The Stimulus Trap

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.