A Primer on Pump-Priming
With a weakening US economy that may well spill over into Canada, it is time to start thinking about fiscal policy responses should recession rear its ugly head. To date much of the focus has been on monetary policy, with calls for central banks to lower interest rates. This is providing some relief, but as many economists have pointed out, the bursting of the housing bubble in the US and the resulting credit crunch due to sub-prime-heavy commercial paper is not a liquidity problem that can be fully addressed with lower short-term interest rates but an insolvency problem that will spur drops in asset prices. And that process is in danger of doing damage to the real economy.
If the worst happens, monetary policy will become ineffective â€“ as Keynes said, “pushing on a string”. Fiscal policy will need to play a much bigger role in that instance. The Center for Budget and Policy Priorities in the US has a new report on what principles should guide a fiscal stimulus. In short,
To boost demand for goods and services, fiscal stimulus should be targeted where it is most likely to be spent immediately and thereby to boost demand.Â This suggests targeting on low- and moderate-income individuals and unemployed workers who need a replacement for lost income.Â People whose income is disrupted in a recession and who lack the savings to tide them over and maintain their normal consumption, and people whose incomes are so low to start with that they have difficultly making ends meet, are the people most likely to spend quickly any added income they receive.Â Assisting them thus provides strong stimulus.
I thought this box from the report was really interesting:
Some Stimulus Measures Have Much More â€œBang for the Buckâ€ Than Others
A good way to assess a stimulus proposal is through its fiscal â€œbang for the buckâ€ â€” how much immediate spending boost it would deliver for each dollar it costs.Â During the debate in 2002-2003 over a stimulus package, economist Mark Zandi of Economy.com evaluated various stimulus options in terms of their effect on the economy in the first year after enactment.Â
While economic conditions have changed since then, Zandiâ€™s rankings continue to provide a useful assessment of the relative value of various measures in generating economic stimulus.Â They indicate that temporarily strengthening unemployment insurance is among the most effective forms of stimulus, because most of the additional unemployment benefits would be quickly spent, while a dividend or capital gains tax cut would be among the most ineffective measures because much of it would be saved rather than consumed quickly.Â
Demand generated per $1 of cost
Source: Mark M. Zandi, â€œAssessing President Bushâ€™s Fiscal Policies,â€ Economy.com, July 2004.
The discussion on state governments is different for Canadian provinces. US states are required to balance their budgets, so downturn leads to pro-cyclical fiscal responses that worsen the situation; thus federal relief to states is more important. In Canada, provinces have their own capacity to tailor fiscal responses to local needs.