Course of Economy Hinges on Fight Over Stimulus

JON HILSENRATH| JULY 26, 2010

WASHINGTON—Eighteen months after President Barack Obama administered a massive dose of spending increases and tax cuts to a weak economy, a brawl has broken out among economists and politicians about whether fiscal-stimulus medicine is curing the illness or making it worse.

The debate is more than academic. It is shaping congressional decisions on whether to respond to the distressing prognosis for the U.S. economy with more government spending or a dose of deficit reduction.

One side says Mr. Obama's $862 billion fiscal stimulus prevented an even graver recession. Cutting the deficit right now, this side insists, would send the economy into a tailspin. The other side questions the benefits of the stimulus and argues addressing long-term deficits now is crucial to avoid higher interest rates and even bigger economic problems down the road.

And then there is a camp in the middle—defending last year's stimulus, but urging a deficit-cutting plan now.

The quarrel over deficits and the economy is at the center of many congressional disputes. Republicans battled against Mr. Obama's proposal to renew the extension of unemployment compensation benefits for up to 99 weeks, insisting on spending cuts elsewhere to avoid widening the deficit, but lost last week. The president argues the benefits are vital to millions of unemployed and would bolster consumer spending.

Meanwhile, the White House says it will allow taxes to rise on families with incomes above $250,000. Republicans and a few Democrats argue that allowing President George W. Bush's income-tax cuts on those upper-income households to expire at year-end, as the law currently provides, will choke the economy.

"Too many are searching for answers in the discredited economic playbook of borrow-and-spend Keynesian policies," Rep. Paul Ryan, a Wisconsin Republican who is pushing a long-run deficit cutting plan, said this month. "I reject the false premise that only forceful and sustained government intervention in the economy can secure this country's renewed prosperity."

Richard Trumka, president of the AFL-CIO union alliance, says if the government starts cutting deficits now, "We'll slip back into recession and possibly depression."

Public opinion seems to be with the deficit fighters. A June Wall Street Journal/NBC News poll asked respondents which statement came closest to their views: (1) The president and Congress should worry more about boosting the economy even if it means bigger deficits; or (2) The president and Congress should worry more about keeping the deficit down even if it means the economy will take longer to recover. Some 63% chose deficit-fighting.

Most mainstream economists agree on some points: The U.S. economy needed some kind of fiscal help in 2009 as the financial system teetered and the Federal Reserve pushed interest rates near zero. The deficit has to be reined in eventually, in part by restraining the growth of spending on health and other benefits. And developing a long-term plan to do so now would reduce risks of a future financial market calamity and help hold interest rates down.

But today, neither side can say with certainty whether the latest stimulus worked, because nobody knows what would have happened in its absence.

Fed Chairman Ben Bernanke backed fiscal stimulus in early 2009. Now he says the economy still needs fiscal stimulus, but says it must be accompanied with a credible plan to reduce future deficits. Like the Obama administration, he doesn't think that plan should be implemented until the economy is on more solid footing.

Unlike the U.S., Europe has embraced, at least rhetorically, the primacy of deficit-reduction now. In some instances this is because of pressure from markets and the International Monetary Fund, such as in the cases of Greece and Spain, and in other instances because of local politics, as in the cases as the U.K. and Germany.

"It is an error to think that fiscal austerity is a threat to growth and job creation," European Central Bank President Jean-Claude Trichet said recently. "Economies embarking on austerity policies that lend credibility to their fiscal policy strengthen confidence, growth and job creation."

The case that government deficit spending can be vital at times of recessions dates to John Maynard Keynes, the British economist whose teachings dominated economics for decades after the Great Depression. "Pyramid-building, earthquakes, even wars may serve to increase wealth," Mr. Keynes said in his 1936 classic, "The General Theory of Employment, Interest and Money."

A counter-revolution led by Milton Friedman, of the University of Chicago, de-emphasized the role of government and gave rise to Ronald Reagan and Britain's Margaret Thatcher. Keynes lost favor during the stagflation of the late 1970s and early 1980s. The Fed and its manipulation of interest rates came to be seen as the best way for governments to manage the short-term ups and downs of the economy.

One big issue: Lessons about fiscal policy in normal times aren't necessarily applicable to today, when the Fed has cut interest rates to zero and unemployment remains high. Skeptics of fiscal stimulus traditionally argue that government borrowing crowds out private investment and pushes up long-term interest rates. True, says Obama adviser Lawrence Summers, but not at times like these.

When private-sector lending was drying up and the credit markets froze, "government investment and creation of demand for consumers was a form of alternative financing, not a threat to private investment," he says.

Both camps emphasize past victories. Keynesians cite deficit spending as the eventual cure for the Great Depression and see parallels to today and to Japan's premature deficit-cutting in 1997 as the cause for its return to recession.

The other side points to Margaret Thatcher, who in 1981—ignoring protests from hundreds of economists—raised taxes and tightened government purse strings to cut a budget deficit in mid-recession. The U.K. emerged with lower inflation, lower interest rates and a recovery.

Keynesians say that episode isn't relevant today because the U.S. can't cut interest rates, as the British did. Another difference: The British pound lost half of its value in the 1980s, spurring exports. The dollar, by contrast, strengthened after the financial crisis hit because global investors saw it as a safe haven.

The Obama administration is stocked with heirs of Mr. Keynes, including academics Christina Romer and Mr. Summers. Ms. Romer famously projected in January 2009 that without government support, the unemployment rate would reach 9%, but with support the government could keep it under 8%. It's 9.5% today.

Some Obama administration officials privately acknowledge they set job-creation expectations too high. The economy, they argue, was in fact sicker in 2009 than they and most others realized at the time. But they insist unemployment would have been worse without the stimulus.

In the first quarter of 2009, when stimulus was enacted, the economy shrank at a 6.4% annual rate. Since then it has grown at a 2.5% annual rate. And the U.S. recently has begun adding jobs, albeit slowly.

It's hard to isolate the impact of fiscal stimulus from other actions. Congressional approval of the stimulus in February 2009 coincided with an improvement in the economy. But before Mr. Obama's stimulus was enacted, the Fed pushed short-term interest rates to zero and began buying mortgage-linked securities to drive down long-term interest rates. Soon after the stimulus was okayed, the Fed expanded its securities purchases. A turnaround in the stock market coincided with the Fed's expanded effort and with a separate Fed-Treasury "stress test" to shore up confidence in the nation's banks.

The Obama stimulus, a third of which was temporary tax cuts and the rest spending on everything from infrastructure to unemployment insurance, is still affecting the economy.

Robert Hall, a Stanford University professor, says there hasn't actually been that much extra government spending overall, because the increased federal spending has been largely offset by a large contraction in state and local government outlays. By the third quarter of 2009, he notes, federal government spending added $66 billion to economic output, less than 0.5% of total output, offset by a $43.1 billion contraction in state and local government spending, he says.

A study of 91 fiscal stimulus programs in 21 developed economies between 1970 and 2007 by Harvard's Alberto Alesina found tax cuts were more stimulative than government spending. "I would have done more on the tax side than on the spending side," he says.

Underlying the debate is a long-running argument about how much of a lift the government gets from spending more or taxing less. Keynesians argue that when the economy is distressed, a dollar spent by the government multiplies in value. It gives a worker income the private sector has failed to produce, which he spends, creating demand for goods and services.

Ms. Romer argued last year that this "multiplier" for government meant every dollar spent created about $1.50 worth of demand.

Some economists say that's too high. Valerie Ramey of the University of California at San Diego, initially thinking as a Keynesian, developed doubts after sifting through historical examples. During the military build-ups of World War II, the Korean War and the Reagan era, a dollar spent added roughly a dollar of growth, she says. Although Ms. Ramey supported stimulus in 2009 because the economy was so weak, she doesn't advocate more now. "We just don't have enough evidence to prove that it's good."

Robert Barro, a Harvard economist, found even smaller multipliers: A government dollar spent creates about 80 cents worth of growth, or possibly less, he says. Government spending, he says, crowds out private sector spending that would otherwise be taking place.

Keynesians say other things were happening at the same time as military build-ups that muddy the results. During World War II, for instance, consumer goods were rationed and Americans were exhorted not to spend.

Economists who say Mr. Obama should have relied more on tax cuts cite research of an unlikely source: Ms. Romer, his adviser. In a study she and her husband, David Romer, conducted before she joined the administration, Ms. Romer found large multipliers from tax cuts, which she concluded "have very large and persistent positive output effects." Tax increases, she also found, hurt growth.

That study didn't address whether spending is better than tax cuts, though. And she says the gravity of the economic situation called for both tax cuts and spending.

Tax cuts haven't been a cure-all. President Bush tried $168 billion of tax rebates in 2008, and a recession ensued anyhow. Economists note that households tend to save temporary tax cuts or use them to pay down debt, so they don't provide much short-term stimulus.

Before the debate over the efficacy the 2009 stimulus is resolved, Congress is turning to whether it's time to start cutting deficits.

Mr. Alesina says it is: In 107 periods since 1980 when governments cut deficits, doing so tended to quicken economic growth, not slow it. But his study focused on periods when central banks could offset deficit cutting with lower interest rates. The Fed has exhausted that avenue.

Carmen Reinhart, a University of Maryland economist who has studied the fiscal aftermath of financial crises, says more stimulus could be counterproductive because it could lead the public to expect even higher taxes in the future.

Instead, policy makers now need to convince the public that they are committed to reducing future deficits, without acting on that commitment right away, she says. That could hold interest rates down, without yanking money from an ailing economy too quickly.

"We are not in an easy position," she says. "Credibility is going to be difficult to achieve."