Feldstein: How to Avert a Recession

Marty Feldstein says it's time to use both monetary and fiscal policy to deal with the weakness in the economy:

How to Avert Recession, by Martin Feldstein, Commentary, WSJ: The American economy is now very weak and could get substantially weaker. Current economic conditions call for lowering interest rates and for enacting a tax cut now that is conditioned on economic developments in 2008. More generally, fiscal policy should be considered in the future whenever there is a risk that an excessively easy monetary policy could cause an asset-price bubble. ...

Almost every economic indicator -- including credit conditions, housing and consumer sentiment -- has deteriorated significantly since the Federal Reserve's October meeting. In my judgment, the probability of a recession in 2008 has now reached 50%. If it occurs, it could be deeper and longer than the recessions of the recent past.

Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral... Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the ... Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.

Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. ...

But rate cuts can still help. Lower interest rates will still reduce monthly interest payments for the one-third of homeowners who have adjustable rate mortgages, thus freeing up cash to spend on other things. When banks make new loans, they will do so at lower interest rates, encouraging more business and household borrowing.

Yet more than lower interest rates is needed. Fed Chairman Ben Bernanke signaled a desire for additional policies to reinforce monetary easing when he called for a dramatic temporary rise in the maximum size of eligible Fannie Mae and Freddie Mac mortgages -- to $1 million from the current $417,000. While this would help to stimulate the market for high-priced homes, it would cause these government-sponsored lenders to assume an even greater share of the U.S. housing market when there is a strong fundamental case for reducing their role. And why should American taxpayers provide an implicit guarantee to mortgages of up to $1 million when the average sale price of a home is now less than $250,000?

In a similar attempt to go beyond Fed easing, the head of the FDIC recently proposed that the government impose an across-the-board limit on the mortgage interest increases that are now scheduled to occur. With more than $350 billion of mortgages scheduled to adjust up in 2008, such an imposed limit could no doubt avoid many personal defaults. But arbitrarily changing the terms of mortgages ... would also destroy the credibility of American private debt. Who would invest in U.S. bonds or mortgages if the government could arbitrarily reduce the contracted interest payments?

What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.

Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process. ....

The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand. Now is surely a time for such a two-part strategy of expansion.

If we go the temporary fiscal policy stimulus route, which can occur through either an increase in government spending or a decrease in taxes, there is a reason to prefer increased spending. A tax cut creates an incentive for households to increase consumption, but there is no guarantee that they will, e.g. they could just retire debt instead. This is just the familiar split of a change in taxes and hence disposable income into a change in consumption and a change in saving, and most of the time consumption and hence aggregate demand will increase when taxes are cut, but we can't be sure in advance how a tax cut will be used. In addition, when the tax cut is temporary, as this one would be, the impact on consumption is generally lower than with a permanent change in taxes.

With government spending, however, the impact on aggregate demand is assured. A change in government spending impacts aggregate demand directly on a dollar for dollar basis so there is no uncertainty at all about whether or how much aggregate demand will increase with a change in fiscal policy. And, with all of our infrastructure needs, it's not as though we can't find places where government spending could increase output and employment and also improve our public capital (there are many other ways spending could help as well, infrastructure enhancement is not our only need).

So, I agree that we may need to try fiscal policy, but I don't see why temporary tax cuts should be preferred to temporary increases in spending. In fact, here's Greg Mankiw on this point. This is from his textbook Macroeconomics (5th ed., pg. 454) and it explains why temporary changes in taxes are not very useful for stimulating the economy:

 The permanent-income hypothesis can help us to interpret how the economy responds to changes in fiscal policy. According to the IS-LM model..., tax cuts stimulate consumption and raise aggregate demand, and tax increases depress consumption and reduce aggregate demand. The permanent-income hypothesis, however, predicts that consumption responds only to changes in permanent income. Therefore, transitory changes in taxes will have only a negligible effect on consumption and aggregate demand. If a change in taxes is to have a large effect on aggregate demand, it must be permanent. ... The lesson to be learned ... is that a full analysis of tax policy must ... take into account the distinction between permanent and transitory income. If consumers expect a tax change to be temporary, it will have a smaller impact on consumption and aggregate demand.

[Update: William Polley continues the discussion. Update: Free Exchange also comments.]