Tax Deal Puts Economy between a Rock and a Hard Place

Tax Deal Puts Economy between a Rock and a Hard Place

Since announcing his tax cut agreement with Republican leaders on a deal that would prevent a large tax increase on Jan. 1, Barack Obama has been heavily attacked by those on both the right and the left. Generally speaking, this is a good place to be, politically, in Washington. But the politics of the matter are really secondary. The reality is that given the economic situation, Obama had no choice but to do what he did. The question is, will it work?

Since the beginning of the economic crisis three years ago – it began in December 2007, according to the National Bureau of Economic Research – economists have been searching for a magic bullet that would turn the situation around. But even now, there is no agreement on the best way to proceed. In large part, this is because there is no consensus on the underlying cause of the crisis.

The liberal theory is that the economy is suffering from a sharp falloff in aggregate demand. In short, people reduced spending and increased their saving to rebuild wealth lost to the collapse of the housing bubble and decline in the stock market. As sales fell, businesses laid off workers, which led to a further decline in spending as the unemployed tightened their belts and downsized their standard of living.

The obvious response, if one accepts this theory, is for the federal government to step in and replace the lost private consumption with public spending on goods and services. Ideally, that would take the form of what economists call “public goods” that would contribute to the nation’s long-term productivity, while also providing short-run stimulus.

The Obama administration put forward a stimulus proposal of $800 billion based on a forecast that unemployment would have risen to 9 percent if no action were taken, and 8 percent with the stimulus. At the time, the unemployment rate was 7.4 percent, but even with the stimulus it rose to 10.1 percent. This suggests that in the absence of stimulus the unemployment rate would have risen to 12 percent. Bringing it down to 8 percent – the rate presently stands at 9.8 percent – would have required a stimulus package two or three times larger, based on the model used by administration economists.

Without Bernanke’s quick, decisive action, it is very
likely that we would have suffered the equivalent
of another Great Depression.

Compounding the problem of stimulating growth, there were fewer public works projects ready to go than had been thought and it was impossible to spend stimulus funds only on public goods. A considerable amount of money was given to state and local governments that was not stimulative at all, except in the sense that it prevented them from adopting more fiscal contraction – tax increases and spending cuts – than they were forced to anyway. The bulk of the rest of the money went to a tax cut called the Making Work Pay Credit that reduced the taxes of every taxpayer with an income below $74,000.

This package, enacted in February 2009, has clearly been inadequate to turn the economy around. Democrats blame the insufficient size of the stimulus, although they also acknowledge that Congress was probably never going to appropriate more than it did. Even if there had been a consensus among economists that the economy was in much worse shape than they thought it was in early 2009, it would have been hard to spend more, given the lack of mechanisms for distributing the funds in a way that would have raised aggregate spending.

Keep in mind that one important constraint is the way people inevitably react to government tax or spending programs. Programs that just put money in their pockets don’t always encourage consumption because people tend to save windfalls. Thus the 2008 tax rebate, which the Bush administration enacted in response to the recession, gave most individuals an extra $600 that year and most couples got $1,200. But there’s no evidence that it stimulated the economy at all because the bulk of the money was saved rather than spent.

In contrast to liberals, conservatives have never had a coherent theory of what caused the recession or a program designed to deal with its specific characteristics. In part, that is because there is no single school of conservative economics. Members of the so-called Austrian School, such as Congressman Ron Paul, basically oppose any stimulus. They think that economic imbalances caused by past government intervention in the economy are what caused the recession in the first place. Stimulus, in their view, will only make matters worse. The best thing is for government to get out of the way and allow the economy to readjust, no matter how painfully, which it will do faster without government interference.

Even most conservative economists view the Austrians as eccentric. Most would consider themselves to be monetarists to one degree or another. Monetarists, who follow the late economist Milton Friedman, think that fiscal policy (taxing and spending) is pretty much worthless. What really matters is monetary policy, which is under the independent control of the Federal Reserve. Following Friedman’s analysis of the Great Depression, monetarists thought that if the Fed just kept the money supply from declining then the economy would turn around relatively quickly by itself.

Fed chairman Ben Bernanke considers himself to be a follower of Friedman and he moved heaven and earth to make sure that the money supply did not contract, as it did in the early 1930s. And because the banking system is the essential conduit for monetary policy, he threw out the rule book in late 2008, when the financial crisis was at its worst, to keep it afloat, lending vast quantities of money to prevent a financial implosion. And it worked. Without Bernanke’s quick, decisive action, it is very likely that we would have suffered the equivalent of another Great Depression.

Unfortunately, it now seems clear that while monetary policy can prevent an economic collapse, it can’t stimulate a prostrate economy. When it tries to do so, the money just piles up in the banks, which are now sitting on more than $1 trillion that is unlent, primarily due to a lack of demand. If people aren’t buying houses, workers are unemployed, businesses aren’t expanding, and consumption is flat, there is no reason to borrow and no way to lend.

Although some conservatives are frightened by all the money sitting in the banks and are critical of the Fed’s policy of quantitative easing because it would add another $600 billion to the banking system and lead to hyperinflation, most conservatives are less worried. They can see that there is no evidence of inflation in the price data or long-term interest rates. The one and only indicator signaling inflation is the rocketing price of gold, which most economists view as a bubble disconnected from fundamentals.

Businesses aren’t going to hire new workers if
there is nothing for them to produce
because consumers aren’t buying.

All along, there have been some conservative economists who argued that tax cuts were the only fiscal policy with the potential to raise growth. However, their arguments have been incoherent and contradictory. They said that government spending is bad because people discount the future taxes that will be necessary to pay off the higher debts – a mechanism that economists call “Ricardian equivalence.” But for some odd reason, they never say that debts arising from tax cuts will trigger the same response.

There are really only three ways that tax cuts could be stimulative. One would be to raise employment by reducing the “tax wedge” between the gross compensation paid by an employer and the net wage received by the worker. In this model, tax cuts reduce the cost of employment and thus lead to additional hiring. While this is a plausible theory under normal economic circumstances, it doesn’t make much sense when the primary problem is insufficient demand for business output. Businesses aren’t going to hire new workers if there is nothing for them to produce because consumers aren’t buying.

A second way tax cuts might raise growth would be to stimulate investment. Low taxes on the wealthy and big corporations, Republicans repeat ad nauseum, will lead to business expansion, new businesses and job creation. Again, this is a plausible theory under normal circumstances, but why would a business expand when it is perfectly able to satisfy existing demand from its current plant, equipment and labor force? A business has to believe that it will be able to sell the additional output before it will engage in expansion. Given flat demand, tax cuts will only increase after-tax profits without doing anything to raise growth.

The final way tax cuts might stimulate growth is by giving consumers more money to spend. But we’ve seen from the experience of the 2008 tax rebate and the Making Work Pay Credit that this is an extremely inefficient method of increasing consumption. And of course, tax cuts are worthless to the millions of those that are unemployed because they have no income to tax. And let’s not forget that because of Republican tax policies in the 2000s, close to 50 percent of all tax filers paid no federal income taxes even before the economy collapsed.

All of this suggests that the tax deal to extend the Bush tax cuts and replace the Making Work Pay Credit with a 2-point cut in the payroll tax is very unlikely to raise growth much, if at all. The one and only justification for this initiative is that it is better than the alternative of raising taxes when the economy is still weak. Given Republicans’ dominance of Congress, Obama really had no choice but to cut a deal on their terms.