Unemployment: Why Stimulus Hasn’t Created More Jobs
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The Fiscal Times
May 25, 2011

In the wake of the Great Recession, why has employment been so slow to recover? One answer is that an important but widely unrecognized change in fiscal policy has taken place.

Due largely to the influence of supply-side Republicans and many Democrats who embrace growth policies, policies that were originally intended to stimulate innovation in the private sector were applied to the government sector and infrastructure spending. This change in policy that puts growth at the forefront has shifted resources and attention away from traditional policies that could have reduced joblessness at a more rapid rate.

To understand the change in policy, it’s useful to divide fiscal approaches into two broad categories: supply-side policies designed to enhance the economy’s long-run growth prospects and demand-side policies designed to stabilize short-run business cycle fluctuations.

Supply-side policies, which almost always involve tax cuts and tax credits, attempt to stimulate the three factors that determine economic growth: technological innovation, growth in the capital stock, and growth in the labor force. Examples of these policies include tax credits for R&D; capital gains and dividend tax cuts to increase investment; and income tax reductions to boost both labor supply and entrepreneurial activity.

Demand-side polices are used when the economy strays off of its optimal long-run growth path. In recent decades we have relied mainly on monetary policy-- and secondarily on changes in tax rates--to offset business-cycle fluctuations and stabilize the economy. But in the Great Recession, government spending has played a more prominent role.

What’s different is that government spending has, in large part, been devoted to infrastructure spending and other policies to enhance economic growth. In fact, around 75% of the spending on goods and services in the American Recovery and Reinvestment Act (ARRA) was devoted to policies that help the economy grow, and the ability to enhance long-run economic growth was a key factor in the selection of projects to include in the stimulus bill.

In past recessions, fiscal policy operated differently. The main goal was to increase aggregate demand through additional government purchases of goods and services, tax cuts, or even through government- created jobs that provided people with the income they need to go out and purchase goods and services themselves. Infrastructure spending was part of the mix, but the main goal was to stimulate demand and boost the economy; the impact on long-run economic growth was not the important consideration.

For this reason, in the past we were much more likely to consider “make-work” as a stabilization tool. Make-work is generally summarized as “paying half the unemployed to dig holes, then paying the other half fill them in again.” But that is a bit unfair since the goal is always to spend money where it does the most good, for example, to clean up a city park that has fallen into disrepair even if that doesn’t directly have an impact on long-run growth.

But as noted above, in the most recent recession, due largely to the influence of Republicans devoted to supply-side economics and to many Democrats who embrace growth policies, supply-side policies that were originally intended as a means of stimulating innovative activity in the private sector were extended to the government sector and infrastructure spending. Republicans would not have approved any other type of policy to combat the recession, particularly policies of the “make-work” variety. Growth had to be at the forefront, and Democrats accepted this approach to stabilization policy. The result was that, contrary to past policy where growth and stabilization policy were independent, present policy addressed both supply-side and demand side concerns simultaneously.

There are advantages to requiring short-run stabilization policy to pass a long-run growth test, but there are also costs. If we are going to move policy in this direction in the future – and it looks like we are – it’s important to know what these costs and benefits are.

One of the main benefits of the emphasis on long-run growth is that it makes government spending to fight recessions politically viable – it’s a type of spending both sides can agree is needed. Another benefit is that unlike, say, tax cuts used to fight recessions, which tend to become permanent and hence create a permanent hole in the budget, infrastructure projects eventually come to an end. And, of course, there’s also the benefit of the additional growth these policies produce.

But there are costs too, and one big cost is evident in the recovery from the current recession. The focus on long-run growth and the shunning of anything that so much as resembles a “make-work” project has made it difficult to deal effectively with the unemployment problem. There are still 11 million people who need jobs, and we are doing very little to help with this problem.

Long-run growth projects are slow to come online, especially when the projects must make it through the political process, and if they are not big enough initially it’s difficult to find the political will to go through the process of implementing another round of spending. Tax cuts are an alternative, but the current stimulus package was just shy of 40% tax cuts and we still have an unemployment problem.

Monetary policy is another option, but the effectiveness of monetary policy is limited when interest rates bottom out as they generally do in severe recessions. Thus, more direct methods of dealing with the unemployment problem are needed.

In the past, we did not pay enough attention to whether the policies used to fight a recession would also help with long-run economic growth. But in the present the pendulum has swung too far in the other direction – long-run growth should not be the only consideration when selecting stabilization policies.

In the future, we must do a better job of attacking the unemployment problem when recessions hit the economy even if it means implementing policies that do not directly have an impact on long-run economic growth. Those who promote supply-side policies above all else might be surprised at how much growth will be helped nonetheless by policies that avoid the long-term problems associated with high and persistent unemployment.

Related links
A Capital Idea: A Budget That Plans for the Future (The Ripon Forum)
Summers Calls for InfrastructureSpending (FT.com)
The President on Infrastructure Investment: "This is Work That Needs to Be Done. There Are Workers Who Are Ready to Do It"  (White House blog)

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.