Was the stimulus too small?

Martin Wolf, the award winning journalist at the Financial Times, makes a convincing case (registration required) that the real debate over the US stimulus is not whether the stimulus package worked but whether it should have been bigger.

Although it’s doubtful that there were enough ‘shovel-ready’ projects to make quick use of a major expansion in stimulus funding, cumulative state government shortfalls from fiscal year 2009 through the end of fiscal year 2012 will likely total over $450 billion, even after accounting for federal recovery dollars.  A substantial minority of states chose to close at least part of their budget shortfalls by raising additional revenue, but real cuts to state budgets will probably total over $350 billion through the end of next fiscal year.  The real effect of these cuts, which resulted in hundreds of thousands of public- and private-sector job losses, was to weaken the effect of the $787 billion included in the Recovery Act by almost half.  Expanding the stimulus through aid to states instead of additional projects or tax cuts could have made the stimulus much more effective at saving and creating jobs in a timely fashion.

But, as Larry Summers, Mr Obama’s chief economic adviser, had said: “When markets overshoot, policymakers must overshoot too”. Unfortunately, the administration failed to follow his excellent advice. This has allowed opponents to claim that policy has been ineffective when it has merely been inadequate.

The economic press has been touting Germany’s more robust recovery as evidence that the “fiscal austerity” route would have been a much more effective policy option than major federal stimulus.  Looking at total government expenditures, however, shows that Germany actually increased government spending more than the US since the beginning of the recession: over 7% for Germany versus just over 4% for the US.  The results?  Germany has an unemployment rate of 7.6%; the US unemployment rate is hovering at 9.5%.

While it’s unlikely that this Congress will support a second large-scale stimulus, there is certainly still a strong case for smaller targeted measures, such as extending some fiscal aid to states and long-term unemployment benefits beyond the middle of next year, that will support the economy and help prevent the possibility of a double-dip recession.

Since there is huge slack in the labour market, not the slightest threat of inflation – far more a risk of deflation – and no constraint from bond or foreign exchange markets on further monetary and fiscal stimulus, these are the policies that have to be pursued.