Tuesday, January 13, 2009

Fiscal stimulus parable - How much is enough?

Mark Thoma has an interesting parable on the fiscal stimulus. He writes,

I think the stimulus package is like driving up an icy hill. If you don't have enough momentum from the start and fail to provide enough "stimulus" to get the car over the crest of the hill, you can slide all the way back to the bottom, crashing into things along the way and ending up worse off than when you started. Maybe you can give it more gas along the way if needed without spinning out, and perhaps you can hold your position if you don't make it to the top, and then start again from the higher level, but that's not a chance I want to take when I'm sitting at the bottom wondering if I can make it to the top without wrecking my car - the possibility of falling all the way back to the bottom and ending up worse off would make me want to start with sufficient momentum and then some. Essentially, I am arguing that there are crucial economic and psychological "tipping points" that must be reached in order for the economic recovery package to be effective (or at least, there's enough of a chance that they exist that they cannot be ignored when formulating robust policy).

The critical issues with tailoring any stimulus, fiscal or monetary, are two-fold - timeliness and quantum. When (or how early) should the stimulus kick-in and how much should the rates be cut or what should be the magnitude of the fiscal stimulus? The Government's reluctance to step in early and adequately enough have been ascribed as the reasons for the Great Depression assuming such magnitude and more recently the Japanese economy slumping into a decade long recession.

With Governments across the world having stepped in early enough, there is an intense debate in the US about the magnitude of the fiscal stimulus that the Obama administration should propose. Paul Krugman has been at the forefront of the voice calling for more, a fiscal "surge" (more here). Lawrence Summers opined that, "In this crisis, doing too little poses a greater threat than doing too much."

Three issues with this line of thinking. One, it is debatable as to whether if these two points are addressed, the stimulus will succeed. Second, I am not sure about what constitutes the "tipping point", if there is any, and whether anybody knows it. Three, in the medium and longer term, we also need to keep in mind the consequences of the fiscal largesse, the need to re-balance Government finances after the wreckage is cleared.

None of this is to say there should not be any stimulus. But it only underlines the need for oceans of good-luck to bail the economy out and the need to straddle a thin and unknown dividing line between rectitude and license. And also the importance of specific strategies that ensure the biggest bang for the stimulus buck.

Update 1
Krugman uses CBO GDP outlook, which predicts an 8% plus potential-actual GDP gap, to claim that the 3% of GDP committed by the proposed Obama Plan will be a blip on the radar. Howard Gleckman describes the Obama Plan, with its $300 bn tax cuts, including $150 bn for businesses, as "Lots of Buck, Not Much Bang".

Update 2
Christina Romer and Jared Bernstein tries to quantify the numbers of jobs created by various spending programs.

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