A Fiscal Solution to the Economic Crisis?

1. A Fiscal Solution to the Economic Crisis? Professor William T. Dickens Northeastern University, The Russell Sage Foundation, and The Brookings Institution

2. 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?

3. My View • We face a nearly unprecedented global economic crisis 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 the recovery depending on how quickly we realize and act on this

4. 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…

5. The Current RecessionThe Downward Spiral What starts in one sector of the economy ends up affecting all sectors of the economy Demand for buildings and equipment Employment and Income Credit Crunch Consumption Multiplier Investment Accelerator Demand for Consumer Goods and Services

6. 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)

7. How Fiscal Expansion Remedies Downturn Tax Cuts If spending increases and tax cuts are big enough they can completely offset effects of credit crunch in previous slide. Directly Employs Workers Government Spending Employment Income Demand for Houses, Goods and Services Incentive Effects Businesses Buy More Machines and Buildings

8. Tax Cuts or Spending? • With spending there is no “leakage” from first round – employment and income rise one-for-one 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)

9. 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)

10. 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).

11. 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)

12. So Why Not Leave it to the Fed Now?

14. The 0% Lower Bound • No one will lend money at less than 0% interest 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.

15. 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

16. 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.

17. 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

19. So How Does the Bill Measure Up?

20. What is in Senate and House Bills vs. What is Needed

21. 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