Deficits, Stimulus and the 3rd Quarter

By Dave Anderson:

Alan Greenspan thinks it is possible that the 3rd Quarter GDP will be a positive 3% or better. 

James Hamilton thinks unemployment claims have peaked for the cycle and are in a steady downtrend.

Paul Krugman thinks the 3rd Quarter annualized GDP could post 4% growth or better. 

Productivity is booming even as hours worked are reduced.

So if either Greenspan or Krugman are right and the initial preliminary GDP report for the 3rd quarter is trend growth or better, what is the over/under for calls to cancel the rest of the stimulus?  I'm betting an under of 1.76 seconds. 

And that would be amazingly dumb.  Right now GDP growth is based on massive productivity increases even as hours worked decrease.  That is non-sustainable and also completely expected as part of a cyclical pattern of change.  Chopping out the stimulus would chop out the legs of the recovery as there is not enough work for the currently employed population much less the un and under-employed population.  And if there is not enough work available for the currently employed, that means a significant drop in near term demand as people realize that their jobs are at risk and they continue to retrench. 

As the Wall Street Journal noted in August, the stimulus provided almost all of the net margin of growth for the 2nd quarter, and it will provide most of the margin of growth for this quarter.

Many forecasters say stimulus spending is adding two to three percentage points to economic growth in the second and third quarters, when measured at an annual rate. The impact in the second quarter, calculated by analyzing how the extra funds flowing into the economy boost consumption, investment and spending, helped slow the rate of decline and will lay the groundwork for positive growth in the third quarter -- something that seemed almost implausible just a few months ago. Some economists say the 1% contraction in the second quarter would have been far worse, possibly as much as 3.2%, if not for the stimulus.

Paul Krugman calculated a Taylor Rule gap that suggests that the Fed "should" drop interest rates another 5 points or more, deep into negative territory.  The Fed can not do that, so unusual responses are the only way to fill the gap between actual behavior and trend performance.  One of those unusual responses is running very large deficits that are very cheap to finance. 

So even if there is a good quarter or two, the fiscally stupid thing but politically attractive call to cancel the stimulus should be ignored as it is more expensive over the long run to pay for a recession by reverting to a lower trend level of growth than paying cheap interest on a stimulus package that could have a chance of kicking us back to trend.