A Fiscal Solution to the A Fiscal Solution to the Economic Crisis?Economic Crisis?

Professor William T. DickensProfessor William T. Dickens

Northeastern University, Northeastern University,

The Russell Sage Foundation, The Russell Sage Foundation, and and

The Brookings InstitutionThe Brookings Institution

What I’m Going to Talk What I’m Going to Talk About About

• How fiscal policy can restore full How fiscal policy can restore full employmentemployment

• Why we don’t normally resort to Why we don’t normally resort to fiscal policy in recessions but need to fiscal policy in recessions but need to nownow

• How much will the fiscal stimulus How much will the fiscal stimulus plan being contemplated help?plan being contemplated help?

My ViewMy View• We face a nearly unprecedented global economic crisis We face a nearly unprecedented global economic crisis

with the potential to be the worst economic with the potential to be the worst economic catastrophe in 75 yearscatastrophe in 75 years

• We need rapid action in the US to shore up our We need rapid action in the US to shore up our financial markets and to prevent further collapse of financial markets and to prevent further collapse of employment and incomeemployment and income

• Fiscal policy will have to carry the main part of the Fiscal policy will have to carry the main part of the burden of shoring up employment and income because burden of shoring up employment and income because monetary policy has become much less effective than monetary policy has become much less effective than it normally isit normally is

• The package of fiscal stimulus that looks headed for The package of fiscal stimulus that looks headed for passage is a large step in the right direction but is passage is a large step in the right direction but is probably too small to restore full employment and may probably too small to restore full employment and may not come in time to prevent further problems in not come in time to prevent further problems in financial markets financial markets

• Thus I expect that we will need further rounds of fiscal Thus I expect that we will need further rounds of fiscal stimulus before our economy recovers, with the speed stimulus before our economy recovers, with the speed of the recovery depending on how quickly we realize of the recovery depending on how quickly we realize and act on thisand act on this

DefinitionsDefinitions

• RecessionRecession – ““A recession is a significant decline in A recession is a significant decline in

economic activity spread across the economic activity spread across the economy, lasting more than a few economy, lasting more than a few months” (NBER Business Cycle Dating months” (NBER Business Cycle Dating Committee)Committee)

• DepressionDepression – When economists have to worry about When economists have to worry about

their jobs too…their jobs too…

The Current RecessionThe Current RecessionThe Downward SpiralThe Downward Spiral

What starts in one sector of the economy ends up What starts in one sector of the economy ends up affecting all sectors of the economyaffecting all sectors of the economy

Credit Crunch

Demand for buildings and equipment

Employment and Income

Demand for Consumer Goods and Services

Consumption

Multiplier

Investment Accelerator

Why Doesn’t the Downward Why Doesn’t the Downward Spiral Go On Forever?Spiral Go On Forever?• Each round of the spiral is smaller than the Each round of the spiral is smaller than the

last due to “leakages”last due to “leakages”– When income falls, people cut their spending by When income falls, people cut their spending by

less than their incomes fell using savings and less than their incomes fell using savings and credit to make up the differencecredit to make up the difference

– When incomes fall people pay less in taxesWhen incomes fall people pay less in taxes– When incomes fall people get unemployment When incomes fall people get unemployment

insurance and other transfer payments insurance and other transfer payments – When incomes fall people cut their spending on When incomes fall people cut their spending on

imports (which doesn’t reduce domestic imports (which doesn’t reduce domestic employment)employment)

• In the end, the sum of the total effect is In the end, the sum of the total effect is thought to be about 1.5 to 2 times the thought to be about 1.5 to 2 times the initial decline in spending (investment plus initial decline in spending (investment plus consumption)consumption)

How Fiscal Expansion How Fiscal Expansion Remedies DownturnRemedies Downturn

If spending increases and tax cuts are big If spending increases and tax cuts are big enough they can completely offset effects enough they can completely offset effects of credit crunch in previous slide.of credit crunch in previous slide.

Government Spending

Directly Employ

s Worker

s

Employment

Income

Tax Cuts

Demand for Houses, Goods and Services

Businesses Buy More Machines and

Buildings

Incentive Effects

Tax Cuts or Spending?Tax Cuts or Spending?

• With spending there is no “leakage” from first With spending there is no “leakage” from first round – employment and income rise one-for-round – employment and income rise one-for-one with increased spending (so long as one with increased spending (so long as money is spent on unemployed resources and money is spent on unemployed resources and doesn’t shift people from other employment)doesn’t shift people from other employment)

• With a tax cut the impact is reduced by all the With a tax cut the impact is reduced by all the leakages – primarily people saving significant leakages – primarily people saving significant parts of the tax cut (partial solution is to give parts of the tax cut (partial solution is to give tax cuts to people who are cash strapped)tax cuts to people who are cash strapped)

Spending or Tax Cuts?Spending or Tax Cuts?

• Tax cuts have incentive effects on Tax cuts have incentive effects on top of just increasing income (by top of just increasing income (by making work pay more or investment making work pay more or investment less expensive you get more capital less expensive you get more capital and labor)and labor)

• Tax cuts will typically be faster acting Tax cuts will typically be faster acting (no long lags in planning, contracting (no long lags in planning, contracting and then paying out the money)and then paying out the money)

So Why Not Cut Taxes and So Why Not Cut Taxes and Increase Government Spending Increase Government Spending All the Time? All the Time? • If there are no unemployed resources then If there are no unemployed resources then

government spending only displaces private government spending only displaces private sector spending (consumption and sector spending (consumption and investment).investment).

• When there is full employment, tax cuts When there is full employment, tax cuts without spending cuts force the government without spending cuts force the government to borrow which drives up interest rates and to borrow which drives up interest rates and “crowds out” investment spending by “crowds out” investment spending by businesses and slows growth (unless Federal businesses and slows growth (unless Federal Reserve keeps interest rates down by printing Reserve keeps interest rates down by printing money in which case there is inflation).money in which case there is inflation).

So Why Aren’t There Calls for So Why Aren’t There Calls for Big Fiscal Stimulus Packages in Big Fiscal Stimulus Packages in Every Recession?Every Recession?• To some extent there are (we often put tax To some extent there are (we often put tax

cuts and spending increases into effect to cuts and spending increases into effect to combat recessions)combat recessions)

• But in every recession since WWII the But in every recession since WWII the primary cause of the recovery has been primary cause of the recovery has been action by the Federal Reserve bankaction by the Federal Reserve bank– Federal Reserve cuts interest ratesFederal Reserve cuts interest rates– This stimulates demand for housing, business This stimulates demand for housing, business

investment, and consumer durable goods investment, and consumer durable goods (appliances and cars – things people tend to buy (appliances and cars – things people tend to buy with credit)with credit)

So Why Not Leave it to the So Why Not Leave it to the Fed Now?Fed Now?

Federal Reserve Instrument and Target Rates

0

0.5

1

1.5

2

2.5

39/

2/20

08

9/16

/200

8

9/30

/200

8

10/1

4/20

08

10/2

8/20

08

11/1

1/20

08

11/2

5/20

08

12/9

/200

8

12/2

3/20

08

1/6/

2009

1/20

/200

9

2/3/

2009

Inte

rest

Rat

e

Federal Funds Rate 4 Week Treasury Bills

The 0% Lower BoundThe 0% Lower Bound

• No one will lend money at less than 0% No one will lend money at less than 0% interest since they can get that rate of return interest since they can get that rate of return on cash under their mattress -- the primary on cash under their mattress -- the primary interest rates the Fed targets can’t go any interest rates the Fed targets can’t go any lower!lower!

• This is similar to the situation in the Great This is similar to the situation in the Great Depression and why people keep comparing Depression and why people keep comparing the current situation to those timesthe current situation to those times

• Also very similar to the problems faced by the Also very similar to the problems faced by the Japanese in the 1990s. Japanese in the 1990s.

So How Far Will Recovery and So How Far Will Recovery and Reinvestment Act Take Us?Reinvestment Act Take Us?

• Both Senate and House versions of Both Senate and House versions of H.R. 1 are estimated to cost about H.R. 1 are estimated to cost about $820 billion dollars$820 billion dollars

• House bill is about 78% spending and House bill is about 78% spending and 22% tax cuts22% tax cuts

• Senate bill is about 65% spending Senate bill is about 65% spending and 35% tax cutsand 35% tax cuts

Criticism of the Stimulus BillCriticism of the Stimulus Bill

• UnfairUnfair– Spending has been tried and failedSpending has been tried and failed

(1930s, Japan in the 1990s). (1930s, Japan in the 1990s). •Contrary to conventional wisdom, Roosevelt Contrary to conventional wisdom, Roosevelt

didn’t do much spending until run up to WWII. didn’t do much spending until run up to WWII. Japanese did use fiscal stimulus but always Japanese did use fiscal stimulus but always too little too late.too little too late.

– Full of pork.Full of pork. •Very careful about restricting earmarks. Very careful about restricting earmarks.

Democrats say that the programs the Democrats say that the programs the Republican’s call pork are what they were Republican’s call pork are what they were elected to put in place.elected to put in place.

Criticism of the Stimulus BillCriticism of the Stimulus Bill

• FairFair– Several new spending programs that are Several new spending programs that are

lumped together in bill deserve to be lumped together in bill deserve to be considered individually and not rushed considered individually and not rushed through with little opportunity for through with little opportunity for deliberation and debatedeliberation and debate

– Spending spread out over 10 years while Spending spread out over 10 years while stimulus is needed nowstimulus is needed now

So How Does the Bill Measure So How Does the Bill Measure Up?Up?

What is in Senate and House What is in Senate and House Bills vs. What is NeededBills vs. What is Needed

Senate Bill

House Bill

2009 2010 2009 2010

Spending 119.7 206.2 107.1 236.4

Tax Cuts 94.5 235.0 62.5 119.7

Impact 280.4 537.1 234.3 503.5

Needed* 820.9 840.6 820.9 840.6

(billions of dollars)* Author’s conservative estimate

What I Would Have Done What I Would Have Done DifferentlyDifferently

• Aim higher – cost of undershooting much Aim higher – cost of undershooting much worse than overshootingworse than overshooting

• More of the stimulus upfront (2009)More of the stimulus upfront (2009)– More relief for state budgetsMore relief for state budgets– Further extensions/expansions of Food Stamps, UI, Further extensions/expansions of Food Stamps, UI,

and Medicaid and Medicaid – More tax cuts and consumption subsidiesMore tax cuts and consumption subsidies– More shovel ready infra-structure(?)More shovel ready infra-structure(?)

• I am very worried that by not doing enough I am very worried that by not doing enough we are inviting even more problems with we are inviting even more problems with financial markets and that the cost of financial markets and that the cost of rescuing the economy will continue to climbrescuing the economy will continue to climb