Economic stimulus....

January 22, 2008

The Senate Finance Committee held a hearing this morning on economic stimulus and the report on the topic that CBO issued last week at the request of the House and Senate Budget Committees. The notes I used for my oral remarks at the hearing are posted below.

  1. The risk of recession is significantly elevated relative to normal economic conditions.
    1. This morning, the Federal Reserve took aggressive action to address what it called "appreciable downside risks to growth."
    2. Especially in light of this most recent Federal Reserve action, many professional forecasters suggest continued -- albeit sluggish -- economic growth in 2008, rather than an outright recession.
    3. In any case, several quarters of unusually weak growth are likely. This type of situation is relatively rare, and the types of policies appropriate to address it are not necessarily appropriate to more normal economic conditions.
  2. In particular, when the economy is particularly weak, the key constraint on short-term economic growth is demand for the goods and services that firms could produce with existing resources.
    1. In most circumstances, by contrast, and certainly over the long term, the key constraint on economic growth is the rate at which firms capacity to produce is expanded, through forces like increases in capital and labor and improvements in productivity.
    2. When the constraint on short-term growth is aggregate demand, as appears to be the case today, both monetary and fiscal policy can help by boosting spending.
      1. On the fiscal policy side, the automatic stabilizers built into the budget will help to attenuate any economic downturn by providing a cushion to after-tax income.
      2. The question is whether additional fiscal action would be beneficial as a complement to monetary policy actions and the automatic stabilizers built into the budget. One way to think about it is that fiscal stimulus can help provide insurance against the risk and severity of a possible recession.
      3. Our estimates suggest that stimulus of between and 1 percent of GDP or so would reduce the elevated risk of recession to more normal levels, as long as the stimulus is well-designed.
    3. The stimulus need not be targeted at what caused the economic weakness. Instead, the key is that it bolsters aggregate demand and thereby helps to jump start a positive cycle of increased demand leading to increased production, until the constraint once again becomes how much we can produce rather than how much we are willing to spend.
  3. Principles for effective stimulus.
    1. So what would work? A well-designed fiscal stimulus would have several central principles:
      1. First, it would be delivered rapidly. A problem with some efforts at fiscal stimulus in the past is that they took too long to take effect -- in a matter of months, not years. If the purpose of fiscal stimulus is to reduce the risk and severity of a recession, it would need to take effect quickly. Stimulus delayed is stimulus denied, and could even prove unnecessary and potentially counterproductive if delayed so long that it takes effect after the period of economic weakness has passed.
      2. Second, it would be temporary. As CBO highlighted in our long-term budget outlook released last month, the nation faces a severe long-term fiscal gap. Stimulus that exacerbates that long-term budget imbalance could impose greater economic costs than benefits.
      3. Finally, it would be cost-effective, in the sense of boosting aggregate demand as much as possible at a given budgetary cost.
  4. Tax and spending.
    1. With those principles in mind, we can briefly examine some of the leading proposals under discussion on both the tax and spending sides of the budget.
    2. First the tax side:
      1. For individuals, the key is to get money quickly to people who will spend most of it.
        1. On that note, the experience with the 2001 tax rebates was moreauspicious than studies of earlier rebates would have suggested. Roughly 1/3 of the rebates were spent in first 3 months, 2/3 by second 3 months.
        2. To boost cost-effectiveness further, policymakers would need to focus on lower-income households and those with difficulty borrowing. The studies of the 2001 tax rebate suggest that such lower-income and credit-constrained recipients increased their spending substantially more than the typical recipient.
        3. The low-income and credit-constrained households most likely to spend money quickly, however, typically dont owe income tax liability. According to the Joint Committee on Taxation, of the 154 million tax units in the United States, about 66 million do not owe income tax liability - and about half of those, or 30 million, have wage income and file an income tax return.
        4. Regardless of whether such households are included, a major administrative issue with rebates involves when the checks could go out given that the IRS is busy with tax filing season. It will be a major challenge to issue checks before May or June at the very earliest. The JCT explores this and other crucial administrative questions in a document prepared for todays hearing.
      2. Businesses:
        1. On the business side, economic theory suggests that temporary investment incentives can create an incentive for firms to shift investment into the short run, which is helpful as stimulus.
        2. The experience from bonus depreciation provisions enacted during 2002 and 2003, however, was somewhat disappointing. So this approach holds promise but the most recent results suggest some caution in our expectations about their effectiveness.
    3. Finally, on the spending side, we can divide spending into three categories.
      1. First, activities like infrastructure:
        1. Any dollar actually spent on these activities is effective as ST stimulus.
        2. But a major challenge is getting dollars out the door in a timely fashion. Although some individual projects may be able to accelerate payouts, in general, this approach ranks low from a cost-effectiveness perspective because of the low spendout rates in the first year.
      2. A second category of federal spending involves assistance to state and local governments, as was provided in 2003.
        1. The effectiveness of this approach depends on what states do it is effective to the extent that it obviates spending cuts or tax increases at the state level.
        2. And that in turn may depend on how much of the money goes to states experiencing fiscal difficulty. Better bang for the buck the larger the share going to hardest hit states.
      3. Final category involves transfer payments like UI and food stamps.
        1. These payments should be evaluated much like individual tax rebates, and they rank relatively high on cost-effectiveness because they tend to get money to people who will spend most of it quickly.
        2. They may also be attractive administratively, because it is possible that the money could get out the door faster than on the tax rebate side.
        3. On the other hand, some of these proposals underscore the tension between whats best in the short-term and whats best in the long-term. During periods of economic strength, for example, expanding UI benefits or duration has been shown to increase unemployment levels somewhat. Such expansions may thus be effective stimulus in the short term, but if perpetuated over the long term, may raise economic efficiency concerns.