Policy Court

Opinion of the Court, delivered by David Lamb, signed by William Leich:

It’s what you might call a “perfect storm.”  In the midst of the worst recession in seven decades, America is also experiencing the most acute shovel shortage in its history.  At least that’s what some might have concluded in the seven weeks after President Obama signed the American Recovery and Reinvestment Act (ARRA)—a bill funding $787 billion of welfare provisions and “shovel-ready” infrastructure projects—and before any such construction projects began.

During those seven weeks, three things happened.  Unemployment jumped ten percent, GDP growth fell to lowest rate since the Great Depression, and, most troubling, Americans rediscovered the power of rhetoric; that “shovel-ready” was a euphemism, and a dangerously shortsighted one at that.  That getting the “shovels” was the hard part.

The truth is that any federal initiative involving states, including the ARRA which gives states money to finance construction projects, takes months to get money in the hands of Americans.  And that’s the root of economists’ debate over how to best legislate fiscal stimulus.

Since people tend to spend a larger fraction of money when its in the form of a reliable monthly paycheck rather than a onetime bonus, hiring new workers to complete projects should, at least in pure economic theory, provide a larger stimulus than distributing the same amount of money as tax rebates.  However the length of time it takes governments to plan projects, hire workers, and begin work may negate the stimulus advantage of employment programs.  After all, $200 billion in stimulus when the economy is risking recession will probably better excite growth than will $400 billion in stimulus two months later, when the economy has already entered recession.

In the past eighteen months both methods have been tried—tax rebates by President Bush and government employment by Mr Obama—and ultimately both have failed.

Although Mr Bush’s stimulus was an admirable, albeit cautious, attempt to spur growth it was far too small to avert the coming recession, and it was made worse by its small multiplier; since people’s marginal propensity to consume (MPC) falls during times of economic uncertainty, even less of the stimulus circulated into the economy than would with rebate checks in a typical economic environment.

Mr Obama’s stimulus was a more informed one.  Having already seen the low MPC of Mr Bush’s program, Mr Obama attempted to incite more spending by distributing the stimulus money to workers in the form of paychecks.  While this method will probably yield a higher MPC and therefore have a larger multiplier, it works too slowly to change the economy‘s course.  Five months into the stimulus program, less than one-quarter of the money has been spent.

And yet politicians around the country are calling for another stimulus.  Before following them, Americans ought to examine the lessons of the last two.

The first stimulus proved that wealth distributed without consumer confidence won’t be spent, and given that consumer confidence remains below 50%, another round of rebate checks would provide very little stimulus.  The second stimulus proved that Congress and state governments aren’t capable of implementing infrastructure projects quickly enough stimulate the economy; by the time states pay money to workers the economy has deviated from the situation the stimulus was designed to address.  If the economy worsens, this will make the stimulus too small to take care of the lack of domestic consumption; if the economy improves, this could make the stimulus larger than necessary, eventually leading to inflation.

If Congress passes a new stimulus package aimed, like the last one, at increasing government employment it could have dangerous consequences, in part because any such stimulus will continue through 2013 and possibly into 2014.  Assuming the current economic outlook—that the domestic economy will begin to grow and unemployment fall in coming  years—the velocity of money will accelerate along with rising consumer confidence.  Once the velocity of money accelerates, the effects of deficit spending will reveal themselves.

Consider the ways in which the Federal Reserve funded the current stimulus—selling Treasuries and quantitative easing, or ‘printing money.’  Both of these are methods of increasing the money supply.  Since consumers tend to save any money given to them during times of economic uncertainty, increasing the money supply rarely leads to inflation when consumer confidence is low.  When consumers regain their confidence, however, they begin to spend the money saved during periods of uncertainty, and when this happens on a macro-economic level too many dollars chase too few goods.  Inflation develops.

But selling Treasuries can also hurt the economy.  Although selling Treasury securities doesn’t carry as high an inflation risk as quantitative easing, it crowds out private lending and investment since money that people invest in Treasuries might otherwise be lent to a non-government debtors or invested in private industries.  A long-term fall in private investment will increase the portion of U.S. GDP that’s composed of government programs.  For Americans this means that too much stimulus for too long a period could ultimately shrink the private sector and foster a nation addicted to government spending.

So what’s to be done?  First, Americans ought to recognize that fiscal stimulus of any breed is a dangerous proposition—an action often more economically damaging than healing particularly when it’s unnecessary or financed through unsustainable means.  Furthermore, Americans should understand that GDP growth led by stimulus is only a temporary economic fix.  Not only does it compromise private industries’ growth potential, but it also breaks down at the end of stimulus spending.  That said, stimulus can be a necessary evil, and when pursued ought to be implemented correctly.

If Mr Obama and his Congress decide to pass another round of stimulus, they should recognize that the stimulating benefits of the ARRA are only beginning, and any similarly structured employment program will have lagging effects when it comes to decreasing unemployment.  Thus any additional stimulus should be in the form of a tax rebate, ensuring a quick, visible spending boost.  This program can be acted on once consumer confidence rises above sixty percent, indicating that the spending will have a larger multiplier.  After all, growth only takes place when rebate recipients actually spend the money they receive.

Yes, we must be cautious, but we can’t lie paralyzed, waiting for the next shovel shipment.

Nicole Adams, dissenting:

Given the number of calls in Washington for a “second stimulus” one might think Dr. John M. Keynes was our president.  That he’s not is one of two interesting observations; the other is that Americans are so eager to forget Mr Bush that they don’t seem to tally his Economic Stimulus Act in their stimulus count.

But perhaps that’s because it wasn’t a stimulus.

As a result of a remarkably high savings rate Americans only spend around forty percent of  their tax rebates.  And with most of the stimulus money being saved or used to repay preexisting debts, the stimulus bill seemed to have little effect on the economy—although the economy expanded by .9% and 1.9% in the two quarters following the package, growth shrank to .3% in the next quarter.  Rising consumer confidence, which the majority references as an indication that tax rebates might become effective, does not guarantee that people will spend  any more of a second round of rebate checks; new rebates could be equally ineffective.

On the other hand, Mr Obama’s stimulus has proved successful.  The beginning of ARRA spending has coincided with a fall in new unemployment claims and an increase in quarterly GDP numbers.  Indeed, employing new workers in stimulus projects takes longer than it ought to, but it does yield a higher MPC, and, in turn, a larger simulative effect.

To the extent that there will be another fiscal stimulus, it needs to employ people in long-term jobs with reliable paychecks.  Particularly since deficit spending has such inflationary potential (outlined in the majority’s opinion), any spending should carry the large multiplier that comes hand-in-hand with employment-based stimulus.

If that takes months to plan, so be it.