Will the stimulus come too late?

I began this blog at the end of March after the stimulus bill had become law. I had been struck by how much the stimulus debate had focused on whether the bill was efficient. (It clearly was not.) There was much less discussion of whether the stimulus would be effective, and of the timing of the macroeconomic boost.

Everyone wants to know when the U.S. economy will start growing. I will focus on a related question: when will the stimulus law begin to have a significant positive effect on U.S. economic growth? And could it have come sooner if the Administration had done something different?

I believe the Administration made an enormous mistake in its legislative implementation of the stimulus. As a result, the boost to GDP will come six to nine months later than it needed to (maybe more). Given the President’s desire to do a large fiscal stimulus, and given his policy preferences, he could have had a different bill that would have been producing significant GDP growth beginning now, rather than in the middle of next year. That’s a huge mistake with real consequences for the U.S. and global economies.

To illustrate this point, let me classify four types of fiscal stimulus:

  1. a permanent tax cut;
  2. a temporary tax cut;
  3. one-time checks to people independent of their tax liabilities; and
  4. increased government spending through federal and state bureaucracies: infrastructure, energy spending, etc.

There is of course a fifth option: no fiscal stimulus law.

If you’re going to do a fiscal stimulus (big if), the best kind is a permanent tax cut. It is effective, efficient, and fast:

  • effective – People spend a large proportion of a permanent tax cut. This is derived from Milton Friedman’s “permanent income hypothesis.”
  • efficient – People spend their own money on themselves, so they waste very little of it, and they spend it on things that matter to them. Again, see Milton Friedman.
  • fast – Checks are delivered quickly, and people spend most of their own money soon after they get the check.

This was part of the short-term logic behind the 2003 tax cut, which we designed to foster both short-term and long-term economic growth. I also have a strong general policy preference for lower taxes rather than more government spending, but that’s a separable question from how it works as short-term stimulus.

In 2008 we knew we could not get a Democratic Congress to enact a permanent tax cut. Q: Do you then go for a temporary tax cut, or do nothing? The President thought the risks of an economic slowdown in 2008 were significant enough that it made sense to pursue a (second best) temporary tax cut with the Congress.

Like the 2003 law, the 2008 law got the bulk of its short-term GDP boost by advancing tax refunds from the year to come, and delivering them as checks from the IRS to taxpayers. As in 2003, the checks were delivered to taxpayers in the summer (mid-June to early-August), and consumers immediately started spending a portion of their rebates.

Because the 2008 law was a temporary tax cut, taxpayers spent a smaller proportion of it than anyone would have liked. While designing the law, we assumed about 1/3 would be spent, and much of that fairly quickly. The rest would be saved, which is also good but doesn’t help short-term GDP growth. Economists agree that GDP in Q3 and Q4 of 2008 was higher than it otherwise would have been because of the 2008 stimulus law. It was efficient, fast, yet only partially effective, with a smaller GDP boost than we would have liked:

  • efficient – People were again spending their own money on themselves. You get very little waste, and people know what they want and need.
  • fast – Checks were delivered quickly, and much of the spending that did occur happened in Q3, with some in Q4, and with very little left by Q1 of 2009.
  • only partially effective – Because it was a temporary tax cut, people saved a lot of their checks, as we expected. Still we got a GDP bump in Q3 and Q4, and in retrospect we certainly needed it.

The 2008 law was mostly (2) from my list above – a temporary tax cut. Some of the money went to (3), checks to people who didn’t pay income taxes. This was necessary to reach a compromise with a Democratic Congressional leadership that placed a high priority on the distributional effects of the law. Speaker Pelosi insisted that poor people who owed no income taxes still get “rebate” checks, and that high-income taxpayers get nothing. So the 2008 stimulus law was mostly (2) with a little bit of (3).

Now fast forward to January of 2009, when President Obama proposed an enormous fiscal stimulus. The President’s mistake was in largely deferring to Congress on the composition of the stimulus bill. Rather than allowing Congress to pump hundreds of billions of dollars through slow-spending and inefficient bureaucracies, the President should have insisted that Congress instead send all the funds directly to the American people and let them spend it quickly and efficiently. Given his policy preferences, he could have directed a large share of those funds to poor people who don’t pay income taxes. He could have again mislabeled these payments as “tax cuts,” or just correctly labeled them as one-time entitlement payments. I would not have liked that policy, but it would have generated a faster macroeconomic boost than what he allowed Congress to do instead.

Let’s compare the two scenarios. The enacted 2009 stimulus is:

  • effective (eventually) – Most of the spending through government bureaucracies will (eventually) increase GDP. Some of the funds transferred to State governments will be used to offset State spending or tax cuts that otherwise would have occurred, so there’s a loss. But clearly the proportion of the $787 B that will eventually increase GDP will be high, and much higher than if all the funds were given to individuals and families.
  • inefficient – It will be inefficient in two senses. The spending represents the policy preferences of legislators (and all their ugly legislative deals and compromises), rather than the choices of hundreds of millions of Americans who presumably know better how they would like money spent on them. The spending will also be wasteful, and we are starting to see signs of this in the press.
  • s-l-o-o-o-w – CBO says that $25 B of spending had gone into the economy by May 22nd. That’s less than 4% of the total budgetary impact of that bill. Other news reports suggest that about $40 B is in the economy if you include the revenue side. Remember that almost all of the 2008 stimulus was in private hands by August 1. We will get very little GDP boost from fiscal stimulus in Q3 of 2009, and not much in Q4 either. The stimulus will begin to ramp up in Q1 of next year, and be in full swing by Q2 and Q3 of 2010.

Had the President instead insisted that a $787 B stimulus go directly into people’s hands, where “people” includes those who pay income taxes and those who don’t, we would now be seeing a stimulus that would be:

  • partially effective but still quite large – Because it would be a temporary change in people’s incomes, only a fraction of the $787 B would be spent. But even 1/4 or 1/3 of $787 B is still a lot of money to dump out the door. The relative ineffectiveness of a temporary income change would be offset by the enormous amount of cash flowing.
  • efficient – People would be spending money on themselves. Some of them would be spending other people’s money on themselves, but at least they would be spending on their own needs, rather than on multi-year water projects in the districts of powerful Members of Congress. You would have much less waste.
  • fast – The GDP boost would be concentrated in Q3 and Q4 of 2009, tapering off heavily in Q1 of 2010.

Why did the President not do this? Discussions with the Congress began in January before he took office, and he faced a strong Speaker who took control and gave a huge chuck of funding to House Appropriations Chairman Obey (D-WI). I can think of three plausible explanations:

  1. The President and his team did not realize the analytical point that infrastructure spending has too slow of a GDP effect.
  2. They were disorganized.
  3. They did not want a confrontation with their new Congressional allies in their first few days.

I think the Administration now recognizes this problem. Last month when they released a CEA paper “Estimates of Job Creation from the American Recovery and Reinvestment Act of 2009,” the paper danced around the timing of job growth and government outlays in 2009 and 2010. Tips for reporters: (1) ask the Administration to give you OMB estimates of quarterly cash flows for the stimulus law, and (2) ask them to give you the quarterly GDP and job growth estimates behind this CEA paper. I know the first one exists, and I’d bet heavily the second does as well.

Fortunately, CBO Director Doug Elmendorf just gave a presentation titled “Implementation Lags of Fiscal Policy” to the IMF’s conference on fiscal policy. All of the following data are from his presentation.

The final 2009 stimulus law broke down like this:

10-yr total

% of total

Discretionary spending (highways, mass transit, energy efficiency, broadband, education, state aid)

$308 B

39%

Entitlements (food stamps, unemployment, Medicaid, refundable tax credits)

$267 B

34%

Tax cuts

$212 B

27%

Total

$787 B

100%

The problem is that only 11% of the first line (discretionary spending) will be spent by October 1 of this year. In contrast, 31-32% of the entitlement and tax cuts lines will be out the door by that time. (I have questions about the speed of the entitlement part. The bulk of that is Medicaid spending, and it’s not clear to me that a Federal payment to a State means the cash is immediately flowing into the private economy.)

If we extend our window to October 1, 2010, then less than half the discretionary spending will be out the door, while almost 3/4 of the entitlement spending and all of the tax cuts will be out the door and affecting the economy. The largest part of the stimulus law is therefore also the slowest spending part. This is fine if you’re trying to increase GDP growth over the next 2-4 years. If you’re going for short-term GDP growth, it makes no sense.

Director Elmendorf drills down further into discretionary spending and shows that defense spending happens quickly, highways and water extremely slowly:

  • If you allocate $1 to defense spending, 65 cents has been spent within one year.
  • If you allocate $1 to highway spending, 27 cents has been spent within one year.
  • If you allocate $1 to water projects, only 4 cents has been spent within one year.

In fact, the infrastructure spending in the stimulus law will peak in fiscal year 2011, which goes from October 1, 2010 to September 30, 2011. That’s too late from a macro perspective.

The Director further points out that the 2009 stimulus law created many new programs. This slows spend-out, as it takes time to create and ramp up the new programs.

The Administration has made much of working with federal and state bureaucracies to find “shovel-ready” projects to accelerate infrastructure spending. All of my conversations with budget analysts suggest this claim is tremendously overblown, and Director Elmendorf asks, “Is this practical on a large scale?”


The 2009 stimulus law will increase U.S. economic growth. But the actuals are matching the budget analysts’ projections for the speed at which that effect will occur.

I would not have liked a stimulus law that would have given cash to people who didn’t pay income taxes. But from a macroeconomic perspective, we need the faster economic growth now. Had the President and his team insisted on giving money to people (taxpayers or not) rather than to bureaucracies, we would be seeing a huge growth spurt in Q3 and Q4 of this year.

It is sad that instead we have to wait until the middle of next year because the White House deferred to Congressional desires to spend on infrastructure. This strategic mistake was avoidable, and the recovery will be delayed because of it.

38 responses

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  3. We all have our weak spots, even the best analysts of which Keith is one. Unfortunately for Keith, one of his weak spots is an abiding belief in Keynsian aggregate demand management. How else to explain his argument that increases in government spending or tax cuts that have little or no effect on incentives to produce are completely ineffective in stimulating the economy?

    Without a doubt, these ineffective means of increasing the national debt (which is their only substantive consequence) will increase elements reported as part of the GDP. Increase cash in people’s pockets as President Bush used to say and you will see some increase in consumer spending. Throw more money at roads and you’ll see more investment. Bail out the states so they don’t have to cut spending as much and you’ll see more state spending.

    But, total GDP is unchanged, unless you believe in magic. The trouble, as I describe at some length in an article in Townhall this month, is that the government has to borrow the money, either from domestic or foreign sources, and the effect is to reduce other areas of demand or to increase the net trade deficit. So this reshuffles total demand without increasing total demand, leaving the economy just as weak – or weaker because the national debt is higher.

    Federal spending cannot magically conger up purchasing power, only monetary policy can do that temporarily.

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  5. So, as the Fed observes that nominal GDP is growing faster than it should, it will respond by slowing the rate of growth of the money supply. Monetary policy is so powerful that it overrides fiscal policy.

  6. The current activity by Congress and this administration, reminds me of the 1970s, though at that time in my life, I didn’t pay very close attention to politics. I did note that Congress seemed to be zigging when the economy was zagging which meant the economy was zigging when the effect of the Congress zig went into effect. This seemed to produce an undamped changing economy – it just never reached stability. The rules were always changing. The end result was stagflation. According to Greenspan’s book (The Age of Turbulence), not one of the economic models of the time predicted stagflation. It didn’t end until Paul Volcker pledged to “kill” inflation. Could we be in a similar situation? Would models today recognize and predict stagflation?

    Small business is still, or again, having trouble getting loans and one has to wonder if the economy would have turned around without all the government intervention. After the Chrysler and GM results, it feels like money has stopped moving once again because it seems the old rules no longer apply.

  7. In a period of time where massive deficits are on the rise and the eventual rise in either interest rates of inflation crowd out private investment and push the government larger, the increases in aggregate demand at the beginning of next year will exacerbate the issue of inflation. Fed Chairman Bernanke has said lately that he will not monetize the debt, but this will hard for him not to do with a Democratically controlled Congress and his job on the line in 7 months.

    What we continue to see is a country who is becoming more and more dependent on the federal government from the latter part of 2008 under the Bush Administration and even more so in only 4 and a half months under the Obama Administration. The government can only hold our hand so long before we find ourselves not knowing how to walk. While these increases in government programs may cause increases in GDP and provide some jobs (not nearly the 3.5 million they have expected over the next two years with only 150,000 being produced so far from the stimulus package), these are government supported jobs and the Keynesian multiplier that they would like to count on is very very low in the current environment, possibly below 1. So fewer dollars will be redistributed around the economy and the eventual rise in either inflation and/or interest rates will all combine for a rough ride for the next couple of years. Just a thought!

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  9. Keith —

    Despite the fact that the disbursements related to the stimulus have not been paid, don’t they have a stimulus effect in that they are earmarked for spending? I guess it depends on how much of the current recession you attribute to the downward spiral of lower income and lower demand, but won’t this planned expenditure encourage growth in industry by improving the future economic outlook? And won’t an improved economic outlook stave off layoffs and increase investment (you imply that the saving rate is higher than normal right now, won’t this encourage more private capital to come in off the sidelines in anticipation of a huge wave of government generated demand?) And it seems to me that this effect would ripple though to stimulate other areas of the economy.

    Of course this does nothing to address inflation or the fact that the stimulus may come at a time when we are looking to restrain growth… but I think the effects in the short term may be a little more than you are giving it credit for.

    As a moderate democrat, don’t always agree with you but enjoy your work.

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  11. The problem with the government’s spending program is that the things it “produces” do not have to meet a market test. How many of the 3.7 million jobs created or “protected” in the $787 billion stimulus bill are being pulled out of more productive work elsewhere? The thousands of green jobs created will not produce anything the market is actually willing to pay a high enough price to cover the costs. These “new jobs” will require higher taxes to keep the government subsidies running. What about the jobs that are not created because of the higher taxes used to pay for the subsidies? Equally pernicious are the mandates that will require people to use this stuff. The resources taxed by the government had been deployed in activities that were producing things people actually wanted. The monetary expansion is creating the same sort of problem. The extra credit being supplied now is leading to higher government and private debt much of which will again prove unsustainable when inflation causes it to be withdrawn.

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  13. I can think of three plausible explanations:

    1. The President and his team did not realize the analytical point that infrastructure spending has too slow of a GDP effect.
    2. They were disorganized.
    3. They did not want a confrontation with their new Congressional allies in their first few days.

    You don’t mention

    4. They couldn’t care less about stimulus, and were using the stimulus rhetoric to throw a bone to Congress, allowing them to fund a bunch of longstanding Dem priorities that would otherwise never get through.

    5. They were not interested in speed. They were mainly interesting in ramming through a bill which would provide the bulk of its stimulus in the election years 2010 and 2012, and in making sure they had lots of discretionary money to spend in those years to reward their political allies.

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  15. I have two quite unrelated questions, Mr Hennessey, which are raised by your text:

    1. By what reason do you object to sending payment to those which do not pay income taxes? I don’t realize the objection on two grounds, but we may be looking at it differently.

    a. Once the government has decided it best knows how and when I need my money and begins effecting those decisions for me without my consent; I don’t see why it is different for them to dispose of it entirely. (Think of the stimulus this way, if you pay me $600 this year, but you financed it by running a deficit, you’ve essentially taken a loan out on my behalf which I am obliged to repay at interest. I don’t think you’d quite appreciate it if a neighbor went to BestBuy, bought you a computer on your credit, but when the delivered it assured you that, “It’s for your own good; you really needed a new computer now, not whatever else you would do later.” Once he started spending my money at the store on my behalf without my agreement, it wouldn’t seem that much different if he just started spending it on other people too.)

    b. Just because one doesn’t pay income tax now doesn’t mean he won’t in the future. Again, with it financed on a deficit, quite a few people who didn’t pay in that year are still likely to pay back more than the check’s value before the loan used to write the check is even close to paid off.

    2. “But even 1/4 or 1/3 of $787 B is still a lot of money to dump out the door.” Yes, it is. How would this not lead to tremendous burst of price inflation? Traditionally you’d look for inflation to be moderated by the stimulus first drawing up slack by hiring the unemployed. However, we hadn’t hit a very high rate of unemployment generally, and it would take time to retrain someone from work in the most contracting sectors of housing and finance for some other employment — time when the money is already circulating. With it coming so fast, I don’t think there would be enough time for businesses to have any idea of what was going on or what their real long term demand would be. I think that would effectively freeze the hiring market, regardless of a boost in short-term demand, because of long-term uncertainty. It would at best promote temporary jobs. The same goes for firing, as it would be at best temporary respite as business waited to see what the real long-term market for their products was. I don’t think there is compelling evidence to suggest that if demand could be stimulated long enough (call it T), that a business that waited T before deciding about layoffs would decide that fewer were necessary, or that they weren’t necessary at all. Such an assertion is speculative at best. This complete scenario as an argument only works if one believes that business and people behave entirely differently than each other: people are skeptical and reticent about short term, temporary income; but business respond to temporary income in exactly the same way as they respond to permanent income.

  16. It is commonly taught in economics that monitary tools are more effective and timely than fiscal policy in stimulating the economy – primarily because it is more timely. Moreover, contrary to textbook theory taught by new Keynesians as Greg Mankiw pointed out, the empirical studies done so far strongly suggest that tax cuts have a much larger multiplier than government spending increases – even Christine Romer’s own work suggests it.

    The problem with “the Stimulus” is that it did not meet Larry Summers own criteria, i.e., that it had to be timely, targeted, and temporary. The policy is supposed to be counter-cyclical, not pro-cyclical. And it has to be temporary as the stimulus from spending loses effectiveness (and begins to crowd out private investiment as the recovery continues).

    The Obama plan has some positive aspects (it contains some business tax cuts), but as a whole it is bad policy. Nick Bloom of Stanford modeled the economy and predicted in January that without any stimulus that the economy would bottom this summer, with a V shaped recovery. Other models, prior to the stimulus, show a similiar conclusion as to the bottom.

    To date, the Stimulus has distributed 37 billion dollars, an insignificant amount (perhaps 5% of the total). The stimulus won’t start having an effect untill the spring of 2010, by which we will already be on the road to recovery. And in the meantime, the stimulus will likely force growth a bit faster through 2010, and be useless in 2011.

    And the result? According to the administartions own numbers we will end up with a deficit of 1/2 trillion a year. According to other economists, the deficit will be 3/4 to 1 trillion a year.

    The ‘stimulus’ is too late, too diffuse, and too permanent.

  17. Pingback: Relevant and Irrelevant Criticisms of the Stimulus Package

  18. Prior to the publishing of worse than expected GDP contraction in the first quarter of 2009, Ray Fair ran his baseline economic projection with and without the stimulus expenditures as timed by the CBO in Feb 2009. Although the stimulus numbers and actual timing are in need of updating, the model is useful in comparing the effects of the likely tradeoffs of a stimulus.

    If the original CBO projected timing of the expenditure funds were carried out then the effects he projected were quite robust for the last 3 quarters of 2009 and first 3 quarters of 2010. With the stimulus the projected growth for the last 3 quarters rose from 1.3 to 3.2 percent per quarter (annualized rate per quarter). Without the stimulus 2009 would have just bottomed in the 3rd or 4th quarter. In 2010 in both cases the economy would grow quite well, with the non-stimulus baseline growth rate catching up to the stimulus growth rate by the the third quarter of 2010. Then the 4th quarter stimulus ends and the growth rate drops quite a bit while in the next nine quarters the baseline non-stimulus provides substantially more growth. The “stimulus” projection sharply drops to an annualized 1.5% growth per quarter (typically) while the baseline non-stimulus provides for 3% to 4.5% (typically).

    It would seem that the economic tradeoff is (with a timely stimulus) that one can force recovery sooner by 3 quarters, and lower maximum unemployment by about a percent IF one is willing to pay for the debt indefinitely and/or raise taxes (which would lower growth). Given the deficit projections made by many economists over the last several months, it doesn’t sound like a worthwhile long-term tradeoff.

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