Saturday, January 12, 2008

Can Fiscal Stimulus Save the U.S. Economy?

More and more people realize that the Fed won't be able to stop the coming recession, although that isn't because the rate cuts is "too little, too late" as Nouriel Roubini argues (That would have implied that earlier, more agressive cuts would have saved the day), but because the rate cuts will only serve to push up inflation at this point. It won't boost the economy, and certainly not in a quantity sufficient to prevent continued economic contraction.

So, instead a lot of politicians and pundits argue for some form of fiscal action, including Hillary Clinton, President Bush (although that is only a rumour)and Larry Kudlow.

Can that save the economy? The answer is that it will be too late to prevent a recession as the recession likely started in the fourth quarter, and fiscal action will at earliest provide a boost in the second quarter, and probably not before the third quarter, making it too late prevent two quarters of contraction even if it is implemented in the second quarter. And it will probably not be implemented that soon.

Whether the fiscal action when it comes will provide a boost depends largely on what kind of fiscal action it is. In order for it to provide a meaningful boost to the economy, it need to come in the form of reductions in marginal tax rates. Here I for once completely agree with Larry Kudlow. In that case, the cuts will boost not only demand but also supply and thus raise growth.

But while most Republican presidential candidates now propose plans featuring marginal tax rate reductions, these plans unfortunately have virtually no chance of getting passed considering the Democratic control of Congress.

However, the plans proposed by Hillary Clinton and the one that reportedly will soon be proposed by Bush will only boost demand temporarily and will in fact lower supply and thus likely reduce long term growth.

While Bush perhaps would have wanted to cut marginal tax rates, he seem to have given up on this, knowing that the Democratic Congress would never agree to it. Bush's plan will instead reportedly be about so-called "tax rebates" to the middle class. However, if, as I suspect, low-income people who don't pay any federal income tax get the rebate too, then it will be a tax rebate in name only. In practice, it will be a form of general transfer payment. But Republicans will still want to call it a "tax rebate" because it sounds better with tax cuts than spending increases. This plan will not boost supply. In fact, it will likely reduce it, particularly if they try to exclude rich people from it. That would create incentive problems at the threshold and that way reduce supply. Moreover, the so-called income effect will mean that even if all people receive the rebate, supply would still be reduced.

With increased demand and reduced supply, the main effect of this will simply be to increase price inflation, as if the Fed weren't already doing enough to increase it.

Hillary Clinton's plan is of course even worse. In addition to supporting a "tax rebate" similar to the one Bush will propose, she wants to increase spending by $70 billion through various forms of government hand-outs to groups she deem worthy of getting it. The effect of this will largely be similar to the effects of the Bush plan. Namely too boost demand and reduce supply, and so increase inflation, but not growth. And the negative incentive effects in the spending increase part of the plan will come from the fact that only low income will be eligible for it.

So, in conclusion. Fiscal action will come too late to prevent a recession. It could however shorten and make it milder it if it is designed the right way. But the way it seems likely to be designed it will mainly simply act to increase inflation and the budget deficit.


Blogger The Rogue Scholar said...

If fiscal action is too late and wont really delay the impending recession--what will? What can people in all walks of life do to alleviate the damage? I don't know much about politics or economics, besides that WWII more or less saved the US from the great depression. Since the states is already at war, what kind of plan would actually prove to be successful?

8:46 PM  

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