Obama's Recession Fix Fits Economists' Models

(Jay Premack - Bloomberg News)
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By Jane Bryant Quinn
Sunday, February 1, 2009

In the fight over the stimulus plan, Republicans are demanding more tax cuts as the best way of lifting the economy fast. "We can't borrow and spend our way to prosperity," said House Minority Leader John A. Boehner (R-Ohio).

Well, maybe we can -- or at least begin. In a crisis, government spending has to be the first responder, with tax cuts coming up behind.

Allen Sinai, chief global economist and president of Decision Economics, a New York-based research and forecasting firm, recently ran various types of government actions through his respected macroeconomic model of the United States. He discovered some surprising things.

First, even a very large stimulus doesn't help the economy a lot. The negative forces are too strong -- centered on the credit collapse and the collapse in consumer spending. Government will lean against this stunning downturn but can't make up for the massive loss of private demand.

Furthermore, the larger the budget deficit, from tax cuts and spending, the bigger the bounce in expected future inflation and long-term interest rates. That will take the edge off future growth.

Sinai forecasts a stimulus-based gain in gross domestic product of perhaps 2 percentage points in the first year and 1 point in the following year compared with where we'd be otherwise. A turn could come as early as summer. Without a significant stimulus, he'd expect the recession to last into March 2010.

More pessimistic economists expect it to last that long anyway. The ugliest months lie directly ahead.

The best way to boost the economy fast, the model shows, is to increase federal spending on goods and services -- things like cars, office space, military equipment and construction. Unemployment drops quickly and GDP jumps. The second-best GDP driver is direct aid to states and cities, to keep current projects going and start new ones.

In both cases, though, the impact on economic growth tapers off after a couple of years. To keep the economy rising, the moribund private sector has to ignite.

For that, Barack Obama's program is counting on individual tax credits. Temporary tax credits and rebates affect the economy more slowly than government spending. Consumers don't spend the whole check at once and may use part of it to build up savings. But the money gradually helps revive private-sector demand.

Permanent tax cuts, for businesses and individuals, take effect even more slowly, Sinai's model shows. On the plus side, they have a longer-lasting, positive impact on GDP and jobs. On the negative side, the long-term deficit grows much larger than it would with temporary cuts. There's a similar result for a permanent increase in transfer payments such as food stamps.

So President Obama appears to have it about right: Government spending, including state and local, for a quick fix; temporary tax reductions to help households pay down debt and, eventually, spend the money to strengthen the private sector; and no permanent tax cuts that would stick us with even worse deficits than are projected now.

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