Is $800 Billion Too Big or Too Small? Yes.

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.

5 Responses to “Is $800 Billion Too Big or Too Small? Yes.”

GuestFebruary 14th, 2009 at 10:50 pm

M Feldstein is wrong wrong and dead wrong on one thing.the last rebates was spent and not saved. we did not see the desired outcome because all the rebates went in to the gas bill and to OPEC, but this time around it will be spent and it should have been higher.

GuestFebruary 15th, 2009 at 8:08 am

hmm an interesting article most of the points I can agree with, begrudgingly but nonetheless. however, I think using rearview mirror arguments in the instance of an unprecedented problem of this magnitude is very flawed. making assumptions based on events that didn’t happen (surpluses to pay down debt) doesn’t make sense either; rather I would propose we examine the items by dollars spent and the impact it can have on employment/curbing unemployment.But truthfully, I’m against the entire measure period point blank, I would rather they use this to stop the banks from hemmoraging even more as that seems like the most fiscally prudent thing to do. Sure the citizens won’t like it, but I think they lost the ability to complain when they signed for NINJA loans on 400k dollar houses.

Jeff FrankelFebruary 15th, 2009 at 10:01 am

Thank you for the two preceding comments. Here are my responses.To the most recent commentator:I wonder on what basis you say that Feldstein is “dead wrong.” It is true that GDP grew surprisingly strongly in the second quarter of 2008; but with so many other moving factors this is only weak evidence. People who have looked at the microeconomic evidence have either come to the conclusion that most of the tax rebate was saved (Feldstein) or that much of it was saved, as is also predicted by economic theory. (One needs to be clear here that paying off credit card debt or other debt is a form of saving.) On what basis do you assert that the tax rebate was spent?To the earlier commentator:I am not sure what you mean by “rearview arguments.” When George W. Bush proposed his massive tax cuts in 2001 many of us responded by predicting that this would rapidly convert the Clinton surpluses into deficits. When the surpluses indeed turned to deficits in less than a year, many of us predicted that this was a new long-run trend, based on the policy changes, and not a temporary artefact of the recession (March 2001-October 2001). When the deficits indeed turned out to be the new long-run trend, many of us predicted that this would hamstring the government from adequately dealing with the next recession, whenever it came, and that as a result the next recession would be worst than the last few. (Citations available.) So in what respect is this a rear-view or hind-sight perspective?Jeff Frankel

Shafique JamalFebruary 19th, 2009 at 1:32 pm

Hello Professor Frankel,From the above I take it that you agree that a fiscal stimulus is a good idea in principal, i.e. if it were large enough and did not have those useless tax cuts, it could close the gap. However other economists have made some really good points against a fiscal stimulus. John Cochrane wrote that the U.S. is experiencing a ‘flight to quality’ that could be solved by having the treasury trade securities for high-quality debt – which seems a cheaper option than the stimulus. Others have also argued that: fiscal stimulus takes too long take effect, the type of jobs (e.g. construction) that it will generate do not experience high unemployment so it would draw employed people away from the private sector; there are not $800B worth of projects where the value added justifies the social cost; the projects need longer planning and approval processes to be worth while; it will crowd out private investment, though I think this assumes that credit markets are functioning normally. But this brings me to the point: the problem originated in the credit markets, so perhaps the solution lies there instead. It seems that lack of access to credit lead to lower spending, which slowed the economy and resulted in a reduced demand for credit. Perhaps once Mr. Geithner fixes the credit markets so that credit is accessible, demand could be reignited (if necessary) by means of tax policy (please don’t stop reading) if only because using tax policy, such as a business investment tax credit, provides the direct incentive effect (yes, I’ve also been reading Professor Mankiw’s blog). I hate to advocate for tax cuts, and I REALLY hate to sound like I’m agreeing with Republicans, but I think that even though there is no method to their madness, the Republicans may actually have a point. The Republican tax-cut mantra is blind for sure, but I don’t believe that all tax cuts are created equal. It seems that ‘flight-to-quality’ solution combined with tax-incentives for businesses to invest may be the cheaper and safer way to proceed, and would be more likely to be effective. I would be very interested to hear your thoughts. Thank you.Shafique

KienFebruary 21st, 2009 at 11:52 pm

There may be a way to stimulate private consumption/investment without substantially increasing the budget deficit – i.e., a large bang for the buck.The Federal Reserve could send every American a credit card with a (say) $50K limit subject to two conditions:(a) any unused credit expires within one year; and(b) any used credit (plus interest) is repayable through the tax system if the person’s taxable income exceeds (say) $100K (e.g., 10% of the debt is repaid each year that taxable income exceeds $100K).The credit may be used to buy anything (consumables, durables, education) but not financial products.This stimulates consumption/investment in the following ways:(a) it reduces any contraction in consumption particularly among the newly unemployed or those fearing unemployment;(b) it is a source of cheap credit for funding investments (e.g., in education, to buy durables, invest in a small business).The Fed would be extending credit directly to the public, by-passing the banks. The increase in consumption/investment (depending on the size of the credit extended) may be able to lift business confidence so that businesses are willing to borrow from banks at interest rates that the banks are comfortable to lend at. The credit would also boost consumer and business confidence directly since the dent is repayable only if taxable income exceeds a specified threshold. The risk of the debt not being repaid is borne largely by the government; arguably this risk largely reflects macroeconomic outcomes and therefore the government is better placed to manage this risk. Since the obligation to repay the debt is secured by the tax collection system, there is no need for any collateral, and this gets around the problem of borrowers not being able to offer sufficient collateral due to falling asset prices.The proposed approach has a further property of being highly progressive. The lower a person’s future taxable income, the cheaper the debt will be.The stimulus should have a relatively low impact on the government budget. It is effectively a stimulus with a built in repayment schedule. Interest can be charged at the Treasury bond rate. Some debt will have to be written off as some borrowers will never reach the requisite taxable income threshold in the future to repay the debt. But overall, this scheme should have a large “bang for the buck” ratio.The credit is a form of monetary stimulus (quantitative easing and qualitative easing). If the credit is issued by the Federal Reserve, it will expand the Fed’s balance sheet to include semi-risky assets (i.e., credit card debt secured by the tax collection system). In the event that inflation returns as a significant threat, the Federal Reserve can contract money supply by offering to buy back any outstanding debt at a discount.The concept of providing a loan repayable through the tax system is not entirely novel. The Australian government provides loans to students to fund the cost of tertiary education. The loan is repayable through the tax system. No repayment is required unless taxable income exceeds A$41,600. Where taxable income exceeds this threshold, a specified percentage of taxable income is collected by the Tax Office until the loan is fully paid off. For details of this program, see

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Aaron Menenberg is Foreign Policy and Energy analyst, and a Future Leader with Foreign Policy Initiative. He also co-hosts Podlitical Risk (@podliticalrisk). He is a graduate student in international relations at The Maxwell School of Syracuse University. Previously he has worked at Praescient Analytics, The Hudson Institute, for the Israeli Ministry of Defense, and at the IBM Corporation. The views expressed are his own, and you can follow him on Twitter @AaronMenenberg. He welcomes questions and comments at