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The case for more stimulus

/ Source: Business Week

President Barack Obama would have been forgiven a few high-fives April 2 after the Labor Department announced the U.S. economy generated 162,000 jobs in March. Instead he was cautious.

At a speech in Charlotte, N.C., Obama did say, "We are beginning to turn the corner," then added that the job numbers "leave us with a lot more work to do." Chief economic adviser Christina Romer was even more circumspect, issuing a statement that said, "the American labor market remains severely distressed." And over the weekend, National Economic Council Director Larry Summers drove the point home on CNN, saying, "We've got a long way to go."

It's not modesty, false or otherwise, that's making the Obama administration so reticent. It's reality. With 10 million Americans out of work, Obama's team knows that the employment growth in March (a quarter of which was driven by the hiring of federal Census workers) actually makes its mission over the next year or two more difficult.

Here's why: The positive jobs report reduces the political urgency for fixing the U.S. economy. If voters and lawmakers decide the economy is healing on its own, it becomes harder to justify more infrastructure spending, aid to stressed states, extended unemployment insurance and the like. Even before the report, the administration had begun to focus on smallish fixes like the $14 billion HIRE Act, which encourages hiring of the unemployed, and new measures to discourage foreclosures. "Stimulus has become a dirty word in Washington," says Augustine Faucher, macroeconomics director of Moody's

That's understandable, but it could be a problem if the economy begins to sputter. The nonpartisan Congressional Budget Office estimates that as of the end of 2009, last year's $787 billion stimulus package had created 1.4 million to 3 million full-time-equivalent jobs that wouldn't have existed otherwise. In other words, the recession would have been even worse without it. Now that stimulus is going away; by September, 70 percent of the funds will have been spent, the government estimates.

While most forecasters see gross domestic product growth of 3 percent this year and next under current policy, there remains a risk that without more support, the U.S. economy will sink into Japanese-style torpor. David Rosenberg, chief economist of investment manager Gluskin Sheff & Associates in Toronto, predicts U.S. growth will slow from 3 percent this year to 2 percent in 2011 and just 1 percent in 2012. He sees a 35 percent chance of a relapse into recession at some point.

Says Mizuho Securities USA Chief Economist Steven Ricchiuto: "Since the [March] payroll data came out the growth optimists are taking a victory lap. But the risk of a double dip remains significant."

All this puts the Obama administration in a tricky spot. The president wants to continue priming the pump, at more modest levels. The 2011 budget requests $266 billion to fight the slump—$166 billion for extended unemployment insurance, more aid to states and localities, etc., and the rest for targeted jobs programs. "We are very much of the mindset that more needs to be done," says Jared Bernstein, Vice President Joe Biden's chief economic adviser.

Yet Obama also wants to reassure voters and the markets that he's serious about deficit reduction. That's the purpose of the new deficit commission and the scattered tax hikes in the 2011 budget. There's a risk of coming down in the muddy middle and achieving neither goal. The conservative Orange County Register editorialized in February that in conveying his dual message, Obama sounds like the young St. Augustine, who prayed: "Give me chastity and continence, but not yet."

As a student of the Great Depression, Christina Romer studied what happened in 1937-38, when ill-conceived fiscal and monetary contraction killed a fairly strong recovery, sending the economy back into a slump that didn't end until World War II. As the current recovery begins, Romer says she continues to worry whether private demand will come back strongly enough as federal spending falls. "We are on track for normal trend growth, but we need much more than that. When you're down so much in jobs, you need a period of very rapid job creation," she said in an April 6 interview.

You don't have to go back to the 1930s to find a nightmare scenario for the American economy. In 1997, Japan was gradually beginning to recover from a downturn that began with the popping of a huge real estate bubble in 1990. Then deficit hawks pushed through an increase in consumption taxes equal to 2 percent of the nation's GDP. Output, which had been growing, abruptly shrank. Unemployment began to rise. The downturn caused the Japanese people to lose confidence in their government's ability to restore growth.

More than two decades later, the funk in Japan still lingers. "After 1997 it was like a funeral in Japan," says Richard C. Koo, chief economist of Nomura Research Institute. "Once people start feeling there is no cure, you're in trouble."

Japan suffered for so long because it failed to find a new source of economic growth. Twenty-eight months after the U.S. recession began, in December 2007, and most of a year after it probably ended, the U.S. may be in a similar fix. No single engine has emerged to pull along the $14 trillion economy—not consumer spending, not business investment, not exports. Clean-energy apostles argue that the transition to a green economy could become the driver, but the Senate seems unwilling to impose a price on carbon emissions, the necessary trigger for massive private investments in alternative energy.

Despite the welcome return to growth and the sunny economic reports of recent days, the outlook remains uncertain. The March jobs report contained the worrisome news that average hourly earnings fell by 0.1 percent from February, a rare decline, leaving them up just 1.8 percent from a year earlier.

Workers have scant bargaining power. The housing bust left them feeling poor, while near-10 percent unemployment has them fearing for their jobs. Bankruptcy filings were up 23 percent in March, to nearly 150,000, from a year earlier. The Conference Board's measure of consumer confidence is as low as it was in the dark days of September 2008, after the collapse of Lehman Bros.

Yes, personal consumption has been rising, but it has been propped up by a drop in the personal savings rate (from 6.4 percent to 3.1 percent over the 10 months through February), and the savings rate can't keep falling forever. Consumers want to be more thrifty, not less, so "households will not be able to continue to spend at this rate in the coming quarters," Capital Economics' U.S. economist Paul Dales wrote March 29.

You would think businesses could lead the economy because they are flush with cash to invest and hire. (Nonfinancial U.S. corporations held $1.8 trillion in liquid assets at the end of 2009, according to investment firm AllianceBernstein.)

They aren't doing so because they still have excess capacity and they don't see enough demand from consumers, who remain cautious because they fear for their jobs. A mini-boom in capital spending late last year is already fading. For the medium term, "we're basically in a structural slump," Edmund Phelps, the Nobel Prize-winning economist at Columbia University, told Bloomberg Television on April 2.

Obama is pinning some of his hopes for growth on trade, vowing that the country will double exports in five years. That requires trading partners to play along by growing robustly and buying more American products. Instead, China and India have raised rates since last year to stave off inflation. Southern European nations are cutting government spending and raising taxes. Many trading partners, from Britain to Germany, intend to pump up their economies via exports.

What's left, then, to accelerate growth? Government. The Keynesian prescription for a prolonged, economywide shortfall of demand is to spend money to get the economy functioning. The idea is that priming the pump now will yield lots more GDP growth (and tax revenue) in the future. Stimulus can be a long-term money-saver.

John Maynard Keynes may stand right next to Karl Marx in the eyes of Tea Party activists, but there's a long history of Keynesian stimulus by both Democratic and Republican administrations. In 2008, President George W. Bush pushed for and achieved a $152 billion stimulus package that he described as a "booster shot" for the economy.

True, Obama has less spending leeway than Bush had. According to the White House's Office of Management & Budget, gross federal debt will reach 94 percent of GDP this fiscal year, up from 69 percent in 2008. Research by economists Carmen I. Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University shows that growth slows in advanced economies when their ratio of gross debt to GDP exceeds 90 percent.

Citing numbers like that, Republican economists say it would be a mistake to spend any more now on juicing the economy. Douglas J. Holtz-Eakin, an economist who advised Republican Sen.  John McCain's presidential campaign in 2008, predicts that "we'll begin to see fairly steady job creation" by summer. "I think it's terrible advice to a Congress to put off getting its fiscal house in order."

Holtz-Eakin is right that the federal debt will be a huge problem over the next decade and beyond. But trimming back on recession-fighting remedies won't solve it. The deficit is growing primarily because of ballooning expenses for entitlement programs such as Social Security and Medicare, as well as national defense. Obama's budget office estimates that even at the peak of stimulus spending this year, more than 70 percent of the federal deficit is accounted for by noncyclical factors—i.e., fundamental imbalances.

The good news is that the deficit is more of a long-term threat (albeit an enormous one) than a present danger. The yield on 10-year Treasury bonds remains below 4 percent, vs. over 8 percent in 1990. Inflation, likewise, is a remote concern: Prices for personal consumption expenditures rose just 1.8 percent over the past year through February.

And there's reason to be encouraged about America's debt-paying capacity over the short term: The increase in the national debt has been slowing. Since 2006, increased federal borrowing has been partially offset by more savings by households and businesses (although households have been less frugal recently). As a result, overall national savings have fallen less than the big federal deficits might lead one to expect. That's a good thing.

Another factor that's taking the pressure off U.S. financing needs is that national investment has declined in the economic downturn. When there's less investment, there's less need for savings to finance it. The result is that the U.S. is importing less savings from abroad. Net national borrowing fell by nearly half between 2006 and 2009, Federal Reserve figures show.

Contrary to popular perceptions, then, Obama may have some fiscal elbow room for measures to boost the economy over the next few years. It will need to do so, argues Nomura's Koo. "If the government refuses to borrow money to compensate for the private-sector pullback, this economy will start contracting in a deflationary spiral."

The Obama administration might have an easier time selling stimulus if it could convince Americans that the money is doing what it's supposed to. That hasn't always been the case. Tax cuts, which constituted most of the Bush stimulus and one-third of the 2009 Obama plan, are especially ineffective in generating growth when there's lots of slack in the economy, according to analysis by macroeconomic forecasters such as IHS Global Insight, Macroeconomic Advisers, and Moody's Businesses won't hire an extra employee, even with a tax incentive, if there's no work to be done.

Most consumers will save rather than spend a tax rebate if they can afford to do so and are intent on repairing their household balance sheets. For instance, Moody's estimates that cutting corporate income taxes raises GDP for one year by only 30 cents for each $1 of tax cuts.

Infrastructure spending may be the most underused tool to fight the slump. It offers lots of bang for the buck (a $1.58 rise in first-year GDP for every dollar spent, Moody's says). It benefits a sector—construction, mining, and energy—whose March unemployment rate was 24.6 percent. And it builds things that society needs anyway, like roads, levees, and sewer systems. It works slowly, but that's O.K. because the economy will have lots of spare capacity for years.

Rosenberg, the bearish Gluskin Sheff economist, dislikes most stimulus measures but does support more infrastructure spending, in particular "totally revamping the energy grid." Says Rosenberg: "That's something you could really rally the population around." (When the Senate turns to energy legislation in the coming weeks, stimulus will be lurking in the pages of the bill.) Princeton University economist Alan Blinder imagines a million-person Works Project Administration that would clean parks, repair facilities, and so on.

Right now any productive investment would help. Labor and capital are sitting idle because the private sector remains depressed. If Obama intervenes in a way that sustains the recovery, then it will surely be time for high-fives.