The Economics of Stimulus

January 14, 2009

The May 1932 issue of the Atlantic Monthly included a piece titled "The World's Economic Outlook." It read, in part, "Formerly there was no expenditure out of the proceeds of borrowing that it was thought proper for the State to incur except for war … I hope that in the future we shall not adhere to this purist financial attitude … the only way out is for us to discover some object which is admitted even by the deadheads to be a legitimate excuse for largely increasing the expenditure of someone on something!"

The author was John Maynard Keynes, one of the fathers of modern economics. The issues he raised are equally -- perhaps frighteningly -- relevant today as President-elect Obama and Congress prepare to write an economic stimulus plan to help pull the United States out of what is shaping up to be the deepest recession in a long time.

One particularly relevant question is: what is that "object" Keynes refers to on which the government should increase expenditure? And: what should the role of tax cuts be in the economic stimulus? These are both questions that policymakers will continue to debate as they form a stimulus package.

But what factors should policymakers consider when seeking answers to these questions? According to W. P. Carey School of Business experts, policymakers should consider: which forms of stimulus offer the best value for the dollar spent, which reestablish confidence in the economy, and which balance long-run with short-run benefits.

Most bang for the buck

With a working title of "recovery and reinvestment," Obama's stimulus plan aims to "save or create" 3 million jobs by the end of 2010 -- ideally with projects thought to have some longer term benefit. In an interview on ABC's "This Week with George Stephanopoulos," Obama said he would focus on stimulus tools that delivered the "most bang for the buck" -- in that they provide jobs to more people, enabling increased spending which should then ripple through the economy.

Getting the most value for the dollar seems particularly important as the Congressional Budget Office projected a deficit in 2009 of an astounding $1.2 trillion -- three times the deficit in 2008.

"The main question facing policymakers is how to use fiscal policy (taxpayer and borrowed funds) to achieve the goal of 3 million jobs by 2010," said Lee McPheters, research professor of economics and director of the JPMorgan Chase Economic Outlook Center at the W. P. Carey School of Business.

"However, there seem to be other objectives as well, including: 1) middle class tax relief; 2) aid to states to prevent cuts in essential services and prevent tax increases; 3) protect the 'vulnerable' with food stamps and unemployment insurance; 4) subsidize 'green' energy; 5) subsidize infrastructure; 6) subsidize education; 7) subsidize health care; and 8) tax incentives to businesses for hiring workers."

But, McPheters asked, "Is this the 'right' list if the objective is to create the most jobs possible? If the list is accepted as the correct list, what is the distribution of funding across the objectives? Should it be first to those components that create the most jobs?"

When it comes to tax cuts, the "bang" they deliver depends in large part on how people spend the extra money. "We know that tax cuts are often used to repay debt or are added to savings, so a dollar spent on tax cuts is going to be less effective in creating jobs in the short run," McPheters said. Indeed, a 2008 CNN/Opinion Research Corp. poll found that only 21 percent of individuals planned to spend their 2008 tax rebates, while 41 percent intended to pay off bills and 32 percent intended to put the money into savings.

Yet government spending can have its own pitfalls, too. The effectiveness of spending depends on how the money is spent -- and many people don't have much confidence in the government to spend money wisely, especially after the widely-perceived failure of the treasury's Troubled Assets Relief Program (TARP).

"When government takes money out of the hands of the private sector and chooses where this money should be spent, policymakers are saying they know better what to spend money on than do the people who labored and created the money," said W. P. Carey economics professor William J. Boyes.

Reestablishing confidence

An October 8, 2008 Knowledge@W. P. Carey story called the global financial crisis a "crisis of confidence." It's a crisis that hasn't yet been resolved -- businesses and consumers alike are still reluctant to spend, a fact which has negative ripple effects across the economy. Policymakers, then, should consider whether the economic stimulus plan reestablishes confidence or creates even greater uncertainty, said Boyes.

"When Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke panicked, going from one policy approach to another when they turned from buying toxic assets to bank equity, the private sector had no idea what was going on. It, therefore, panicked as well. People have to believe their property is secure, that the regime of security over that property is not changing, and that property will not be confiscated. Much like the early 1930s, people today are not confident that their property is secure and that what they earn with their labor they will be able to keep," Boyes said.

Long-run vs. short-run benefits

The current stimulus debate largely centers on what types of programs to include in the package, and the balance between spending and tax cuts. But W. P. Carey School of Business Dean Robert Mittelstaedt said focusing on these issues misses the core of the problem -- the consumer. "The truth is that we will never survive the longer run, after the stimulus program can no longer be sustained, unless people learn to live within their means."

The crux of the problem, Mittelstaedt said, is that "the conditions of the last two decades have made it too easy for consumers to spend and accumulate debt that they can't afford in the long run. If consumers do not reduce their debt, they will get into the same problems again." Unresolved, this issue will plague us again in the future, he said.

Policymakers must consider ways to prevent that from happening. Not everyone will voluntarily start to live within their means, Mittelstaedt said, so "we have to find ways to help people, but also put sensible rules in place around lending so we don't get into the same situation again in a few years."

At the same time, the short-term health of the economy, largely dependent on consumer spending, is in jeopardy as consumers have tightened their purse strings, Mittelstaedt said. "The problem is how much of a reduction in consumer spending the U.S. economy can stand and still recover. This was Japan's problem (for different reasons) over the 1990s -- consumers who didn't want to spend."

In other words, according to Mittelstaedt, "policymakers must look very carefully at the things that will have some permanent benefit to the economy and must walk a fine line between encouraging consumers to have confidence again and not going overboard and enabling them to get into trouble again."

The key questions for the economy's health over the long run, he said, are how to stimulate business formation and growth in ways that will provide jobs for the long term and in areas where the U.S. has a competitive advantage. "The government has not historically been great at picking winners," he said.

Mittelstaedt said that "government must learn how to do things that will have lasting value and create jobs in the short run, much like what the New Deal accomplished, but then also learn to build incentives for business formation and growth in the longer term in areas that are freely chosen by entrepreneurs and existing companies in a well-constructed, globally-competitive business climate. Government needs to make sure incentives are proper for the private sector and stay out of it."

But Boyes believes that that the government needs to let the private sector do the fix -- short and long term: not take money from the private sector and pass to others, as FDR did in the 1930s.

"A stimulus will only be stimulating if it encourages the private sector to save, invest and consume," Boyes said. "The most important component is private investment; businesses must buy new technology, build offices, plants, factories and hire workers."

Businesses will do that, he said, if there are strong incentives to invest -- if the expected return on investment exceeds its cost. "This can only be done by ensuring that taxes are reduced, uncertainty about rules and regulations and future taxes is reduced, and prices are allowed to adjust so that the market can begin functioning."

McPheters said "in the very short run, targeted subsidy to parts of the economy that tend to hire a lot of workers would create the most jobs. It helps if there is expansion of industries that have higher pay, since this increases consumer spending by those workers. And, there are also benefits if there are longer-term effects of spending, so this is why spending on construction infrastructure such as rebuilding schools and roadways is so attractive."

In the end, Mittelstaedt said, the U.S. economy needs both a short-term boost that will increase consumer confidence as well as a long-run solution that will allow U.S. businesses to find new sources of 21st-centurycompetitive advantage and consumers to spend within their means.

Mittelstaedt's advice: "Do the short-term fix, no matter how well done, without the longer-term fix and we will never recover. Fail to do the shorter-term fix and we will have a depression, but if the longer-term fix is done well we will eventually recover. Either way, a thorough analysis of what used to make us the most competitive and innovative economy on the planet must take place and be acted upon or we will be doomed to second-rate status."

Bottom Line:

  •  One question facing policymakers is how to use fiscal policy (taxpayer and borrowed funds) to achieve the goals of saving or creating 3 million jobs by the end of 2010 -- ideally with projects thought to have some longer term benefit.
  • When it comes to tax cuts, the "bang" they deliver depends in large part on how people spend the extra money. Tax cuts are often used to repay debt or are added to savings, so a dollar spent on tax cuts is going to be less effective in creating jobs in the short run.
  • The effectiveness of spending depends on how the money is spent -- and many people don't have much confidence in the government to spend money wisely.
  • There is still a crisis of confidence -- businesses and consumers alike are still reluctant to spend, a fact which has negative ripple effects across the economy. Policymakers, then, should consider whether the economic stimulus plan reestablishes confidence or creates even greater uncertainty.
  • The core of the problem is that the conditions of the last two decades have made it too easy for consumers to spend and accumulate debt that they can't afford in the long run. The U.S. economy will never survive the longer run, after the stimulus program can no longer be sustained, unless people learn to live within their means.
  • The U.S. economy needs both a short-term boost that will increase consumer confidence as well as a long-run solution that will allow U.S. businesses to find new sources of 21st-centurycompetitive advantage and consumers to spend within their means.