In 2009, GDP in the U.S. is expected to be about $900 billion below its normal growth path. The ideal stimulus would have most of its effect in 2009 and would close a reasonable fraction of that gap. We see five general strategies for stimulus:
- Further expansion by the Fed
- Income tax cuts with rebates, as earlier this year
- Tax cuts that reduce the prices of consumer goods temporarily
- Tax cuts that reduce the cost of labor to businesses
- Increase in purchases of goods and services by state and local governments
Expansion by the Fed
The Fed controls short-term interest rates by adjusting the quantity of reserves it supplies to the banking system. To lower rates, the Fed buys securities and pays for them with reserves, thus increasing the total quantity of reserves at banks. Banks then try to alter their portfolios to move out of reserves and into higher-paying assets, including loans. The increased demand for these assets reduces their interest rates and stimulates investment and consumer spending. The Fed and other central banks have been using procedures based on the principle that the central bank can adjust overall conditions in an economy to keep it on an even keel, with low stable inflation and relatively mild booms and busts. The principle has worked well in most countries over the past 25 years. The main exception was Japan in the 1990s, where the principle broke down in the same way as in the U.S. today.
The logic above indicates that thre is no scope for further expansion in this way. The reason is that the Fed pays 1 percent interest on reserves, which is above the rates that banks can obtain from other similarly safe short-term investments. An expansion of reserves leaves banks with more of an asset they crave because banks prefer reserves at 1 percent to loans at a higher rate; it does not set in motion any process that would result in expanded lending and lower rates for business and consumer borrowers. For reasons we are unable to explain, the Fed raised the rate it pays on reserves recently. The standard analysis of the payment of interest on reserves by central banks makes it clear that increases in the attractiveness of reserves are contractionary. Because the Fed has also increased the quantity of reserves enormously over the same period, we are not saying that the net effect was contractionary, only that the increase in the reserve interest rate went in the wrong direction. (We should add, but only in parentheses, that we support paying interest on reserves at a rate somewhat below other safe rates as a general principle of central banking in normal times.)
Although we believe that restoring the Fed’s interest rate paid on reserves to its traditional level of zero would be a good idea as a temporary stimulus, we do not believe that it would have much expansionary effect in an economy where safe short-term rates are already very close to zero
Fed Chairman Ben Bernanke gave a speech on December 1 explaining the Fed’s plans for further expansion. Oddly, he explained the new policy of paying 1 percent interest on reserves as a way of elevating short-term rates up to the Fed’s target level of 1 percent. This amounts to a confession of the contractionary effect of the reserve interest policy. More importantly, he stated that the Fed might start buying longer-term Treasury securities. He did not describe how the Fed would pay for them. If the Fed expands reserves further, it would be taking the long-term Treasuries out of the market and replacing them with short-term federal debt, namely reserves. If the Fed and the Treasury cooperated, as they have for many other asset purchase and lending by the Fed, the Treasury would issue new debt, place the proceeds in its Fed account, and the Fed would use the funds to buy the long-term Treasuries. In any case, the effect would be the same as if the Treasury by itself retired long-term debt and replaced it with short-term debt. There is much to be said for this policy. Based on current interest rates, it would give investors what they want, more short-term Treasury debt, for which they require interest rates close to zero, and less long-term, for which interest rates are rather higher. The policy would probably save the taxpayers a lot of money. But nobody thinks that it would have much effect on interest rates. Notice that any downward effect on long-term rates would be offset by an upward effect on short-term rates. The federal government needs better coordination on this issue. At the same time that Bernanke said the Fed would buy long-term Treasury bonds and finance the purchase with short-term federal debt, the Treasury announced that it would sell 10-year bonds in the coming week. How much easier for the Treasury not to issue those bonds and to issue correspondingly more short-term debt!
Although Chairman Bernanke did not use the term, the policy of substituting short- for long-term debt through the central bank is called “quantitative easing.” There are good reasons to go ahead with the policy, but it seems quite unlikely to give much net stimulus to the economy.
Income tax cuts with rebates
Last summer, consumers enjoyed a moderate tax cut paid out to most people as an immediate rebate. The experience demonstrated that the federal government is capable of a speedy fiscal action, but it also showed that consumers don’t go out and spend rebate money when they receive it. Instead, just as the received theory of consumption predicts, consumers smooth the spending increase, reserving most of it for future consumption, by saving it or using it to pay down debt. It raises their standard of living more than their immediate spending. It’s good news that most Americans do not have their backs to the wall financially, but it makes an income- tax rebate ineffective as a stimulus concentrated at the time most needed. Rather, rebates result in consumption incrases spread well into the future. The following graph, created by John Taylor in a recent op-ed, shows what happened last summer:
Tax cuts that reduce the prices of consumer goods temporarily
The most desirable time-concentrated stimulus would raise consumer spending during 2009 without changing it much in future years. The government lacks the power to compel consumers to spend more, so it must rely on a incentives. Britain has just cut its sales tax (VAT) by 2.5 percentage points for the next 13 months to provide a small incentive concentrated in the period when the recession is expected to be most severe.
An important article in the American Economic Review in September 1986 by James Poterba, Julio Rotemberg, and Lawrence Summers demonstrated the high potency of a sales-tax cut as a stimulus. They studied the reverse situation, where a big increase in the British sales tax caused a severe recession.
Because the U.S. lacks a national sales tax or VAT, the logistics of a temporary consumption subsidy would be a little more complicated. The Kotlikoff-Leamer proposal would operate through state sales taxes. All but a few small states have sales taxes–the exceptions are Alaska, Delaware, Montana, New Hampshire and Oregon. Under the plan, the federal government would buy out sales taxes for the period of the needed stimulus, say the year 2009. The states without sales taxes or with low sales taxes would receive comparable federal funds to cut other types of taxes. Sales tax revenue is currently $440 billion per year, so the proposal would cost around half of what the Obama administration appears to be planning to spend on stimulus.
The plan needs to take effect soon after it is announced. The announcement will cause consumers to defer purchases until the tax cut takes effect. Similalry, toward the end, they will accelerate purchases and then buy less after the sales tax resumes. Phasing in the resumption might be a good idea.
Critics of consumer subsidies point out that some consumer goods are imported, so the stimulus benefits the producing country, not the U.S. Often that country is said to be China, though Japan is also a major source because of its dominance of the world car market. Given that the U.S. has pledged to engage in joint stimulus with its major trading partners, including China, the stimulus to the import source countries is entirely appropriate. But imports of consumer goods are only 18 percent of consumer spending on goods (excluding services), so the leakage into import stimulus is not a major consideration anyway.
We feel that a temporary elimination or reduction in sales taxes would be an effective stimulus to consumer spending, concentrated in the period when it is needed most and phased out later. It should be part of the stimulus plan.
Tax cuts to reduce the cost of labor
If the objective of a stimulus is to lift employment, why not operate directly on that margin, by lowering the cost of labor to employers? The federal government has a completely straightforward way to do this, because it levies a 7.65 percent rate on payrolls for virtually all employment. The tax yields just under $500 billion per year. Elimination of the tax for the year 2009 would provide a substantial incentive to employment concentrated during the year. As with the temporary removal of sales taxes, both anticipation effects and ending effects would occur.
One problem with the employment stimulus is that the funds go in the first instance to the owners of businesses and not to consumers generally. Ownership is highly concentrated in the U.S., so the distribution of the immediate benefits is skewed. By contrast, the consumer rebate can be directed to lower-income consumers because it is part of the income tax and the sales tax reduction at least is in proportion to purchases rather than business ownership.
If the response of employment to the payroll tax cut were strong enough, its contribution to the incomes of workers might be enough to overcome the disadvantage of its business-subsidy character. If business hiring responded aggressively to the subsidy, profits would decline as business put more output on the market and the winners would be workers rather than owners. Everything turns on the strength of the employment effect. But, alas, the strength of the effect depends on one of the most unsettled issues in macroeconomics, the role of supply increases in raising the quantity of output produced in the short run. One line of thought treats this issue just as one would in a standard market, where an increase in supply raises the quantity sold by the principles of the standard supply-and-demand diagram of elementary economics. Another line believes that special principles operate in the short run that makes demand the controlling factor–an increase in supply has little effect on the quantity sold in the short run in this view. We are among the few economists who regard this issue as still open. Most are doctrinaire believers in one or the other view. We are sufficiently concerned about the potential validity of the demand-limiting view that we are reluctant to state with confidence that a supply-based stimulus such as the payroll-tax suspension would have a large effect on employment.
Increase in construction spending by state and local governments
President-elect Obama supports federal funds for state and local construction projects as an element of a stimulus package. Increases in spending are plainly attractive because the response of state and local governments to the federal willingness to support projects is likely to be enthusiastic. Government units have backlogs of projects waiting for funding. The questions are how big are the backlogs, how quickly spending can accelerate, and how beneficial are the projects.
State and local construction spending is currently $300 billion per year. The Obama team is hard at work trying to find out how much of a backlog is “shovel-ready” in the President-elect’s neat phrase. We are not aware of any easy source for this information.
Timing may be a problem, as it was in the old days when these kinds of projects were called public works. Complicated projects take time to ramp up to high spending and employment levels. Some interstate repairs can be executed in a year, as was the case in rebuilding the collapsed I-35 bridge in Minneapolis last year and in re-opening earthquake-damaged freeways in Los Angeles in 1994, while it took many years to reopen all the damaged roads in San Francisco after the 1989 earthquake.
The president-elect has also mentioned less conventional spending programs, including broadband facilities and online medical records facilities.
All of these proposals for stimulating state and local spending suffer from a common problem–they will end up generating employment for highly specialized businesses and workers, rather than stimulating economic activity more broadly. The consensus of macroeconomists across the spectrum is that a spending stimulus raises total spending by between 1.0 and 1.5 times the amount of the direct increase in spending. The follow-on or multiplier effects are between zero and half the driect increase in spending. Thus a program that funnels money to construction firms and their workers mainly raises their incomes and employment levels and has relatively little effect elsewhere. Rebuilding aging interstates and upgrading the energy efficiency of public buildings calls for highly specialized skills. A large-scale infrastructure program will drive up the profits of the limited number of firms capable of doing this type of work and drive up the wages of the skilled workers who know how to do the work.
It’s hard to imagine that a significant fraction of the large stimulus under consideration for 2009 will take the form of state and local construction and other infrastructure spending. We are hoping that discussion of stimulus will not become sidetracked over this part of the program and neglect the opportunities to stimulate consumer spending broadly without complicated, detailed, and time-consuming decisions.
Conclusions
We foresee a mixture of stimulus policies for the coming year. Monetary policy can only a small further contribution. Income-tax rebates seem to have little support and would probably have relatively small effects within the year, with undesirable continuing effects in later years. We are enthusiastic about removing sales taxes for the year and perhaps somewhat longer, with a phaseout. We are not sure that an employment stimulus from a reduced business payroll tax would raise employment enough to be a contender as a stimulus and to prevent the flowing through of the funds to business owners rather than workers. We believe that some federal subsidies to state and local spending would make sense, but are concerned that too large a program would result in stimulus continuing past the time when it would be needed and that it would create excessive rents for contractors and skilled workers. Thus the sales-tax buyout seems to be the best way to spend the bulk of the stimulus dollars.
Financial Crisis and Recession 