Stimulus forever?

(NOTE FROM JOHN: Steven Kyle, a professor of economics at Cornell, is joining us as a regular writer on economics issues, and then some.)

History sometimes has some interesting lessons we all ought to remember. There has been a lot of talk recently about the stimulus, whether it has been big enough, and whether it should be extended and/or made bigger. A lot of the talk makes it sound as if people are just grabbing numbers out of the air, and that ANY kind of stimulus would be favored by one side and opposed by the other. But there is some real world guidance to what we ought to be doing and how long it should last

First, lets remember what a stimulus is for. In a recession like the current one, consumers are pulling back because they have too much debt, their stock portfolios have crashed, and their houses are worth way less than they thought they were. Business investment is also weak because nobody is buying anything and they arent even using all the capacity to produce they already have installed. The foreigners are in the same boat we are so there is not going to be a big help from exports.

That leaves only government as a potential engine of growth. And even there, government is fighting with one hand tied behind its back – In every recession since the 1940’s one of the main tools to stimulate demand has been a decrease in interest rates engineered by the Federal Reserve. But with interest rates already at near zero levels there is no more ammunition left in monetary policy, so the only way to stimulate things is to do it directly through government spending. For the greatest stimulative effect (!) there is a preference to spend money in ways that will put money in the hands of people who will themselves spend it – e.g. the unemployed or quick disbursing infrastructure projects rather than tax cuts where the cut may or may not induce more spending.

So here is a question everyone should ponder: When stimulus spending starts to wind down after the first half of 2010 and various incentive programs end in a few months, will all those nervous citizens step up and start spending and will business embark on a surge of investment spending? Will the roughly one third of the stimulus that is tax cuts inspire people to spend money rather than pay down debt? If your answer is yes, then be happy and don’t worry. If your answer is no, then we ought to be thinking about more stimulus and soon – because if we let things wind down again we will have to start all over but from a starting point with higher debt than we had at the beginning. Or we could just wait for everything to take its natural course . Paul Krugman has made a similar point recently.

How long will it take housing prices to return to “normal” levels relative to incomes? If incomes are falling, then obviously it takes longer for this to happen. How long will it take consumers to be happy with their debt burden? It is very unlikely that any of these happy situations will come to pass by the end of 2009 which is when several of the incentive programs passed under the stimulus will end. Housing prices will still be down in the dumps, foreclosures will still be high, and unemployment will very likely be rising since it tends to lag other indicators. All of this means we will need to keep up the stimulus until the housing market has stabilized (and that doesn’t mean mere falling at a slower rate) and consumers have worked off their excessive debt.

Back in the days before governments thought it was their job to enact stimulus programs it would often take 10 years or more for a cycle to come full circle. That is what happened in Japan in the 1990’s after a financial meltdown similar to ours. Do we want to wait that long? I sure don’t. But I wish I had more confidence in our elected representatives….

I teach economics at Cornell University and specialize in macroeconomic policy both in the US and in developing countries. I often travel overseas to do research and consulting in other countries, most recently in Africa and Central Asia. I sometimes wonder how this ever happened, but I guess it is no real surprise after previous careers as a bond trader in the British government bond market, an economist at the World Bank, and a short order cook on the beach in Delaware. My personal obsessions are politics and sailboats so I alternate between being a complete news junkie and being completely unplugged from any media or communications whatever on sailboats wherever there is warm weather. Having grown up overseas in various countries in Latin America I always have a desire to be nearer to palm trees.

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