Imperfect stimulus plan is still the best answer

Mark Zandi

is chief economist at Moody's Economy.com

I have been a professional economist for nearly a quarter-century, and I've never seen anything like the unraveling of our economy over the last year.

Even if everything breaks our way, the current downturn will easily be the longest, most severe, and broadest - crossing occupations, industries, and regions - since the Great Depression. The only way to avoid another depression is through very aggressive action by the Federal Reserve, Congress, and the administration.

The fiscal-stimulus plan that will soon become law, though far from perfect, is an important part of the policy response needed to shore up our sliding economy.

The plan includes tax cuts and government spending worth nearly $800 billion, including about $300 billion in tax cuts for individuals and businesses; $250 billion in aid to fiscally strapped state and local governments; $150 billion in various kinds of infrastructure spending; and $100 billion in income support for workers who lose jobs. By my calculations, the plan will add more than two million jobs by the end of 2010 to the number that would exist without a stimulus, and the unemployment rate will be more than a full percentage point lower.

Income support and aid to state and local governments will provide quick help to the economy. Without this relief, workers losing jobs have little choice but to immediately slash spending, costing the economy even more jobs. State and local governments struggling with falling tax revenues must in most cases balance their budgets by cutting payrolls and programs and raising taxes, adding to the economy's burdens. Federal help for the unemployed and for state and local governments will thus prevent even worse job losses.

Tax cuts stimulate job creation as individuals spend and businesses invest some of their added cash. But the near-term economic benefits of individual tax cuts are diluted, as some is saved and some used to repay debt. These are not bad things in themselves, but they do not help the economy as much as spending the money quickly.

The stimulus plan also helps the troubled housing and auto industries with tax breaks, including a nonrefundable tax credit worth up to $8,000 for first-time home buyers who purchase in the next year, and a write-off of state sales taxes and interest on loans to buy new vehicles.

The home-purchase tax credit will help some families with a down payment. Though the credit won't forestall further declines in home prices, it could break the housing market's current deflationary psychology, with many potential buyers waiting for prices to fall further. The tax break for a new vehicle purchase will provide less of a sales boost, but it won't hurt.

The economic benefits of infrastructure spending are generally not quick - it takes time to get these projects under way - but they will be significant, particularly for the depressed construction and manufacturing industries.

Because the economy will struggle well into 2011, this spending will be particularly welcome as the impact of other stimulus efforts fades. The stimulus plan has drawn criticism for its mixed bag of infrastructure targets, from roads and bridges to the electric grid and the Internet backbone. But given the uncertain returns on such projects, diversification is probably a plus. Moreover, the Japanese experience during their "lost decade" of the 1990s showed there are diminishing returns to infrastructure spending. Investing only in bridges, for example, ultimately produces bridges to nowhere.

There are concerns that the stimulus plan's $789 billion price tag is too large. To pay for it we will have to borrow the money, adding significantly to the government's debt load. But without a stimulus, the depression would undermine tax revenue and fuel more government spending, producing even larger deficits and debt burdens.

It is fortunate that we are still the global economy's triple-A credit; even though this calamity began in the United States, global investors still prefer the safety of U.S. Treasury bonds. We will thus be able to borrow the money at record-low interest rates.

Indeed, my most significant criticism of the current stimulus plan is that it is too small.

Our struggling economy will produce nearly $1 trillion less than it is capable of this year and will underperform again by at least as much in 2010. The $789 billion in spending and tax cuts to be distributed over those two years is not going to fill this expected hole in the economy. I would thus not be surprised if policymakers are forced to consider a second stimulus plan soon.

Nonetheless, when combined with other aggressive policy steps, including efforts to shore up the financial system and stem foreclosures, this fiscal-stimulus plan will go a long way toward relieving the current economic crisis.