Congress has finally agreed on a $790 billion stimulus package. Is it too small, as many Democrats claim (such as Paul Krugman), or too big, as many Republicans claim (such as the minority party leadership in Congress)? The answer is yes. It is too big and too small.
If the criterion is how much annual stimulus to demand is needed to bring the economy back up to the level of potential output in 2010 and beyond, and to bring the unemployment rate back down to the natural rate of unemployment, then $800 billion is to small. The Congressional Budget Office has estimated that the economy will fall short of potential output by about 7 per cent of GDP, in both 2009 and 2010. (The source is testimony on January 27 by the new Director of CBO, Doug Elmendorf – an outstanding choice to run that agency, by the way. The news on jobs and other economic indicators since then has continued to show rapid deterioration of the economy.) The $800 billion is to be spread over several years; the peak is to be about $356 billion in 2010, which is about 2 ½ per cent of GDP. The most optimistic estimate of the “Keynesian multiplier” that anyone has is 2, which would imply a 5 per cent boost to GDP. That is less than the 7 per cent gap, and so not enough to return the economy to full employment.
In practice, even if interest rates were to stay very low, the actual multiplier effect would almost certainly be substantially less than this. For one thing, much of the stimulus takes the form of tax cuts, and the part of the tax cut that households save will not contribute to demand and therefore will not enter the stream of spending and income. (Of course a shortage of national saving is part of how we got into this problem, so that an increase in private saving is welcome in the longer run. But the question here is how to stimulate spending that has been depressed by the current crisis.) And another part of the tax cuts, a one-year AMT patch — while again desirable — will have no effect on spending because the beneficiaries, along with the forecasters and everyone else, were already assuming that they would not be paying the AMT tax. If we are lucky, the American Recovery and Reconstruction Act will close half of the gap, relative to the magnitude of the recession we would have otherwise had. So, no, it is not enough.
But in another sense, $800 billion is too much. The 2009 fiscal-year deficit is already expected to exceed $1.2 trillion, so we are talking about deficits thereafter that could surpass 10 per cent of GDP. This is far above the levels that are considered danger signals when they come from any other country. Until now, the US has not been “any other country;” The rest of the world has been willing to finance American profligacy cheerfully. But there have already been signs in the last few weeks that the prospect of this much Treasury debt coming onto the markets is already beginning to push bond prices down and long-term interest rates up. My feeling is that if the current stimulus package were to break the $1 trillion mark, it might truly alarm international financial investors, who would in that case stop acquiring dollar assets, thus precipitating the hard landing of the dollar that so many of us have feared for so long. In those circumstances, the Fed would lose the ability to keep interest rates low, and we could be in even worse trouble than today.
Everything would be different if we had spent the last 8 years preserving the budget surpluses that Bill Clinton bequeathed to George Bush. Then we would have paid down a big share of the national debt by now, instead of doubling it. We would be in a strong enough fiscal position to undertake the expansion today that we really need.
In that light it is ironic, to say the least, that the politicians who are warning against the size of the stimulus bill (”generational theft”), particularly the Congressmen who are voting against it, are mostly the same Republicans who supported the original fiscal policies that gave us the doubling of the national debt: the huge long-term tax cuts of 2001 and 2003 and the greatly accelerated rate of government spending. What we need now is a fiscal policy that maximizes short-run demand stimulus relative to long-run damage to the national debt. Lots of bang for the buck. The Republicans supported fiscal policies that did the opposite. Lots of buck for the bang. They are still doing it today when they argue that tax cuts give stimulus and spending does not. One doesn’t even hear them give an economic argument in support of this proposition. They just close their eyes and endlessly repeat their “tax cut” mantra, like a religious cult that can’t even remember why.
Admittedly it would be hard for the congressional naysayers to give an economic argument for their position. Not only have the more extreme theories of the supply siders been discredited, but Martin Feldstein, the father of respectable pro-saving tax-cut thinking, has recently been in the vanguard of those warning that the current economic downturn requires increased spending rather than more tax cuts, and pointing out that 2008’s tax rebates didn’t work because such a large share of them was saved.
Originally published at Jeff Frankel’s Weblog and reproduced here with the author’s permission.