Fiscal Policy Choices in Uncertain Times

September 16, 2010

I’m speaking this afternoon to the Washington Policy Seminar sponsored by the Macroeconomic Advisers forecasting firm.  My presentation draws on several reports that CBO has released over the course of this year and emphasizes these points:

  • CBO and most private forecasters expect that the economic recovery will proceed at a modest pace during the next few years. For example, in the forecast that we completed in early July, the unemployment rate remains above 8 percent until 2012. In addition, the economic data released since we finished that forecast have been weaker than we had expected, so if we were to construct a new forecast today, we would project slightly slower growth in the near term.
  • Weak economic growth has serious social consequences. About 9½ percent of the labor force is officially unemployed, but many other people are underemployed or have left the labor force. The increase in unemployment is not uniform across demographic groups or regions, with larger run-ups for less-educated workers, men, and people living in certain states. The incidence of unemployment lasting longer than 26 weeks has been the highest by far in the past 60 years. As discussed in our April issue brief, the short-term and long-term impact on people of losing a job during a recession can be very significant.
  • Some observers have argued that there is not much that policymakers can do about the weakness of the recovery. That is not our view at CBO. Although there are no magic cures, we do think there are both monetary and fiscal policy options that, if applied at a sufficient scale, would increase output and employment during the next few years (but not overnight). Such options would have costs though—in particular, expansionary fiscal policy would increase federal budget deficits and debt relative to current baseline projections, which are already quite worrisome.
  • One key question I’ve been asked in the debate about fiscal policy: What sorts of fiscal policies would actually encourage greater economic activity and more employment? Fiscal policy can affect behavior through several channels: by changing direct demand for goods and services, changing people’s current and/or expected income, changing the payoff from extra work effort and saving, changing the cost of investment, and so on. Predicting the effects of particular policies is difficult, and estimates are quite uncertain.
  • In January of this year, we published a study titled Policies for Increasing Economic Growth and Employment in 2010 and 2011. We studied temporary policy changes to be enacted in early 2010, because most observers were interested in the question of how to provide a short-term boost to the economy without significantly worsening the medium- and long-term budget situation. In most cases, permanent changes would generate larger short-term stimulus but would have substantially larger medium- and long-term budget and economic costs. We estimated the “bang for the buck” of different policies; of course, the effect on the economy would also depend on the scale of the policies. This graph summarizes our estimates:

Cumulative Effects of Policy Options on Employment in 2010 and 2011, Range of Low to High Estimates


  • The other key question I’ve been asked: How can short-term fiscal stimulus be reconciled with the imperative—and it is a critical imperative—to put fiscal policy on a sustainable medium-term and long-term path? As I said to the Fiscal Commission at the end of June, there is no intrinsic contradiction between providing additional fiscal stimulus today, while the unemployment rate is high and many factories and offices are underused, and imposing fiscal restraint several years from now, when output and employment will probably be close to their potential.
  • If taxes were cut or government spending were increased permanently that would worsen the already worrisome fiscal outlook, as shown in the graph below.  Even if changes were temporary, the additional debt accumulated during that temporary period would weigh on the budget and the economy in the future. Achieving both stimulus and sustainability would require a combination of policies. If policymakers wanted to avoid worsening the large medium-term and long-term imbalance between federal spending and revenue, any policies that widened budget deficits in the near-term would need to be accompanied by specific policies to reduce spending or increase revenue over time.

Rising Burden of Federal Debt Held by the Public

  • In summary, the economic recovery will probably proceed at a modest pace—leaving total output well below its sustainable level, and the unemployment rate well above its sustainable level, for a number of years. In CBO’s judgment, the available monetary and fiscal tools, if applied at sufficient scale, would improve economic conditions during the next few years—though with costs and risks in the medium and long term. Policymakers need to address those trade-offs.