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Monday, October 27, 2008

The Financial Crisis and Short-Run Stabilization Policy

Short-run stabilization policy for the economy during a downturn involves either cutting taxes to stimulate consumption and investment (and sometimes net exports), or increasing government spending. Which of these is used and the specific policy adopted has important implications for the effectiveness of policy, but no matter how it is done it will raise the deficit, and the increase in the deficit is often used to oppose the policy.

Theoretically, however, there is no reason at all why short-run stabilization policy ought to impact the long-run budget picture. Ideally, the deficits that accumulate during bad times are paid for by raising taxes or cutting spending during the good times so that there is no net change in the budget in the long-run.

Historically, we have been pretty good at spending money in bad times, but not so good at paying for the spending when times are better. But if we are serious about stabilization, that's what we need to do. When output is below the long-run sustainable rate we increase economic activity by deficit spending, and when output exceeds the long-run sustainable rate, we decrease activity by running a surplus. Doing this fills the troughs with the shaved peaks from the booms and keeps the economy closer to the long-run trend value.

I've been wondering if the current crisis will change our attitude about paying for stabilization policy, i.e. if it will make us more willing to raise taxes and cut spending when times are good. One of the problems with the last two boom-bust cycles was unchecked exuberance. Any calls to raise taxes or interest rates were met with howls about how it would cut off the boom, and who would want to do that? But tempering the boom might have helped to reduce the size of the meltdown we are experiencing now and left us much better off.

When the next boom develops, will we be more willing to raise taxes, cut spending, and tighten Fed policy? Will we remember what happened when the previous two booms ended and be more willing to step in and slow down the booming economy, will we be less susceptible to the argument that doing so will eliminate creative and productive innovation (as opposed to misdirecting resources during the mania phase)? This doesn't mean creating a recession or slamming on the brakes so hard we hit our heads, it doesn't mean ending innovative activity, it simply means what it says, bringing the growth rate down to its sustainable rate, and attenuating the exuberance that leads to housing and dot.com bubbles. Will we be more willing to take the necessary steps the next time the economy begins to boom?

I doubt it.

And the problem is that if we aren't willing to pay our bills during the good times, then it will be much harder to spend the money we need to spend when times are bad -- our hands will be tied when it comes to stabilization policy.

So perhaps a business cycle version of Paygo is needed. Legislation could be clearly identified as a countercyclical measure, and it would contain both the deficit spending to address the downturn along with an explicit plan to pay for the policy when times get better. That is, the legislation would contain a specific trigger saying that when the recession is over and GDP growth, employment growth, etc. exceed some predefined amount (e.g. two quarters of strong growth), taxes would go up or spending would be cut by enough to pay for the stabilization package.

My concern is that worries over the deficit will prevent us from taking the countercyclical policy steps we need to take to protect people who are vulnerable to job loss, etc. in a downturn. Thus, the goal here is to find a way to ease the long-run budget worries so that we don't hesitate to do what's needed to stabilize the economy. I'm not sure if a business cycle version of Paygo is the answer, it may be just as hard to promise to raise taxes in the future as it is at any other time (though perhaps this would be easier if it returned rates to old levels), and the triggers would be hard to define, but somehow we need to learn to pay for the policies we put in place so that they will still be there the next time we need them.

A better answer would be a legislature that does this on its own without the need for mechanisms such as Paygo to force them to do what is best for the economy over the long-run, but that hasn't worked. Maybe we''l get a better class of legislators in the future, but I'm not counting on that.

Finally, this is separate from spending on infrastructure, health care, etc., and whether we can afford it. I think we can afford it, and that we should invest in infrastructure to enhance future productivity, that we should take on health care (our biggest long-run budget worry), and that we should make other investments in our future, but that is a different discussion. They can be connected - short-run stabilization can be directed a longer-run problems when it's feasible to do so - but the case for short-run stabilization can be made independent of whether or not it contributes to solving longer run issues. If it does, so much the better.

    Posted by on Monday, October 27, 2008 at 02:25 PM in Budget Deficit, Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (52)

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