Recession…What Now?

America is in recession, the National Bureau of Economic Research (NBER) announced last week. To many, this may be stating the obvious, given the layoffs and economic slowdown after September 11th. What may not be as obvious, however, is the fact that the recession was well underway before the terrorist attacks. Looking at crucial economic data such as industrial production, real income, employment, and wholesale-retail trade, the NBER puts the start of the recession in March 2001. This ended a ten-year economic expansion, and the downturn has only been compounded by the economic uncertainty generated by terrorism. As in past recessions, Washington is brimming with proposals to jump-start the economy. Yet beyond getting the incentives right, there is little that Washington can do to boost the economy.

Troubled economic times increase pressure for a “quick fix” to a sagging economy; politicians are acutely aware of higher unemployment in their home districts. Rightly or wrongly, politicians want to be seen as proactively addressing the economic downturn. The primary tool at Washington’s disposal is fiscal policy, or the use of the federal budget to promote specific economic goals. Determining how much—or how little—to tax, how much—or how little—to spend, and how much—or how little—to redistribute in transfer payments are all elements of fiscal policy.

In its heyday, fiscal policy was believed to be a discretionary tool that economic planners could use to stabilize the economy. If the economy was heating up and the prices of goods and services were increasing too quickly, demand could be dampened by raising taxes and cutting government spending. Conversely, in times of recession, tax cuts and spending programs could be used to boost spending and pull the economy out of recession. However, because the impact of government spending is direct, while tax cuts have only an indirect effect, many proponents of fiscal policy opt for spending rather than tax cuts as a tool of fiscal policy.

With the country in an economic slump, many in Congress are falling back on expansionary fiscal policies as a solution. The numerous spending proposals and spending bills already approved seem to suggest that the government can spend our way back to prosperity. Yet historically, attempts at fiscal stabilization have fared poorly. The stagflation of the 1970s resulted from a decade of expansionary fiscal policies and government tinkering exacerbated by energy supply shocks. As a result, the economic climate was harsh and economic growth was slow. Interest on home mortgages reached double digits by the end of the decade and remained stubbornly high for years. If Washington forgets these lessons of the past, it could be costly for consumers.

Originally designed to address an economy with idle resources, fiscal policy was viewed as a tool to put these resources back to work. However, in an economy where resources are not idle, increasing demand through more government spending has negative effects on the private sector. If the government borrows money to fund its spending, interest rates are driven higher. While this may not affect government spending to a significant degree, private sector investors are more attuned to interest rates and may forgo borrowing additional funds. To the extent this is true, funds will be diverted away from the private sector and into the public sector. In this sense, expansionary fiscal policy can increase the growth of government relative to the private sector.

Much of what Congress is currently debating is a mix of tax cuts and more government spending. Along with higher defense spending, Congress already has spent billions on the airline bailout. Proposals abound for more spending on everything from pipeline safety to a high-speed rail system. It is plausible to suggest that all of this government spending would ultimately increase inflationary pressures on the economy, driving prices higher and slowing economic activity. In fact, some suggest that the economic slow-down may be due to the record tax surpluses collected by the government as a result of the economic boom. The budget surplus resulted not from fiscal restraint, but from a booming private sector that generated more tax revenue. Rather than return the excess revenue to the private sector where it could be invested, government budgets grew and government spending ramped up just as quickly. This excessive spending ultimately requires more tax revenues. State and local governments are already feeling the pinch, as revenues have dried up and can no longer support bloated spending programs. Across the nation, states and localities are scrambling to raise taxes to meet budgetary shortfalls.

Alternatively, tax cuts are important because they can increase the incentives to commit capital and labor in the marketplace and thereby increase economic growth. However, not all tax cuts are equal. Tax cuts aimed at stimulating spending in the short run or tax cuts that do not change long-term incentives will have limited impact because they won’t change the overall level of economic activity. However, tax cuts that promote investment and allow workers to keep a larger percentage of their income can increase both the amounts of capital and labor supplied in the marketplace.

Just because the government cuts taxes does not mean the burden of big government is reduced. Many elements of the stimulus package are government spending programs. With reduced tax collections, government spending programs will require eliminating the surplus, increasing government borrowing, or printing money to cover the costs of these programs. Any economic stimulus package, therefore, should limit federal spending and focus on providing the correct incentives for private sector growth.

In addition to economic questions about the effectiveness of fiscal policy, the political process makes government tinkering a poor tool for economic policy. Even if economists could make accurate forecasts that could be used as a basis for fiscal policy (a very bold assumption, indeed) political wrangling creates lags that delay the timing of fiscal policy to the point where political solutions can do more harm than good. The president and Congress must agree who to tax and how much, what to spend on what projects, and which transfer payments should be made. Once the political bargaining is complete, it is dubious that the stimulus package will be a sound economic package. Political logrolling will ensure a vast array of pork-barrel projects as the needs of favored constituents are addressed.

When all is said and done, Congress has no silver bullet that can halt a recession and turn the economy around. At best, Washington can strive to eliminate barriers to private sector growth. Lowering taxes in order to provide greater incentives to invest and to work is an important step to take. Lower marginal rates on income taxes, repealing the alternative minimum tax, accelerating depreciation, reducing or eliminating the capital gains tax—all these provide incentives at the margin. At the same time, these need to be accompanied by fiscal restraint that limits federal spending. Together—lower taxes and less spending—can provide promote a stronger economy and faster economic growth.