When does fiscal stimulus work?

[dkf]

I continue to refine my views on the subject. I think that in almost all cases, monetary stimulus should be the first option. I think it can nonetheless be useful and necessary to deploy expansionary fiscal policy. A large but clumsy fiscal stimulus can help arrest a sharp decline in output and expectations (monetary authorities permitting). Beyond that, it seems to me that fiscal stimulus will work well in countries where it is believed that fiscal stimulus will work well.

What do I mean by this? Well, one obvious point is that a country that understands stimulus should experience an immediate jolt to confidence when stimulus is enacted. But other factors are likely to be more important. A country committed to stimulus will take care to prepare to use stimulus. It will construct a system of automatic stabilisers that provide immediate countercyclical aid as an economy deteriorates. It may have a backlog of needed infrastructure projects at the ready, which can be rushed into action as conditions warrant. A country generally sceptical of stimulus, on the other hand, will reach for it in an emergency and find that it is unprepared. Automatic stabilisers will be too small and will require constant Congressional maintenance. Too few projects will be shovel-ready. The need to legislate will lead to inclusion of pork items that aren't particularly stimulative. Stimulus will be less targeted, timely, and effective as a result.

A country that believes in stimulus will see little sense in equivocating over the size of the boost needed, for several reasons. First, the preparations made for stimulus will make it easier to fine-tune the response if inflation or interest rates begin to rise. And second, there won't be a cadre of sceptics aiming to negotiate the size of the bill downward as much as possible (and whose criticisms proponents will fear and respond to of their own accord). In a sceptical country, by contrast, the mechanics of a bill will be clunkier, and legislators and markets may be less confident that spending can be constrained if necessary. The majority will find itself negotiating with opponents, pre-emptively in some cases. President Obama's advisors originally went to him with a plan for a stimulus in excess of $1 trillion (and this was when they were significantly overconfident of the path of recovery), and that was subsequently revised down, for political reasons, to under $800 billion.

A country that believes in stimulus will be less anxious about waste, because planned cuts and expenditures will be prepared ahead of time, and because stimulus proponents will feel less defensive of the concept of stimulus. A sceptical country, by contrast, will feel the need to be very careful about waste, because money is flying out of the door for thrown-together projects, and because stimulus opponents will seize on any opportunity to discredit the stimulus programme. The result will be a slower deployment of funds that will reduce the effectiveness of the programme.

And finally, a country more comfortable with stimulus may handle deficit issues better. It may maintain its finances better in good times so as to freely deploy fiscal policy in bad times, and it might well be able to stay the course longer in the face of pressure from those urging fiscal consolidation in early recovery. A sceptical country, on the other hand, will disregard the deficit in good times and fret about it pre-emptively in bad times.

http://www.economist.com/blogs/freeexchange/2010/07/fiscal_policy

[roamer65]

1. Increase top income tax rates to 60%...

and use the money for partial deficit reduction and massive infrastructure-based stimulus programs.

This country will turn around in 2 years and the deficit will disappear.

[Kalidurga]

2. I agree about the tax rates,

but I think it is too late for tax hikes alone to save our economy. I think we need to make deep cuts in the military as well. We also need to put a preemptive tax on money being transferred out of the country, that way if factories and what not is being built with it then at least that way those funds are taxed. And finally a central bank...