$800 Billion: Too Much? Too Little? Yes.

by: Jeffrey Frankel

Is the $800 billion stimulus package too small, as many Democrats claim (such as Paul Krugman), or too big, as most Republicans claim? The answer is yes. Too big and too small.

If the criterion is how much annual stimulus to demand is needed to bring the economy back up to the level of potential output in 2010 and beyond, and to bring the unemployment rate back down to the natural rate of unemployment, then $800 billion is not enough. The Congressional Budget Office has estimated that the economy will fall short of potential output by about 7 per cent of GDP, in both 2019 and 2010. (The new Director of OMB, Doug Elmendorf – an outstanding choice to run that agency, by the way — testified on January 27. The news on jobs and other economic indicators since then has continued to show rapid deterioration of the economy.) The $800 billion is to be spread over several years; the peak is to be at most $356 billion in 2010, which is about 2 ½ per cent of GDP. The most optimistic estimate of the “Keynesian multiplier” that anyone has is 2, which would imply a 5 per cent boost to GDP. That is less than the 7 per cent gap, and so not enough to return the economy to full employment.

In practice, even if interest rates were to stay very low, the actual multiplier in effect would almost certainly be substantially less than this. For one thing, much of the stimulus takes the form of tax cuts, and the part of this that gets saved will not contribute to demand and thereby enter the stream of spending and income. (Of course a shortage of national saving is part of how we got into this problem, so that an increase in private saving is welcome in the longer run. But the question here is how to stimulate demand that has been depressed by the current crisis.) And the part of the tax cut that is another one-year AMT patch, while desirable, will have no effect on spending because the beneficiaries, forecasters, and everyone else were already assuming that they would not be paying this tax. If we are lucky, the American Recovery and Reconstruction Act would close half of the gap, relative to the magnitude of the recession we would have otherwise had. So, no, it is not enough.

But in another sense, $800 billion is too much. The 2009 fiscal-year deficit is already expected to exceed $1.2 trillion, so we are talking about deficits thereafter that could surpass 10 per cent of GDP. This is far above the levels that are considered danger signals when they come from any other country. Until now, the US has not been “any other country.” The rest of the world has been willing to finance American profligacy cheerfully. But there have already been signs in the last few weeks that the prospect of this much Treasury debt coming onto the markets is already beginning to push bond prices down and long-term interest rates up. My feeling is that if the current stimulus package were to break the $1 trillion benchmark, it would increase the odds of truly alarming international financial investors, who would in that case stop acquiring dollar assets, thus precipitating the hard landing of the dollar that so many of us have feared for so long. In those circumstances, the Fed would lose the ability to keep interest rates low, and we would be in even worse trouble than today.

Everything would be different if we had spent the last 8 years preserving the budget surpluses that Bill Clinton bequeathed to George Bush. Then we would have paid down a lot of the national debt by now, instead of doubling it. We would be in a strong enough fiscal position to undertake the expansion that we really need.

In that light it is ironic, to say the least, that the politicians who are warning against the size of the stimulus bill, particularly the Congressmen who are voting against it, are mostly the same Republicans who supported the original fiscal policies that gave us the doubling of the national debt: the huge long-term tax cuts of 2001 and 2003 and the greatly accelerated rate of government spending. What we need now is a fiscal policy that maximizes short-run demand stimulus relative to long-run damage to the national debt. Lots of bang for the buck. The Republicans supported fiscal policies that did the opposite. Lots of buck for the bang. They are still doing it today when they argue that tax cuts give stimulus and spending does not. One doesn’t even hear them give an economic argument in support of this position (such as the, admittedly discredited, theories of the supply siders). They just close their eyes and endlessly repeat their “tax cut” mantra, like a religious cult that can’t even remember why.