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By Steve Levy

Stimulus 101--A Bridge Over Troubled Waters

Uploaded: Jan 31, 2010

This is the first of a series of blogs about the economy, stimulus efforts and the role and challenges of government anti-recession efforts.

Sometimes our economy hits a downturn. There is not enough spending to keep everyone employed. Production drops and unemployment rises as workers are laid off. Recessions can start as a result of an energy price shock as in 1974 or policies by the Federal Reserve Bank to raise interest rates to fight inflation as in the early 1980s or from a sharp slowdown in investment spending as in 2001 after the bust and the Y2K buildup..

The current recession started with a downturn in housing and quickly spread to the financial sector as lenders held loans that were facing default. The resulting financial market paralysis, stock market and housing price declines left consumers with high debt and losses on their homes and retirement portfolios. Consumer spending fell on top of the sharp drop in construction and the recession accelerated. Most businesses faced a loss of customers and had no reason to expand production or hiring. In fact businesses responded to the decline in sales with layoffs as they had fewer customers to serve.

It is the federal government's role to lead the fight to end recessions and help the economy grow. This is written in law, has been a widely accepted role for government and has been broadly supported in all previous recessions.

Federal policy has lots of tools to fight recessions. These tools fall into two broad categories—1) incentives for consumers and businesses to spend more and 2) direct additions to spending by governments. Another way to categorize anti-recession policies is that some are monetary policies dealing with interest rates and lending and some are fiscal policies dealing with tax rates and government spending.

The two most widely used policies historically have been interest rate cuts, tax cuts and increases in safety net spending, for example, for extended unemployment insurance benefits and food stamps... In this recession these policies have been used but in addition Americans are experiencing and now debating several other policy approaches that have been adopted.

In the current recession the Federal Reserve Bank has reduced short-term interest rates, the traditional policy, but in addition has extended large credit guarantees and become a major lender for housing. The most hotly discussed policy, though not the largest, was the TARP program to provide funding to banks, car companies and AIG in order to prevent further financial system collapse. Congress has approved two small general tax cuts in 2008 and 2009), the traditional policy, but, in addition, adopted specific tax cuts targeted at home and car purchases.

Congress boosted direct spending for extension of safety net programs such as unemployment insurance and food stamps, the traditional policy, as part of the $787 stimulus program adopted in February 2009. But in addition, the stimulus plan included support for state and local governments to minimize layoffs and service cuts and investments in construction projects and the beginning of long-term investments in energy, education and health care.

Although the $787 billion plan is called the "stimulus" plan, in fact all of these efforts are part of federal government policies to stimulate spending and economic growth.

Stimulus efforts are "a bridge over troubled waters" designed to support spending in the economy until private investors and consumers regain confidence and resources to increase spending that results in workers being hired and unemployment being reduced.

Good stimulus efforts, i.e. the sturdiest bridges over troubled waters meet three criteria. They are temporary, timely and targeted.

Stimulus programs should be temporary because they all contain long-term problems if they go too long. Too much monetary policy ease can lead to high inflation down the road. And too much deficit spending can create a high debt burden for future generations and damage America's credit rating.

The temporary tax cut and spending increases in the current stimulus efforts will increase the short-term federal deficit. That is actually the point—to borrow from the future to put extra money into the economy now while the private sector regains confidence. Stimulus efforts are designed to temporarily make up for the shortfall in spending that is leaving workers unemployed.

The problem is not the temporary deficit to jump start the economy but whether we have the will to reduce the deficit in the future when the recession is over.

The test for when to end stimulus efforts is when you think the private sector is strong enough to support sustained job growth, i.e., when we no longer need a bridge over troubled waters. I will write about this in the next blog. But there is a conflict—stopping too soon leaves the economy subject to high unemployment; stopping too late risks inflation and high debt levels.

The current stimulus efforts can be criticized for not being sufficiently timely or targeted. Both parties fudged the criteria in the current stimulus plan by including funding to eliminate the alternative minimum tax for 2009 and including funding for what are really long-term investment projects. As a result the infrastructure monies have taken very long to get into the economy in some cases.

CNN is running a series on uses of the $787 billion stimulus package. Some uses seem silly to viewers and raise legitimate questions. It is good to remember that local projects are chosen locally and submitted for funding. Doing better would involve more, not less, federal control.

While there is partisan debate about the stimulus (is there anything now that does not spark hot and partisan debate?), the evidence as to where we get the biggest bang for the buck is quite consistent whether you listen to the economist who advised John McCain or to the administration's economists.

The biggest bang for the buck comes from unemployment insurance and food stamps, followed by funding for infrastructure investment and state and local government followed by temporary payroll tax cuts.

We are still treading troubled economic waters. The calls for tough long-term budget discipline make sense. But the dangers of high unemployment remain serious. The next blogs will discuss whether the stimulus plans have worked, whether we need more stimulus and where this all fits into the debate we are having about the size and role of government.