The Federal Stimulus

329px-official_seal_of_the_american_recovery_and_reinvestment_act_of_2009svgThe US Government has implemented three major bailout programs to deal with the current situation. The first was the Emergency Economic Stabilization Act of 2008 which was designed to deal with the financial crisis by setting up the TARP fund. We discussed this in an earlier section of this report. [link] The last two were fiscal stimulus programs addressed to the economic recession.

In early 2008, the Bush Administration’s Economic Stimulus Act was enacted. The program, based on the supply side principles, consisted of $152 billion worth of tax rebates to individuals and depreciation allowances to businesses, split roughly two to one. The intent was to induce consumer and investment spending to prevent a recession. While this initiative may have helped, a major downturn in economic activity occurred nonetheless.

In our analysis of the recession, we outlined the nature of the problem: businesses only produce output (and provide jobs to workers) if they expect to be able to sell their products. Total expenditure on US goods and services has declined due to a collapse in investment spending and more modest declines in consumption and export spending. Since spending is down, so are production and jobs.

What will it take for the US economy to recover? The lower housing prices we’ve been experiencing will stimulate demand for housing, but the large inventory of unsold homes must be eliminated before additional residential investment will occur. We can expect some improvement over time in business investment as firms’ plant and equipment decline below desired levels. Exports will improve with the global economy, but that’s unlikely to happen significantly until after the US leaves recession behind. Falling imports can not be expected to make up the difference. Consumer spending is largely tied to the state of the economy. While we stay in recession, it’s unlikely consumer spending will improve enough to offset the shortfall in investment spending. Yet until something does, we will remain in recession.

In February 2009, the American Recovery and Reinvestment Act (ARRA) was signed into law.1 This act provided a standard Keynesian response to recession but with a twist—an emphasis on infrastructure investment. The solution proposed by the Obama Administration was a massive increase in Federal spending to counteract the decrease in private sector spending.
Government spending is commonly criticized as being wasteful and inefficient, yet even conservatives recognize the existence of public goods. Public goods are typically big ticket items where once they are provided they are available for everyone without paying. Examples of public goods include highways, education and police. Because of the nature of public goods, potential users have strong incentives to free ride, that is, to forego their purchase in hopes that someone else will pay after which they can use the public goods for free. As a consequence, the private sector under-provides public goods. An adequate supply requires collective action, in other words, government.

Photo courtesy of mangee (via flickr)

Photo courtesy of mangee (via flickr)

Many public goods are infrastructure investments. They provide benefits to society over an extended period of time. The downside is they tend to require large expenditures up front and they often are not maintained as well as they should be.  Note, for example, how run down US highways and bridges have become over the last generation. But this is not costless. A recent study estimated the annual cost of highway accidents due to poor road conditions at $217 billion. It is for these reasons that the Obama administration’s stimulus package was designed to focus on infrastructure investment. Compromises necessary to get the bill passed, however, meant that the final bill was less focused on infrastructure than initially proposed.

The ASSA was a $787 billion stimulus package, the largest fiscal stimulus in the US since the Second World War. The package consisted of $507 billion in spending and $282 billion in tax cuts, but only 36% of spending (23% of the total package) was infrastructure, broadly defined. The rest included healthcare, education and extended unemployment benefits and other income security programs.

We observed in our earlier analysis of the recession that there was no evidence of the fiscal stimulus through the first quarter of 2009.  One problem is that infrastructure takes time to implement, thus the emphasis on ‘shovel ready’ projects. For purposes of economic stimulus, it is probably a good thing that much of the increased government spending is not investment, since the impact of extended unemployment benefits will likely be quicker.

There is a legitimate concern that the very large fiscal deficits resulting from the stimulus package, will depress economic growth over the long term.2 Short term, though there seems to be little alternative. Note that the extent to which federal spending is on infrastructure it may mitigate the crowding out effect on economic growth. The Obama administration has claimed it will reverse the fiscal stimulus after the recession is over.

  1. Details of the Act can be found at .
  2. The Congressional Budget Office forecasts a short term improvement due to the stimulus but a small decrease in economic growth over the long term.