Responding to the Recession: Exploring the Stimulus Options
About This Event

With the economy mired in a deep recession, economic recovery is slated to be the top policy priority of the incoming Obama administration. A wide variety of tax, spending, and financial-market measures will be on the table in January as Congress debates a stimulus package that may approach $1 trillion. Listen to Audio

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What can or should the government do to stimulate the economy?

Martin Baily, senior fellow at the Brookings Institution and former chairman of the Council of Economic Advisers in the Clinton administration, will review the severity of the recession and evaluate various stimulus options. Christopher J. Mayer, senior vice dean of the Columbia Business School, will discuss proposals to revive the housing market. Nicholas Souleles of the University of Pennsylvania's Wharton School will examine whether tax rebates promote consumer spending. AEI resident scholar Alan D. Viard will discuss the general principles of fiscal stimulus. Kevin A. Hassett, AEI's director of economic policy studies, will moderate.

9:45 a.m.
Martin Baily, Brookings Institution
Christopher J. Mayer, Columbia Business School
Nicholas Souleles, University of Pennsylvania, Wharton School


Event Summary


Stimulus Needed, Tax Experts Say at AEI, but Its Shape Is Debatable



WASHINGTON, JANUARY 14, 2008--The top item on Washington's agenda is stimulating the contracting economy. A wide variety of tax, spending, and financial market measures are under consideration as Congress debates a stimulus package worth nearly $800 billion. A panel of tax and fiscal policy experts at an AEI event on January 12 generally agreed that some form of economic stimulus is necessary, but panelists differed over the best way to deliver a timely and effective boost without breaking the bank in the long run.

Martin Baily of the Brookings Institution, a former chairman of the Council of Economic Advisers in the Clinton administration, said that a stimulus package comprising both tax and spending measures is necessary, despite uncertainties about how much it will actually benefit the economy. Baily said he supports the Obama proposal to provide payroll tax rebates to individuals and families. "That's not going to change the universe," he explained, but, unlike the 2008 rebates, "it's not something people will be likely to save a great deal of." Baily applauded measures to encourage new hiring and investment, such as business tax cuts designed to give the stimulus bipartisan appeal. "I am a supporter of some additional spending on infrastructure," he added, "but it needs to be done carefully with the right planning and supervision, potentially involving private sector funding so it doesn't become a drag on the budget deficit."

Instead of discussing discretionary fiscal stimulus measures, Columbia Business School's Christopher Mayer spoke about two plans that would directly target the ongoing turmoil in the housing market. "It is going to be hard to envision an economic turnaround before the housing market stabilizes," he said. "Until we stop the hemorrhaging of the financial system, consumers will continue to be in big trouble." Mayer's plan, designed with R. Glenn Hubbard, is intended to create a more efficient way for the government to determine mortgage rates and to lower long-term housing costs for millions of homeowners. "If we were willing to knock rates down a half to a full percentage point," Mayer explained, "you could see as many as 25 to 34 million people refinancing mortgages at an average savings of $425 per month." The plan's costs would be limited since the government would be issuing profitable loans backed by tangible assets instead of wasting government revenues on "bridges to nowhere."

Mayer also described a loan modification program he designed with Columbia colleagues Edward Morrison and Tomasz Piskorski. The program is aimed at reducing foreclosures by creating a fund to pay loan servicers for collecting mortgage payments, which would align incentives among servicers and investors. The program would reward servicers for modifying loans in ways that enable distressed borrowers to continue making payments. According to Mayer, the plan would also create a "legal safe-harbor for servicers to maximize returns to investors as a group." Because loan modifications would take place only when there is a net benefit to investors on the whole, relatively few investors would be hurt by the program. Mayer explained that the costs of the program would be limited and "would save hundreds of thousands of homeowners from foreclosure on their homes."

Nicholas Souleles of the University of Pennsylvania's Wharton School provided empirical measures of consumer responses to recent tax rebates. In a study examining the 2001 tax rebates, Souleles estimated that consumers spent roughly one-third of their rebate checks within the first period of their distribution. Consistent with his hypothesis that "it is liquidity-constrained households that are going to respond most to an increase in liquidity," Souleles found that low-income households spent a substantially greater portion of their rebate check relative to the average household. Although he acknowledged that the impact of rebate measures are difficult to calculate because of "the absence of a counterfactual," Souleles estimated that without the tax rebates in 2008, GDP growth in the second quarter could have been as low as negative 0.1 percent, which was "much less than the actual 2.8 percent rate of growth."

AEI's Alan D. Viard addressed a number of popular "fallacies" related to demand stimulus, including the notion that stimulus provides a permanent boost to the economy and creates jobs in the long term. Because stimulus measures redistribute output between time periods rather than providing a permanent increase in output, the goal of fiscal policy should be stabilization--boosting demand during downturns and lowering it during periods of growth. "Any additional output gained by boosting aggregate demand will eventually be 'paid back' through later output loss," Viard explained. "In the long run, boosting one type of spending reallocates jobs between different sectors rather than creating them." Despite his reluctance to embrace discretionary fiscal stimulus measures, Viard, a self-described "stimulus scrooge," admitted there is need for some discretionary fiscal stimulus given the severity of the current recession. In addition to other tax and spending measures, Viard suggests offering more generous business loss carrybacks as a way both of "leveling the playing field on risky investments" and encouraging investment spending in a downturn.


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