Stimulus Can Work, But Not During a Debt Crisis
Stimulus spending during a time of major national deficit does more harm than good
November 4, 2011
The degree to which stimulus spending "works" depends entirely on the broader economic circumstances and the policy objective. At its core, fiscal stimulus involves new deficit spending by the government to try and boost aggregate demand and near-term economic performance. But even this objective needs to be more clearly defined and there are three questions to keep in mind when examining the trade-offs of a new stimulus policy:
- What if stimulus boosts aggregate demand, but then the economy falls back to its old trend line for growth after it's withdrawn?
- What if stimulus boosts demand, but only at uneconomic rates—where a dollar spent nets less than (or only about) a dollar in new output?
- What if stimulus works only when consumers remain confident in their expectation that the government will not have to pursue offsetting tax increases in the future?
Unlike periods in U.S. history when the government's fiscal house was in order—and deficits were small and the total public debt burden was under control—the last few years have been marked by a flurry of seemingly unchecked deficit spending experiments. In fact, today's debate comes on the heels of enacted deficit-spending stimulus in 2008, 2009, and 2010.
But, is the U.S. fiscal picture really so dire that prioritizing near-term fiscal stimulus no longer makes sense? In 2011, the government is projected to run a $1.3 trillion deficit, which is roughly 8.5 percent of GDP and the third largest deficit over the past 65 years (eclipsed only by the deficits in 2009 and 2010). Debt as a percentage of GDP is now closing in on 70 percent having been closer to 40 percent before the financial crisis. By 2020, the U.S. debt-to-GDP ratio is projected to approach 90 percent. This trend matters. Professors Rogoff and Reinhart (of Harvard and the University of Maryland, respectively) have studied the link between a country's debt level and its economic growth and concluded that for countries above the 90 percent threshold, the average growth rate was about two percentage points lower than for countries under 30 percent.
With this backdrop, Americans now understand that further increasing deficits today to finance more near-term spending, or tax cuts, will almost surely require the government to raise taxes or cut benefits in the future. This partly explains why stimulus plans over the past few years have had diminishing returns. Stimulus in a rapidly contracting economy, like early 2009, was much less likely to do long-run damage than stimulus in 2010 or 2011 when many businesses were earning profits and hoarding cash.
To now achieve a true "reset" of American expectations—that might even allow for more stimulus—Congress needs to enact sufficient spending reductions and structural reforms set out over a 10 year window and at a measured pace. This is the best way for households and businesses to gain some confidence that the government will not pursue other (counter-balancing) changes in the future like increasing taxes on investment. Importantly, the process of enacting longer term reforms also presents the best opportunity for achieving the structural changes that can lead to more job creation and faster economic growth.
- Rick Newman: The Biggest Losers Under Obama's Debt-Cutting Plan
- Check out a roundup of editorial cartoons on the economy.
- Peter Roff: A Plan Better than Obama's to Create Jobs