January 6, 2008
Why America must have a fiscal stimulus
By Lawrence Summers
The odds of a 2008 US recession have surely increased after a very poor employment report, growing evidence of weak holiday spending, further increases in oil prices, more dismal housing data and further writedowns in the financial sector. Six weeks ago my judgment in this newspaper that recession was likely seemed extreme; it is now conventional opinion and many fear that there will be a serious recession. Markets now predict the Federal Reserve will provide further stimulus to the economy by cutting rates by an additional 125 basis points on top of the 100 basis points they have already been cut so that rates fall to the 3 per cent range.
There is now a compelling case for the president and Congress to create a programme of fiscal stimulus to the US economy that could be signed into law in the next several months.
Given the market’s prediction of Fed policy actions, the debate now is not about whether or not to provide macroeconomic stimulus. That question appears to be settled. The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.
The remainder of this column can be read here. Debate from our guest economists appears below.
Martin Weale: Reading Summers’ article I found myself wondering why, if fiscal expansion is a stimulus, won’t there be an offsetting contraction when the borrowing is repaid (or permanent damping from interest payments if the debt is never repaid). What sort of policy does Summers propose adopting to the overall size of the American national debt and when is borrowing going to be lower than expected to offset the fact that has proposal will make it higher than previously expected.
Supporting economies by fiscal expansion in the short term without thinking of the long term makes no more sense than doing so by generating private-sector credit and house price booms. In both cases the question of how to handle the debt burden needs to be addressed.
Posted by: Martin Weale | January 7th, 2008 at 10:30 am | Report this commentStephen Cecchetti: Arguing with Larry Summers is a losing proposition. Since we met over 25 years ago I can’t remember doing it even once. But throwing caution to the wind, here goes: Larry makes a good case that avoiding a deep recession in the United States requires policy intervention. Here I agree. Forecasts for a mere stalling of American growth implicitly assume that there will be either a fiscal or monetary response, or both.
But when it comes to the use of fiscal policy as a stabilization tool, I part company with Summers. My view is that short-term stabilization – insuring high, stable growth combined with low, stable inflation – should be the mandate of monetary policymakers. Government revenue and expenditure policies should be focused on providing the foundations for maximum sustainable growth.
As always, Summers’s argument is constructed very carefully and is based on solid economics. He is clear to enunciate what we might call the three “T’s” of fiscal stabilization policy: Timely, Targeted, and Temporary. This is solid economics. For better or worse, however, economists do not run fiscal policy; politicians do. Can we really expect politicians to follow the three T’s? I doubt it. Let me explain why.
1. Timely: If there is going to be a real recession in the United States this year, my strong suspicion is that it has started already. Since WWII, American recessions have averaged less than 10 months in length, with the longest ones (1973-75 and 1981-82) going on for 16 months. That means that we can expect the recession of 2008 (if there is one) to be completed before the end of this calendar year. Can a tax or expenditure change really be written, enacted, and put into effect in this amount of time? And even if new legislation were to become a reality by the summer, would it have a fast enough general economic impact? I guess it’s possible for the US Congress to create a program that sends people checks during the summer – just in time for the fall election – but I doubt it.
2. Targeted: This is my biggest problem with using fiscal policy as a short-term stabilization tool. Economists do not write economic stimulus packages, politicians do. And fiscal stimulus is one place where economics and politics collide. Economists prefer policies that focus attention on getting a few important people to do something they were not planning to do while avoiding paying for others to do what they would have done anyway. Temporary incentives to spur investment and income tax reductions for the less well-off who will spend what they get are good examples. Politicians, by contrast, look for programs that reward the largest number of people possible in order to win support and ensure re-election. In economists’ jargon, efficient tax policy is about having an impact on marginal actors; politicians like to reward infra-marginal actors.
3. Temporary: Again, Larry Summers is right that a well-designed fiscal stabilization policy should be temporary. But in the current environment, this again puts economics and politics on a collision course. The rhetoric of the current US presidential campaign suggests that many politicians view allowing temporary tax cuts to expire is the equivalent of implementing a tax increase. And for an individual looking at their weekly or monthly paycheck, this is correct. When a temporary tax cut expires, take-home pay declines. So, while the current Congress might write legislation that is explicitly temporary, future Congresses are very likely to extend the program when expiration looms.
My conclusion is that I would certainly sign up to support any fiscal stabilization program that Larry Summers were to write. Unfortunately, though, supporting fiscal policy as a tool for short-term stabilization means signing up for a program written by a Congress that can commit future Congresses not to extend actions intended to be temporary. On a practical level, such proposals will almost always fail on all three T’s. Maybe I’m being too cynical, but I would rather just leave the Federal Reserve in battling the recession threat.
Posted by: Stephen G. Cecchetti | January 9th, 2008 at 1:09 pm | Report this commentWillem Buiter: Larry Summer wants a tax cut for the US of between $50bn and $75bn. Robert Rubin, the former US Treasury secretary, wants a fiscal stimulus worth $100bn. Who bids more? And on top of this, the chairman of the Federal Reserve Board has declared (using either the royal ‘we’ or speaking for the FOMC): “We stand ready to take substantive additional action as needed to support growth and to provide additional insurance against downside risks.”
I consider further policies to stimulate demand in the US economy undesirable. The US needs a fall in domestic absorption (the sum of private consumption, private investment and government spending on goods and services, or ‘exhaustive’ public spending) to support a lasting depreciation of the US real exchange rate. Such an increase in the relative price of traded to non-traded goods is in turn required to reduce the US trade deficit to sustainable levels, say by a permanent three percentage points of GDP.
This reduction in domestic consumption ought to come through a reduction in private consumption. Public spending on goods and services in the US is already low by international standards. Underfunded public services and substandard infrastructure also support the view that exhaustive public spending should not be cut. US private investment rates are not particularly high, either by historical or by international standards. There is also the need to invest on a large scale in energy security, energy efficiency and other green ventures. That leaves private consumption. US private saving rates are far too low, so lower private consumption is the obvious way to support a reduction in the trade surplus.
Larry responds to any sign that private consumption may be doing at last what it ought to have done a long time ago, that is, decline, by suggesting monetary and or fiscal measures to reverse this decline. This is perverse. The fall in private consumption should be welcomed, not fought.
Would the proposed tax cut actually boost private consumption materially? First, the amounts proposed are tiny. US GDP is around $14,000bn. The $50bn-$75bn proposed by Larry would be 0.36 per cent to 0.54 per cent of GDP. Rubin’s proposal amounts to all of 0.67 per cent of GDP. By no means all of these tax cuts would end up with liquidity-constrained households. Of the part that does, the combined marginal tax and benefit-withdrawal leakage and the marginal import leakage (plus any marginal saving leakage the liquidity-constrained consumers may possess) make for a smallish Keynesian multiplier. So any stimulus would be small. A good thing from my perspective but a bad thing from Larry’s and Robert Rubin’s.
And that assumes away both the “inside lags” or policy formulation, adoption and implementation lags, and the “outside lags” between the implementation of the tax cut and its effects on spending, production and employment. These lags are long, variable and uncertain. They are the reason discretionary fiscal policy to fine-tune the business cycle has been abandoned in most of the thinking world. If Larry’s or Rubin’s proposal were to blunder ahead, it would in all likelihood end up delivering a modest boost to demand and output sometime well into the next upswing of economic activity in the US, around the middle of 2009.
Monetary policy also works with long, variable and uncertain lags, although actions to smooth disorderly financial markets and to ease the credit crunch through expanded open market operations, easier collateral requirements and more relaxed access terms to the discount window, may have their impact a lot faster than the interest rate cuts that Bernanke more than hinted at.
The same arguments against measures to boost domestic demand I made against fiscal policy also apply to monetary policy, although monetary policy is more likely to be effective. It is not the mandate of the Fed to boost demand to levels that imply an unsustainable external balance. The Fed’s poor recent record on inflation and the combined further threats to price stability posed by high oil prices and elevated inflation expectations would appear to mandate an end to rate cuts for the time being. A significant slowdown in the US, perhaps even a mild recession, is necessary to restore sustainable national saving rates. Why wait?
Posted by: Willem H. Buiter | January 10th, 2008 at 9:35 pm | Report this commentLawrence Summers: Sorry for delay in responding. It does appear that these arguments are having real impact on US policy so the issues raised are important.
1) it would be best as Martin Weale implies for fiscal stimulus to be offset by deficit reduction actions in the outyears. But even if this is not done the burden of an extra say 8 billion a year in interest from$150 billion in stimulus does not seem high. In the long run the right assumption is of normal employment so aggregate demand impacts do not arise.
2)Steve Ceccetti is right on the importance of timely, targetted and temporary. Listening to the debate on the Hill right now I think he looks wrong in his cynicism about the political process. It may be that negotiations will bog down but as of now both the congressional democrats and the president’s proposals look timely targetted and temporary though I think the targetting achieved through refundability in the congressional proposals is far better on both impact and moral grounds.
Posted by: lawrence summers | January 21st, 2008 at 5:31 am | Report this comment3) Willem’s mentor Jim Tobin would I suspect be appalled to see his protege endorse the doctrine of “catharic recession”. I see no reason why an increase in US saving has to happen with so much speed that it causes a recession. With the current state of the financial system a failure of policy authorities to act boldly runs great risks in my view of vicious cycle of credit problems followed by economic decline which exacerbates the credit problems and so forth. I have in light of events and some of the considerations Willem adduces come to believe as illustrated in my recent congressional testimony that somewhat larger fiscal stimulus probably is a good idea.