Monday, August 24, 2009

Letting The Stimulus Run Its Course

Local governments that cut their budgets may be undermining the efforts of the federal government to stimulate the economy and may kill the momentum that the stimulus has generated. The following post from the Economist's View discusses Cornell economist Robert Frank's argument on why we can't afford to let the stimulus fizzle.

Robert Frank makes two points. First, state and local governments facing budget problems due to the recession need more help from the federal government. Second, those who object to federal help for states, or to government spending to stimulate the economy more generally, "have not offered persuasive arguments":

Don’t Let the Stimulus Lose Its Spark, by Robert Frank, Commentary, NY Times
: Encouraging economic news has been reanimating the critics of President Obama’s stimulus program. But heeding their admonition to end the program would be a grave mistake. We need more stimulus now, not less.

Even if the economy is improving, it is still very weak. Another quarter-million jobs were lost last month... Now we face an ominous new threat to recovery from sharp cuts in state and local government spending. ... These cuts were mandated by laws meant to stop politicians from spending beyond their means. While such measures may be beneficial on balance, sharply reduced government spending is exactly what the economy doesn’t need right now.

Through its legal authority to run deficits to stabilize the economy, the federal government can keep recovery on track by transferring revenue to states and cities. Of course, opponents of the original economic stimulus program have no desire to see it extended this way. Yet they haven’t made a persuasive case. The flaws in their arguments don’t rise to the absurd heights seen in recent town hall meetings on health care reform. But it is a difference in degree, not kind. ...

In a recent column in Forbes magazine, the economist Lee Ohanian of the University of California, Los Angeles, a stimulus opponent, explained why he believes that increased government spending wouldn’t help... The problem, he says, is that “the higher taxes on incomes or expenditures that ultimately accompany higher spending depress economic activity.” ...

His argument, and that of stimulus opponents generally,... boils down to this striking contention: As the government spends borrowed funds, consumers will start to realize that the resulting debt spells higher taxes in the future, which will lead them to curtail their current spending. Those cuts will offset increased government spending, leaving no net stimulus.

Although there may be people who would actually spend less now to hedge against uncertain future tax bills, it’s unlikely that you know any of them. As behavioral economists have been saying for decades, that’s just not the way most people act. Hardly any consumers even know how ... the national debt ... will affect future taxes.

More important, there are good reasons for believing that stimulus spending will make people’s future tax payments lower, not higher. Yes, government borrowing adds to the national debt. But if the stimulus also hastens the downturn’s end, it will accelerate the growth of future incomes and tax revenue. In that case, the net effect would be to reduce future taxes, compared with what they would have been without the stimulus. ...

The recent state and local spending cuts are a major setback to the stimulus program, which many economists have argued was much too small to begin with. A small minority disagrees but has not offered persuasive arguments.

The downturn threatens every goal we care about. Doing everything possible to limit state and local spending cuts will help end it faster.

Helping states is a good idea, and more help is needed. But that's not enough by itself to bring aggregate demand up to the necessary level, other types of spending are also needed (think of it this way - saving every state and local job that would be cut without federal aid is not enough to solve the employment problem).

However, a state that knows the federal government will step in and help if it gets into trouble may be unwilling to take steps to smooth the state's business cycle such as creating a rainy day fund (i.e., build the fund during boom times bringing output closer to its long-run trend, and spend the fund during the bad times also bringing output closer to its long-run trend). Because of this, if the federal government stands ready to backfill state budgets during recessions, we may want to require that states meet certain restrictions (such as having a rainy day fund of a particular size) before they can receive help.

Allowing state government to contract during a recession makes things worse, and I believe this recession will teach us that the federal government needs to provide much more help than it did this time around. But if the federal government does explicitly take on the responsibility to prevent state governments from contracting when the economy turns downward, then the obligations of local, state, and federal governments need to be clarified. We also need to make sure, as much as possible, that the states cannot game the system to their advantage.

Update: Brad DeLong adds, in reference to Lee Ohania's argument:
This is, as I say every day, simply wrong as a matter of very basic economic theory. Increased nominal government spending financed by future taxes is crowded out by a reduction in nominal private consumption spending if and only if what the government spends money on is a perfect substitute for what private consumers spend money on. That just is not the case.

This post has been republished from Mark Thoma's blog, Economist's View.

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