IGPA economists weigh in on Obama stimulus proposals | Institute of Government and Public Affairs

President-elect Barack Obama is expected to push Congress for passage of a massive economic stimulus plan soon after he takes office. The plan, which is reported to include about $300 billion worth of tax cuts for individuals and businesses, could total as much as $775 billion over two years, according to news reports.

IGPA economists Daniel McMillen, Richard Dye, J. Fred Giertz, and David Merriman have taken a look at the early information regarding the proposal and offer some analysis:

Dan McMillen:

The primary tools available to influence the economy are monetary policy and fiscal policy. Of the two, monetary policy is far more effective. The problem is that one of the main tools available to the Fed (i.e., monetary policy) is the Federal Funds Rate, which now is essentially zero. This is the rate that banks charge each other for overnight loans. If an interest rate of zero still doesn’t stimulate the economy, then we’re facing a classic “liquidity trap,” which means that monetary policy can do little in the short run to stimulate the economy. The Keynesian solution to the liquidity trap is stimulative fiscal policy, which is what President-elect Obama is trying. There are three main factors involved in assessing fiscal policy:

When will the combination of tax cuts and spending take effect? Even if everything goes very smoothly it will take at least a month before Congress does anything, and then it may still be several months before any money gets in the hands of consumers. By that time, the Fed’s monetary policies may have already stimulated the economy.
Will the money go into the hands of people who actually spend it? President-elect Obama’s idea of targeting lower-income families is probably a good one. It also would probably be a good idea to send some of the money directly to state and local governments.
What will the long-run effects be? I am very concerned about the proposal to reduce taxes. Our already enormous deficit has increased dramatically recently; reducing taxes will make the long-run problem worse. The motivation for decreasing taxes appears to be political since Republicans will be more likely to support tax reductions than expenditure increases. Either option ends up increasing the deficit, but somewhere down the road we need higher tax rates to make up for the deficits we are running.

Overall, I think the main goal of the program is to alter expectations. In the end, it is monetary policy that will determine what happens.

Richard Dye:

There are a number of related confidence problems, policy effectiveness problems, and sequencing (chicken-and-egg) problems.

I second Dan's point about the primacy of monetary policy in normal times but the ineffectiveness in a major downturn as we are currently experiencing. I've always liked the simile that in trying to use monetary policy in times like these "is like pushing on a string." As measured by short term bank-to-bank interest rates, monetary policy is already very expansionary.

The other thing holding monetary policy back is the crisis of confidence in financial institutions and in assessing risk. The old institutional arrangements don't apply. The old risk assessment models don't apply. So, even with low rates for Fed-supplied credit, we still can't get low rate loans as consumers or business.

That leaves fiscal policy to increase spending.

It’s a political rather than an economic judgment, but including business tax cuts seems a wise move. If businesses are unable to get credit because of the risk and uncertainty issues, then increasing their cash flow with more immediate loss carry-backs would allow businesses to spend when they otherwise would not be able to do so.

A more important motivation for business spending (than the liquidity crisis) is current and expected consumer spending--businesses spend in anticipation of future sales and future profits. This exposes the more fundamental chicken-and-egg problem, consumer spending drives the economy. Consumer tax cuts, especially those targeted to lower income families do seem to be the best way to increase total spending and start an upward spiral, but I remain very skeptical that even such a large and bold plan as this will get us out of the hole we're in within a year. These are structural and confidence problems that are not amenable to short-term correction.

Fred Giertz:

The old adage that "there are no atheists in foxholes" has been adapted to the current economic crisis to suggest that: "There are no non-Keynesians in economic policy positions." The traditional Keynesian prescription for an economic downturn on the fiscal policy front is more spending and/or lower taxes and on the monetary front, an expanded money supply and lower interest rates.

For good or for ill, policy makers want to be proactive in regard to the economy. Intervention, not restraint, sells politically. No one wants to appear like the caricature of an impassive Herbert Hoover during the Great Depression. It can be argued that Roosevelt's policies in the 1930s were not particularly effective, but he clearly is remembered in a favorable light for his aggressive actions.

The problem with analyzing the stimulus package relates to a fundamental problem in economics: the poverty of macroeconomics. Economists do not really know what caused the current crisis and why it is so much more severe than recent downturns.

It is difficult to analyze the efficacy of a stimulus package when no one is sure exactly what the problem is. The last couple of decades, economists have downplayed the role of fiscal policy, relying more on monetary policy. Today, few experts believe in the long term positive impacts of a stimulus package. However, many believe that fiscal policy has a role to play in the short term. Note that Republicans endorsed such tools early in the Bush administration and again in 2008.

This creates a problem: fiscal stimulus is only needed in the short term, but limited-term changes such as temporary tax cuts, tend to have less impact than permanent changes. People spend less of a temporary tax cut than a permanent one. However, given the long-run fiscal challenges the nation faces, the country cannot afford large permanent tax cuts or a large permanent increase in spending. The stimulus package should not be a backdoor way of achieving permanent tax cuts for Republicans or a larger-sized government for Democrats.

David Merriman:

Fiscal policy is slower than monetary policy but you can target it directly to job creation and also can do more to assure that it benefits lower income groups.

Sen. Mitch McConnell, R-Ky., has suggested that aid to states should be extended in the form of loans. I do not think this makes sense since (a) many states have balanced budget requirements so could not take advantage of the loans (b) there is little evidence that states (as opposed to private businesses) are having trouble getting access to credit markets (Illinois recently successfully floated a bond issue) and (c) requiring states to pay back loans would be likely to suppress their spending and would thus be pro-cyclical (it would contribute to the economic slowdown)

Sen. McConnell's criticism of the proposal to increase the match rate for states' Medicaid expenditures may however be well-founded since when this was done after the 2000 recession states expanded Medicaid significantly and this has result in increased federal spending on the program.

More generally, the Fed must restore confidence that the financial system is sound and appropriately regulated. The most important objective of the fiscal stimulus should be to restore confidence that the U.S. economy will continue to grow. The most important objective of fiscal stimulus is psychological. To achieve this goal, I believe the new administration must credibly commit to doing "whatever it takes."

They must (and have) put a strong emphasis on job creation. In this sense, the actual timing of the spending might be less crucial than it first appears. Even if it takes a while for the government to actually spend the money, the commitment to spend can be made soon (February 2009) and this can have an important salutatory effect even before the money is spent.

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