Fiscal Stimulus

I participated in a discussion on the Oregon economy and the government's fiscal stimulus plan this morning on OPB's "Think Out Loud" program so I thought a post that summarizes my thoughts would be appropriate.

The fiscal stimulus plan being proposed by the federal government is based on good old Keynesian theory that in a temporary down turn in the economy, fiscal policy can have a role in stimulating the economy and lessening the blow. Keynesian theory underwent a withering attack from the rational expectations revolution in macroeconomics which suggested that fiscal policy is ineffective as agents in the economy understand that any fiscal spending today has to be paid back in the future so behaviors will adjust immediately. However, assuming this is true, economies do not adjust immediately to behavioral changes - there is wage and price 'stickiness' - which means that, in the short-run, fiscal policy can still be effective. The key with fiscal policy as opposed to monetary policy is that if it appears that consumer confidence is low and present and future consumer spending is and will be low then firms react my lowering investment and employment and wages suffer - further enhancing the low consumer confidence and spending. This leads to the downward spiral that can enhance and lengthen recessions. Cash transfers to those that are likely to spend it will cause a temporary shock in this cycle which, it is hoped will lead to new investment and job recovery - further stimulating consumption - and lessen the extent of the economic downturn.

So two pertinent questions are: does the current situation look like the one I have described, and what is the catch to such a policy?

First, it is not entirely clear that we are in such a cycle and that this is the appropriate policy response and the main reason I say this is that it is not clear we are seeing the big effect on investment and jobs probably due to the very strong export market thanks to the weak dollar. But it is hard to know exactly as data lag the present. I am weakly in favor of the plan broadly conceived (but I think we could do a lot better targeting benefits to those most likely to spend them) - largely because the risk of a severe downturn is real and recessions hurt the most vulnerable hardest, so I generally err on the side of caution.

Second, the catch is that short term stimulus increases the debt which will be a drag on the economy when it returns to sustained positive growth. So, once again, there is no free lunch.

What does this all mean to Oregon? Well, there are two competing facts: one, Oregon has traditionally be a high unemployment state and was hit particularly hard by the last recession, and two, Oregon's housing market is is good shape (so far) relative to other parts of the country. Local conditions matter only partly for the economy so any national recession will be shared by Oregon, but I do think we will not be exceptional like last time. Exports are strong (10% of Oregon GDP), house values have not crashed and there is a chance that tourism (generally down when incomes fall) will remain healthy in Oregon as people substitute Oregon vacations for overseas ones due to the dollar. So I remain cautiously optimistic. The wood products industry and construction industry are already being hit hard by the slump in construction, however, and demand for Oregon's manufactured goods within the US is falling. So, only time will tell.