U.S. Economy: The Case for More Stimulus

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John Maynard Keynes may stand right next to Karl Marx in the eyes of Tea Party activists, but there's a long history of Keynesian stimulus by both Democratic and Republican Administrations. In 2008, President George W. Bush pushed for and achieved a $152 billion stimulus package that he described as a "booster shot" for the economy.

True, Obama has less spending leeway than Bush had. According to the White House's Office of Management & Budget, gross federal debt will reach 94% of GDP this fiscal year, up from 69% in 2008. Research by economists Carmen I. Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University shows that growth slows in advanced economies when their ratio of gross debt to GDP exceeds 90%.

Citing numbers like that, Republican economists say it would be a mistake to spend any more now on juicing the economy. Douglas J. Holtz-Eakin, an economist who advised Republican Senator John McCain's Presidential campaign in 2008, predicts that "we'll begin to see fairly steady job creation" by summer. "I think it's terrible advice to a Congress to put off getting its fiscal house in order."

Holtz-Eakin is right that the federal debt will be a huge problem over the next decade and beyond. But trimming back on recession-fighting remedies won't solve it. The deficit is growing primarily because of ballooning expenses for entitlement programs such as Social Security and Medicare, as well as national defense. Obama's budget office estimates that even at the peak of stimulus spending this year, more than 70% of the federal deficit is accounted for by noncyclical factors—i.e., fundamental imbalances.

The good news is that the deficit is more of a long-term threat (albeit an enormous one) than a present danger. The yield on 10-year Treasury bonds remains below 4%, vs. over 8% in 1990. Inflation, likewise, is a remote concern: Prices for personal consumption expenditures rose just 1.8% over the past year through February.

And there's reason to be encouraged about America's debt-paying capacity over the short term: The increase in the national debt has been slowing. Since 2006, increased federal borrowing has been partially offset by more savings by households and businesses (although households have been less frugal recently). As a result, overall national savings have fallen less than the big federal deficits might lead one to expect. That's a good thing. Another factor that's taking the pressure off U.S. financing needs is that national investment has declined in the economic downturn. When there's less investment, there's less need for savings to finance it. The result is that the U.S. is importing less savings from abroad. Net national borrowing fell by nearly half between 2006 and 2009, Federal Reserve figures show.

Contrary to popular perceptions, then, Obama may have some fiscal elbow room for measures to boost the economy over the next few years. It will need to do so, argues Nomura's Koo. "If the government refuses to borrow money to compensate for the private-sector pullback, this economy will start contracting in a deflationary spiral".

The Obama Administration might have an easier time selling stimulus if it could convince Americans that the money is doing what it's supposed to. That hasn't always been the case. Tax cuts, which constituted most of the Bush stimulus and one-third of the 2009 Obama plan, are especially ineffective in generating growth when there's lots of slack in the economy, according to analysis by macroeconomic forecasters such as IHS Global Insight, Macroeconomic Advisers, and Moody's Economy.com. Businesses won't hire an extra employee, even with a tax incentive, if there's no work to be done. Most consumers will save rather than spend a tax rebate if they can afford to do so and are intent on repairing their household balance sheets. For instance, Moody's Economy.com estimates that cutting corporate income taxes raises GDP for one year by only 30 cents for each $1 of tax cuts.

Infrastructure spending may be the most underused tool to fight the slump. It offers lots of bang for the buck (a $1.58 rise in first-year GDP for every dollar spent, Moody's says). It benefits a sector—construction, mining, and energy—whose March unemployment rate was 24.6%. And it builds things that society needs anyway, like roads, levees, and sewer systems. It works slowly, but that's O.K. because the economy will have lots of spare capacity for years. Rosenberg, the bearish Gluskin Sheff economist, dislikes most stimulus measures but does support more infrastructure spending, in particular "totally revamping the energy grid." Says Rosenberg: "That's something you could really rally the population around." (When the Senate turns to energy legislation in the coming weeks, stimulus will be lurking in the pages of the bill.) Princeton University economist Alan Blinder imagines a million-person Works Project Administration that would clean parks, repair facilities, and so on.

Right now any productive investment would help. Labor and capital are sitting idle because the private sector remains depressed. If Obama intervenes in a way that sustains the recovery, then it will surely be time for high-fives.

With Roger Runningen

Coy is Bloomberg BusinessWeek's Economics editor.

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