Even before President-elect Obama takes office, critics are circling his yet-to-be-released stimulus plan. There is skepticism from both the left and right, but the most emphatic objections come from conservatives, who question the utility of deploying old-fashioned fiscal stimulus—tax rebates/cuts/reductions or government spending—to boost demand and right the economy.
The objections come in several flavors. First, ideological. Amity Shlaes, George Will, and assorted libertarians cling bitterly to the notion that the New Deal didn't work, that FDR's policies of regulatory reform and sharply increased government spending were an abject failure, that the economy didn't turn around until the day Japanese bombers dropped their payloads on Pearl Harbor. They believe Keynesian-style stimulus didn't work in the 1930s, so it won't work now.
A second objection is aesthetic. Sure, boosting government spending and sending out tax rebates will encourage more people to spend. But it's not elegant. German finance minister Peer Steinbruck warned his fellow policymakers against the evils of "crass Keynesianism." (Perhaps he prefers the crass way his predecessors dealt with the crisis of the 1930s?)
Harvard economist Greg Mankiw has been compiling a list of skeptics who question the efficiency of fiscal stimulus. By definition, stimulus packages are the outcome of messy negotiations between Congress, the president, and, frequently, lobbyists. They're a magnet for special-interest pleading and frequently include tax credits for favored industries. In addition, Mankiw argued in his New York Times column, people, being rational, generally make pretty good use of their money, "[b]ut the same cannot always be said of the government." Having served in the Bush administration, Mankiw certainly witnessed his share of inefficient government spending. "If the stimulus package takes the form of bridges to nowhere, a result could be economic expansion as measured by standard statistics but little increase in economic well-being."
These critiques share a common assumption—that it's silly to rely on fiscal stimulus when we can use a tool that is more elegant, more efficient, and more powerful: monetary stimulus. The Federal Reserve can influence the trajectory of the economy by controlling interest rates. Lowering interest rates is more elegant and efficient because it's independent of politics (in theory), it's quicker than legislation, and it lets markets do the heavy lifting. Christina Romer, the Berkeley economist who has been tapped to head the Council of Economic Advisers, argued in a paper, co-authored with her husband in 1994, that in postwar recessions—normally generally modest ones—monetary policy has been more influential than fiscal policy in the early stages of recoveries.
Such research has dovetailed with the rise in recent decades of the cult of the Federal Reserve. During the New Deal, the Fed was still an immature institution. But the two men who led the institution for 27 years from 1979-2006, Paul Volcker and Alan Greenspan, became invested with mythic powers. Using nothing more than the federal funds rate and well-timed words, Volcker slew the demon inflation and Greenspan banished the business cycle. Between March 1991 and December 2007, there were only eight months of contraction. Wouldn't you prefer have Tall Paul and the Maestro making crucial economic decisions to letting the clowns in Congress run things? Most economists certainly would.
The changing structure of the U.S. economy has also led to a bias in favor of monetary stimulus over fiscal stimulus. In an economy where consumers don't have much debt and are mostly buying goods and services produced by their neighbors, as was the case in the 1930s, creating make-work jobs has a quick and significant impact. But in an economy where consumers and businesses have lots of debt and where they buy a lot of goods and services made by foreigners, as is the case today, monetary stimulus would likely pack more of a punch. To the extent lower interest rates filter into the broader economy—through mortgage refinancing, or lower rates on consumer debt—monetary stimulus can improve everybody's financial well-being without boosting deficits.
That's the theory. The problem is that in this downturn, massive monetary stimulus hasn't worked its efficient, elegant magic. The Fed has reduced the short-term interest rate it controls from 5.52 percent in September 2007 to 0.25 percent today, effectively lowering the price of short-term money by 95 percent. But the cuts haven't translated into proportionately cheaper money for the economy at large. As I pointed out last summer, banks used the cheap funds to patch up their own balance sheets and prepare for further losses. What's more, the favored version of fiscal stimulus—tax cuts and rebates—hasn't worked, either. The rebate checks sent out in the spring of 2008 were eaten up by higher food and gas prices.
That leaves two possible solutions. One has never really been tried in a sustained manner. Having exhausted its traditional tools of regulating interest rates, the Fed could print money and use it to buy assets from banks and financial institutions. The second solution—a big stimulus package fueled by government spending—hasn't been tried in 75 years. The main concern about the package as currently envisioned is not that this type of stimulus won't work, it's that, as Paul Krugman frets, it might not be big enough.
Critics of fiscal stimulus would have us think that policymakers face an either/or choice—either fiscal or monetary stimulus. The reality is that the situation calls for an "all of the above" approach. Fed Chairman Ben Bernanke warned Tuesday that fiscal stimulus alone won't do the trick. In general, I think analogies between the current economic situation and the Great Depression are overblown. But there's one comparison that holds true. Just as in the 1930s, the financial and political powers that be have screwed things up so powerfully that the usual tools and established orthodoxies aren't of much use.