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One Small Step for Recovery, One Giant Leap Still Needed

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Electoral disaster has a way of focusing the mind. Perhaps this is the best way to explain President Obama's latest initiatives: an investment in the nation's roads, railways and runways that would cost at least $50 billion, along with a permanent extension of the research and development tax allowance, which represents a further $200 billion in tax breaks for businesses.

All well and good, although it remains to be seen whether Obama's journey represents a genuine conversion on the road to Damascus, or another detour into a fiscal cul de sac of the kind that has long characterized his Presidency.

Sure every little bit helps, but if the $787 billion package introduced in March 2009 wasn't sufficient to bring unemployment down, is $50 billion more in infrastructure spending really going to make up the difference? As for the R&D and bonus depreciation tax credits: nice cosmetic gestures to a business community that is coming to view this President as "anti-business", but it's fundamentally a supply-side measure to address a weak economy characterized by lack of demand. It remains the case that firms will only borrow, produce, invest, and employ now if they feel they will be able to sell the output in the future. They're reluctant in the absence of robust consumption, not investment.

Much like his approach to the banking system, Obama continues to practice stimulus from the top down rather than bottom up. His administration needs to restore income growth among households, not businesses, to mitigate the need to for families to resort to borrowing and the continuation of negative saving trends (that is, household deficit spending). If tax cuts are to be implemented, far better to introduce them to assist non-financial institutions, whose dire financial situation is at the heart of the crisis.

The US labor market remains locked into a situation where the tepid employment growth barely absorbs new entrants and the most disadvantaged workers are trapped in long-term unemployment. In this state, we get what the institutional labor economists, such as Professor Bill Mitchell, call "bumping down". What "bumping down" means is that when there is an overall shortage of jobs, higher-skilled (more educated) workers tend to take jobs that were previously occupied by lower-skilled workers. The low-skilled are then forced out into the unemployment queue. So there are two inefficiencies: (a) the skills-based underemployment; and (b) the unemployment.

Which means a bigger stimulus number is required. Politically, that's a tough sale right now, no question. But in order to make that case, the President must first challenge the canard that last year's stimulus package was wasted because unemployment still remains stubbornly high.

On May 25th of this year, the US Congressional Budget Office released a detailed study: Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from January 2010 Through March 2010. The CBO suggests that "nearly 700,000 FTE jobs during the first quarter of 2010″ were created by the fiscal stimulus. Even with the caveats introduced in the study, they conclude that the impact of ARRA for the first quarter of 2010 were:

• Raising the level of real (inflation-adjusted) gross domestic product (GDP) by between 1.7 percent and 4.2 percent.
• Lowering the unemployment rate by between 0.7 percentage points and 1.5 percentage points.
• Increasing the number of people employed by between 1.2 million and 2.8 million.
• Increasing the number of full-time-equivalent (FTE) jobs by 1.8 million to 4.1 million compared with what those amounts would have been otherwise. (Increases in FTE jobs include shifts from part-time to full-time work or overtime and are thus generally larger than increases in the number of employed workers.)

By the same token, a recent study by former Federal governor Alan Blinder and economist Mark Zandi concludes that that the peak to trough decline in gross domestic product would have been close to 12 percent with no policy response last March, compared to an actual decline of just 4 percent. Similarly, the unemployment rate would have peaked at 16.5 percent, instead of the actual 10 percent. And for all of the gnashing of teeth about "wasteful government spending," Blinder and Zandi also estimate that the resultant bigger collapse would also have meant a fiscal deficit of $2,600 billion in fiscal year 2011, which no doubt would have had the Concord Coalition and Tea Party brigade screaming from the rooftops.

Even so, we still have almost double digit unemployment, which does not suggest that the first stimulus package was wasteful; rather, that it was insufficient to deal with the scale of the problem. The real economy responds to spending, and if the growth in nominal aggregate demand had not fallen, no matter what happened in the financial markets the real economy would have been okay. The key is to devote billions to the real economy, not dump good money after bad into zombie banks.

To get an idea of the paucity of the new proposal's ambition, contrast it with the tens of trillions of dollars of financial assistance that was committed to deeply insolvent financial institutions, which have used the funds mostly for their sole benefit. If we wanted to leave insolvent institutions open, all we had to do was to use regulatory forbearance. A government can always keep an insolvent bank afloat by simply guaranteeing the bank's deposit base while getting rid of the incompetent management. The FDIC does this all of the time. And, in truth, that is the only reason why so many of the larger financial institutions are still open for business.

In fact, some of the banks are clearly committed to worsening households' financial position and have oriented their activity toward this end in order to maximize their profitability (see here). On the other side, households and other non-financial institutions, whose financial hardship is at the heart of the crisis, have received very limited help, especially when one considers that federal spending stimulus is increasingly being offset by states' respective fiscal crises. So what the left hand giveth, the right hand taketh away.

If President Obama now truly believes that fiscal stimulus is the answer, then he has to re-educate his fellow Americans, who remain under the influence of a host of deficit hawks. The President must explain that ongoing attempts to reduce government spending in the context of a slowing economy will produce higher deficits -- the very antithesis of what the so-called "bond market vigilantes" are allegedly demanding of the government. If the government tries to go against expanding and sustaining budget deficits, then the income adjustments that follow will eventually lower planned non-government saving and public net spending and raise levels of unemployment. Total saving will also be lower. So it is better to have "good" deficits than "bad" ones (the latter being forced on the economy by the automatic stabilizers driven by the income adjustments, as opposed to aggressive proactive expenditures that foster faster employment growth, higher incomes and ultimately lower deficits via higher economic activity).

The government's deteriorating fiscal position is fundamentally a reflection of a weak economy, not "reckless spending". During recessions, its position loosens anyway, courtesy of the automatic stabilizers, as private spending and tax revenue collapse. But these stabilizers provide some constraint against the free fall in demand that would have otherwise occurred after the calamities of 2008. The best way to avoid unemployment becoming long-term and hence, more structural, is NOT to let it linger.

Why has it taken President Obama so long to find religion? Well, the looming disaster of the midterms must figure prominently. More fundamentally, the President has remained in thrall to a neo-liberal philosophy that has persistently downplayed the effectiveness of fiscal policy and over-hyped monetary policy. But monetary policy alone cannot provide the solution. It's not a suitable tool for controlling longer-term problems, such as price bubbles in specific asset classes, because the interest rate weapon is a very blunt one. Much like chemotherapy can kill good cells along with cancerous ones, interest rate increases can bludgeon productive parts of the economy that aren't suffering from excess. It's like conducting an operation with a meat cleaver instead of a scalpel. Fiscal policy is more precise. Perhaps the President is beginning to question the basis of the mainstream macroeconomics consensus that has dominated the policy debate for 30 odd years and culminated in the worst financial and economic crisis in 80 years. Good for him, but take it further.

For those who remain irrationally paranoid about deficits, it is worthwhile to reiterate that full employment keeps GDP at permanently higher levels, which means that by definition the government will reduce spending on a number of unemployment-related items. It also enhances financial stability, given that a fully-employed worker is one who can best service debts and support borrowing, which also means that the lending bank is unlikely to require as many write-offs.

In any event, it is becoming increasingly untenable to argue that the prevailing policy responses of the past 30 years can address serious swings in private spending. Monetary policy has been categorically proven to be ineffective in dealing with aggregate demand failures of the sort we have witnessed in the current crisis. When an economy is in this sort of state and is situated in a world that is still largely recessed, the only way to get out of the malaise is to use fiscal policy to support demand and to provide some basis for firms to keep producing and hiring. Hopefully, the President is beginning to figure that out. Better late than never.

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Cross-posted from New Deal 2.0.