The paper is clear, and that’s not what I’m confused about. I’m confused because Christina Romer is one of the administration’s top economists, and the insights in her research are not being reflected in policy.

Romer and Romer find that there is a large negative tax multiplier, perhaps over three percent. That is for one percentage-point change in taxes as a percentage of GDP, you get an opposite three percent change in output, GDP. So, a one percentage point increase in taxes, as a percentage of GDP, results in a GDP decrease of about three percent. Conversely, a one percentage point decrease in taxes generates about three percent GDP growth.

The size of the tax multiplier stands in stark contrast with the best estimates of the spending multiplier. For example, Valerie Ramey, in a very recent paper that is currently unpublished but will surely be published in a top journal, uses a methodology very similar to the Romers’ and finds the spending multiplier is positive and in the range of 0.6 to 1.2.

The implication of the research is clear. Tax policy is a far more powerful economic stimulus tool than is spending policy. Why isn’t this research reflected in current policy?

Beats me.

Given the popular belief that economic conditions are important to a party’s reelection, ignoring this research appears to be irrational.

The Romers’ paper has other insights. One is that the purpose of the tax change seems to matter. Tax increases intended to reduce deficits are less harmful than a random tax increase. The authors speculate that part of this phenomenon is that tax increases to reduce deficits are usually accompanied by complementary spending cuts.

The most fascinating result is that the multiplier works mostly through investment. A tax increase has a small negative effect on consumption, but a large negative effect on investment. Similarly, a tax cut’s stimulative effect is mostly through investment and not consumption.

These findings have important implications for today. A lack of investment is a key characteristic of this business cycle. If we are in a recovery, this is why it will be so weak. Obviously, raising taxes would be the opposite of a stimulus, and best avoided for now. Instead, we need the mother of all investment tax credits.

I’ll stipulate his second point, but his first point is all wrong.

The data make it pretty clear that unemployment insurance increases unemployment in good times.  An amazing percentage of unemployed find jobs the last week of eligibility.   Of course, these aren’t ordinary times. Given the difficulties in finding a job in this market, and given the average duration of unemployment, it is easy to believe that there are very few people who are unemployed because of unemployment benefits.

Laffer presents the following chart, and he claims that is proves his point that unemployment benefits cause unemployment.

He says:

“As the chart nearby clearly shows, since the 1970s there’s been a close correlation between increased unemployment benefits and an increase in the unemployment rate. Those who argue that things are different today don’t have the data to back up their claims.”

There is a correlation, no doubt about that, but as Mr. Laffer has surely heard countless times, correlation does not imply causation.  It looks to me that the unemployment insurance lags unemployment.  That would imply that unemployment causes unemployment benefits.

Of course, that’s the way it seems to work in practice.  When unemployment becomes extraordinarily high and its duration long, governments extend benefits.  That seems like the right thing to do.  It’s not stimulus, and people who claim it is stimulus are uninformed or dissembling.  It’s just one of those humanitarian things we do to share the costs of a deep recession.  Think of it as mutual insurance.

New unemployment claims also rose to 444,000, again exceeding “consensus expectations.”

There was also a report that will receive much less attention, but it is important. Inventories increased in November, the most recent month for which data are available. If inventories were increasing over the Christmas shopping season, and sales were declining, retailers ended the year with excessive inventory. That means reduced production in the first and second quarters of 2010.

2009’s third quarter output (GDP) growth was positive, and many expect a very impressive positive number for the fourth quarter, some as high as five percent. If the fourth quarter does come in with a strong GDP growth rate, it will be hailed as the harbinger of a soon-to-be-realized vigorous recovery.

Don’t buy that, and you won’t be disappointed.

That vigorous recovery may eventually come, but it is unlikely to come in 2010. Whatever growth generated in second-half of 2009 was government-supported consumption, ephemeral, not a solid foundation for economic growth, certainly not the basis for sustained vigorous job growth.

A vigorous recovery will be a result of investment, technological growth, and improved productivity. Recent productivity numbers have been encouraging, but in large part, they are probably the result of firms downsizing. Technological growth and solid job growth require investment, and that is the problem.

Our banks are in no condition to fund any vigorous expansion. Indeed, bank loans have been declining since October 2008. Businesses and consumers remain over-leveraged, unable to increase spending on consumption, unable to invest, desperately trying to reduce debt.

We won’t see a vigorous recovery until balance sheets are improved and banks can lend.

Government programs haven’t helped. Most of the spending programs have been consumption based instead of investment based. Some have been outright counterproductive, programs such as foreclosure-delay, paying interest on bank deposits at the Fed, and cash for clunkers. Even worse, the banking problem has been ignored, and now new taxes on banks are being discussed. That is as bad an idea as I’ve heard in a long time.

I’m as concerned as anyone about total government spending and the deficit. I’m probably more concerned than most about bank lending to business. But, conspiracy isn’t the problem.

Part one of Melloan’s theory is that the Fed is causing banks to be excessively risk averse. He says “The Federal Reserve, which supervises some 7,000 banks, has been telling bankers that they must cut risk.”

The FDIC reported today that there are 552 banks on their problem list. Banks have been charging off $40 to $50 billion per quarter in loans for a year now. Capital has been eroded, and banks are way overleveraged, in part because of excessive risk taking. You think that maybe banks should be more risk averse today? You think that maybe there is a rational reason for banks to lend less to business and purchase more government securities?

The real problem is not some government conspiracy. The real problem is the government’s quiescence.

Too many of our banks are zombies, and we face something like Japan’s lost decade if we don’t fix them. This is the single most serious United States problem today. It drives me crazy that we are wasting huge amounts of resources and political capital on second-order problems while ignoring the bank problem.

Robust recovery requires banks lending to businesses. Banks can’t lend to businesses until they are adequately capitalized, and the bad assets are off the books. We will not have a robust recovery and put people back to work until our banks are fixed.

Bankruptcy is one way to clean up our banks. Since the FDIC fund is currently upside down, -8.2 billion, this would require external funds to the FDIC. The other option is the one successfully used by Sweden. They nationalized the banks, cleaned them up, and resold them. This would also require an investment.

Either way, fixing the banks is a far better use of money than some Stimulus 2 program or even the unspent portion of the current stimulus program.

I think Fed policy has been too tight. Instead of paying interest on excess deposit, they should be charging a fee. Of course, many disagree and worry about inflation, and that is what I thought I was reading as Shelton proceeds with her thesis that the Fed’s policy may be fueling a new asset bubble. This is pretty standard stuff, boringly standard in fact. I was about to quit reading and go on to something else when I came to a paragraph that stopped me cold:

“Deflation is seen as the bugaboo of Keynesian economics. But it can actually serve to spur economic activity as lower prices enable struggling consumers to get back in the game, and enterprising individuals can build businesses using tangible assets that yield valid profits.”

That paragraph is breathtaking, so wrong on so many levels, so counter to what we know to be true. I couldn’t believe that an economist would say that. So, I looked for her tag line. Sure enough, it says she’s an economist. I did a web search. She’s got at least one book out. She’s in the WSJ frequently. She’s all for a gold standard.

Shelton received her Ph.D. in Business Administration at the University of Utah, and she’s a professor at the Duxx Graduate School of Business at Monterrey, Mexico. One observer—goes by Federalist on the web, but I couldn’t find a name—described her as having few credentials. I don’t think that is exactly true. She has impressive credentials, just not as an economist.

Let’s correct her paragraph:

No one is going to mistake me for a Keynesian, but I’m certain that deflation is bad. Economists in general, not just Keynesian, know deflation is bad. I don’t know of one credible economist, from a top 50 school, with a Ph.D. in economics, who believes that deflation is not bad.

Shelton goes beyond saying deflation is not bad. She claims deflation is good, stimulative, spurring economic activity, “enabling struggling consumers to get back in the game.” Amazing.

Here’s the story on deflation: As prices fall, no one has an incentive to purchase anything, the cost will be less tomorrow; consumption and investment decline. Borrowers pay with deflated dollars, making real interest rates very high, again leading to less investment and consumption. Wages don’t adjust quickly, leading to unemployment, 25 percent in the depression. Asset values decline, but debts become more burdensome, leading to credit defaults and over-leveraged banks, businesses, and consumers. Lending, borrowing, consumption, investment, and economic activity decline.

One problem of smart people pontificating outside their field is that they come up with ideas that sound good, don’t hold up to serious analysis. Economists have performed a huge amount of research on inflation and deflation, empirical research and theoretical research. The profession has rejected the thesis that deflation is good. The risk is that someone with authority listens to someone like Shelton and tries to implement her recommendations. That would be tragic. Bad policy leads to a bad economy, and the costs of a bad economy are immense and not just financial. Serious recessions change lives, usually for the worse. Careers, families, and lives are destroyed. It is a shame that Shelton has a mouthpiece as big as the Wall Street Journal.

Their piece is titled “The Stimulus Didn’t Work.” They provide data and cite the work of two economic gods: Friedman and Modigliani. I think the argument is convincing, but then I never expected the stimulus to work.

The piece is well worth reading.

Paul Krugman will claim it didn’t work because it was too small. Of course you can always say that. After the inevitable recovery, less intellectually honest politicians will claim it worked. Heck, some are already claiming it worked.

There is a problem with this. There will be another recession some day, and there will be another stimulus, even if it is counterproductive. It doesn’t matter which party will be in office. Every administration going back to and including at least the first Bush has engaged in some sort of stimulus-type programs when faced with a recession. Clinton was lucky enough to not have a recession in his tenure.