Objections to Fiscal Policy are Groundless—It Works

Objections to Fiscal Policy are Groundless—It Works

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One of the more controversial policies instituted in an attempt to stimulate the economy out of the Great Recession was the $816.3 billion fiscal stimulus package enacted just after Obama took office. 

The stimulus package, known formally as the American Recovery and Reinvestment Act, had three main components: tax benefits ($290.7 billion), contracts, grants, and loans ($261.2 billion), and entitlements ($264.4). Roughly, the first category is tax cuts, the second is new government spending, and the third is enhancements to programs such as unemployment insurance and Medicaid/Medicare, what economists call “transfer payments.” 

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Why is the first category, tax cuts, controversial as a stimulus policy? The problem is that tax cuts might be saved rather than spent and thus fail to stimulate aggregate demand. This is a bigger worry when the tax cuts go to the wealthy rather than the working class since the wealthy are more likely to put any reduction in taxes into saving. An additional worry is that if the tax cuts are permanent, they may lead to reductions in important social programs down the road.

However, the fact that some households use the money to rebuild savings or pay off debt rather than purchase new goods and services may not be so worrisome after all. After a “balance sheet recession” such as we had, where housing equity and financial assets are wiped out while high debts remain, households need to deleverage and recover their losses before their consumption habits will return to normal.

If tax cuts are used to pay off debt and rebuild assets, the result is a faster recovery of consumption than otherwise, and hence a faster recovery of the economy more generally. In addition, the tax cuts were largely devoted to working class households, e.g. programs such as enhancing the EITC and “Make Work Pay,” so the worry that the tax cuts were focused on the wealthy is not a big issue in this case. 

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Objections to the second category, government expenditures to stimulate the economy, are based upon a “crowding out” argument and the belief that government cannot spend money as efficiently as the private sector. Crowding out occurs when government spending reduces or “crowds out” private spending. The idea is that government borrowing to pay for new spending drives up interest rates, and as interest rates increase consumption, investment, and net exports fall and offset the increase in government spending. The result is a net stimulus of near zero. 

However, as we’ve seen in the recent recession, this argument doesn’t hold when interest rates are stuck at the zero bound. Interest rates would fall below zero if they could, but the zero bound prevents this. An increase in government spending simply removes some of this downward pressure, it doesn’t cause interest rates to increase and crowd out other spending. In normal times, when interest rates are not at the zero bound, crowding out is an issue, but in a severe recession this is not a worry.

What about the argument that the government is less efficient at spending money than the private sector? One need only recall that the private sector caused the housing bubble and all the damage it caused to realize that the private sector isn’t always so good at spending money (think of all the failed projects each year, e.g. restaurants that don’t make it, etc., as one measure of private sector waste of resources).

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But even setting that aside, there are “public goods” that the private sector will not provide at all, or won’t provide in sufficient or efficient quantities even though there is a clear demand for them. The classic example is defense. Why should any individual voluntarily pay for defense? If everyone else pays, and you don’t, you will still be protected, so why not let everyone else pay while you free ride? If everyone makes this calculation, then there is no way to have a private sector store where each month people voluntarily purchase their fair share of defense. There would be few, if any, customers.

The solution is for the government to use its powers of taxation to make everyone pay a fair share, and then provide (or contract for) this service itself. Many, many goods are public goods, e.g. most infrastructure projects have this characteristic, and we have great infrastructure needs. Thus, the argument that the federal government cannot spend money as efficiently as the private sector falls apart when it comes to infrastructure and other public goods.

The last category is entitlement spending, e.g. the increase of $61.3 billion to the unemployment insurance program in the stimulus package. The worry here is that government “handouts” will cause the unemployed to live off the payments from social insurance programs and stop looking for employment. However, there is little evidence for this claim

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At one point during the recession there were as many as seven people unemployed for every open job, and firms had no problem filling vacancies with qualified workers. The problem was that there weren’t enough jobs, and the social insurance programs made it a little more bearable, though far from comfortable, for those who were not able to find a job no matter how hard they tried. 

There were some costs to these programs, for example although unemployment insurance and other social insurance programs did not affect the rate at which workers found jobs, it appears some workers did stay in the labor force longer than they would have otherwise before dropping out. But that cost is small relative to the large benefits that these programs provided to the unemployed and their families.

The policies needed to effectively fight a recession will vary according to the cause of our economic problems. For example, in a recession caused by an oil price shock household balance sheet repair is much less important, and policy should adjust accordingly. But for a balance sheet recession, tax cuts targeted at both balance sheet repair and increased consumption, government spending on infrastructure and other projects, and enhanced social insurance to smooth the way for the unlucky workers struggling to find employment are all desirable policies. The ARRA largely followed this prescription, and most research concludes that it helped to prevent an even worse recession. The problem was the size of the stimulus package, not its composition. It was far too small to address the huge problems we faced.

The bottom line is that we haven’t seen the negative effects from the fiscal stimulus package that the naysayers warned about, but we have seen many benefits. When the next big recession hits, as it surely will at some point in the future, we should not be afraid to do far more than we did to stimulate the economy and help struggling households.

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