The Magazine

Not All Stimuli Are Created Equal

The best plan is a cut in the payroll tax.

Jan 5, 2009, Vol. 14, No. 16 • By LAWRENCE B. LINDSEY
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When it comes to fighting recessions, there's a tendency to see "fiscal stimulus" packages as wasteful, as a form of "throwing money at the problem." The critics have a point. But the conclusion that therefore we should do nothing is also wrong. Instead, careful attention should be paid to the details. Just as a family pinched for cash might find borrowing for the purchase of a new car or appliance prudent while taking a vacation in Las Vegas wouldn't be, some government programs to combat recession make sense while others do not.

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 economy, 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. Our 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.