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Fiscal Stimulus: Too Little or Ineffective? What Next?

Raj Nallari's picture

All over the world, countries have put in place fiscal stimulus packages as a response to the global crisis. In the US and UK, despite the large fiscal stimuli, the economies are stalling and unemployment rates are still high. Now, Paul Krugman is advocating a second $800+ billion stimulus as he is worried of a Third Depression (i.e. 1873-4, 1929-30 and now) or at best a low job creation and low GDP growth for the short to medium term. According to Krugman, low growth and high unemployment are shorter term problems that have to be resolved before fiscal austerity and debt reduction (which are longer term issues as bond financiers are still buying US securities). Others of conservative leanings, such as John Taylor and Gary Becker, are of the opinion that the Bush tax relief of 2008 did not work and that the Obama stimulus may not work because of small “fiscal spending multiplier”, and as the package is badly designed.

Carmen Reinhart and Rogoff document eight centuries of financial crisis and come to the conclusion that almost all the time it ends in tears with “deficits, debts and defaults.” Reflecting this view, leaders at the recent G-20 meetings pledged for fiscal austerity as the fiscal stimulus packages are quite unpopular in the western world.

Keynes’ reasoning was that increased government spending during a recession employs idle labor and capital and this boosts employment and output. In turn, additional income of such utilized labor and capital will be spent on goods and services, and this will help multiply the benefits to society, and so it continues. In reality, things don’t work so smoothly or so instantaneously. There are long delays between legislation and spending. For example, no more than fifty percent of US stimulus was spent during the first 12 months. The stimulus was spent not on construction or infrastructure but on public servants’ salaries, healthcare, school teachers, police, alternative energy sources, all of which are important for society, but did not create enough new jobs. Consumer confidence is still low, which means that consumers are not ready to spend. Moreover, despite regaining strength, the commercial banks are not allowing free flow of credit and are highly selective (a lesson they learnt from the recent housing bubble burst and financial crisis of 2008-9). Further, with a near zero federal funds rate, there is no scope for easy monetary policy. At least for now, the industrial policy of bailing out GM seems to have saved auto jobs temporarily as the new GM appears to be doing well while the old GM is still saddled with unpayable legacy costs in the form of benefit plans to ex-employees.

Keynes reasoning was within a closed economy where ‘leakages’ were possible only if the households and firms increased their savings rate. We now live in a globalized world where spending on imports is another leakage of the stimulus. Debt levels were not a concern for Keynes either. But, US and UK households, businesses and governments are fully lefiveraged and debt-ridden. The world has changed since Keynes and economies have become more complex with confidence about economy among consumers and businesses driving spending decisions.

What now? The US can hope that the remaining government spending will get the job done. These are troubling times but hope and inaction will condemn the US and UK to follow Japan which muddled through for 15+ years in ‘fits and starts’ coinciding with low growth and high unemployment. The US has a couple of policy options but this is the last chance: (1) Have a seven to ten year fiscal framework that shows a trajectory and target to fiscal balance over time through a policy of fiscal consolidation and spending cuts in the medium term while it quickly implements –another– medium sized fiscal stimulus that is targeted at construction and infrastructure; and (2) at the same time, commercial banks should be encouraged to lend prudentially to small and medium enterprises (moral persuasion). However, politicians don’t seem to have an appetite for more government spending. How will all this end?


You write: “and (2) at the same time, commercial banks should be encouraged to lend prudentially to small and medium enterprises (moral persuasion)” Yes but no one, not even the World Bank, supposed to be the prime development institution in the world, utters a word of protest when financial regulators require banks to hold higher capital requirements when lending to small and medium enterprises... which is similar to placing the heaviest “handicap” weights on the weakest horses in order for the race to be more equal. Currently, just because the regulators decided to allow the banks to lend to those who are perceived as being less risky with lower capital requirements, the small businesses and entrepreneurs, on top of the risk-adjusted higher interest rates they pay, need to pay an additional 2 percent a year only to remain competitive when accessing bank credit. Since it is precisely in the tuff times when we most need the tuff small businesses and entrepreneurs to get going, this all amounts to sheer lunacy.

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