Wednesday, January 14, 2009

What kind of stimulus is needed right now?

Much attention has been placed in the media regarding President-elect Obama’s stimulus plan. The question of debate basically comes down to whether or not it is needed and, if so, what form of stimulus will work best?

Three criteria are crucial for evaluating fiscal stimulus packages. First, does the program target the weakness in the economy that caused the recession, or is it largely peripheral? Second, are the funds going to be spent in a timely fashion? Third, does the program fundamentally strengthen the economy going forward into the expansion phase? A look at the economy's current circumstances suggests that a large fiscal stimulus is needed, but a badly designed one will, in the words of an old song, merely leave America "another day older and deeper in debt."

The cause of the current recession is buried in the balance sheet of the private sector, particularly the financial sector and the household sector. The government and the Federal Reserve have begun a number of programs to fix the balance sheet of the financial sector, some more effective than others.

The main challenge facing the new administration and Congress is how to handle the inevitable efforts of Americans to fight the effects of the financial crisis by saving. It would be foolish to stop this adjustment with government policy both because any efforts to do so would fail and because the restoration of a healthier household balance sheet is essential to the long-term recovery of the economy. Instead, the government must focus on how to ameliorate the effects that the resulting reduction in household spending will have on the economy.

The household saving rate is likely to rise by roughly 7 percentage points, from roughly one-half of one percent of disposable income to between 7 and 8 percent. The majority of this adjustment is likely to occur well before the end of 2009, with some further modest increase thereafter. One estimate suggests a drop in consumer demand of roughly $500 billion in 2009 and a further drop of roughly half that figure in 2010. These frame the quantitative parameters for an appropriate fiscal stimulus.

The bulk of government spending programs that have been suggested involve transfers of federal resources to state and local governments. While any or all of these programs might qualify as meritorious in their own right, they collectively fail the tests of well targeted stimulus.

Note first that such spending programs do not directly address the household balance sheet problem. The history of such programs overwhelmingly suggests that states and localities will simply substitute federal funds for their own resources for the vast bulk of the money spent. As such, little net impact will be had on household balance sheets.

These programs also generally fail the test of timeliness. Consider the phrase "shovel ready" being used to describe many of these programs. By definition a shovel-ready project is one that state or local government has already spent a good deal of money developing and is likely to continue spending on. On the other hand, infrastructure projects that actually will produce net new spending are never shovel-ready. Most of the spending will end up occurring at the peak of the business cycle when it is not needed, not at the bottom.

By contrast, there are some ongoing federal spending programs that can be quickly ramped up during a recession. Most notable is defense procurement. There is wide agreement that we have run down our defense infrastructure substantially. Much of this can be remedied by simply increasing the pace of existing production programs. Think of it as "assembly line-ready" instead of shovel-ready. Defense spending also gets around the problem of federal dollars supplanting other spending, as only the federal government is involved.

The third test involves whether projects assist the economy in entering the expansion phase. In general, government spending programs divert resources from the private sector as it tries to expand. Some infrastructure projects genuinely assist the private sector by making it more efficient. One such project now being discussed is the creation of a national energy grid. This has been tried before, but failed to get through the legal roadblocks thrown in its path by environmental groups and private landowners. Thus, a project may be highly desirable, but not timely. It may be a good idea, but it is not stimulus.

The question to ask about any infrastructure project being sold as "stimulus" is why the project hasn't been done already. The most common answer is that the state and local political process didn't find that the benefits met the costs--a sure sign that the project is not likely to pay for itself during the expansion phase of the business cycle. Another test of the genuineness of the stimulus intent is whether the federal political process is willing to let go of its own political interests in an effort to maximize the stimulus effect. For example, will Congress waive the requirements that drive up costs and reduce the job creating benefits of infrastructure spending? Will they abandon earmarks alltogether? Not likely, IMHO.

The final argument made for federal funding of infrastructure spending by states is that it is needed to prevent or offset cuts that states will have to make in a weak economy. This argument essentially concedes the points made above, that such spending is really just a safety net for the public sector. It is at best job preserving, not job creating.

Permanent tax cuts offer a much better option. The incoming chairman of the Council of Economic Advisers, Christina Romer, has estimated that the macroeconomic benefits of tax cuts can be two to three times larger than common estimates of the benefits related to spending increases. The relative advantage of tax cuts over spending is even clearer when the recession is centered on the household balance sheet. Some relatively minor changes, like making the current 15 percent tax rate on dividends and capital gains permanent, would not only help household cash flow, but also put a floor under equity prices much as their introduction did in 2003. This would help protect against further wealth destruction and balance sheet deterioration.

But the centerpiece of any tax cut should be employment taxes: in particular, a permanent halving of the current 12.4 percent Social Security payroll tax on the first $106,800 of wages, split evenly between workers and employers. The direct revenue effect of that would be a bit under $400 billion per year, roughly in line with the present quantitative needs of the economy.

It also meets our three tests of effective stimulus. First, the funds would flow directly to households through higher take-home pay and indirectly through a reduction in the cost of employment. Economic studies conclude that the benefits of a reduction in the employer portion of the payroll tax are ultimately received by employees. But the immediate effect would be an improvement in the cash flow of credit-starved businesses (as well as being a marginal incentive to keep employment up).

Second, the funds would be extremely timely; with the benefits hitting the economy with the first paycheck after the plan was implemented. Third, by lowering the taxation of labor, the plan would help produce a higher-employment recovery than would otherwise be the case.

HT: Larry Lindsey


jrm said...

Great post! I certainly hope the new administration structures their stimulus package in this way. But I have 2 questions.

First, can you explain how making the 15% tax rate on dividends and capital gains permanent would "put a floor under equity prices"? I understand how it prevents further wealth destruction and balance sheet deterioration, I think its just the phrase that has me confused.

Second, I whole-heartedly agree that the reduction in payroll taxes is the quickest and most effective form of stimulus we could hope for right now. But isn't reducing the Social Security tax going to be a hard sell? For the last 15-20 years, we've been talking about how Social Security will be insolvent in the early 2030s (about the time I'll be thinking about retiring). Now we're going to further reduce the amount of taxes going into the fund? I forsee a lot of lobbyists and Congressmen lining up to resist this. How would you sell this to them?

Thought of a couple more questions while typing this - Would there need to be an accompanying reduction in Social Security benefits? Would the increased savings rate significantly offset any necessary reduction in Social Security benefits?

Wayne M said...

Charlie -- this is a compelling article. Is there any way you can make it "printer friendly"? I'd like to have hard copy to discuss with others.

Dr. Charlie Hall said...


Good comment. Thanks for your insight!

1. "put a floor under equity prices" = limiting the potential loss resulting from a decline in stock value.

2. You are correct. It would be most challenging given its political implications.

3. Yes, benefits would to be restructured. If we see savings habits reverse as is being predicted, that might very well be the case. Another factor -- folks will be working longer and putting off retirement. Recent stock market performance will almost guarantee this trend.

Dr. Charlie Hall said...

You are correct in that Blogger posts print in an unfriendly way. I usually cut & paste the post into Word when I want to to print a copy!
Thanks again for your comment!

Sid said...


I heard it said the other day that all the politicians are calling for a stimulus package but NO economists are. Is that true, or does it include you?

Had three people from the supply side of the business who were at Montana Green Expo last week ask me if independent garden centers have a future. Do you get the feeling that this question is being asked throughout the industry? I'm thinking it may be and that could be a problem if they are losing confidence. I think it started several years ago by some of the bigger retailers who expressed the concern of having supply in the future if there are too few retailers left, which can be a valid concern. I think their comment may have had a part in causing the problem though. Your thoughts?


Dr. Charlie Hall said...

Hi Sid!
Your email spurred this blog comment r.e. the proposed stimulus. Also, yes I am hearing the same kinds of comments, and the current shakeout will derail some more IGC's. But what is interesting is that if you compare retail market share from the mid-90's to today, it is WalMart that has lost market share to HD/Lowes. IGC's market share has remained relatively constant at about 30% of the overall market. It will be interesting to see if this decreases though.

Sid said...

Thanks Charlie,

I like the perspective on what it takes to create stimulus.

It seems like a reduction of social security tax would be a very hard-sell given the increased retirement rate coming, and the shortage of funding to make the payouts. Isn't there a need to put more money into social security going to be necessary soon?

The military build up is probably a very good idea. Certainly bringing home a lot of soldiers won't help the economy recover faster. I sure can't see the Obama camp going anywhere near an increase of military spending though. More likely they'd reduce spending, but I am sure hoping the daily security briefings will bring a dose of reality about the imminent risks to light. It will be interesting to see if Obama can sell his core constituents on supporting any military related need he sees.

When it comes down to it we will have to pay for this somehow out of increased tax income (not tax rate but in-flow from a growing economy), or reduction in government spending, or both.

It seems to me that we need to fully implement campaign finance reforms, get the lobbyists out of the capital and all the state houses, restrict politician income from speeches, writing, and other ways they disguise their contributions, and in general turn the influence of government back over to citizens instead of to major corporations and special interest groups they, smaller firms, uber rich, and celebrities support. The balance of power has been bought. I heard that Ben Franklin said our constitution is as good as they could come up with after examining governments around the world, but the only thing it couldn't prevent was corruption. We've legalized corruption with the way politicians can take in money from special interests. It simply costs too much to get elected these days because they have access to the money. If that was cut off the TV ads would end and the cost come down and citizens would again have a voice over the shouting of all the ads and bought rhetoric.