Thursday, May 6, 2010

A Potential Solution To Failed Fiscal Policy

Economist Mark Thoma discusses the flawed implementation of fiscal policy during the recession due to political delays. He suggests the use of automatic stabilizers which can take effect immediately when things get bad. See the following post from Economist's View.

One of the lessons of this recession is that fiscal policy is a very imperfect policy tool. In deep recessions when monetary policy has run its course -- when moving interest rates all the way to zero and trying non-traditional policies has not fixed the problem -- fiscal policy can provide the needed boost to aggregate demand. But the politics surrounding fiscal policy means it will be put into place far too late, if it is put into place at all, there will be fights over how to structure the stimulus, e.g. tax cuts versus government spending and the compromise may not be good policy, and there is no guarantee at all that the policies will be paid for when times improve (which undermines the policy the next time politicians promise it will be "temporary")..

One option would be to create a Fed-like structure responsible for fiscal policy, an agency that has a reasonable degree of independence from Congress and the administration. This agency would be required to be in balance its budget over, say, a ten year period, but could run surpluses or deficits in the interim as needed to manage the economy (it could have a list of ready to go infrastructure projects, use tax changes, etc.). So it could not change the average level of spending, that would still be determined by Congress, but it could shift that spending around as needed. But a proposal like this would never, ever make it through Congress, and even if it did I'm not sure I could support such an institution.

So what to do? One answer is automatic stabilizers such as social insurance programs that kick in when things get bad and turn off automatically when things get better. These worked well during the current recession, but by themselves weren't large enough to provide the needed stimulus. So more automatic stabilization is needed. When these policies are set in advance, and implemented down the road when the next recession hits, it avoids the political problems that plague discretionary policy. Congress doesn't have to do anything, and if their constituents don't like it, they can blame the program on their predecessors. And we don't have to limit ourselves to enhancing current programs, we could get much more creative with these stabilizers, e.g. payroll taxes that vary with the unemployment rate.

A harder problem is how to use automatic stabilizers to help to backfill the hole that recessions blow in state and local government budgets, but creative policies ought to be able to help here as well (however, the automatic nature of the help means that the policies must address potential gaming of the system -- states would have an incentive to make their budgets look bad in recessions -- but cost-sharing and other mechanisms can help with this). I think it's particularly important to add an automatic mechanism that provides help to states since states can quickly undo attempts to stimulate the economy at the federal level as they cut spending or raise taxes to balance their budgets as required by law, and the political problems with providing help to states in real time are severe.

Unless we get better legislators, and a couple of hundred years of history says not to count on that, enhancing the automatic stabilizers may be our best bet going forward. There's considerable empirical evidence showing that they work, including this new evidence that automatic stabilizers work "always and everywhere":

Fiscal Policy and Macroeconomic Stability: Automatic Stabilizers Work, Always and Everywhere, by Xavier Debrun and Radhicka Kapoor, IMF Working paper: [Full Text]: Summary: The paper revisits the link between fiscal policy and macroeconomic stability. Two salient features of our analysis are (1) a systematic test for the government’s ambivalent role as a shock absorber and a shock inducer—removing a downward bias present in existing estimates of the impact of automatic stabilizers—and (2) a broad sample of advanced and emerging market economies. Results provide strong support for the view that fiscal stabilization operates mainly through automatic stabilizers. ...

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