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 For example, Valerie Ramey, in a very recent paper that is currently unpublished but will surely be published in a top journal, uses a methodology very similar to the Romers’ and finds the spending multiplier is positive and in the range of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.

The idea has merit, and now might be a good time to implement it. Business investment has been extraordinarily weak for a long time now. Businesses may be feeling the lack of investment, but they are unwilling to invest now, because of uncertainty about the recovery. A tax credit might be just what is needed to push some of them into investing. It would also encourage hiring. Capital and labor are compliments. More capital would improve the productivity of labor, reducing the cost of hiring.

Certainly, it would be better to run a deficit to fund investment than continue the existing program of funding current consumption with deficits. This policy would imply a higher steady-state level of future capital stock than with the current policy, with greater future productive capacity. The higher future capital stock means the economy would have more resources available for consumption, further investment, or (heaven forbid) paying down debt.

Ricardian Equivalence asserts that only the amount of government spending matters, not how it is financed. This is the same thing as saying government debt does not matter. The logic is that taxpayers aren’t stupid. They see the debt as future taxes and save exactly what they need to pay the tax at some future date.

Now, Reinhart and Rogoff, in their highly recommended book “This Time is Different: Eight Centuries of Financial Folly,” provide evidence that high debt levels cause slower economic growth. They report a threshold: When debt exceeds 80 percent of GDP, gross product growth slows two percent. Today, David E Sanger, in a New York Times piece says “two numbers stand out as particularly stunning:”

“The first is the projected deficit in the coming year, nearly 11 percent of the country’s entire economic output. That is not unprecedented: During the Civil War, World War I and World War II, the United States ran soaring deficits, but usually with the expectation that they would come back down once peace was restored and war spending abated.

But the second number, buried deeper in the budget’s projections, is the one that really commands attention: By President Obama’s own optimistic projections, American deficits will not return to what are widely considered sustainable levels over the next 10 years. In fact, in 2019 and 2020 — years after Mr. Obama has left the political scene, even if he serves two terms — they start rising again sharply, to more than 5 percent of gross domestic product. His budget draws a picture of a nation that like many American homeowners simply cannot get above water.
For Mr. Obama and his successors, the effect of those projections is clear: Unless miraculous growth, or miraculous political compromises, creates some unforeseen change over the next decade, there is virtually no room for new domestic initiatives for Mr. Obama or his successors. Beyond that lies the possibility that the United States could begin to suffer the same disease that has afflicted Japan over the past decade. As debt grew more rapidly than income, that country’s influence around the world eroded.
Or, as Mr. Obama’s chief economic adviser, Lawrence H. Summers, used to ask before he entered government a year ago, “How long can the world’s biggest borrower remain the world’s biggest power?””

These are clearly challenges to the concept of Ricardian Equivalence. So, why would Ricardian Equivalence not hold? I think the answer is that Ricardian Equivalence holds for relatively normal debt levels, but it falls apart at high debt levels. Why?
One reason may be that at very high debt levels it becomes clear that future generations will be paying a significant portion of the debt. To the extent that taxpayers value their own consumption over their decedents’ consumption, the motivation to save is reduced. Economists have long accepted a bequeath motive for savings. So, this argument is not particularly persuasive to me.
A more believable reason is the one implied by Reinhart and Rogoff and by Summers: High debt levels increase the probability of default or inflation, a slow form of default. This would explain both low savings levels and challenges from other governments.

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.

Scheer doesn’t give his reasons for supporting a new Glass Steagall, but he quotes McCain extensively. McCain’s comments are essentially a populist rant against “fat cat bankers on Wall Street.”

That’s a problem. I’m all for a new Glass Steagall, but let’s get the reasons right. Populist rants only confuse things.

The Glass-Steagall Act, passed in 1933, was part of the response to the Great Depression. The component relevant to today’s debate was the restrictions on the breadth of financial institutions’ operations. Investment banks were restricted from commercial banking, and commercial banks were similarly restricted from investment banking. An investment bank engages in transactions involving capital, securities, mergers and the like. Commercial banks take deposits and make loans.

The repeal of Glass-Steagall, in November 1999, was supported by both political parties. The arguments for repeal were that it would reduce risk by diversification and that advances in financial technology meant that risk was low.

Right.

The diversification argument sounds reasonable: Banks could diversify, and if one business was in trouble, the other probably won’t be in trouble. But, there is a problem with that argument. Financial theory and experience is clear. Stockholders can diversify for themselves. Businesses should concentrate on their core competency, the one where they maintain a comparative advantage.

The diversification argument also implicitly assumes a relatively low correlation between the returns from the various businesses. Financial panics throughout history have demonstrated that when things go bad, the correlation goes to one. When things go wrong, they go wrong everywhere.

The argument that financial technology has improved, and we now know how to do things with low risk is an old one. I refer readers to Reinhart and Rogoff’s book This Time is Different: Eight Centuries of Financial Foll. In it, these respected economists document the plethora of financial panics this type of thinking has created.

We do need to reinstate the separation of bank business. Let’s do it for sound reasons. While we’re at it, let’s limit the maximum size of any corporation. We also need to get rid of the Too Big To Fail concept.

We have said in the past and continue to say that the United States economy will not pull out of this recession quickly. While jobs are a lagging economic indicator, they feed back into the household’s spending ability. The weakness in jobs will imply weakness in median household income. The two biggest factors that drive consumption, income and wealth, have still not recovered to an extent that will motivate a household-sector-driven rebound in expenditures. Finally, Main Street as well as Wall Street will continue to suffer from high foreclosure rates due to the negative employment situation.

However, there is some good news. Industrial Production has been rising for three months now. The level of 98.5 is a bit low to be consistent with robust economic growth. In recent cycles, Industrial Production index levels have exceeded 100 when the economy was growing. Interestingly, if it continues to rise then manufacturing could lead the United States economy out of the recession. I believe that this would consist of only gradual growth though, as other sectors, namely banking and real estate will likely remain weak for some time after any manufacturing rebound.