WILL THE STIMULUS BE BIG ENOUGH TO BOOST THE ECONOMY?

12/21/08

It is still unclear whether the recovery program will be big enough to stop the economy's downward momentum. 

Summary:  The size of the economic recovery package planned by Congress and Barack Obama's advisers has increased significantly since the election.  But a strong case can be made that the total amount is still too small to sufficiently boost the economy, based on the calculations of reputable economists.  Rather than focusing overly much on the question of which expert is making the most accurate prediction, the difficulty of deciding on the amount of  stimulus is made easier by asking which policy option has the least risk.  By this criterion, the highest stimulus amount of $1.2 trillion is the best option.  It is less risky because it has a higher probability of turning the economy around and can be quickly scaled down if the economy recovers sooner than expected.  Any mistakes from a lower stimulus amount would take longer to correct since the longer the downturn lasts, the more difficult it would be to reverse it.  Savings from a lower stimulus amount would be illusory, since a slower economy would generate less tax revenue.    

Despite the "consensus" around the need for a "substantial" program, it remains to be seen how substantial.  There are various sizeable stimulus numbers being proposed, but there is a sizeable difference between them. 

Until two weeks ago, a figure of roughly $250-300 billion per year for two years ($500-$600 billion total), was the amount the media was reporting as likely to be pushed by the Obama administration and Congressional Democrats.  But a number of experts had said for a while that this would not be nearly enough to counteract the economic downturn.  For example, Nobel Prize winner Paul Krugman estimated that $600 billion would be necessary during the first year, as did Jan Hatzius, chief domestic economist of Goldman Sachs.  Dean Baker of the Center for Economic Policy Research calculated that $430-540 billion per year for two years would be needed, and later changed his estimate to $500-600 billion per year for two years.  (Related background information is provided below.) 

On December 13, the Wall Street Journal reported that the Obama team was at work on a "far larger" plan.  "Obama aides and advisers have set $600 billion over two years as a ‘very low-end estimate' - - The final number is expected to be significantly higher, possibly between $700 billion and $1 trillion over two years.  - -   On the upper bounds, liberal economists have staked out $600 billion in the first year and $300 to $600 billion in the second, depending on economic conditions" (emphasis added). 

The news reports also said the Obama team was sounding out a large array of economists with the hope of forging a consensus.  But what if "consensus" means simply averaging what many economists think, including those who grossly underestimated the housing bubble or risk of an extremely deep recession or depression. 

On December 15, Speaker Nancy Pelosi said again, in an interview, that the total stimulus bill is planned to be $600 billion spread over two years ($300 billion per year).  On December 17, it was reported that the Obama team's more likely number would be $850 billion spread over two years.  On December 19, one report indicated the President-elect's proposal had been scaled back to between $675 billion and $775 billion (although it might top out to $850 billion), while another report said the price tag would be $800 billion. 

If the Obama team's proposal is actually as high as $850 billion spread over two years, or $425 billion per year, it is still significantly smaller than the drop in economic activity some economists have calculated must be filled by the stimulus.    

Jan Hatzius, chief domestic economist for Goldman Sachs, said: "‘the private sector retrenchment could subtract an annualized 4 percentage points or about $600 billion from economic growth through the end of 2009.'"  Paul Krugman also said the stimulus should be "as much as 4 percent of GDP" and posted a figure of $600 billion for the first year on his blog.   Dean Baker's calculation of the need for $500-$600 billion per year of stimulus for two years is based on a "well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption - - [and a] wealth effect of 3-4 cents on the dollar [for stock market wealth]."  These numbers are multiplied by the economy's total loss of housing and stock wealth to arrive at the expected drop in economic activity.  (It is not clear whether the former two analysts used a method similar to that of Baker.) 

If we double the per year amounts recommended by Hatzius and Krugman, we get $1.2 trillion spread over two years.  (Apparently, neither of the two have stated publicly what they would recommend for the second year.  However, the New York Times reported on 12/21 that the highest amount recommended to the Obama team was $1.3 billion, without saying who made the recommendation.)

Of course, the stimulus amounts proposed by the President-elect and Congress might increase; some reports have speculated they may be as high as $1 trillion (spread over two years).  But we cannot be sure of that, and even $1 trillion is still $200 billion less than what the above analysis would indicate. 
   

One response to this might be "Well, does the exact amount of the stimulus really make much of a difference in terms of impact on the economy so long as the total stimulus is close to $1 trillion (i.e. $850-900 billion)?  This would be a huge stimulus, bigger than we have seen for generations".  A little, but not a lot, of support can be found for this line of thinking in the Campaign for America's Future's Main Street Recovery Plan, which proposes a stimulus package of $900 billion spread over two years (not very different from the latest $850 billion guesstimate for Obama's plan).  This plan is endorsed by large numbers of economists, national leaders and grassroots organizations.  However, the amount of $900 billion in the Main Street Plan is clearly stated as being the "floor, not the ceiling, of what needs to be done".  Further, this amount is intended to replace a 3% drop in GDP, not the 4% drop calculated by both Paul Krugman and Jan Hatzius of Goldman Sachs. 

Another significant concern is that of political feasibility.  There is no getting past the fact that the political leaders recommending the lower stimulus numbers are faced with the reality of getting legislation through significant roadblocks in Congress. 

A related obstacle appears to be Obama advisers' "fear [of] being accused of adding too much to the country's long-term budget deficit".  Consequently, they "hope to keep the package below the trillion-dollar mark, a psychological threshold that could carry political consequences".   

Again, we could ask "Is a $200 billion or even $350 billion difference in the total stimulus amount really so important in terms of its impact on the economy?" 

Obviously, no one can be absolutely sure how big of a stimulus will be needed to turn the economy around.  But one thing is for sure, the necessary amount depends on the arithmetic of what is happening in the economy, similar to the laws of gravity, not the opinion of this or that person based on gut feeling.  

We would best heed the advice of good economists who pay close attention to the arithmetic of the real economy.  That doesn't solve the whole problem, of course, since economists disagree and some are recommending a smaller stimulus. 

But another approach to this problem is to ask "What risks are associated with each of the two approaches?"

By aiming for a lower stimulus amount, we would increase the probability of not impacting the economy strongly enough to reverse the downward momentum.   It would not be easy to correct this mistake, since the longer the economy stays down, the more difficult it is to bring back up.  Unemployment might remain high considerably longer, a significant amount of economic activity could be lost, and the "savings" from spending less on the stimulus would be more than wiped out by the lower tax receipts resulting from a slower economy.

The potential for loss from employing the highest recommended stimulus amount (assuming it is recommended by reputable economists) is much harder to see.  As some have pointed out, a big package can be scaled back quickly if it turns out to be larger than necessary.  If the economy picks up speed more rapidly than expected we can slow down the spending and ease up on the deficit.   It is easier to correct problems resulting from over-shooting the mark than those from aiming too low. 

The decision, therefore, becomes easier if we determine which option has the least risk, instead of overly fixating on the question of whether we can be absolutely sure of the right stimulus amount.  The high stimulus amount has both lower risk and a greater potential payoff.     
  

There will still be legitimate concerns about the federal deficit.  First, as some experts have pointed out, basic economics says that a larger stimulus program will, at first, increase the deficit, but then reduce it over time by keeping the economy going at a higher rate, thereby generating more tax receipts.  Of course, after the economy recovers, we must take additional steps to reduce the long-term structural deficit that will be left over.  Second, even if we do actually return to the World War II highs of federal debt to counteract his economic crisis, we can, as we did before, work the debt down through productive public investments in the types of infrastructure and high quality services that made the postwar economy such a success.  Granted, this is a very difficult choice to make.  But is it a better option to leave ourselves open to a very long, deep recession, as Japan experienced for a decade, or at best a prolonged period of stagnation with high unemployment?  A lack of decisiveness could leave us in the ditch for a long time. 

Another reason for spending a full $1.2 trillion on the stimulus program (spread over two years) is that the extra $200-350 billion, above what Obama's advisers seem to want, would provide a margin of safety, similar to insurance.  We need insurance that the economy's downward spiral will be stopped in its tracks.  No ands, ifs or buts.  Would you rather sleep well at night, knowing we have done as much as possible to avert a truly unfortunate outcome?  If the downside of this option is minimal, why not do it? 

To conclude, if there was ever a time to be bashful about telling the public what really needs to be done to fix a problem, this is not it. 

Would you rather risk:

being accused of raising the deficit by implementing a stimulus program of over $1 trillion or

being blamed 2-4 years from now for doing less than you could have to prevent a deep, multi-year mega-recession?

Yes, it will be more difficult to get the larger amount through Congress.  But this is a time when the bully pulpit can be used effectively to educate the public and sway decision makers.  Even if the better package does not pass Congress, those who push for it will benefit from greater public esteem than if they settle for the weaker alternative.   They will have also built a stronger base for winning the next time around. 

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