Monday, September 6, 2010

Is it time for more stimulus?

With the economy in a rut President Obama has started selling a second economic stimulus package. I have mixed emotions over another package (here is a good dialogue on the debate). When the economy hits a downturn the federal government feels complied to act. This action can be through added government spending, tax credits, or reductions in tax rates.

It is important to differentiate between tax credits and tax rates. Tax credits are one time payments to an individual or household, these included the first time home buyer credit, temporary exclusions to the alternative minimum tax, and lump sum checks handed out in the summer of 2008. Reduction in tax rates can include reductions in the personal income tax rate (like we had in 2001) and corporate income taxes.  Few economists questioned the need for a stimulus package, but there was plenty of debate over the size and make up of the bill. Should the bill be $500 billion or $2 trillion? Should we target government spending or tax cuts? When the government decided it was time for a stimulus package, they passed the American Reinvestment and Recovery Act. The bill added over $800 billion in government spending and tax cuts which appeased some politicians but angered nearly every economist.

Economic research shows government spending on infrastructure and state aid (for unemployment) and reductions in the tax rates have the largest multiplier effect. Unfortunately, political pressure forced the bill to abandon nearly $400 billion earmarked for infrastructure projects and placed into one time tax cuts. We essentially took money out of programs that would have helped create jobs, passed them along to individuals who saved the money. In times of economic slowdowns added income is saved. Normally this is not all bad, added savings gets funneled into banks and in time loaned out. But because of large loan losses in real estate banks decided to hoard cash. Tax cuts had little economic impact. (The CBO confirms this in their quarterly updates of the ARRA)

A better bill would have done four things. First, a large portion of the stimulus should have gone to upgrading infrastructure (roads, bridges, hospitals, schools, energy grid, air traffic control) that is vital to economic growth. Further, these projects would have created jobs for those in the manufacturing and construction industry. Second, the government should have addressed the expiring Bush tax cuts. Although I think the tax cuts in 2001 were not very effective in helping the economy recover from the recession back then and further worsened our government debt letting them expire at the end of 2010 will greatly hamper any recovery we maybe experiencing. Third, the stimulus package should have provided ample aid to states. Again multiplier estimates show unemployment compensation has one of the largest stimulus effects. Finally the stimulus package would have included money to help struggling homeowners. There are a large number of homeowners who did things right and have jobs, but find themselves underwater in their mortgage. Imagine buying a $300,000 home and putting $30,000 or $60,000 down to find yourself living in a home worth $150,000. You did nothing wrong, the government wanted everyone to be a homeowner and live the American Dream. Why are we punishing individuals that are doing it the right way? The government needed to help these homeowners restructure their loans which would have provided badly need stability to housing prices. In the end this bill would have cost significantly more, probably in the $1.5-2 trillion dollar range (nearly half would be from the extension of the tax cuts), but we would address a lot of future uncertainty back in 2009. As it stands we are left doing a patchwork of bills that will likely cost more than $2 trillion.

(One thing I didn't address was the tax credits for developing alternative energies. I think a more direct approach would be to tax dirty energies directly and let the market develop sustainable alternative energies. I will talk about this more in a later post.) 

Now the government is wanting to pass another bill. Although this bill sounds like it has some good intentions, it is hard to say what the bill will look like after it goes through the political process. Additionally, we have to ask ourselves if we can afford another bill. Right now the patchwork process is not helping anyone, adding another $100 billion in spending will likely have little to no economic impact in the short run. At the same time I don't think we can afford a $1 trillion package that is similar in make up to the ARRA. This really puts the economy and politicians at a crossroads.

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