Is Fiscal Stimulus The Right Medicine?

The asset bubble in the United States that has recently burst has wiped out an estimated $13-$14 trillion of net worth between declines in stock and real estate prices. The impact of this value loss is working its way through the economy with dramatic effect. GDP has fallen at a rate of over 6% for the past two quarters, several sectors of the economy are on life support from the government and the Federal Reserve, and we are now entering the 17th month of a recession that began in December of 2007. We already provided an economic stimulus package of approximately $160 billion under the former administration, and we are now looking at a much larger stimulus plan under the current administration. There has been some debate over the effectiveness of fiscal stimulus. Those opposing it claim that fiscal stimulus (that is, when the government borrows to spend and/or provide temporary tax relief) crowds out private sector investment thereby hurting the real economy. Another claim is that fiscal stimulus is ineffective because money that gets to individuals through the stimulus is used to repay debt rather than spent so the economy does not benefit from the multiplier effect of a dollar being spent several times over. I believe fiscal stimulus is the correct response to today’s economic situation, even if a large portion of it goes to repaying debt.

To work through the current situation we need a few economic basics. Individuals earn income. We spend some of this income and we save some. When we save we provide a source of funds for businesses to invest. Our savings flow to businesses through the financial system and the institutions that make up the financial system. Banks are the prime example. Banks take deposits and then use those deposits to make loans. Businesses borrow from the banks to invest in new opportunities. The stock market is another example where businesses raise equity capital to invest from the savings of individual households. Business investment means more jobs and that means more income, more spending, saving, and so on. This is how the economy grows in normal circumstances. Today, however, circumstances are anything but normal. For a long time we borrowed from our future income to consume more in the present (and support a price bubble) running up household debt relative to our incomes. We borrowed for lots of reasons, but the primary asset we borrowed against was our real estate. To put this in perspective, our household debt (that includes mortgages, credit cards, auto loans, etc.) to disposable personal income (that is, income after taxes) has increased from 66% in 1983 to 135% in 2007. The graph below shows the trend in household debt to disposable personal income (debt-to-income) from 1977 through 2008.


(DPI from BEA.gov. HH Debt from Federal Reserve Z1)

The debt to income ratio peaked in 2007 at 135%. It has since fallen back to 130% by the end of 2008. 76% of the debt was mortgage debt in 2007 as opposed to 66% in 1987. The 2008 decline in the debt-to-income ratio illustrates the fact that people are now borrowing less than they were relative to their incomes. The lower level of borrowing means less spending. In addition, we have begun to save again. While we were on our borrow-and-spend spree of the last decade we also spent more of our incomes and saved a lot less. The next graph illustrates the trend in the personal savings rate.


(Personal Saving Rate from BEA.gov)

From this perspective we now see the impact of the rapid declines in housing and stock prices. This mountain of debt, concentrated in mortgage loans, is no longer supported by the price of the underlying collateral. Many homeowners owe more on their home than it is worth and the home as a source of collateral for borrowing additional spending cash has dried up. In addition to this balance sheet impact there is also the cash flow impact. As payments adjust upward incomes are squeezed making it difficult to spend or to borrow more. It’s like a huge number of families borrowed as much as they could and blew it on a mega-vacation and are now saddled with paying back the debt for years to come. Finally, there is the wealth effect. If you thought you had a large portion of your retirement needs accounted for in the value of your home and investments in stocks you are feeling a lot less wealthy today. For all of these reasons households have switched from borrowing and spending to saving as illustrated by the personal savings rate turning up and household debt-to-income ratio turning down. So, this sounds like we are on the right path. If everyone saves we will eventually pay down the debt and everything will be OK, right? Wrong.

Welcome to the paradox of thrift. Saving is good for individuals and for the economy. Remember that savings becomes investment and that helps the economy grow. But when everyone increases saving at the same time overall spending goes down. As we collectively start saving and stop spending business contracts. In this environment business investment falls because there are fewer good business opportunities. So, at the very time individuals start to save businesses don’t need the savings for investment. This is why I do not believe that government stimulus crowds out private investment in the current environment. When businesses are investing less there is nothing to crowd out. And when businesses aren’t investing, people aren’t finding new jobs. As more businesses cut back, more people lose their jobs and can’t find new ones. That means less spending again, and that leads to less investment, and fewer jobs, and so on. This is one way economies fall down into long-term underutilization. How far down and how long depend on a multitude of factors, including the size of the bubble that burst. The losses in tax revenue and other costs to society can be very dramatic. So what do we do about this problem?

Enter the Federal Government, the one borrower that can raise cheap money when everyone else is too worried to borrow and/or can’t find anyone willing to lend (the willing to lend problem is the other side of the rescue plan - repairing bank balance sheets to assure loan supply). As the government spends the money it borrows it provides income to individuals just when individuals need the income because many are losing their jobs and needing to save. If the government provides enough stimulus it may stop the downward spiral of lower incomes and investment discussed above. If those receiving income from the stimulus spend the income there will be some immediate impact on demand in the economy and that could help jump-start business investment. On the other hand, if those who receive the income from the stimulus use it to pay down debt there will be less of an immediate impact on the economy but incomes will be supported while individuals pay down debt. Once debt levels are back to normal individuals should return to spending more of their income. In effect, we are replacing private debt with public debt by providing income through fiscal stimulus to avoid the potential devastation that can result from the de-leveraging of household balance sheets that needs to take place. So even if the recipients of stimulus income use the money to repay debt the economy benefits from the resulting de-leveraging necessary for economic activity to return to normal.

In the end, whether fiscal stimulus is a smart investment depends on its impact on the economy. If it helps to prevent a long protracted depression but costs less than a long protracted depression would, then the stimulus provides a positive economic return. Of course we will never know the true cost-benefit analysis because we will have no way of measuring exactly how much of an economic downturn was prevented.

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Why I Think We Will Have A Recession

Here is why I think we will have a recession. The graph above plots the Financial Obligations Ratio from the Board of Governors of the Federal Reserve. This ratio is an estimate of consumers' fixed payment obligations as a percent of their disposable income. Here is how the Board describes it:

The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt.
The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments to the debt service ratio.

So this ratio tells us the estimated percentage of the average person's disposable income that is already committed to making these fixed payments. The rest of the disposable income goes to pay for everything else including food, clothing, energy, education, savings, and so on.

The wavy line is the FOR for the third quarter of each year and the dark straight line is the trend line. I think this graph says a lot about why I hear people talking about being "tight" and not having extra income to spend lately. Add rising food and energy prices and I think there is just less truly discretionary money in the average household. This is also why I think any stimulus should be focused on consumers.

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Where Should The Stimulus Go?

There is a lot of talk today about a stimulus package from the Federal Government to help counter the slowing economy. A lot of generalities were discussed during Fed Chairman Ben Bernanke's testimony before The House Budget Committee. You can read his prepared statement here.

Some pundits and politicians are arguing the stimulus should be focused on business with ideas such as accelerated depreciation. The thinking behind this is that it will stimulate businesses to acquire capital goods and the only cost to the government is the time value of money because businesses get the tax benefit now instead of over time. I haven't heard anyone yet limit such a plan to goods manufactured in the US, and without that this idea could be very watered down. That's also an issue with any of the other plans, however, but using a depreciation incentive to spur purchases of capital goods could be targeted toward domestic manufacturers as other plans may not be. Of course there are likely trade partner issues with any such limitations.

On the other end of the spectrum is giving to the poor. Expand the food stamp program and other help to the poor. The argument here is that these people will immediately spend the money and it will have the most immediate stimulative impact on the economy. If the stimulus is limited to tax breaks these people will see no help at all because they are not taxpayers to begin with.

Then there is tax relief for the investor class, otherwise known as the good old trickle down theory. According to this thinking, if we cut taxes on investing businesses will have access to capital and will invest thereby putting people to work and lifting all boats. Of course, if business in general is already sitting on large piles of capital then this plan would have no impact other than to add to the coffers of the wealthy.

Also under consideration is a tax break for the middle-class. The thinking here is that many people will spend it because times are tough, and so the stimulative impact will be relatively quick. An argument against this is that so many middle-class families are in so much debt that a large portion of such stimulus will go to paying down credit cards rather than new expenditures. This would help in the long run as consumers in too much debt can't consume, but there would be a delay in the impact. This plan could be attractive to the banks and credit card companies, so I think it has a pretty good chance of being at least part of any plan.

There are those who argue that this is the time to make the Bush tax cuts permanent. This just goes to show how extreme the position of this wing of the Republican party is. This would have zero impact until 2011, and is simply not relevant to the discussion of a stimulus plan. You can, however, count on those regular foot soldiers of the neocons who have gone a long way to destroying the fiscal health of our country to come out and tell us why this would be a good idea now.

As far as the Fed Chairman is concerned, he was non-committal on any particular stimulus package although he clearly warned that any plan that increased the structural fiscal deficit must be avoided, and government must address that issue sooner rather than later. He avoids recommending the solution to Congress, as he should, because he is not political (not supposed to be anyway) and this is clearly a political issue. What he does say is that the long term problem is simple arithmetic. What comes in must equal what goes out or at some point we have a crisis (and that point is within the next decade or two). In crafting a stimulus package:

As I have discussed on other occasions, the nation faces daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors. A fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult.

I have a suggestion for Congress and the President. Since the years of following a policy of tax-cuts, borrow and spend have left us in the painfully foreseeable position of a pending fiscal crises, perhaps it is time to change course. As a place to begin, I suggest the research of Romer and Romer oft-cited by supporters of tax cut policies as evidence that their way is the best. What we do not hear about is the conclusion reached in that very same research report that a tax increase to repay an inherited deficit does not have a negative impact on economic growth. Just in case those tax cut pundits misplaced their copy, here is a link to it.

For tax increases to deal with an inherited budget deficit, the results are more interesting. The
point estimates imply that output does not fall at all following deficit-driven tax increases.

(From page 24)
If you would like a really good example of how the tax cut soldiers use this kind of report, here is a link to a recent Art Laffer report, as in the Laffer Curve. If you search this report for "Romer" you will find that he relies on it heavily. I cannot, however, find any reference in his report to an inherited deficit. I also love the title of his report: THE ONSLAUGHT FROM THE LEFT, PART I: FACT VS. FICTION. The true onslaught is a 28 year old attack on the poor and middle class from the right.

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