Thoughts on Fiscal Stimulus

Thoughts on Fiscal Stimulus December 9, 2008

Should the United States and other countries on the brink of severe recession try a fiscal stimulus, or a ramping up of deficit spending by the government? Given the conventional wisdom from the 1990s– that the Clinton-Rubin-Summers pitch to lower the deficit led to lower long-term interest rates and paved the way for higher growth– it seems strange to be making such a pitch. It seems even stranger when we look at some of the misadventures from the 1970s, which saw debt in countries like Belgium, Ireland, and Italy exceed 100 percent of GDP, leading to great suffering in the aftermath. What happened to the stability mantra?

The answer is simple: we do not live in normal times. We do not have the luxury of worrying about such things at this moment. There are those, inspired by a Calvinist tradition, who see austerity as a mark of virtue, and call for the government to tighten its belt when its income falls, just like a family. But this analogy is so flawed that it gets it backwards: the great insight of John Maynard Keynes (other than his warnings– along with Pope Benedict XV– about the dangers lurking the Treaty of Versailles) was that economies can become trapped in recessions because aggregate demand is too low. If nobody buys, nobody will produce, and if production falls, employment falls– which again affects spending in a vicious cycle. In such a situation, often brought about by massive uncertainty and loss of confidence, only the government is in a position to step in.

The first line of defense is usually monetary policy: the central bank lowers short-term benchmark interest rates which determine all other interest rates in the economy. Lower interest rates encourage people and corporations to borrow afresh, and break out of the slump. The problem is that the ammunition in this monetary cannon is all but exhausted. When interest rates are close to zero, there’s not much more that can be done. Complicating the picture is that (to put it rather technically) the financial crisis is impairing the monetary transmission mechanism. What this means is that the key interest rates that determine lending and borrowing in the economy are increasingly sundered from the official rate. The reason is that banks do not want to lend to each other, or to customers. There is a lack of trust, owing to the toxic assets on their own balance sheets and uncertainty about what is on their counterparty’s balance sheets. Thus a bank will hoard cash both to guard against future losses on its own books, and because it doesn’t trust other banks. In such a situation, there is severe credit rationing, and the only borrowing comes at high interest rates. In other words, cutting official rates is limited. It gets a lot worse when interest rates approach zero, as a full-scale liquidity trap can arise: all money is simply hoarded as the return it lending it out is simply not worth the effort. In this situation, monetary policy becomes completely impotent.

In such situations, the usual retort becomes fiscal policy: the government can stimulate demand by increasing spending or cutting taxes. What matters is the size of the multiplier, or how the initial increase in demand ultimately feeds through to growth. One thing is clear: spending multiplers are larger than tax multipliers since spending has a direct a direct impact on aggregate demand, whereas a chunk of the tax cut will be saved. Beyond this, the evidence is rather murky. Evidence across various countries and times suggest that fiscal multipliers are actually very low. This could lead to the worst of all worlds, whereby the deficit mushrooms with no payoff.

Why might this be the case? The basic answer is crowding out. As the deficit expands, interest rates rise as the government issues debt to finance it, and this crowds out other lending, and thus consumption and investment. In an open economy, moreover, there will be leakage through imports, as the stimulus benefits the economies of other countries. There is also a more fundamental objection to the Keynesian hypothesis that consumption depends exclusively on current income. Economists like Milton Friedman and Franco Modigliani instead postulated that people think more longer-term, and that expected future income matters too. People like some stability and like to smooth consumption over their lifetime, and achieve this by borrowing and saving. Hence people will borrow while young, save when middle-aged, and draw down savings when old. What does this have to do with fiscal stimulus? Well, if you believe this story, it says that people will not bother spending if they think they will have to pay for today’s party tomorrow. One extreme version of this story says that if taxes are cut today, absent any change to the pattern of spending, people will just assume taxes will rise again tomorrow (not even governments can run deficits forever) making them no worse off in the long term. What do they do? They save the entire tax cut, in anticipation of being worse off tomorrow. Hence there is no effect at all from the tax cut. This case is known as Ricardian equivalence. Although nobody believes it holds in reality (the assumptions are too extreme), it is the case that people do think ahead, and pay attention to things like the long-term sustainability of the government finances.

Does all of this neutralize the case for a fiscal stimulus right now? Not all all. A good case can be made that all of these caveats are less important in today’s environment. Higher deficits are unlikely to translate into higher interest rates given the low yield on treasuries brought about by the flight to safety. In other words, since everybody wants treasuries, financing should not prove difficult. The open economy leakage can be mitigated by a broad-based stimulus across major trading partners, as is occurring in the United States, the European Union, and China. And given impaired financial markets makes smoothing consumption across time more difficult, people are more likely to base spending decisions on current income, just as Keynes said they would.

The bottom line is not at all comforting. Fiscal stimulus is one of the last weapons left to avert disaster, and yet we have no clue if it will actually work. I think it will, but we don’t actually know. The way to increase the chance of it working is to target it properly. That means spending rather than tax cuts. That means something that can get off the ground pretty quickly. I agree with many that large-scale capital spending could have a high bang-for-buck ratio. This has the added benefits of offering jobs immediately, since people must always come first, and developing infrastructure that will benefit future growth. My personal preference would be for public transportation systems, such as high-speed trains, as this would also support a further goal of reducing carbon emissions. Leading health care expert Jonthan Gruber argued recently that spending on health care reform could also serve as a fiscal stimulus. He points to technology jobs from computerized medical records and health care jobs from increased primary care provision, as well as more indirectly from allowing families to spend some of the money held in store for medical expenses. So Obama does not have to sacrifice any energy or health care goals to achieve this stimulus. Many of the goals are complements, not substitutes. The key is to be bold, and do it now.

What about tax cuts? Republicans prefer this route, usually on more ideological than economic grounds since tax multipliers are smaller than spending multipliers. If part of the package, tax cuts must be targeted to those most likely to spend the extra dollar in their pocket, and this means people towards the bottom of the income scale. In other words, it does not mean cutting taxes for the rich, or cutting capital gains tax (the latter is especially silly, given the dearth of capital gains in the current financial environment). So here too, the goal of a more even distribution of income, so important in Catholic social teaching, gels nicely with the need for stimulus.

Let’s hope and pray this works. This is more than an intellectual debate. Real people are suffering here.

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