The economic stimulus package: How does spending help?

A reader asks: "Could you please explain how a stimulus package (which creates more federal debt but puts cash into the hands of consumers) helps the economy? It is hard to understand how spending more money helps the economy. Isn't this what got us into this mess? The nation has a negative saving rate, the Republican Congress encouraged spending at the federal level and at the consumer level, housing prices became inflated, people took out mortgages that they now cannot afford (overspending)…. Isn't it better to have a good balance of spending and saving?"

The reader is basically right, says Barry Bluestone, a dean and economist at Northeastern University, Boston. Many consumers have overspent and maxed out their credit cards. Housing prices have soared, making Americans regard them as a clever investment as well as a home. "Mischievous" mortgage brokers made a mint providing inappropriate loans on home purchases.

Paraphrasing Professor Bluestone further, he sees the United States now facing a "perfect storm" with the potential for serious inflationary pressures. Oil prices have soared toward $100 a barrel. The dollar has tumbled, making it easier for domestic businesses to raise prices and still compete with imports.

Moreover, the decline in housing prices, the subprime mortgage mess, plus approximately a 15 percent drop in stock market values since October, has left many people feeling poorer. Even if still employed, they rein in their spending. They delay building an addition to their house. They skip a vacation. They don't buy expensive furniture, and so on.

This trend raises the risk of a worsening economic slump. It needs countering with easier monetary policy and "short-term fiscal stimulus," says Bluestone. He emphasizes the words "short-term." Tax rebates or tax cuts shouldn't be permanent, he says. Putting an extra $300 or more into the pockets of consumers will prompt some of them to spend, some to reduce debts, and some to save.

"It will make people feel less poor," says Bluestone.

Yes, the tax stimulus raises federal debt. But with the economy already slowing, the nation must avoid hitting the economic brakes; rather keep it moving to slow rising unemployment and the weakening of businesses.

When the temporary tax cuts end, the economy should be moving forward again and federal revenues will rise to trim or end the federal budget deficit. That, explains Bluestone, is what happened in 1995-96 under President Clinton. And if necessary, the government could dampen a new vigorous economic expansion to trim rising inflation.

"At least we tackle that problem when the economy is growing, not declining," says Bluestone. "It's a timing problem."

Certainly, the 80 percent of Americans who have seen no increase in their real income for the last five years will benefit from the fiscal stimulus, Bluestone says. Many "working stiffs," he says, will spend their tax rebates.

The impact of a recession on people is nothing to sneeze at. Fearing the political and economic consequences, Congress and President Bush, Democrats and Republicans, have managed – so far – to agree on a fiscal stimulus package.

Should the present slump worsen into a real recession, economists John Schmitt and Dean Baker predict that the labor market will suffer for about the next three years (as happened in the economic downturns of the early 1990s and 2000s). The problem might last four years if a recession is as bad as the 1980-82 dive. The latter was the worst downturn since the Great Depression of the 1930s. If the recession is modest, the national unemployment rate could rise 2.1 percentage points to 6.7 percent through 2010, adding 3.2 million people to the rolls of the jobless. If the downturn is more severe, the unemployment rate might soar to 8.4 percent by 2011, with 5.8 million more Americans unemployed.

Depending on its severity, a recession could add 1.6 to 3.5 percentage points to the 2006 poverty level of 12.3 percent, calculate Mr. Schmitt and Mr. Baker, both from the Center for Economic and Policy Research in Washington. Further, a mild-to-moderate recession would reduce the median family income by some $2,000 a year and leave an additional 4.2 million individuals without health insurance.

Considering the potential damage of a recession, the Federal Reserve decided to cut a key interest rate a further 0.5 percentage points last Wednesday.

But not all economic seers are gloomy. One optimist, Brian Wesbury of First Trust Portfolios in Lisle, Ill., told a congressional committee last week that since 1982, the economy has been in recession only 5 percent of the time, whereas between 1969 and 1982, the US was in recession roughly one third of the time. He called attention to that 1980-82 recession when both unemployment and inflation exceeded a 10 percent annual rate. The 30-year mortgage rate rose to 18.5 percent when then Fed president Paul Volcker braked the economy hard to stop what was called "stagflation."

Most economists don't expect anything as bad this time around.