If you had quizzed economists on the topic a decade ago, most would have told you that passing legislation to stimulate the economy was pointless. Getting the timing right was too hard. Increasing the deficit could bring higher interest rates that would stifle growth. Besides, the Federal Reserve, with its legions of smart economists and ability to make quick changes in monetary policy, was in a far better position to battle downturns than Congress was.
Times sure have changed. Fiscal stimulus is Topic A in Washington. Congress is returning for a lame-duck session with plans to pass a spending bill in the $100 billion range. An even bigger effort is likely in January, when Barack Obama moves into the White House. And it's not just Washington: China has announced a $586 billion stimulus plan, although it's not clear how much of that will be new spending. Germany has approved $29 billion in spending and tax cuts. British Prime Minister Gordon Brown is expected to announce tax cuts soon.
The simple idea behind all these efforts is that consumers and businesses aren't spending enough to keep the economy growing; government either needs to tempt them into doing so with tax cuts or do the spending itself. In the U.S., many economists are urging a total stimulus of at least $300 billion, or 2% of GDP. A few say $500 billion or $600 billion makes more sense--and that's on top of the hundreds of billions already committed to bailing out financial institutions. Goldman Sachs chief U.S. economist Jan Hatzius, who is in the $500 billion camp, estimates that private spending will drop by at least 6% of GDP over the next year or two. To keep that retrenchment from yanking the economy downward into depression, government must step up.
At least that's the thinking. But remember, the thinking a decade ago was that stimulus was pointless. What changed?
First, the most extreme economic argument against temporary fiscal stimulus--that consumers and businesses would see through it and restrict spending to prepare for the tax increases or spending cuts to come--has lost almost all its adherents. Economists no longer believe humans are that farsighted.
Second, a stimulus package--the tax rebate of 2001--was widely credited with helping end that year's downturn. The good timing was in part luck; President Bush had been pushing for a tax cut whether there was a recession or not. But it showed that fiscal stimulus could work.
Finally, and most important, what we're facing now isn't your garden-variety recession. This downturn is likely to be deep, and the economy will probably remain weak for several years--meaning there isn't much cause to worry that stimulus would overheat an already strong recovery. Meanwhile, the Fed, which normally stimulates the economy via the financial system, is having trouble doing so because the financial system is broken. And the usual concern that government will crowd out private borrowers isn't an issue. "The government has a window in which it can borrow very aggressively," says Mark Zandi, chief economist at Moody's Economy.com "because no one else is borrowing."
The big question is what form the stimulus should take. Pretty much any kind can work--what finally put a definite end to the Great Depression was military spending in World War II. But some kinds are more effective than others. For the past eight years, tax cuts have been the favored means of pumping up the economy. There's much to be said for putting spending power in the hands of hundreds of millions of Americans rather than in those of a few bureaucrats, but there is a catch. People tend to save part of their tax rebates. In 2001 about two-thirds of the $38 billion mailed out to taxpayers was spent within six months. It looks as if the spending percentage will be smaller for this year's $95 billion in rebates.
Armed with this information and a few reasonable if not entirely uncontroversial assumptions about how the economy works, Zandi's firm has estimated the one-year impact on GDP of several stimulus proposals per dollar of spending or lost revenue; for example, a tax rebate like this summer's would generate $1.22 on the dollar. Extending unemployment benefits would bring in $1.63; infrastructure spending, $1.59; and a temporary increase in food-stamp benefits, $1.73. Making the Bush income tax cuts permanent would bring in just 31¢ on the dollar. So spending increases would seem to be in order. Bush has resisted that so far--and may continue to resist. In January that won't matter anymore. Then we get to find out if fiscal stimulus really can save us.