Pretty much everybody seems to agree that the economy needs stimulating. They agree on this because the United States has been in recession for more than a year and the outlook is bleak. There aren't a lot of options left to policymakers. In most recessions, the Federal Reserve increases demand by manipulating interest rates. But, in December, the Fed effectively lowered those rates to zero and lost a lot of its leverage over the economy. The nation's central bank now has to rely on other forms of monetary policy--mostly printing money--in order to help the United States pull out of recession. But that might not be enough.
By keeping interest rates so low for so long over the past decade, then lowering them some more after the recession hit, the Federal Reserve stumbled into a "liquidity trap." You get caught in a liquidity trap when monetary policy loses its effectiveness even though interest rates are at zero--just like today. It's as though the Fed has been dancing the limbo and has finally reached its limit. Rates can't go any lower to get money moving. The central bank has done all that it can do.
During the 20th century, two countries fell into a liquidity trap: the United States during the Great Depression and Japan in its "Lost Decade" of the 1990s. These examples aren't exactly reassuring. In each case the economic doldrums lasted a long time. No single policy seemed to have any real traction. How did they finally escape the trap? No one is really sure. There's still a debate over it.
We do know that, off and on, the leaders of Depression America and Lost Decade Japan tried to follow the Keynesian model of how to fight a recession. The model says that when monetary policy is no longer effective, the government's only remaining tool is fiscal policy. You dig your way out of a liquidity trap through deficit spending. Another word for deficit spending is "stimulus." This is the thing that everybody suddenly likes.
Should they? In early 2008 Congress passed and President Bush signed a $150 billion stimulus package that included tax rebates and some additional spending. By late spring most taxpayers had received a check. Many of them saved the money or used it to pay down soaring personal debt. The macroeconomic benefits were negligible. The best you can say about the 2008 stimulus bill is that it didn't make things any worse. But that is not necessarily true of all stimulus bills.
Deficit spending comes in two forms. The government can borrow huge amounts of money for public projects and redistribute income from taxpayers and creditors directly to others in the hopes of increasing overall spending--what economists call "aggregate demand." Or it can slash tax rates in the hopes that deficit-financed lower taxes will increase overall spending by spurring private investment and consumption. (Deficit-financed tax cuts are a form of spending because the interest on the debt accrued as a result of the tax cuts has to be financed and repaid just like any other spending program.)
Ideally the government combines the two approaches and sustains the deficits until the economy grows again. This is how Reagan fought the recession of the early 1980s. He coupled a massive reduction in marginal tax rates with a huge increase in public spending for national defense. And he had help. At that time the Federal Reserve had plenty of room to spur growth through lower interest rates.
The trick is getting both elements of the stimulus right. Higher spending and higher taxes doesn't work. Lower spending and lower taxes is a political nonstarter. The compromise is higher spending and lower taxes. This satisfies both political persuasions. Conservatives tend to favor tax cuts. Liberals tend to favor spending programs. Both agree that the deficit can grow in order for the economy to escape recession and avoid depression.
But it's the Democrats who are about to run Washington. Hence the talk these days is of a massive stimulus package that could reach close to $1 trillion in new spending and tax reductions. The direct spending probably will be divided into aid to state governments, funds for infrastructure projects, and subsidies for green technologies and initiatives such as insulating homes and--I am not making this up--helping you change light bulbs.
At this writing, the Obama plan includes $300 billion in tax breaks. The bulk of these cuts (about half) fall under Obama's "middle class tax cut" pledge from the campaign. This is unlikely to help the economy a great deal. For one thing, it is not really a tax cut. It's a refundable payroll tax credit of around $500 for individuals making less than $75,000 a year, and $1,000 for couples making less than $150,000 a year. Reports are that a partial credit will be made available to individuals making between $75,000 and $85,000, and couples making between $150,000 and $175,000.
Right now, it seems that payroll taxpayers won't get a check in the mail. The credit may be applied retroactively and reflected in your paycheck. In effect, it's something of a short-term pay raise, courtesy of Obama. But, in a larger sense, the payroll credit plan is similar to the 2008 stimulus. It's not a permanent cut in the payroll tax, so the credit is unlikely to change long-term hiring and wage incentives. People are likely to save the rebate or use it to pay down personal debt. The "cut" is too small. Pretty thin gruel. The good news is that there are some pro-business tax provisions in the Obama plan, including credits for new jobs, accelerated depreciation, and an accounting trick that allows companies to apply this year's losses to yesteryear's tax liabilities. And, to its eternal credit, the Obama team is reluctant to raise taxes in the middle of a recession. Keynes would be pleased.
Conservatives would prefer that some of the money be spent on defense and would rather the tax cuts be deep, broad, and permanent. But no one really listens to us anymore. Hence the temptation facing conservatives is to be overly critical rather than constructive. Obstructionist rather than meliorist. Yet there is a real role for conservatives to play in the coming debate over the economic stimulus package. Who else will point out that the Obama plan, as currently conceived, is unlikely to work? That the new administration is about to follow the Federal Reserve into a dead end? Conservatives can warn Obama that he's about to walk right into the stimulus trap.
What is the stimulus trap? It's what you fall into when you forget that the secret to Keynesian stimulus is a combination of increasing expenditure (public spending) and decreasing revenue (tax cuts). A review of economic history suggests that relying on public spending alone won't get you out of the ditch. It may even make things worse. That's because spending creates a political environment in which interests clamor loudly to raise revenue in order to reduce the growing budget deficit.
And where does the additional revenue come from? From tax hikes and increased tariffs and other measures that delay any recovery. This doesn't matter to the deficit hawks. To them, the huge deficits are too scary. They haven't yet seen the gains from public spending on things like infrastructure (because those gains take a while to materialize). The deficit hawks have the natural human tendency in times of economic distress: Batten down the hatches and hope the house survives the storm. They forget that what is good behavior for people is not always good for governments.
But they have pull. And politicians are always happy to raise more money to spend. So taxes go up. Budgets are cut. The economy slides back into recession. The stimulus trap has been sprung.
It's happened before. The federal government expanded considerably during the Great Depression. Total government purchases of goods and services grew from $13.6 billion in 1929 to $22.8 billion in 1939. The decade saw the creation of the programs and agencies that liberals hold up as models for the Obama administration: the Civilian Conservation Corps, the Works Progress Administration, the Tennessee Valley Authority, the Civil Works Administration, etc. FDR's government, to use the latest cliché, "put people to work" digging ditches, building roads, fixing public spaces, and electrifying rural communities.
There was only one problem. It didn't help. The economy remained in depression until 1942 and the onset of wartime spending. Why did fiscal policy have so few noticeable effects? Because FDR was ensnared in the stimulus trap. Unlike today's Democrats, he actually believed in pay-as-you-go budgeting. He thought that what the government appropriated needed to be recouped in taxpayer revenue. And he was partly right. During prosperous times government has a responsibility to balance its books. But not in times of scarcity. Then the government's duty is to sow the seeds of growth.
Herbert Hoover had signed into law a sequence of tax increases in 1932--on estates, corporations, and incomes--and FDR built on his legacy. By the end of the decade the government had imposed taxes on agricultural goods and other commodities and had levied a fee on labor in the form of payroll taxes to fund Social Security. Indeed, every time the economy seemed to be getting better, taxes were raised and the economy regressed. The president who revolutionized the politics of redistribution in the United States got Keynes wrong. FDR relied solely on public expenditures to fight the Depression. And he didn't produce a sustained recovery.
The president had it in for the "economic royalists" and wasn't interested in the economic distortions that high taxes and direct subsidies produce. What he was interested in was income equality and durable political coalitions. Sound familiar?
The Japanese economy in the 1990s proved susceptible to the same maladies. A collapse in the real estate sector and a shaky financial system gave the Japanese year after year of economic contraction mixed with minuscule growth. Little the government did helped. First its central bank stepped into the liquidity trap. Soon thereafter its government fell into the stimulus trap.
The latest International Monetary Fund report on the current global financial crisis tells the tale (you can read it on the IMF website). By 1996, public spending had helped stir the Japanese economy into a recovery period. Thinking the worst was over and staring warily at some of the worst budget deficits in economic history, the Japanese promptly hiked consumption taxes and cut spending in order to pay for the earlier stimulus bills. The economy went back into recession. Then the government tried another stimulus package consisting of public spending and financial reform but no tax cuts. No go. "Despite these actions," writes the IMF, "little fundamental progress was made toward resolving banking problems while the recession continued." Entirely predictable. And entirely preventable. The Japanese had fallen into the stimulus trap--and couldn't get out.
Is Barack Obama about to make the same mistake? All signs point to yes. At the moment his stimulus plan, including the "middle class tax cut" that is really spending by another name, is mostly expenditure. He downplays revenue. He's only grasped one half of Keynes.
This isn't to say that Obama's plan is completely misguided. States need federal aid because their constitutions force them to balance their budgets even during recessions. That means they cut spending and raise taxes exactly at the worst possible moment. They are constitutionally bound to get caught in the stimulus trap--minus the stimulus.
It's also hard to get worked up over additional spending on roads, bridges, tunnels, and runways. These are public goods. There ought to be more of them, and they ought to be maintained. Americans spend far too much time stuck in traffic and waiting on tarmacs. It's time wasted. A better infrastructure could spur productivity and therefore improve living standards. Hence criticism of Obama's infrastructure plan will probably center on process. And rightly so. Will the money go to state and local governments, who know best which projects to spend it on? Will the money be spent on pavement, which commuters need, and not on pie-in-the-sky mass transit projects that no one will ride? Those are the sorts of questions that deserve to be asked.
As for those parts of the stimulus bill that deal with energy and "green jobs," well, the jury hasn't yet reached a verdict. Maybe office buildings and homes will become more efficient as a result. That would reduce demand for energy and help push prices down. Not bad.
But there is also the considerable risk that Obama's energy program will be filled with subsidies, duties, and restrictions that will introduce economic distortions right when we least need them. Shoveling aid to domestic ethanol producers while doing nothing to eliminate restrictions on imported ethanol is bad economics, bad energy policy, and harms poor people in other countries by raising food prices. Other subsidies and duties might provoke retaliation from America's trading partners.
Obama says, "the drop in oil prices, I do think, makes the conversation about energy more difficult, not less necessary." Sorry, Mr. President-elect. The energy conversation is not only less necessary, it's superfluous. The drop in the oil price is the only good thing happening for consumers right now. In a way, it's a sort of tax cut. A recession is simply not the time to impose policies that will raise energy prices and thus the cost of doing business--especially when you have no corresponding plan to lower the cost of work. (See Charles Krauthammer's "Net-Zero Gas Tax" in THE WEEKLY STANDARD of January 5 / January 12, 2009.)
As long as he doesn't raise taxes, however, Obama's stimulus plan isn't likely to do much harm. It may even spur some job creation. But let me pull a Joe Biden and say again: as long as he doesn't raise taxes. There's the rub. With its whopping price tag, the incoming administration's economic plan makes it more likely taxes will be raised sometime soon. And, if that happens, Obama will have failed his first test. He will have stepped into the stimulus trap.
Why does the price tag matter? Because the stimulus bill will add hundreds of billions, and possibly trillions, to a budget deficit that the Congressional Budget Office predicts will reach $1.2 trillion in 2009. Sure, for the moment, the consensus in Washington is that the economic crisis has rendered the deficit irrelevant. Economic recovery is more important. The onetime deficit hawks advising Obama have changed their minds. They are now willing to blow a hole in the deficit if it means America and the world can avoid economic calamity. On this point the Democrats all agree. They have adopted the mantra of someone who left their fold long ago: The deficit is big enough to take care of itself.
To hear the Democrats, then, you would think Obama has a free pass. He can implement a true Keynesian stimulus--big spending, tax cuts--until the economy is growing again. But just because the deficit is irrelevant now doesn't mean it won't matter in 2010, 2011, or 2012. It will.
The Republicans are still here, despite everything, and it is just a matter of time before they abandon their devil-may-care budgetary attitudes and become deficit hawks. They will oppose Obama, because the first duty of an opposition party is to oppose, and will therefore ratchet up the pressure on him to ease the public debt burden. And since the gains from his road-building bill probably won't be apparent by 2010, Obama might give in. What's more, he won't have to lift a finger. The Bush tax cuts are set to expire around that time anyway. The trap is already set. If he wants to pursue a truly Keynesian stimulus, then, Obama will have to exert real pull in order to delay the end of the Bush tax cuts. This won't be easy. He'll face criticism from deficit hawks on the right and tax-and-spenders on the left. But it has to be done. Otherwise his plan will fail.
"If Obama looks like he's throwing money at the wall," writes GOP consultant Patrick Ruffini, "and undermining his own promise to build a green economy to boot--there is ample opportunity to reclaim the mantle of sane governance and fiscal responsibility." The Republicans, in other words, could ride the deficit to gains in the midterm elections. Sounds like good politics for the GOP. But the economy? It would be left in the lurch.
So budget politics could force Obama into the stimulus trap. But he could just as easily walk into it by himself. That's because our incoming president, like FDR, has an ideological predilection toward higher taxes. He says higher taxes on upper incomes are a matter of fairness. The vice-president-to-be says high taxes are a matter of patriotism. Obama ran on tax increases on upper incomes, on capital gains, on estates, on dividends, and on payrolls by raising the ceiling on wages subject to tax. He suffered no political penalty for supporting such increases. It wasn't a hindrance. He won with the largest share of the vote since George H.W. Bush in 1988.
Obama supports higher taxes on moral grounds. He's immune to arguments in favor of tax cuts on economic grounds. The most famous example of this occurred during an ABC News debate in April 2008. Anchor Charlie Gibson asked Obama why he supported increasing the capital gains tax when, the last two times the tax was cut, the government took in more money with the lower rate. Obama appeared stymied. (This doesn't happen often.) He and Gibson went back and forth, but Obama never gave in. He said he would raise the rate, regardless of revenue, "for purposes of fairness." Who decides what's fair? You know who.
With these sorts of instincts, it's not only amazing that Obama has put off repealing the Bush tax cuts in 2009 and includes some tax breaks in his economic plan. It's a sign that he recognizes the depth of the economic problems facing America and the world. But he hasn't gone far enough. Rather than delaying his tax increases, Obama should be saying he won't raise taxes as long as the economy is in recession. But those words have not crossed his lips.
The danger is that, pushed into a corner next year by a coalition of deficit-griping Blue Dog Democrats and Republicans, Obama will give in. He will say, "You want to lower the deficit? Well, you got it!" He'll allow the Bush tax cuts to expire. He'll levy some more taxes of his own. And the steel jaws of the stimulus trap will ensnare the economy.
Obama wants to be another FDR. He might get his wish.
But there's another option. While the stimulus trap is set, it can be avoided with some of the "pragmatism" that Obama says he admires.
Once again history provides some clues. The tendency of economies is to grow. Obama's own economic advisers have argued that, during the Depression, the U.S. economy was still able to make great strides, recouping almost all of its strength before World War II. Recovery might have come sooner had Roosevelt reduced the tax burden and the cost of doing business. He didn't. Thus the economy had to rely instead on slow, steady monetary expansion and, eventually, the gargantuan deficit spending occasioned by World War II.
Is this a model for Obama? Not really. A geoeconomic depression was replaced by a geopolitical calamity. It was a genuine global emergency. There was a draft. The government imposed rationing. Government spending reached 42 percent of the country's gross domestic product--more than twice its share today. Deficits as a percentage of GDP reached astronomical heights. Perhaps that was the amount of deficit spending needed to end the Depression. Even so, no one would be willing to accept similar interventions in the economy in 2009. Nor would anyone think of proposing such interventions.
Japan offers a more positive example. In 1998, Japan increased capital injections into its banking system and nationalized two of its largest financial institutions. This finally got the financial sector going again and increased lending to businesses and consumers. Then, in November 1998, the Japanese passed a major economic recovery program that included deep and permanent cuts in individual and business taxes as well as public spending. The result was growth. By lowering tax rates, and by keeping them low, the Japanese finally escaped the stimulus trap.
Let's not pretend that Congress is going to pass, or Obama will propose or accept, an across-the-board permanent tax cut anytime soon. And let's not expect Obama to abandon his economic stimulus proposals--even if those proposals make it more likely he'll fall into the stimulus trap. Instead let's be realistic. Here are two things Obama can do to navigate the minefield in front of him:
A No-New-Taxes-Right-Now Pledge. The first thing he can do is pledge not to raise taxes on income, capital, or labor until the economy has experienced two consecutive years of growth. Why two? Because governments in the past, thinking a crisis has abated, have raised taxes too soon and sent the economy back into recession. One election cycle ought to be enough to see whether the economic recovery seems durable. Let's hope so.
The beauty of this pledge is that it allows Obama to eat his cake and have it too. He can still repeal the Bush tax cuts and address equity and fairness. All in good time. More important, he can oversee an economic recovery. The pledge simply requires Obama to acknowledge that the recovery must come first. Without the recovery, it's entirely possible Obama will be a one-term president.
You'll note that consumption taxes are absent from the pledge. This is where the realism comes in. A consumption tax is Obama's out. If the deficit hawks are rapacious, he can try to appease them by raising taxes on alcohol, cigarettes, and the like. Yes, it's better not to raise taxes at all. But, if one must raise taxes, then one ought to try to raise them on consumption and not on labor and capital. And if Obama does go for a consumption tax hike, conservatives will be in a good position to argue along the lines of a dollar-for-dollar cut in the payroll tax.
A No-New-Taxes-for-Now Pledge also allows Obama to avoid the trap set by the expiring Bush tax cuts. He can continue to delay their repeal until the economy is growing again. Instead of a vote for early repeal or for making the changes permanent, Congress can vote annually to extend the cuts. That way Republicans get low tax rates, the country gets an economy on the path toward renewal, and Democrats still get the chance to eliminate Bush's tax legacy one day in the future. Everyone's happy.
The Hamilton Test. The second thing Obama can do is ensure that his public spending proposals pass the Hamilton test. Alexander Hamilton had no problem with government interventions in the economy if they meant a stronger America. Hence the aim of a Hamiltonian stimulus program would be to foster American strength through what used to be called internal improvements. If you are going to spend public dollars to boost aggregate demand, you might as well do it on public goods.
The place to start is national defense. Obama says he supports increasing the size of the Army and Marine Corps. Hold him to his pledge. He can spend money to recruit more soldiers, improve soldiers' pay and retention, and improve veterans' health care. Then he can begin repairing military inventory: tanks, jeeps, MRAPs, helicopters, ships, fighters, bombers. And when he signs the bill appropriating money for those projects, Obama will be able to note that the factories building American arms provide jobs for American workers. Thanks to him we'll have a bigger, better equipped military, and more people at work.
We're sure to see additional infrastructure spending. Fine. The question is whether or not the spending projects pass the Hamilton test. Does a project improve America's competitive edge in the global economy? Does it increase mobility and productivity? Or is it a drain on national resources for the benefit of a local few? The Interstate Highway System would pass the Hamilton test. The Bridge to Nowhere would not.
Of course, the trouble with spending money on public goods is that everyone has a different idea of what a public good is. Some people like F-16s, others highways, still others more schools and more spending on children's health care. When you open up the floodgates of public money, pretty soon everybody and their mother is trying to jump in. And to make things even more complicated, Hamilton's categories of national strength--military and economic power--are fairly elastic. For example, one could argue that a healthier, better educated population increases America's economic strength.
But this introduces a problem. Such arguments are political. They invite disagreement. If Obama includes health care and education spending in his stimulus package, as it looks like he might, he guarantees opposition from Republicans. He makes it easier for them to oppose the bill and, down the road, force him into the stimulus trap.
The solution? Confine the stimulus bill to hard power. That means tangible objects like boots, guns, asphalt, and bullet trains. The soft power stuff, the schools and hospitals, can wait. They should have their own legislation. This would increase the chances the stimulus bill will pass and help foster growth. And it would leave the conflict over education and health care for another day.
It's a tricky moment. The capital is in transition. No one knows how long the global downturn will last. Policies that might have made sense during the election no longer apply. The Federal Reserve has exhausted the main weapon with which it has fought past recessions. It's in the liquidity trap. And the incoming president is politically and ideologically inclined to step right into the stimulus trap and prolong the economic suffering. Even more uncertain are the challenges that await. After all, global downturns have this nasty habit of turning into global showdowns.
The new political realities dictate that compromise, not confrontation, is the way forward. At least where the economy is concerned. At least for now. So, to that end, conservatives and liberals, Republicans and Democrats, need to recognize that they may have to accept things that they do not like in order for the economy to return to normal. For conservatives and Republicans that means accepting a level of government intervention in the economy that would normally make them blanch. For liberals and Democrats that means accepting the fact that raising taxes in the middle of a recession is the worst possible intervention a government can make. For budget-hawks that means living, at least for the time being, with a federal deficit substantially higher than they would usually tolerate.
If we are able to make such compromises, then growth will return sooner rather than later. If not, then not. Policy-makers will be left with even fewer options than they have already. They will be trapped on monetary policy. They will be trapped on fiscal policy. And the crisis will endure.
It's up to our next president. If he doesn't raise taxes, if he's sensible about how he spends the people's money, he can put this bad spell behind us and embark on the rest of his agenda. He can lay the foundations for growth and prepare to tackle the structural problems that put the global economy at risk in the first place. If he plays his cards right. Then he can skip right over the stimulus trap.
Matthew Continetti is associate editor at THE WEEKLY STANDARD .