A Fiscal Solution to the
Economic Crisis?
Professor William T. Dickens
Northeastern University,
The Russell Sage Foundation, and
The Brookings Institution
What I’m Going to Talk About
• How fiscal policy can restore full
employment
• Why we don’t normally resort to fiscal
policy in recessions but need to now
• How much will the fiscal stimulus plan
being contemplated help?
My View
• We face a nearly unprecedented global economic crisis
•
•
•
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with the potential to be the worst economic catastrophe
in 75 years
We need rapid action in the US to shore up our financial
markets and to prevent further collapse of employment
and income
Fiscal policy will have to carry the main part of the
burden of shoring up employment and income because
monetary policy has become much less effective than it
normally is
The package of fiscal stimulus that looks headed for
passage is a large step in the right direction but is
probably too small to restore full employment and may
not come in time to prevent further problems in financial
markets
Thus I expect that we will need further rounds of fiscal
stimulus before our economy recovers, with the speed of
Definitions
• Recession
– “A recession is a significant decline in
economic activity spread across the economy,
lasting more than a few months” (NBER
Business Cycle Dating Committee)
• Depression
– When economists have to worry about their
jobs too…
The Current Recession
The Downward Spiral
Credit Crunch
Demand for
buildings and
equipment
Investment
Accelerator
Employment
and Income
Consumption
Multiplier
Demand for Consumer Goods and Services
What starts in one sector of the economy ends up
affecting all sectors of the economy
Why Doesn’t the Downward Spiral
Go On Forever?
• Each round of the spiral is smaller than the last
due to “leakages”
– When income falls, people cut their spending by less
than their incomes fell using savings and credit to
make up the difference
– When incomes fall people pay less in taxes
– When incomes fall people get unemployment
insurance and other transfer payments
– When incomes fall people cut their spending on
imports (which doesn’t reduce domestic employment)
• In the end, the sum of the total effect is thought
to be about 1.5 to 2 times the initial decline in
spending (investment plus consumption)
How Fiscal Expansion Remedies
Downturn
Tax Cuts
Government
Spending
Incentive Effects
Directly
Employs
Workers
Employment
Income
Demand for Houses,
Goods and Services
Businesses Buy More
Machines and Buildings
If spending increases and tax cuts are big enough
they can completely offset effects of credit
crunch in previous slide.
Tax Cuts or Spending?
• With spending there is no “leakage” from first
•
round – employment and income rise one-forone with increased spending (so long as money
is spent on unemployed resources and doesn’t
shift people from other employment)
With a tax cut the impact is reduced by all the
leakages – primarily people saving significant
parts of the tax cut (partial solution is to give tax
cuts to people who are cash strapped)
Spending or Tax Cuts?
• Tax cuts have incentive effects on top of
just increasing income (by making work
pay more or investment less expensive
you get more capital and labor)
• Tax cuts will typically be faster acting (no
long lags in planning, contracting and then
paying out the money)
So Why Not Cut Taxes and Increase
Government Spending All the
Time?
• If there are no unemployed resources then
•
government spending only displaces private
sector spending (consumption and investment).
When there is full employment, tax cuts without
spending cuts force the government to borrow
which drives up interest rates and “crowds out”
investment spending by businesses and slows
growth (unless Federal Reserve keeps interest
rates down by printing money in which case
there is inflation).
So Why Aren’t There Calls for Big
Fiscal Stimulus Packages in Every
Recession?
• To some extent there are (we often put tax cuts
•
and spending increases into effect to combat
recessions)
But in every recession since WWII the primary
cause of the recovery has been action by the
Federal Reserve bank
– Federal Reserve cuts interest rates
– This stimulates demand for housing, business
investment, and consumer durable goods (appliances
and cars – things people tend to buy with credit)
So Why Not Leave it to the Fed
Now?
Federal Funds Rate
4 Week Treasury Bills
2/3/2009
1/20/2009
1/6/2009
12/23/2008
12/9/2008
11/25/2008
11/11/2008
10/28/2008
10/14/2008
9/30/2008
9/16/2008
9/2/2008
Interest Rate
Federal Reserve Instrument and Target Rates
3
2.5
2
1.5
1
0.5
0
The 0% Lower Bound
• No one will lend money at less than 0% interest
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since they can get that rate of return on cash
under their mattress -- the primary interest rates
the Fed targets can’t go any lower!
This is similar to the situation in the Great
Depression and why people keep comparing the
current situation to those times
Also very similar to the problems faced by the
Japanese in the 1990s.
So How Far Will Recovery and
Reinvestment Act Take Us?
• Both Senate and House versions of H.R. 1
are estimated to cost about $820 billion
dollars
• House bill is about 78% spending and
22% tax cuts
• Senate bill is about 65% spending and
35% tax cuts
Criticism of the Stimulus Bill
• Unfair
– Spending has been tried and failed
(1930s, Japan in the 1990s).
• Contrary to conventional wisdom, Roosevelt didn’t
do much spending until run up to WWII. Japanese
did use fiscal stimulus but always too little too late.
– Full of pork.
• Very careful about restricting earmarks. Democrats
say that the programs the Republican’s call pork
are what they were elected to put in place.
Criticism of the Stimulus Bill
• Fair
– Several new spending programs that are
lumped together in bill deserve to be
considered individually and not rushed
through with little opportunity for deliberation
and debate
– Spending spread out over 10 years while
stimulus is needed now
So How Does the Bill Measure Up?
What is in Senate and House Bills
vs. What is Needed
House Bill
Senate Bill
Spending
Tax Cuts
2009
119.7
94.5
2010
206.2
235.0
2009
107.1
62.5
2010
236.4
119.7
Impact
Needed*
280.4
820.9
537.1
840.6
234.3
820.9
503.5
840.6
(billions of dollars)
* Author’s conservative estimate
What I Would Have Done
Differently
• Aim higher – cost of undershooting much worse
•
than overshooting
More of the stimulus upfront (2009)
– More relief for state budgets
– Further extensions/expansions of Food Stamps, UI,
and Medicaid
– More tax cuts and consumption subsidies
– More shovel ready infra-structure(?)
• I am very worried that by not doing enough we
are inviting even more problems with financial
markets and that the cost of rescuing the
economy will continue to climb