According to the National Bureau of Economic Research, the official arbiter of when recessions begin and end, the Great Recession began in December 2007 and ended in June 2009. For the millions of Americans who still cannot find a job, the recovery that began in July 2009 has been disappointing, to say the least. Now that we are approaching the fiscal cliff, which is a set automatic spending cuts and the expiration of the Bush tax cuts, recessionary forces are looming once again. Sadly, economists are still debating the exact causes of the last recession and what the optimal response to it would have been. For the purposes of this post, I will focus on the use of fiscal policy as a way to stimulate the economy. More specifically, I will address the optimal balance of tax cuts and spending increases that the federal government should implement to get the economy back on track when it has slipped off the rails. I will put aside the issue of monetary policy, though it remains a very strong tool for combating recessions.
After receiving input from his team of economists and other advisers, President Obama proposed the American Recovery and Reinvestment Act (ARRA) of 2009 as a way to boost the flagging economy he encountered upon taking office. Though other government programs, such as the Troubled Asset Relief Program (TARP), were already underway to counteract the financial crisis and economic downturn, the ARRA represented arguably the strongest action taken by the federal government to fill output gap caused by the recession (here, output gap is defined as the difference between potential GDP and actual GDP). One of the most contentious aspects of any stimulus package is how to balance tax cuts and increase in government spending. In the case of the ARRA, Obama chose a balance of about 2 to 1 for spending increases to tax cuts.
The strongest case for including more tax cuts in the package at the time was that they would take effect immediately and boost consumer spending in short oder. This stands in contrast to government spending programs, which normally take months or even years to fully go into effect because of the scarcity of true “shovel-ready” projects at any point in time. In fact, the argument for more tax cuts could be made by just looking at the title of the Act: the American Recovery and Reinvestment Act of 2009. The ARRA was signed into law on February 17th, 2009 by President Obama, but by that point the economy had already been contracting for almost fifteen months.
The argument for tilting a stimulus package toward government spending has always been that this type of stimulus has a larger fiscal multiplier than tax cuts do, meaning for each dollar spent there will be larger boost to national income. Fiscal multipliers are notoriously difficult to measure, but most economists believe the multiplier for government spending is higher than the multiplier for tax cuts (they mainly disagree on the magnitude of this difference).
So if tax cuts are the faster form of economics stimulus, but government spending has a larger impact, how should policymakers respond to recessions? What’s the optimal balance? I believe the debate over this issue is missing one key element that would change the calculus: deleveraging. At the time of the debate over the ARRA, critics of the tax cuts approach argued that people would just pay off debts with their free money, rather than spend it on goods and services. This, they said, is why tax cuts have such a low multiplier and are the inferior method of economic stimulus. But deleveraging is exactly what the economy needed to achieve an enduring recovery, as opposed to the occasional “recovery summer” or “recovery winter.” In an article for the Washington Post about the role of mortgage debt in the recovery, Zachary Goldfarb cited the work of economists Atif Mian and Amir Sufi to explain how debt effects consumer spending:
“But Mian and Sufi’s research showed something more specific and powerful at work: People who owed huge debts when their home values declined cut back dramatically on buying cars, appliances, furniture and groceries. The more they owed, the less they spent. People with little debt hardly slowed spending at all.”
Also, in a must read piece for the Boston Review, Mike Konczal laid out the argument for why what we went through can best be described as a “balance sheet recession”:
“In the housing bubble prior to the economic crisis, households took on significant amounts of mortgage debt. But homeowners judged the debt to be manageable because it was balanced by double-digit growth in housing values. Those housing values started to crash in 2006. Households then began to pull back on their consumption in order to pay down debts and restore their balance sheets.”
If we are to trust the work of Mian and Sufi and the analysis of Konczal, then the biggest critique of favoring tax cuts in the 2009 stimulus package, that they would be used to pay down debts rather than spent in the economy, turns out to be one of their most appealing qualities. Since we now know that consumer spending, which accounts for roughly two-thirds of our economy, is highly sensitive the an individual’s level of indebtedness, the optimal response in a balance sheet-type recession would be to help along the deleveraging process as much as possible. Hopefully after the next recession, “mostly used to pay down debts” will be listed in the “pro” column and not the “con” column for tax cuts.
Total U.S. Household Debt (not adjusted for inflation)