward conventional fiscal policy, such as cuts in taxes and increases in government spending, to prop up aggregate demand. Rather, fiscal policy should aim at incentivizing interest-sensitive components of spending, such as investment. In essence, optimal fiscal policy tries to do what monetary policy would if it could.

The fourth and final level of the hierarchy is reached when monetary policy is severely constrained and fiscal policymakers can rely on only a limited set of fiscal tools. If targeted tax policy is for some reason unavailable, then policymakers may want to expand aggregate demand by increasing government spending, as well as cutting the overall level of taxation to encourage consumption. In a sense, conventional fiscal policy is the demand management tool of last resort. [Emphasis Added].

Welfare Economics Not Considered In Environmental Costs And Policy

A paper in the current American Economic Review about economy-wide accounting for the cost of pollution, "Environmental Accounting for Pollution in the United States Economy" by Nicholas Z. Muller, Robert Mendelsohn, and William Nordhaus finds that coal fired power plants can cause environmental damage of over 5 times the value added from the power plants.

The authors have to qualify their tabulation of the negative effects of energy, agriculture and manufacturing production in the US by stating:
We note several qualifications. First, our estimates are accounting measures and not measures of economic welfare.....Second, we note that although GED [Gross Environmental Damage] exceeds VA [Value Added] for some industries, this does not necessarily imply that these industries should be shut down. [Emphasis Added].
Welfare economics might undo some of the negative effects of pollution. For example, cheaper but polluting electricity, i.e. coal fired plants, might have more welfare benefits than closing the power generating plant or raising the price of electricity to pay for the added cost of pollution control equipment.

As posted on "There He Goes Again" on The Big Questions Blog by Steve Landsburg:
taxing the source of an externality might or might not be efficient policy, depending on the available alternative remedies. It would, for example, be tragic to tax coal plants out of existence if it proved substantially cheaper to clean up their emissions after the fact, or to relocate the victims of those emissions.

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