The economic crisis has made two things clear. First, monetary policy won’t always be capable of stabilizing the economy on its own. When the problems become large enough, fiscal policy must be part of the response.
Second, even when our economic problems are severe and righting the ship ought to be the primary concern, Congress is incapable of implementing fiscal policy with the timeliness and effectiveness that is needed. As Alan Blinder said recently, “I’m looking at the political system turning itself into a paralyzed beast.”
We need a better way of conducting fiscal policy, one that avoids the political fights in Congress that lead to delay and compromised, watered down policies, or to complete gridlock that prevents any response at all.
Automatic stabilizers are a tried and true means of stabilizing the economy. Increased reliance upon this type of stabilization could help solve the political problems that prevent Congress from responding effectively when the economy is most in need of help.
The first, and most important place automatic stabilizers could help is in reversing the automatic destabilization that balanced budget requirements at the state and local level bring about. Balanced budget requirements force state and local governments to either raise taxes or cut spending to offset budget shortfalls induced by a recession, measures that make the recession even worse.
In the recent recession, some help was provided to state and local governments, but political fights blocked efforts in Congress to provide as much help as was needed. Because of this, contractions at the state and local level were so large that they offset the stimulus at the federal level to the point where the net stimulative effect was essentially zero. No wonder the stimulus package didn’t have more powerful effects.
Before the next crisis hits, we need to develop mechanisms to make federal help available automatically so that states do not find themselves in this position again. One worry is that promises to bailout state finances will induce states to game the system. But standard remedies – the equivalent of deductibles and co-payments in insurance markets – can help with this and keep the potential gaming at a minimum. (Stan Collender discusses a revenue sharing program linked to economic conditions that was created in 1980, but never funded.)
A second big problem that could be addressed through a more automated policy process is in finding worthy, “shovel ready” projects that can be brought online quickly to stimulate the economy. Andrew Samwick and others have proposed a project bank that would maintain an ongoing list of needs for infrastructure and other public goods – there are plenty of unmet needs in this area – and put them into action when a crisis hits. Here’s how Andrew Samwick expressed the idea:
The federal government has a critical role in maintaining and developing public infrastructure, whether in transportation, telecommunications or energy transmission projects. A sensible capital budget would include a prioritized list of projects … slated for this year, some for [the next year], and so on... When economic growth falters, the government would be in a position to move some of the projects from later years into the present year.
Unfortunately, that may be too sensible for Washington.
Another way automatic policies could be helpful is in the stabilization of household balance sheets and household consumption. This recession hit household balance sheets particularly hard because of declines in two major sources of household wealth, housing and stock values, and this led to large declines in consumption. If we are going to bailout bank balance sheets, why not extend the same benefits to households who are, collectively, every bit as systemically important as large banks?
We need well-targeted tax cuts that stabilize both consumption and household balance sheets, and we need to link tax rates to economic conditions to avoid the political problems associated with these policies.
We also need to reexamine unemployment compensation, food stamps, and other existing automatic stabilizers and improve them as best we can. Unemployment compensation in particular needs another look, and we should consider other ways to provide automatic stabilization as well.
There is, however, a problem with automatic stabilizers that prevents us from using them as effectively as we might. Many existing automatic stabilizers lead to budget shortfalls during a recession. Spending on social services, for example, provides needed help, but it also leads to a larger deficit. When things return to normal, the budget shortfall is not automatically made up – there is nothing that compels a surplus once the recession is over.
If we are going to increase our reliance on automatic stabilizers, we will need to build in automatic mechanisms that pay for these programs when conditions improve. If we can do this credibly, and that’s a big if, then people would be less likely to object to these policies.
But even if the policies are credibly budget neutral, putting them into place won’t be easy. There will still be some redistribution of income, that’s unavoidable, and that will lead some people to resist these measures. Some people will also object to government intervention on an ideological basis.
The fact that it’s so difficult to accomplish all of this is precisely why we need to do get this done before the next recession hits. However, quite a bit of opposition should be expected, from an amalgam of deficit hawks, conservatives and libertarians, and states’ rights zealots. Worries that the new stabilizers will not be budget neutral; worries that government intervention creates moral hazard and bad incentives, and worries that the federal government is exerting too much power over state finances will present large barriers to new legislation. Disagreement about the nature of these programs – spending versus tax cuts for example – will also create difficulties. In total, the opposition may be too large to overcome.
But this recession shows that the need is great for more effective fiscal policy, and if we give up before we start, nothing can possibly change. My best guess is that we will enter the next large recession as unprepared to use fiscal policy as we were this time. But maybe not, and the stakes are too high to give up without a fight.