What Kind of Fiscal Stimulus Package Do We Need?

It is now a given that the Obama government will have a large fiscal stimulus package.  Even the staunchest supply-siders are succumbing to the temptation of Keynesianism.  The question is how that package will be spent.  There are several ideas floating around.

The idea with the most traction so far is infrastructure spending.  The potential projects have mostly already been identified and can be spent right away.  However, the problem with infrastructure spending is potential for graft and rent seeking.  How the money will be spent will be subject to heavy lobbying by states, in a process that will likely be opaque, unfair, subject to backroom dealings and political favors.  When the money is allocated, then the various federal and state agencies will further involve lobby, rent seeking, and paybacks down to the state / agency level.  All of this then gets repeated at each level all the way down to the individual contractor.  It is not hard to imagine how inefficient and wasteful this process can be.  It is also questionable that the fed will pick the projects wisely.  We’ve all heard of the bridge to nowhere in Alaska.  The only reason this plan is so popular is because all the congressmen are drooling at the prospects of large federal outlays coming to their state, which surely will win them a lot of political points in their constituency and it can also be used to grant favor to their friends and associates.

The Republicans’ favorite remedy to every single economic woe seems always to be tax cuts.  To them, any tax distorts incentives and growth will magically come back once you cut business and personal income taxes.  Businesses will start hiring and the tax cuts to the top earners will automatically trickle down to the rest.  The problem is that this idea has become ideologically rigid and inflexible.  The Republicans seem to be still longing for the days of the Reagan revolution, when marginal income tax rates came down from the 70s to 28.  As a macroeconomic policy tool, tax cuts will be rather ineffective in kicking up demand in the economy.  The marginal propensity to spend by the higher earners will always be much lower than that of the average Joe.  It is hard to imagine John Paulson or George Soros spend that much more if they get a big tax cut.  Frankly, it’s hard to imagine that they will work much harder, either.  At some point, the change of the marginal tax rate at the very top of the scale has lower and lower impact on people’s incentives to work hard, to produce, or to consume.  I call that the diminishing returns of tax rate cuts.  That’s where the supply side economics becomes fairly ineffective.  At some level, the inefficiency created by a progressive tax system is compensated for by the practical need to collect revenues for public goods.  In the current economy, to collect enough tax receipts to keep a reasonable federal spending level cannot really be supported by a flat tax system.  Very few people will completely abolish a progressive tax system, and hence the only disagreement is a matter of degree.  In that context, a tax cut as a Keynesian measure to restart spending is not the best idea.

This brings us to the last one I will discuss here, rebates.  Opponents of rebates claim the original Bush rebate at the beginning of 2008 was ineffective.  What they failed to mention is that the main problem of the rebate was that it was too small.  Knowing what we know now, $160 billion in the context of over $500 billion of write-down in the banking system, $9 trillion of wealth evaporating in the housing and stock market is clearly vastly insufficient.  A much larger stimulus package of the order of $1 trillion will be a vastly different story.  Another objection is that consumers used a big portion of the rebate check to pay down debt, instead of spending.  This seems a false negative to me.  The amount that is used to repay debt serves a very useful purpose, in restoring health to the consumer credit industry.  In reducing consumer delinquencies, the default rates on mortgages, credit cards and auto loans will go down.  This will help stabilize the ABS market, in turn shoring up bank balance sheets.  The confidence in the consumers’ ability to repay will be the key to banks’ willingness to start lending again.  Plus, once consumers get some confidence back regarding their debt situations, their spending patterns will improve.  The debt repayment is not money lose.  This has great ancillary benefits which simply do not come with infrastructure projects.

Ultimately, rebate checks are a form of tax cut.  It has several advantages over the other alternatives.  First, it is a vastly progressive cut, which has much more direct impact on spending.  Second, it does not distort incentives and it does not invite rent seeking behavior.  Ultimately, consumers will have the discretion on how they spend the money, and hence we know it will be allocated with less waste.  It also is unlikely to have large moral hazard consequences as it will be a one time rebate only, instead of a permanent tax cut.  Lastly, let us know forget what got us into this mess is consumers are over leveraged.  To restore the system, a solution that does not de-leverage the consumers will not work.  None of the debt restructuring, loan modifications, foreclosure moratorium or 401(k) redemption ideas will de-leverage the consumers effectively.  Instead, it will encourage them to further extend the length of their indebtedness and prolong the pain.  Rather, recapitalizing consumers by transferring the debt to the public sector might be the most effective and quickest way to restore some confidence into the system.