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Policymaking in a Pan(dem)ic
The case for stronger automatic stabilizers.
As many of you know, I co-host a weekly podcast for MarketWatch. It’s called Best New Ideas in Money, and each episode runs around 25 minutes. It’s perfect for a quick workout, a brisk walk with the dog, or running a couple of errands. You can subscribe to the show here.
Last week, I talked with ADP’s chief economist Nela Richardson about inflation, the labor market, and the economic outlook for 2023. You’ll be able to listen to that episode after the holidays.
We’ve also been working on a topic that I’ve been itching to cover for a long time — automatic stabilizers. You can think of automatic stabilizers sort of like the shock absorbers in your car. You don’t have to press a knob or pull a lever to engage them. If the road becomes bumpy or uneven, the shock absorbers will automatically cushion your ride. They don’t guarantee a perfectly smooth journey, but they’ll dampen some of the more jarring impacts as road conditions change.
Switching gears—pun intended—we’ve equipped our economic system with various stabilizers that are designed to automatically respond to changing economic conditions. For example, in a slowing economy, more people become eligible for unemployment insurance and food stamps, so government spending automatically increases in those categories of the federal budget. Meanwhile, tax receipts automatically decline as the weak economy leaves corporations and individuals with less taxable income. With higher spending and lower tax revenue, the federal deficit automatically increases. The bigger deficit cushions the economic slowdown. In a booming economy, the reverse happens. (Click here for more.)
If we didn’t have the automatic stabilizers, we would have to rely on some combination of discretionary monetary policy and fiscal policy to counteract fluctuations in output, employment, and inflation. That would leave us in worse shape because: (a) Congress might be unwilling to pass discretionary legislation to adjust spending and/or taxes as needed to help stabilize the economy; (b) the Federal Reserve might struggle to restore full employment and price stability on its own.
That’s exactly what happened following the financial crisis of 2007/08.
Back then, Congress mustered the votes to pass a discretionary fiscal package known as the American Recovery and Reinvestment Act (ARRA), while the Federal Reserve dropped the overnight interest rate to zero and launched several rounds of large-scale asset purchases (LSAPs) known as ‘quantitative easing’ (QE). What appeared—to some—as a massive counteroffensive against The Great Recession did relatively little to stave off a downward spiral.
Ironically, what ended up saving our bacon were the things policymakers didn’t have to choose to do.
In June 2009, the US economy officially exited recession. The following month, Paul Krugman published a column declaring, “Deficits Saved the World.” But as Krugman (and others) rightly noted, the downturn was arrested not so much by the relatively small deficits that came via the discretionary fiscal package but by the big deficits that happened because of the automatic stabilizers. Here’s Krugman:
[G]overnment deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression . . . absent the absorbing role of budget deficits, we would have had a full Great Depression experience. What we’re actually having is awful, but not that awful — and it’s all because of the rise in deficits. Deficits, in other words, saved the world.
Looking back on that period, Martin Wolf of the Financial Times argues that a more robust fiscal response would have been even better. Unfortunately, too many governments pivoted to austerity, prematurely withdrawing (discretionary) fiscal support for their economies. The result was an anemic ‘recovery’ with devastating effects on the labor market.
[I]n order to sustain demand when the private sector has been as badly hit as it was in 2007 to ‘09 — and this seems to me the most fundamental lesson that Keynes tried to introduce in thinking about depressions — it is necessary for governments to run large deficits. . .
And unfortunately, basically in every country, including the US for different reasons, this fiscal support was curtailed in my view too soon. And that meant that the recovery was not sustained. Because the recovery wasn't sustained, business became more cautious. So that made [the recession] longer-term.
Now in the longer term we need to create a more robust financial system, a less-leveraged economy, and a more balanced world economy. These are huge challenges. I feel we have not taken the measures we need to make our economy simply more robust.
One way to make our system more robust is to strengthen the automatic stabilizers so that fiscal deficits swing into motion with an even stronger countercyclical response to changing macroeconomic conditions. I emphasized the need for stronger automatic stabilizers in my book, The Deficit Myth, and other MMT scholars have put forward innovative ways to automate more of the policy response.
In her final speech at Jackson Hole in 2016, Fed Chair Janet Yellen focused on the Past, Present and Future of Monetary Policy, but she also had something important to say about fiscal policy:
Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy. For example, steps could be taken to increase the effectiveness of the automatic stabilizers, and some economists have proposed that greater fiscal support could be usefully provided to state and local governments during recessions.
Around the same time, San Francisco Fed President John Williams said:
If we could come up with better fiscal policy...then that takes the pressure off of us to try to come up with other ways to do it, like through a large balance sheet. It also means we don't have to turn to quantitative easing and other policies as much.
What Yellen and Williams (and Ben Bernanke) were saying is that monetary policy isn’t enough, especially when we’re up against a severe economic downturn. But if Congress refuses to engage its own policy lever (fiscal) with sufficient force, then the entire job will be left to the central bank, and that means running all sorts of policy interventions (like ZIRP or QE) that most central bankers would prefer to avoid.
Whereas the lesson of 2007/09 is that we couldn’t get enough discretionary fiscal policy to restore full employment in a timely manner, some argue that the lesson of 2020/21 is that we got too much discretionary fiscal support—three rounds of stimulus checks, $600/week enhanced unemployment insurance, PPP loans, etc. I’m not going to re-litigate the latter debate here. The reality is that it took almost 7 years to claw back the roughly 9 million jobs that were lost in The Great Recession but only 2.5 years to restore the 22 million jobs that were lost in the COVID recession. I’ll take the latter performance over the former any day of the week.
We did better this time, but not because we got better policy from the Federal Reserve. Indeed, we got mostly the same thing we got after 2008—i.e. zero interest rate policy (ZIRP) and massive bond-buying (QE). We did better because Congress delivered not one, not two, but three substantial pieces of legislation that actively supported the economy with around $5 trillion in additional spending.
And so, once again, Deficits Saved the World. But this time deficits didn’t increase mainly due to Congressional inaction—i.e. the automatic stabilizers—but because of the proactive—i.e. discretionary—actions of Congress and the White House.
Did they get everything right? No. Did we need all $5 trillion? Probably not. Could some of that spending have been better targeted? You bet. Should some of it have been set to phase out sooner? Probably.
But remember that the three biggest packages ($2.2 trillion in March 2020, $900 billion in December 2020, and $1.9 trillion in March 2021) were all passed in the middle of a global pandemic. For better or worse (I think it was for the better), lawmakers decided it was preferable to err on the side of doing too much as opposed to doing too little.
In the future, we should try to avoid cobbling together multi-trillion dollar fiscal rescue packages in a state of panic. One way to do that is to begin to strengthen our automatic stabilizers. An old rule of thumb advised drivers to consider replacing the shock absorbers in their vehicle every 50,000 miles or so. When it comes to our economic shock absorbers, we’re long overdue for an upgrade.
Happy holidays and please consider subscribing to the podcast.