A better approach to the stimulus

By Philip Zelikow

In my posts yesterday and today (here, here, here, and here), I’ve reflected a bit on the reasons for my unease about the stimulus. So it’s only appropriate that I try to offer some constructive suggestions for improving our fiscal situation. I’m not arguing for cutting deficits and raising taxes. Some fiscal expansion is needed, but not against an arbitrary macro target. 

Here are four areas on which we might focus:

1. State and local capabilities:  There is an exceptionally strong case for buttressing the financial capabilities of state and local governments. These governments wield some key automatic stabilizers that have an important countercyclical role. Their finances, often based on property taxes, have been disproportionately damaged by the downturn in asset prices.  They are having trouble getting access to normal lines of credit.

The federal government could consider solutions that don’t rely on block grants, micromanaging state and local project choices, or penalizing states that have been more fiscally responsible. For example, perhaps the Fed could become a lender of last resort for state and local governments (as the EU is now doing for some of its member states). The Fed could buy up creditworthy state and local bonds at discounted or deferred rates, with the hope of reselling the state and local paper with low exposure to taxpayers, or even at a profit, once those bond markets have more fully recovered. This approach keeps the policy development burden at lower levels of government but obliges those governments to make creditworthy choices about what bonds they can service as their revenues recover.

2. Defense spending:  There is a strong case for recapitalizing depleted inventories of the armed forces. This spending has a strong temporary element and the plants appear to be there.  Martin Feldstein recently made a case for about $30 billion extra spending in this sector in 2009 and 2010, for a total of $60 billion.

3. Payroll tax cuts paired with new taxes on carbon or other energy consumption. Payroll tax cuts might disproportionately hit the most credit-constrained households, thus those more likely to spend the extra money.  The effect could be prompt. Pairing this with a tax on carbon or greenhouse gas emissions maintains a sense of fiscal seriousness. 

Such a tax also has other beneficial economic effects, such as: (a) discouraging a new jump in dependence on the oil imports which have contributed so much to keeping the US current account deficit so high, even when export competitiveness has improved; and (b) discouraging high reliance on commodities with great inflationary potential, since oil prices could well spike again once the world economy starts to recover.

It would be difficult to raise payroll taxes, once cut. All the more reason to pair this with a tax on carbon/energy consumption. Remembering 1993 and falsely analogizing that to the present, some Democrats may shy away from such a tax combo. If so, they should notice the political opening reflected in the support for such a pairing coming from people like Lawrence Lindsay, here (read all the way to the end) and Charles Krauthammer, here.

4. Infrastructure and other investments that are … well … good investments:  By kicking the door open to investments of all kinds, with a macro-dollar target, the government sends two messages, both potentially pernicious. One is that these investments are really just "helicopter money," so the merits aren’t all that critical. The other is that when times are bad we can just spend our way out. 

Doubtless there are long-deferred or needed projects that seem likely to increase the long-term productivity of the United States. In that case, the debt is expected to improve, or at least not harm, the long-term debt-to-GDP ratio of the United States. A focus on project merits is different from making up a list to meet a macro stimulus target or prioritizing projects that are dubious but "shovel-ready." 

One of the best aspects in President-elect Obama’s address at George Mason yesterday was in the way he described his intentions for infrastructure investment. His list wasn’t about being "shovel-ready." He was ready to make his cases on the merits for American productivity. Good. That kind of approach, credibly sustained, will maintain confidence in America’s commitment to fiscal sustainability.

So to wrap up: These cautionary suggestions are not so distant from the kind of suggestions about fiscal stimulus that good economists were making just a few months ago. In the middle of 2008, for instance, Larry Summers focused on unemployment insurance, offsets for shortfalls in municipal bond markets, some other "carefully designed" infrastructure support, all coupled to "budget process reform that provides reassurance that, once the crisis passes, the fiscal policy discipline of the 1990s will be reestablished." Given the huge political momentum that has now gathered for massive stimulus spending, Summers, Geithner, and Orzsag may now feel they are riding the tiger. 

Since the administration spokesmen necessarily downplay the risks, with consequences they might regret, outsiders are right to stress the risks of doing too much, doing it too unilaterally, or doing it in the wrong way.  The foundations of U.S. prosperity and influence are at stake.