U.S. Fiscal Stimulus Package: Little Bang For Buck?
On February 17, Obama signed the much delayed fiscal stimulus package which includes tax incentives and transfers for households to contain the ongoing contraction in consumer spending. To stimulate hiring and investment, the package offers tax incentives for firms. And large chunk of government spending includes transfers for state and local governments, education, unemployment benefits, Medicaid, food stamps, infrastructure, transport, renewable energy, health care and technology.
While tax cuts for households are well-targeted, over two-thirds of these might be saved, used to pay off debt or spent only with a lag when households file for taxes to receive these tax credits and economic uncertainty diminishes. This is because households will continue to face financial pressure in the coming months due to lay-offs, erosion of financial and housing wealth, slower compensation growth and tighter borrowing conditions. Again leakages via imports will occur as tax cuts targeting lower and middle-income groups might spent on low-value goods. Nevertheless, food stamps, extension of unemployment benefits and Medicaid access for the unemployed with high multiplier effects will alleviate the impact of recession on households during 2009-10. On the other hand, tax credits to buy homes and vehicles are too small to stimulate demand for durables since factors such as tighter credit conditions and lending standards (credit score, down payments, expectations about future income and employment), job and wealth losses, and rising savings will play a more important role in constraining demand, so most of the tax credits will be saved.
With the contraction in domestic consumer spending, and global consumer and industrial import demand through most of 2009 and a sluggish recovery in 2010, tax incentives for firms will play a smaller role as theywill continue to cut capital expenditure sharply while laying-off large number of workers. Firms will invest and hire new workers only when they see consumer and credit market recovery.
Many U.S. states are in recession with large deficits and problems in financing public services and paying workers amidst slowing property and sales tax revenues. Though states will continue to reduce spending and raise taxes in the coming months, the budget deficit for over 35 to 45 states is likely to exceed $150 bn in FY2009-10. Federal assistance including for unemployment benefits and Medicaid will help states contain the cutback in essential services such as education, health care, infrastructure and prevent large job cuts. The stimulus package will somewhat ease bond financing needs for state and local governments which have taken a hit from the muni bond market turmoil in 2008. While Medicaid and unemployment benefits with high multiplier effects will impact the economy in 2009-10, spending on public services and infrastructure will stimulate the economy mostly during 2010-13 though some estimates suggest that states might have $35 bn in shovel-ready and transport projects which can impact the economy sooner. But there are also time lags in transferring funds from the federal to state and local governments. States and municipalities using these funds to pay off debt will also reduce the multiplier effects of the stimulus.
In spite of having high multiplier effects, over 55% of government spending will impact the economy after 2009-10. Since large spending on infrastructure, renewable energy and energy efficiency, technology, health care and education will rightly boost the potential growth and productivity of the economy only in the long-run, these expenditures should have been part of a recovery package rather than a recession-alleviation stimulus package. However, given that the recession will last long enough with subdued growth even during the recovery, ongoing construction, repair and maintenance activities might provide a boost.
Impact on Growth and Employment:
With the pullback in private demand and large output losses, government spending in the short run can crowed in private demand rather than crowding out and offset the output gap. But for the fiscal stimulus to boost growth and pull the economy out of recession, dealing with bank insolvency and credit market strains are a necessary condition (See: Total $3.6T Projected Loans and Securities Losses, $1.8T Of Which At U.S. Banks/Brokers: The Specter of Technical Insolvency, Jan 2009). Also, continued decline in home prices is pushing more homeowners into negative equity and foreclosures, exacerbating the contraction in consumer wealth and spending. Thus, a much larger policy measure will be required to deal with foreclosures than the Housing Plan laid out by Obama recently (See: U.S. Housing Sector Far From Bottoming Out Needs Greater Government Intervention, Jan 2009).
We strongly believe that the administration’s estimates about the stimulus multipliers and their impact on GDP growth and employment in an environment like this are rather optimistic. RGE Monitor expects the contraction in GDP growth to be most severe in Q4 2008 and Q1 2009 whereas the stimulus will be implemented by Q2 2009, so the stimulus is certainly not ‘timely’. Starting Q3 2008 when the economy fell off the cliff, through Q4 2009 until when GDP growth is expected to contract, RGE Monitor forecasts that private demand will decline close to $900 bn. RGE Monitor estimates that out of the $787 bn fiscal package, only around $364 bn of stimulus will actually kick-in during 2009-10, which might raise GDP growth by 2.5% during 2009-10. Thus, fiscal policy will still be insufficient to offset the contraction in private demand, let alone lead to positive GDP growth in the second half of 2009. For the impact of individual stimulus measures on the economy and on GDP growth rate during 2009 and 2010, See U.S. Fiscal Stimulus Package: High Fiscal Cost For Little Bang For Buck?.
With limited multiplier effects of tax cuts for households and firms and delay in the multiplier effects of federal and state government spending, much of the impact on growth in 2009-10 will come from automatic stabilizers such as unemployment benefits, food stamps, Medicaid, and transfers to states. Therefore, the stimulus should have allocated higher spending on automatic stabilizers, transfers to states and payroll tax cuts and cut back spending on government projects that have high short-run fiscal costs but impact growth only in the long run.
On a quarterly basis, many households will receive tax credits from tax filing, some shovel-ready infrastructure projects will start at the federal and state levels, and states will use federal transfers to fund immediate needs in education, Medicaid, transport and unemployment benefits – these factors might temporarily boost spending in
Q2 and Q3 2009 before the economy wears off again starting Q4 2009. In fact, a similar trend was witnessed in Q2 2008 when tax rebates temporarily boosted consumer spending, retail sales and leakages via imports, before the economy fell off the cliff in Q3 2008. In 2010, as jobs losses and bank writedowns continue and home prices keep falling, GDP growth and private demand will remain sluggish. And though the amount of stimulus and its impact on growth will be relatively higher in 2010 than in 2009, it might still be insufficient if financial sector woes and consumer recession worsen. As a result, we expect another stimulus package by late 2009 or early 2010.
The extent of job creation estimated by the administration might also be optimistic since the boost to consumer spending and investment by firms due to the stimulus will be limited in 2009-10. The extent to which the unemployed from finance, retail, professional services and even high-value manufacturing can move to the construction, energy and health care sectors is also limited in the short-term. Jobs in renewable energy, green technology and the technology sector will be created in the later years subject to investment in these sectors and labor training. Services that accounted for a large share of job creation in recent years will continue to shed jobs at a high pace while lay-offs in corporate, finance and manufacturing (exports) sectors will remain elevated. In fact, RGE Monitor expects job losses to reach close to 3 million in 2009 while lay-offs will continue through early 2010 as consumer spending remains sluggish, and firms restructure and cut costs. Thus the stimulus, at best, might slow the pace and scale of lay-offs rather than prevent them all together or restart hiring.
The Congressional Budget Office estimates that the stimulus package will raise the fiscal deficit by $185 bn in FY2009 and by $399 bn in FY2010. RGE Monitor forecasts that the need for another stimulus package and funds for the banking sector will push the fiscal deficit to over $1.6-1.8 trillion in FY2009 (already $569 bn in FY Oct 2008-Jan 2009) and will keep it over a trillion even in FY2010.
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LIQUIDITY TRAPS AND THE STIMULUS VS RESTRUCTURING POLICY CATCH-22If the fiscal stimulus does not get enough money into the hands of people that will actually spend it, then the US economy risks sinking into a liquidity-trap.If the stimulus is effective, on the other hand, then there is the risk that the incentives for vital restructuring will be lost.CENTRIST POLICY: SIMULTANEOUS DISINFLATION AND INSUFFICIENT RESTRUCTURINGIf fiscal stimulus is watered down by centrism, inflation will remain low. If inflation remains low while nominal interest rates are at 0%, real interest rates will not get above 2%. The combination of low real interest rates and fiscal stimulus used to prop-up zombie banks (that are financing inefficient businesses) removes the incentives for vital restructuring. Such a policy would produce results analogous to Japan’s decade of stag-deflation and government debt of 180% of GDP.DEMOCRATIC POLICY: HIGH INFLATION FOLLOWED BY RESTRUCTURINGIf fiscal stimulus is monetized and goes to the state governments, job creation, and possibly permanent long term tax cuts for the LOWER-middle class, the stimulus would be effective. This would help avoid a liquidity trap.Simultaneously, insolvent banks need to be nationalized, have their bad loans thrown into a new RTC, have their management restructured, have their coffers recapitalized, and get privatized at a later time. This would begin the process of restructuring where it is needed most.If inflation is allowed to run sufficiently hot for long enough (i.e. significantly above 2006-2007 levels…), cost push inflation will set in and asset bubbles should become macroeconomically unfavorable. In such an environment, real interest rates can be sent back above 2% for a few years without the risk of recreating another liquidity trap – but while simultaneously creating the necessary incentives for vital restructuring. Such a policy would produce results analogous to the Volker austerity of 1979-1982.REPUBLICAN POLICY: RESTRUCTURING FOLLOWED BY INFLATION TARGETINGIf the stimulus is allowed to be too little &/or too late, then deflation would force real interest rates above 2%. This would, again, provide ample incentives for restructuring.Later, massive fiscal stimulus could be applied to bring the economy out of the liquidity-trap. Such a policy would produce results analogous to the US economy emerging from the great depression.POLICY ANALYSISSince it is harder to escape a liquidity trap than high inflation; the Democratic policy would be the most tractable of the three policies. The Republican policy, on the other hand, has the advantage of adverting a major dollar crisis.