Opportunities in smallcaps header image 2

Another stimulus package?

August 8th, 2008 · No Comments

There is talk of another stimulus package. Is fiscal policy the right tool to get the US out of it’s funk?

Here from well known economist Greg Mankiw:

  • My friend in the White House emails me his analysis of a possible second stimulus package:We are frequently asked whether there should be a “second stimulus” bill. Unfortunately, what is being considered on Capitol Hill is a very different animal from what we did earlier this year.

Well, this is what well known economist Martin Feldstein had to say about the previous one:

  • Congress enacted the tax rebate program earlier this year because it perceived a growing risk of recession. In addition, it feared monetary policy alone would not be effective because of the dysfunctional credit markets. As American taxpayers know, most of the rebate checks have now been mailed and cashed. Recent government statistics show that only between 10% and 20% of the rebate dollars were spent. The rebates added nearly $80 billion to the permanent national debt but less than $20 billion to consumer spending. This experience confirms earlier studies showing that one-time tax rebates are not a cost-effective way to increase economic activity.

But Mankiw disagrees:

  • We disagree with this analysis. First, we think the stimulus bang is bigger than $12 B. Prof. Feldstein assumes that the growth in consumer outlays would have been flat had there been no stimulus. He then observes that consumer outlays actually grew by $12 billion more from Q1 to Q2 than they did in the prior quarter, and attributes that to the stimulus. Many observers think that, without the stimulus, consumer outlays would have grown more slowly in Q2 than in Q1. If this is the case (and we believe it is), then the effect of the stimulus is bigger than $12 billion.
  • In addition, we have felt only part of the bang so far. The stimulus enacted in February will have ongoing impacts in the upcoming months. Almost all the cash to consumers is out the door, but the resulting boost in consumer spending has not yet reached its full effect. We anticipate that the past stimulus law is continuing to increase GDP in the 3rd quarter, with a diminishing amount in the 4th quarter of this year. Monetary policy works with an even “longer lag” – the evidence suggests that when the Fed cuts interest rates, it takes about a year for half of the economic effect to take hold. So there’s more bang left in the remainder of this year from past actions on both the fiscal and monetary sides.

Of course, it was Keynes who famously argued the case for government stimulus in the depth of the 1930s depression, and that is not in dispute here. Fiscal stimuli work, but how effective are they? Mankiw:

  • Also allowing people to keep more of their money for one year is better than not doing so at all, so the loss of government revenue is actually a good thing if that money stays in the hands of the taxpayers who earned it, even if we can only get Congress to agree to do that for one year. We agree with Marty that the stimulus would be more effective if we had been able to enact a permanent tax cut, rather than a temporary one. Legislative realities forced it to be temporary.

The last element has a whiff of one of the weirdest economic pieces of theory, the ‘Ricardian equivalence theorem‘.

This argues that rational agents (economic speak for consumers here) would not be swayed by lower taxes, because they would realize that these will increase the government deficit, and it would be only a matter of time before the government had to act on that, raising taxes again, so consumers will save the tax rebates now to be able to finance higher taxes in the future!

It’s complete baloney, of course, consumers are not nearly as rational an agent as this economic theory has it. If you disagree with that just answer the following question: Would you save all your tax rebate because you know that taxes would go up in the future again as they cause the Federal deficit to increase, sooner or later forcing higher taxes? Asking the question is answering it..

But there is something to be said for permanent tax cuts having a bigger impact than temporary ones, here Feldstein has a point.

And Mankiw doesn’t use the argument, but data from consumer credit at least indicate that the famous US consumer, that linch-pin of the world economy, hasn’t given up old habits:

  • June consumer credit rose $14.33 billion, or at a 6.7 percent annual rate, to $2.586 trillion, the Federal Reserve said. Analysts polled by Reuters were expecting a $6 billion rise. May was revised to a $8.05 billion increase from an originally reported $7.78 billion rise.

But there is a logical explanation for that:

  • U.S. consumers borrowed more than twice as much as economists forecast in June as the slump in real-estate prices prevented American homeowners from tapping into home-equity lines of credit.

So what do we have here? Because of the housing crisis, consumers can no longer treat their houses as depositless ATM’s and withdraw money at will from them. Faced with the choice of spending less or get other forms of credit, they apparently chose the latter.

That shows a rather big predilection for spending over saving, even in the rather bare economic conditions of today. We have a feeling that these tax rebates have worked rather better than Feldstein suggests..

But we have argued earlier that for stimuli package to work, it is best to give the biggest tax rebate (or cash advance or whatever form of financial assistance) to those people that will have the biggest propensities to spend. These are likely to be:

  • The poor and/or unemployed
  • State and municipal governments bound by requirements to balance their budgets
  • People on the verge of having their house reposessed.

It’s just a matter of the biggest bang for the buck. This is why those first tax cuts seven years ago were not particularly efficient in terms of economic stimulus, as they were concentrated on the rich and well off, who are least likely to spend a significant part of it…

Mankiw has a point also in that he argues that tax cuts act faster on the economy than increased government spending, but he sees a risk in the latter because it’s an election year..

Tags: The Markets