Smith Faculty Opinion Article
The 30 Seconds Outlook
February 15, 2010
"With the budget expected to reach 95% of GDP this year we are nearing
the point of no return."
- The Pragmatic Capitalist, SeekingAlpha.com, February 9, 2010
An important issue that demands urgent attention is an analysis of the
short-term benefits and long-term costs of fiscal stimulus. Freedman, et al.
(IMF Working Paper, November 2009) use an integrated monetary and fiscal model
for this purpose.
The impact of financial shock reduces potential economic growth, and
increases corporate risk. Corporations thus face an external finance premium
that increases with leverage. Increased interest costs reduce corporate
investment and lowers earnings, which leads to lower dividends and lower
household income, wealth, and consumption. The decline in corporate investment
and household consumption results in lower inflation and lower real GDP.
In the short run, fiscal stimulus measures that include (1) increase in
government investment, (2) increase in lump-sum transfers to households, (3)
increase in lump-sum transfers to liquidity-constrained households, and (4)
decrease in tax rates on labor income all provide an equal discretionary
stimulus. The fiscal multiplier simply equals the percentage change in GDP for
the same years.
In the long run, the risk is that deficits associated with fiscal stimulus
measures become chronic and lead to permanently higher debt.
The complex analysis leads the authors to the following conclusions:
“. . . [A] carefully chosen package of fiscal and supporting monetary
stimulus measures can provide a significant contribution to supporting . . .
economies during a period of acute stress. But such measures should also be
imbedded in a conservative medium-term fiscal framework [that] ensures
deficits and debt do not drift upwards permanently when the economy
recovers. In the absence of such a framework the long-run costs would far
exceed the short-run benefits.”
The huge redistributive spending of the Obama administration does not provide
confidence in a long view of government spending and deficits.
The Administration states that in fiscal 2011 it will hold the line on the
35% of the budget that is discretionary. Operating budgets have already been
increased by 24%. And then there are the costs of Obamacare and Cap and Trade,
and a tax and spending agenda that does not generate economic growth.
John A. Haslem
