Why More Government Stimulus Is Needed Now

The third quarter of 2009 witnessed an economic growth rate of 3.4 percent, nearly three-fourths of which was driven by consumer spending. The announcement that consumer spending decreased by 0.5 percent in September, however, indicates that economic recovery may be less robust than analysts had previously predicted. Mark Thomas explains why more government stimulus is needed now in the following post from Economist's View.

I have something at Room for Debate (written last Friday) on the the extent to which the recent improvement in GDP growth can be attributed to the stimulus package, and whether more stimulus is needed ("Did the Stimulus Work?").

The link is to the much shorter version that appears on the NYT site. Here's the wordier, unedited version:

A Shaky Start, by Mark Thoma: With the news yesterday that output grew by 3.5% during the third quarter of this year, it appears we may finally be seeing the green shoots that signal the onset of the recovery. But what is driving the growth in output, what will it take to sustain that growth, and how long will it take to make up for the lost output and employment we experienced during the crisis?

A look beneath the growth numbers announced yesterday answers the first question. Increased consumer spending accounted for 2.4% of the 3.5% increase in growth, and much of the increase in consumption was driven by the Cash for Clunkers and other government stimulus programs. Today’s announcement that consumer spending fell by .5% in September now that the Cash for Clunkers program has ended raises serious questions about the sustainability of the growth we are seeing. Without further help from the government, which has clearly aided the economy despite what you may have heard from naysayers, will the private sector be able to sustain growth on its own?

One of the big dangers we face is that we will declare victory too soon and begin raising interest rates and cutting back on stimulus before the private sector has recovered the ability to sustain growth without help from the government. I believe that we need more stimuli right now to maintain the growth we are seeing, particularly given how far the recovery in employment lags behind the recovery in output, but adding to the stimulus package is a political non-starter. However, amid the worries about the growing deficit and fears of inflation that make further stimulus political poison, we can and must maintain the stimulus that is already in place.

The need to at least maintain the stimulus we have, if not increase it, is enhanced by the fact that even though a 3.5% growth rate is far better than the negative rates we have seen recently, it’s not nearly enough to make up for the output we lost during the crisis in a reasonable amount of time (Paul Krugman says that at this rate, “we wouldn’t reach anything that feels like full employment until well into the second Palin administration”). The recovery period from past recessions were associated with output growth rates of 6-7%, enough to resume the level of growth that existed before the crisis, and to make up for losses in a reasonable amount of time. If those losses had not been recovered, if the level of output had been permanently lower instead of just a temporary deviation from its long-run trend, then employment and income would have also been permanently lower. That is not a desirable outcome in any case, and in the current recession the weakness in employment markets combined with the stagnation in middle class incomes even before the crisis began makes such an outcome even more undesirable. Unfortunately, at a rate of 3.5% -- which is only slightly above the long-run trend rate of growth -- it will take many, many years to make up for losses and return to the long-run trend, and any further slippage in growth would make the losses permanent.

The recovery we are seeing is being driven, in large part, by government stimulus programs. The fact that growth is weaker than we need to fully recover losses in a reasonable amount of time, and the even slower recovery we are seeing in employment markets, indicates that the stimulus programs already in place are too small. Thus, even though it’s unlikely to happen, the economy could use more help than it’s getting, but in any case it’s imperative that we avoid cutting back too soon.

The signs are encouraging, and at some point the private sector will be able to sustain growth on its own, but it’s far too soon to declare victory.

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