Fiscal Stimulus 2009

January 29, 2009

With the economy now in recession since December 2007 and shedding nearly two million jobs during this time, the new Administration is quite sensibly focused on how to best get the economy moving again. It has put forward an economic stimulus package of more than $800 billion composed primarily of higher spending, but also with tax cuts.

It should be noted that this stimulus package is the third round of stimulus in less than twelve months. The first round, the Economic Stimulus Act of 2008, enacted in February of last year, was sized at about $150 billion. Round two consisted of the Emergency Economic Stabilization Act of 2008, providing $700 billion in funding for the TARP to deal with the problems in the financial sector and another roughly $100 billion in tax cuts. All certainly hope that round three will be the last and final installment, but that may well be wishful thinking.

While we all agree that we need to move the economy back to sustainable growth, the role and form of fiscal stimulus is less than clear. A good place to start is a set of principles to guide policy.

Do no harm.

First and foremost, demand-side countercyclical fiscal policy should be designed with proper consideration of how such policies affect the prospects for longer-term economic growth. Fiscal stimulus is deficit financed, increases the government debt and can have an offsetting effect on long term economic performance through higher long-term interest rates. Fiscal stimulus needs to avoid financing other policy objectives merely relabeled as stimulus for political expediency, but with no real immediate effect on output.

A strong policy preference for stimulus that works quickly.

The first line of defense for counter-cyclical policies to stabilize the economy and bring it back to full employment is monetary policy. This avenue, however, has been largely exhausted. Moreover, even if this arsenal were not empty, conventional wisdom holds that it takes six to nine months for reductions in the Federal Funds target rate to work their way through the economy. Indeed, the main rationale for fiscal stimulus is that further changes in monetary policy may not be effective. Whatever the form of fiscal stimulus, there should be a strong policy preference for stimulus that will work quickly to stimulate demand.

Stimulus should be temporary and/or balanced with longer-term objectives.

Demand-side fiscal stimulus that is temporary will have the greatest chance of moving aggregate demand without negatively affecting long term growth through higher long-term interest rates. Fiscal stimulus that both encourages economic activity and simultaneously improves the prospects for long-term economic growth is a win-win.

An example of such a policy is the lower tax rates on dividends and capital gains enacted in 2003. This policy simultaneously provided support to the equity markets and encouraged business investment at a critical juncture in the recovery, and also improved prospects for economic growth in the longer-term by reducing a number of tax biases, such as the tax bias for debt finance, for underinvestment in the non-corporate sector, and against firm dividend payments.

The form of stimulus is less important than its success.

Ultimately, fiscal stimulus needs to work. Much of debate on stimulus thus far has centered on what fraction takes the form of tax cuts rather than spending. Presumably, even the proponents of tax cuts would not support a fiscal stimulus package dominated by tax cuts that were shown to be ineffectual for moving the economy in the near term, and did nothing to improve supply-side economic growth in the long term or actually degraded long-term growth by increasing long-term interest rates. Similarly, proponents of higher government spending presumably would not support a package dominated by spending with similar effects.

A diverse set of policies is more likely to succeed.

The effects of many types of fiscal stimulus are uncertain in both their timing and magnitude. Even if policies have been successful in the past, this recession may well be different. Pursuing a broad range of policies means that there is a greater chance that the overall package will have positive effects.

With these principles in mind, how should we view the stimulus making its way to the President Obama’s desk? One point to make it that there are a broad set of spending and tax provisions included in the package. One could view this as a diversified policy approach to addressing the current economic turmoil. Another point, however, is that many of the provisions, especially on the spending side, appear unlikely to be delivered quickly.

Consider, for example, the recent analysis from the Congressional Budget Office (CBO). Only about 15 percent of the proposed spending (i.e., $93 billion of the $604 billion total) is expected to be delivered during this fiscal year (i.e., by September 30, 2009). In contrast, roughly 35 percent of the tax relief (i.e., $76 billion of the $212 billion total) is expected to be delivered during the same period. Through fiscal year 2010, these percentages are 53 percent on the spending side and 98 percent on the tax side. Thus, based on the CBO, it would appear that the tax cuts will be delivered much more quickly than the spending increases.

Of course, as discussed above, ultimately we are interested in policies that will work; that is, that will help bring the economy back to full employment. Just as spending that is slow to make its way into the economy is unlikely to have immediate effects, tax cuts that are delivered quickly, but saved, are unlikely to have significant effects on consumer spending.

Again, seeing a broad range of policies contained in the package should give us some comfort, but it would seem that the emphasis on spending programs, which, as noted by the CBO, many of which involve construction or investment activity that would take several years to complete, may not quite be the medicine the economy needs.


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