Rethinking the Fiscal Stimulus Approach

We've been writing regularly about the possibility of an increase in discretionary government spending to offset the decrease in consumer spending over the next few months: the fiscal stimulus packages under discussion in the US, UK and elsewhere. Broadly speaking, I think both Rory and I lean in favour of such measures during serious economic downturns, as long as they are targeted appropriately.

But here's a refreshing dose of perspective: a set of IMF graphs that illustrate the cumulative impact of tax cuts & fiscal spending over the course of 4 and 12 months in various OECD countries. Of the economies analyzed, only Australia seems to gain any significant benefit from fiscal spending after a year has passed. Most other countries, including Canada, the UK and US, get negligible or negative effects from greater fiscal spending.

Why? Leakage. OECD economies are open and thus liable to see any stimulus effects quietly disappear, leaving behind a deficit that burdens future economic performance. This makes the whole notion of aggressive anti-recession spending problematic. Interestingly, the IMF findings show a roughly similar pattern for tax cuts - the "go-to" policy for the opposite end of the ideological spectrum.

(Updated thought: could it be that 12 months is not enough time to see return on fiscal spending targeted towards more long-term projects like infrastructure?)

So where does that leave policymakers in times of crisis? Stephen Gordon suggests more defensive measures: beefing up the social safety net, particularly for the soon-to-be unemployed. Robert Reich, a former US Secretary of Labor, broadly agrees. Although Reich supports the idea of a comprehensive fiscal package, he also thinks that the starting point for any crisis-management policies should be strengthening unemployment measures. Moreover, if an American fiscal stimulus package is rushed through Congress now, it may not be very effective at targeting the problem:

The coming stimulus package... will be voted on by a lame-duck Congress, many of whose members will want to reward campaign donors with juicy pieces of pork. Other lawmakers will see it as their last opportunity to include their pet project or tax perk, and some who won't be accountable because they'll be out of office in a few weeks anyway. In other words, it'll be less a stimulus than a Christmas Tree.

That's something to keep in mind, but there is one thing I do know: strengthening and expanding unemployment benefits isn't as sexy as a massive stimulus package. So, leakage or no leakage, I think we should expect that Christmas Tree to start get decorated a little earlier this year.

(graphs via a Worthwhile Canadian Initiative)