The Stimulus Debate: A Medium Term View

It seems that everyone is now weighing in on the stimulus package. And with good reason. As it exists now the assortment of bits and pieces included in the plan represent a mixture of sensible immediately effective expenditure, along with what appears to be a wish list of projects that the Democrats in the House of Representatives couldn’t figure out how to put elsewhere. Even more importantly the discussion is shifting towards the long term impact of debt being issued to pay for the stimulus. Here’s an interesting take on this latter subject by Jeffrey Sachs at Columbia: FT.com / Comment / Opinion – The stimulus is a fiscal straitjacket

First of all let’s get beyond the need for a stimulus. I must admit that the Senate Republicans are beginning to look a little silly in their steadfast objection to any kind of program. They are digging their heels in along firm partisan lines and holding to the old Reagan party line that a few well aimed tax cuts are all we need and that anything beyond this is ‘socialism’.

Sorry but that’s not too helpful.

As I have said here before tax cuts are very inefficient ways to stimulate an economy as poor as ours. The effect of a dollar’s worth of tax cuts is less than two thirds the impact of a sensibly aimed spending plan, and the fiscal burden to future taxpayers is the same. In many ways the current argument put forward by the Senate Republicans shows how hard it is for them to absorb the extent of their recent repudiation by the electorate. After all economic policy has had a distinctly right of center perspective for thirty years. The current crisis is a result of the over zealous application of that perspective.

It may be that the House Democrats included too many ‘pinata’ stuffers [to use Sach’s words] but a little constructive opposition would, and could, have dealt with that. Instead we have partisan bickering. So we are most likely going to suffer through an unnecessary period of confusion while the Senate looks for a compromise.

That’s fine as long as the result is not the inclusion of any more tax cuts. There shouldn’t be any in the first place!

Second, and I think the more interesting contribution Sachs makes, is that the stimulus package needs to be set in a medium or longer term context. The Federal budget is already a shambles. We are facing large structural deficits resulting from the excessive tax cuts of 2001 and 2002. Those tax cuts failed to jump start the economy and have left us with minimal fiscal wiggle room. Ideally the budget would have been in better shape than it is to provide a basis for stimulus. Instead we start from a very weak position.

So on top of the current deficits we now have to pile a massive load of new debt. Not just the stimulus package but also the bank bailout money and any further aid we might need next year as well. The upshot of this is a rapidly deteriorating fiscal balance, and a corresponding rapid rise in funding costs.

One of the great advantages America has had since World War II is that its debt has been bought by investors around the world who regard the American economy as the world’s safest. This has enabled a flow of funds into America despite near continuous trade and Federal deficits. Dumping a ton of new debt onto those same investors places a huge strain on their willingness to keep buying. No one is suggesting, yet, that foreign investors will flee American debt, but the cost to attract sufficient money will surely rise. That means higher interest rates here in America.

Not only this, but the extent of future deficits will be catapulted into the dizzying heights of the early 1950’s and will cramp any attempt to deal with other structural issues like health care. Remember that the larger threat to our fiscal soundness is going to come from health care costs, not from retirement or savings problems. Health care is projected to consume nearly 20% or all our wealth in a few years. That leaves insufficient to maintain or sustain our productivity and wealth generation. The health care burden is an existential threat to our budget, but we are now being forced to spend our ammunition on more short term issues.

So Sachs sensibly points out that we need to have a plan to rein those deficits back in. And that means higher taxes at some point.

Naysayers of higher taxes will argue that this is exactly why we cannot afford a stimulus. But the better point is that we cannot afford to do nothing. At the same time we have to assume that the stimulus will work and that we are then going to have to deal with the consequences of our immediate actions. So, unfortunately, we have to plan for fiscal restraint in the future or for better financing of Federal actions.

It bears repeating that we fell into this hole with our eyes wide open. The Federal budget has been bleeding red ink for the last eight years. At no time was there a serious effort to get our fiscal house in order and return us to the surplus of the late Clinton administration. I do not laud Clinton: his surpluses were an unforeseen byproduct of the ‘dotcom’ bubble. They were not planned, except that Clinton did raise taxes, despite which the economy boomed. But accidental or not, the surpluses were there to be hoarded.

Unfortunately since then we have squandered that advantage and generated nothing in return for the waste except the real estate bubble.

So, as the debate over the exact content of the stimulus package rages we all need to keep a firm eye on fiscal policy out a year or two. A strategy needs to be set that provides a context of fiscal balance in which private business and consumers can invest and save confidently.

After all the whole objective of the stimulus is to solve our problems, not simply to punt them into the future.

Addendum:

Elsewhere today Paul Krugman hammered away at the apparent resistance to nationalization of our failing banks. Here’s his column: Krugman on Bailouts, Feb 2nd

The essential point here is the cost of nationalization. We should focus on what we could buy for the money we are handing over. The market cost of Citibank and Bank of America combined is around $50 billion. That means we could buy them lock stock and barrel for less than half of the money we are using as a guarantee. As Krugman argues those guarantees are essentially a gift to the bank’s shareholders. So instead of being forced to accept their proper equity risk of both gains and losses, those shareholders only get gains. We taxpayers get stuck with any losses. That’s called lemon socialism. And like most lemons it leaves a sour taste behind.

Nationalization is the way to go!