As the Senate and the House look to reconcile competing stimulus plans, the big debate is whether to emphasize government spending or tax cuts. A new paper by the New York Fed’s Gauti Eggertsson argues that the risk of deflation should tilt the balance to government spending.
Our current problem is deficient aggregate demand. The government can raise total spending either by buying more stuff, or it can lower taxes and hope that consumers take their tax breaks to the mall. If consumers do indeed spend their full tax cuts (a big if), you might think that either approach stimulates aggregate demand in roughly equal measure.
But that’s not the whole story. Tax cuts stimulate both aggregate demand and aggregate supply. If taxes are temporarily lower, they make working today more attractive than working tomorrow, and thus increase labor supply. This boost to the nation’s productive capacity means that a tax-cut-based stimulus doesn’t do as much to narrow the gap between output and what we can produce.
Under normal circumstances, this doesn’t present a problem, because the Fed can lower interest rates to close this output gap. But right now, the Fed has set interest rates as low as they can go, and so different principles apply. Eggertsson’s concern is that a big output gap will lead inflation to fall, leading real interest rates to rise in the middle of the recession. These higher real interest rates further dampen economic activity, and with the Fed powerless to offset this, there’s the very real risk of a deflationary spiral. And so a tax-cut-based fiscal stimulus might actually backfire. In fact, Eggertsson reckons there’s a chance that tax cuts could even deepen the recession.
Is Eggertson’s conjecture right? Unfortunately the historical record can’t tell us: there’s never been an episode in which we’ve tried reducing taxes when interest rates were this low. When we’re in uncharted waters, we’ve got nothing but economic theory to guide us. And the theory says it’s safer to stick to a spending-based stimulus plan.
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The bigger problem is hyper-inflation in the out years. It will be like we had in the late 70s early 80s and worse. Print money now, pay later. The best thing the government can do is get out of the way and stop meddling. Government intervention is only needed to stop catastrophic failures, such as banking institutions. Let the car companies go bankrupt if they cannot make it in the market place. Detroit may be down to the big two. If we had government bailouts in the past, we would still be producing carts for horses.
Like Amtrak?
I think the key would be not like Amtrak. Or at least not like it’s current “high speed” service in the northeast, which is not particularly high speed and far more expensive than flying.
Those insisting on tax cuts with religious zeal do not accept analysis in a neo-Keynsian framework. They also seem unable or unwilling to accept what “deflation” means.
“”A government owned, high speed train. Very cool. And very needed.”
Like Amtrak?”
You think Amtrak is high-speed? I’m talking 200 miles an hour high-speed, like they have in Europe and Japan.
That kind of train needs it’s own tracks. New terminals could be built as well. Scrap Amtrack and use the money on a better system.
How about we quit assuming that the economy can be rescued? Maybe it’s just a question of crashing, and the question is for how long, and how much deflation will occur?
Might giving the money back to taxpayers to save, so they have some chance of riding out the mess, be the best thing to do with it, rather than have the government dig a deeper debt-hole for our kids?
I meant “like Amtrak?” as in “like the federally-owned rail system that hasn’t turned a profit in years?”
“We were given tax credits last year, spent them, and now we’re in a worse spot than we were before.”
Thats like saying last year I threw a rock and it started to rain. Not really cause and effect.
“Fair or not, intelligent or not, we’re just going to save whatever money we get to save ourselves.”
Some will do this, but others will need to spend the money to pay bills, such as morgage. Plus where will people save the money? I’m guessing that most people will not put it under their mattress. What does not go towards bills or the matress will go into banks or other investments. The real problem is what will happen when the banks get the money, will they keep it or start to make loans?
I’m just not clear why a tax refund isn’t the obvious solution. I would much rather decide where to spend my money than let my congressional rep do it–even assuming they weren’t crooks, I would suggest that my spending is more likely to improve the economy than an investment in some silly white elephant project.
You can eliminate the “perverse incentive” of encouraging work by making the cut retroactive: you get a refund off your 2008 taxes but are on your own for 2009.
Likewise, there’s no reason to choose a regressive refund–that’s just a straw man. A one time, short term, “must be spent by May 1″ refund is a far better idea than a 2 year stimulus package loaded down with pork. However, it seems that the latter is what we get.