The Case against the Fiscal Stimulus

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INTRODUCTION

When President Barack Obama took office on January 20, 2009, the U.S. economy had been in recession for over a year, and the prospects for a quick recovery appeared bleak. The Federal Reserve had already lowered interest rates to zero, which implied that monetary policy was unlikely to provide further stimulus. (1) Thus, the Administration, along with many economists and pundits, turned to the other key pillar of stabilization policy: fiscal stimulus.

The fiscal approach was immediately controversial, however, for two main reasons. First, academic economists have come to regard fiscal policy as less suitable than monetary policy for stabilization purposes, principally because monetary policy can act quickly, whereas fiscal policy can suffer significant delays in adoption, implementation, and impact. (2) Second, the U.S. was already facing a dismal long-term fiscal outlook because of programs like Medicare, Medicaid, Social Security, the wars in Iraq and Afghanistan, and the TARP bailout. This outlook made some economists wary of new measures that would increase the deficit, even if only temporarily. Yet the Administration apparently concluded that it had no alternative given the state of the economy, so it plowed ahead with a fiscal stimulus.

Deciding to adopt a fiscal stimulus, however, did not resolve all of the issues. The other question was what combination of tax cuts and expenditure increases to include in the stimulus package. Strict Keynesian theory holds that any tax cut or spending increase can stimulate the economy, even if the tax cut is badly designed and even if the increased spending is for worthless junk. (3) If this perspective is right, quibbling about the exact composition of the package is neither necessary nor fruitful.

I argue here, however, that the structure of a fiscal stimulus is crucially important and that the package Congress adopted was far from ideal, regardless of the merits of the Keynesian model. Whether countercyclical fiscal policy is beneficial is a more difficult question, but it is not the critical issue if a stimulus package is properly designed. In fact, the Administration could have created a package that stimulated the economy in the short term while improving economic performance in the long term. This package, moreover, would have been immune to criticism from Republicans. The stimulus adopted was a missed opportunity of colossal proportions.

That the Administration and Congress chose the particular stimulus adopted suggests that stimulating the economy was not their only objective. Instead, the Administration used the recession and the financial crisis to redistribute resources to favored interest groups (unions, the green lobby, and public education) and to increase the size and scope of government. (4) This redistribution does not make every element of the package indefensible, but even the components with a plausible justification were designed in the least productive and most redistributionist way possible.

The remainder of this Essay is organized as follows. Part I discusses the arguments for and against fiscal stimulus. Parts II-IV examine the main components of the stimulus (tax cuts, energy programs, and infrastructure spending, respectively). Part V addresses other miscellaneous components. Part VI considers the broader implications of the fiscal stimulus.

I. THE KEYNESIAN MODEL

The standard justification for a fiscal stimulus relies on the Keynesian model of the economy. This model has been taught to generations of college students in economics classes around the world, and economists widely--though not universally--accept it as the starting point for analyzing booms and recessions. (5)

According to the Keynesian model, recessions occur because of a lack of aggregate demand, and government can remedy this shortfall by stimulating demand. On the one hand, government can increase its own demand for goods and services, for example by building more highways, purchasing more military aircraft, or funding additional research and development. …