Is More Fiscal Stimulus Needed?

Uri Dadush, Director, International Economics Program, Carnegie Endowment for International Peace

Fiscal stimulus is neither as effective as its advocates claim nor as expensive as its opponents claim. According to the OECD and IMF, stimulus spending may only have prevented one-fifth of the 5 percentage point increase in unemployment during the crisis and accounted for one-fourth of the 7.5 percent drop in deficit-to-GDP ratios in advanced countries. Nevertheless, the decision of whether or not to continue fiscal stimulus should be based on three considerations:

1. The state of the global recovery. It is happening, but we are not out of the woods yet. The global economy has been growing for at least a year, but unemployment and excess capacity remain high, and private demand growth shows signs of slowing. Though emerging markets are still pulling world demand, Europe’s debt crisis poses a big threat.
2. The capacity of monetary policy to keep the recovery going. With inflation still subdued, monetary policy can remain expansionary for the foreseeable future. Its effectiveness will be undercut, however, if risk-appetites falter and lenders hoard cash. Furthermore, exclusive reliance on monetary policy may create problems later, especially in the overheating, fast-growing emerging markets.
3. Confidence that countries can repay their debt. Markets continue to let large advanced countries borrow at record-low interest rates despite the 20-30 percent of GDP increase in their debt levels. However, Greece is probably bankrupt, and Spain and other troubled economies in Europe are paying a premium of 150-200 basis points over German rates. These countries have no choice but to reduce their deficits quickly.

Countries that can afford to should continue fiscal stimulus until the private sector recovery is clearer. Among the G7, this group clearly includes the United States, Germany, France, and Canada, and may include Britain and Japan, but not Italy. Further fiscal stimulus is essential in Germany, where domestic demand is stagnant and exports are booming, putting even more pressure on the European periphery. Germany has too much at stake in the euro to pursue mercantilist policies. Booming China’s massive stimulus must be withdrawn but gradually and with care, given the international uncertainty.

Gary Burtless, Senior Fellow, Economic Studies, Brookings Institution

There is little doubt the stimulus measures taken by the Bush and Obama administrations in 2008 and 2009 were effective in preventing a worse slump. Automatic stabilization programs and the two stimulus packages helped limit the drop in disposable household incomes to just 1 or 2 percent. As a result, household consumption fell substantially less than it would have without any stimulus.

The long-term danger of fiscal stimulus is loss of confidence in government debt and sharply higher public and private borrowing costs. But the notion that we cannot increase the deficit in the short run while simultaneously reducing the long-term debt is dubious. Taking both kinds of actions would improve both the short-term and long-term economic outlook. The question is whether these actions together are politically achievable.

In the near term, the government should boost spending or keep taxes down in order to spur faster economic growth. While private sources of demand are very weak, judging by current interest rates on Treasury debt, both U.S. and overseas investors believe the U.S. government is highly creditworthy. This means there is still room for the government to borrow funds to relieve the unemployed and state governments, and invest in public infrastructure.

The U.S. government would strengthen its creditworthiness by simultaneously taking credible steps to reduce the long-term deficit. Most of that deficit growth is traceable to a single, widely recognized development: federal healthcare spending is growing much faster than the overall economy. To keep healthcare affordable long term, the country must reorganize insurance and care provision to reduce wasteful administrative spending and cost-ineffective care. The health reform law will curb some future cost growth, but Congress can and should take additional steps to cut future costs.

The situation in Europe is different. Many small countries with dubious credit records cannot add significantly to their public debt. But that is hardly the case for big countries with good borrowing records, including France, Germany, and Britain. If monetary policy alone does not push Europe toward faster economic growth, more stimulative fiscal policy may be needed.

Daniel Gros, Director, Centre for European Policy Studies

The public debate on fiscal policy’s future has degenerated into a shouting match between purported adepts of Herbert Hoover and irresponsible Keynesian spendthrifts. As usual, the reality is much more nuanced.

The chart below shows the basic facts about the change in the structural deficit (adjusted for the effect of the recession) for the United States, Britain, and the average for the three major euro area countries: Germany, France, and Italy.

Euro-area countries used fiscal stimulus somewhat less than the United States and Britain, in the sense that, on average, their structural deficits have increased only by about 2.5 percent of GDP since 2007, compared to the United States, which increased its structural deficit by more than 6 percentage points of GDP.  The chart shows that deficits will be reduced rather gradually in Europe, even taking into account the round of budget cuts announced in Europe after the euro crisis.

By contrast, the United States has a steeper trajectory of fiscal tightening, with the structural deficit projected to improve by almost 4 percentage points in only two years. U.S. growth is also projected to be above 3 percent in 2011 and 2012, higher than its average annual growth rate for the last decade. By this logic, there is no reason to postpone fiscal tightening.

Some argue that fiscal stimulus should continue to reduce unemployment, which is projected to remain above 9 percent. While this is much higher than the average U.S. unemployment rate over the last decade, it is probably also unavoidable if the United States is to transition to a less import-dependent growth model. Obama has set the goal of doubling U.S. exports in five years, but achieving this goal requires doubling manufacturing capacity, which cannot happen overnight. No amount of fiscal stimulus can create the new jobs in manufacturing needed to underpin an export-led recovery. It is not possible, for instance, to employ jobless real estate agents in high-tech manufacturing.

Therefore, the reduction in fiscal stimulus already in place at varying speeds across the world’s major economies is appropriate.

Daniel Gros, Director, Centre for European Policy Studies

The public debate on fiscal policy’s future has degenerated into a shouting match between purported adepts of Herbert Hoover and irresponsible Keynesian spendthrifts. As usual, the reality is much more nuanced.

The chart below shows the basic facts about the change in the structural deficit (adjusted for the effect of the recession) for the United States, Britain, and the average for the three major euro area countries: Germany, France, and Italy.

Euro-area countries used fiscal stimulus somewhat less than the United States and Britain, in the sense that, on average, their structural deficits have increased only by about 2.5 percent of GDP since 2007, compared to the United States, which increased its structural deficit by more than 6 percentage points of GDP.  The chart shows that deficits will be reduced rather gradually in Europe, even taking into account the round of budget cuts announced in Europe after the euro crisis.

By contrast, the United States has a steeper trajectory of fiscal tightening, with the structural deficit projected to improve by almost 4 percentage points in only two years. U.S. growth is also projected to be above 3 percent in 2011 and 2012, higher than its average annual growth rate for the last decade. By this logic, there is no reason to postpone fiscal tightening.

Some argue that fiscal stimulus should continue to reduce unemployment, which is projected to remain above 9 percent. While this is much higher than the average U.S. unemployment rate over the last decade, it is probably also unavoidable if the United States is to transition to a less import-dependent growth model. Obama has set the goal of doubling U.S. exports in five years, but achieving this goal requires doubling manufacturing capacity, which cannot happen overnight. No amount of fiscal stimulus can create the new jobs in manufacturing needed to underpin an export-led recovery. It is not possible, for instance, to employ jobless real estate agents in high-tech manufacturing.

Therefore, the reduction in fiscal stimulus already in place at varying speeds across the world’s major economies is appropriate.

Klaus Abberger, Scientific Coordinator, Ifo Institute for Economic Research, University of Munich

Economically, the world was at the edge after the fall of Lehman. It was important that governments all over the world stepped in and set up stimulus packages. This prevented an even longer and deeper recession or even a depression of the global economy. Now we are at a point of inflection. Crises often come in waves, but the waves come from different directions. And it could be that the next wave comes from government debt. So the current recovery in private spending should be accompanied by reduced public spending. High levels of public debt raise a number of problems. Higher borrowing costs restrict the scope of action for governments. Lower credit ratings lead to higher borrowing costs, and vice versa, and governments are forced to implement harsh austerity programs, as we have seen in some European countries.

High government debt could displace private investment. This was not a concern in 2009, when we had large declines in private investment, because governments had to step in. But now is the time for a gradual shift back toward private investment, because when consumers believe fiscal spending is not sustainable, public spending becomes less effective. (The expectation of higher taxes and future interest rates tightens the purse strings of consumers and firms.)

This does not mean that we should implement deep spending cuts. But in many countries, we have to get on a more sustainable track. For example, Germany’s debt reduction strategy is not a harsh austerity package; it is more about slowing the rise of the country’s debt ratio to make the ongoing recovery more sustainable.

And markets’ focus on public debt is not a bad thing. After the introduction of the euro, the interest rate spreads between countries within the common currency zone almost disappeared, meaning creditors no longer differentiated between the soundness of different countries’ public debt. This left some countries free to continue irresponsible spending habits. To some extent, that laxity in fiscal policy has changed, forcing more sustainable policies that will avoid harsh corrections in future.

John B. Taylor, Professor of Economics, Stanford University

The U.S. economic recovery slowed significantly this year. What is holding the economy back? Most likely, it’s uncertainty about government policy, especially about the growing debt. The nonpartisan Congressional Budget Office calculates U.S. debt will reach an unbelievable 947 percent of GDP by 2084. Something’s got to give, and people are worried about whether U.S. creditworthiness will fall or higher interest rates will rise in the future.

The rising debt comes from the recession, recent expansion in government spending, growth of entitlements, and, of course, so-called "stimulus packages," which increase the current deficit and distract us from reducing it longer term. A clear and credible path of fiscal consolidation starting with an immediate move away from deficit-increasing stimulus packages would build confidence and stimulate the economy. Most of the G20 countries have begun to follow this route, rejecting pleas for more deficit spending by Treasury Secretary Timothy Geithner and President Obama. The United States is the big outlier now. Obama’s view is that more deficit spending now is needed to grow the economy. But previous stimulus packages have not grown the economy by much, if at all.

The claim that the stimulus packages worked is based on models that assume the answer to show large effects from stimulus spending. But other models--such as the ones my colleagues John Cogan and Volker Wieland and I use--show small effects. I have more faith in the latter models, because they have more realistic assumptions about how people react to policy, but there is no consensus.

However, we can look beyond models to focus on data. In the 2008 stimulus, checks were sent to people on a one-time basis. Their income jumped dramatically, but consumption did not increase by much. The same is true for the stimulus of 2009: no noticeable effect.

We can also look at the government spending parts of the packages. The changes in GDP during the recession and recovery provide evidence that government spending had a negligible contribution: the ups and downs are largely due to private investment--including inventory investment. The United States should sign on with the G20’s fiscal consolidation program and provide a foundation for strong global growth.