Plain Sense Economics

This segment on NPR highlights the discussions taking place in Washington as the prospects for a recession increase. Reporter Jim Zarolli describes a panel discussion among notable economists and policy experts, including Harvard’s Martin Feldstein, and past Treasury Secretary Robert Rubin – on the topic of using fiscal policy to stimulate the economy.

As a quick review, fiscal policy is the use of the government’s power to tax and spend. Monetary policy is the other government lever on the economy, and uses the ability of the Federal Reserve to influence interest rates through changes in the supply of money.

In his lead in to the piece, Zarolli notes that Federal Reserve chairman Ben Bernanke gave strong signals that the Federal Open Market Committee will act vigorously to reduce interest rates when they meet later this week. Others, Zarolli reports, worry that monetary policy actions may not be sufficient to fight an economic slowdown. Hence the discussion of fiscal policy.

In order for the government to move its fiscal policy lever Congress and the President must agree on a solution. Any government spending or tax decisions require legislative action and a presidential signature. The requirement for action and agreement among politicians is the root of the problems associated with fiscal policy.

Fiscal policy is often ill-timed. We note a recognition lag – where members of Congress, lacking a full staff of forecasters and economists, are often slow to act on changes in economic conditions. They also tend to “read” data that affect their constituencies. There is nothing wrong with a member of Congress reacting to increased housing foreclosures or factory layoffs, but the story is often more complicated.

Once Congress decides action is needed they need to agree on a solution. As President Roosevelt took office in the the first third of the Great Depression he was successful in galvanizing Congress to pass a series of spending bills that would become part of his New Deal legacy. Today, in the absence of a catastrophic event and also missing a charismatic president Congress will be less focused and more argumentative. Many of the earlier solutions being floated involve tax cuts – either making earlier tax cuts permanent or granting one time tax credits or refunds. There are some spending proposals as well, including improving unemployment benefits and food stamp programs. Of a necessity, the final compromise will be a mixture, and it will not be well designed. We can safely assume that many Congressional leaders will use this opportunity to push longer term political goals, with only a partial nod to the economic situation facing us today.

Once Congress and the President agree on a fiscal solution, the implementation takes time. The exception is a quick tax rebate, such as we enjoyed in the summer of 2001. Other than a rebate most solutions won’t impact the economy until much later in 2008, if then.

And any fiscal stimulus puts greater strain on the federal budget deficit.

So, why do we bother? The strongest driving force for fiscal policy is the responsibility felt by members of Congress towards their constituents and supporters. In addition, the investment markets, both here in the United States and around the world, look for political leadership in tough times. No movement by Congress can be interpreted as a sign of weakness or lack of resolve and drive investors away from US assets.

Let’s watch this play out in the next month or two.

Addendum – January 12: From Greg Mankiw’s blog, comes this link to an excellent description of the issues surrounding fiscal policy. This is a pdf document (24 pages) written by Douglas W. Elmendorf and Jason Furman, posted by the Brookings Institution.