John Irons's Blog


Economic News, Data and Analysis

How to Fight a Recession

Recession talk
is all the rage these days. And it seems as if everyone is jumping on the
bandwagon to fight for lower taxes, or to back the Federal Reserves’ interest
rate cuts.

On one side, President
Bush is arguing that we need a tax cut, in part, to fend off a potential
slowdown. But on the other, there are people who are arguing that the Fed
is already taking action, and that a tax cut would come too late to be
an effective recession-fighting tool.

We might be in
favor of a tax cut for other reasons – for example, a marginal rate reduction
will lessen any work-disincentives in the labor market – but is fiscal
policy a good way to fight recessions? Most economists think that in the
current political system Monetary policy is the best tool for the job.

Monetary or
Fiscal Policy?


Monetary Policy: 

The regulation
of the money supply or interest rates in order to influence economic outcomes.
In the U.S., monetary policy is determined by the Federal Reserve System

Fiscal Policy:

The manipulation
of government expenditures and tax collections to influence economic outcomes.
In the U.S., the Federal Government via legislation plays the most important
role in determining fiscal policy.


In principle,
both tools are able to help get the economy moving quicker in the short
run.* Is there any reason we should prefer one tool
over another? In other words, if you were the Economic Dictator of the
United States and able to control both fiscal and monetary policy – which
policy would you choose: lower taxes or lower interest rates (or a combination
of both)?

One difference
between the two kinds of policies arises when we consider the impact of
the actions on the interest rate and hence investment. A stimulative monetary
policy lowers interest rates and hence encourages investment. This is in
contrast to an expansionary fiscal policy – either a decrease in income
taxes or an increase in spending – which will lead to higher interest rates
and less investment (this is the “crowding out” effect you may remember
from your economics course).

A second potential
difference is the time lag between when the policy is enacted and when
the impact will be felt by the economy as a whole: often referred to as
the “outside lag”. If the economy reacts quickly to one policy and slowly
to the other, then we will probably prefer the fast-acting policy. If we
could accurately forecast downturns in the economy, then the speed of action
would not be very important as we could plan ahead and enact the policy
in anticipation of the recession. However, recessions are notoriously hard
to forecast ahead of time (just ask Ed Yardeni who was the most vocal of
the Y2K recession alarmists).

Political Reality:
Inside Lags

you are not the Economic Dictator of the U.S. (and, contrary to what many
people think, neither is Alan Greenspan). So we have to make due with our
current political system to enact our counter-cyclical policies. 

In order to combat
a recession we need to go through several political and decision-making

First we
need to gather information on the economy and analyze it to the best of
our ability. Both the Monetary policymakers (the Fed) and the fiscal policymakers
(Congress and the President) each have a large number of economists who
follow the economy and make recommendations. This is not an easy job and
it can take a good amount of time (as in months) to fully measure and understand
both how the ecnomy is currently doing as well as where it is likely to
go in the future. I think the Fed has a slight advantage in this category
given that it employs a large number of economists to do this and only
this. (In the interest of full disclosure – I have worked at the fed and
my loyalties may be affecting my judgement on this issue!)

once we learn that we are headed into a recession or a slowdown (or at
least can make a forecast that convinces us of a looming slowdown), we
then have to then make a decision as to what to do about it. Here too,
the Fed has an advantage in terms of the speed in which it can move from
analysis to implementation. The FOMC (the decision making body at the Fed)
meets every 6 weeks or so, and can even act in between meetings as the
fed did recently. 

On the other hand
Fiscal policy requires an act of Congress and the President’s signature.
This means debates, compromises, partisan fights, etc. By the time an appropriate
fiscal response is enacted, the recession may very well be over. Anyone
remember Clinton’s “stimulus package” proposal from 1992? The recession
was over before the bill made it to the floor. Bush’s tax cut proposal
is not even scheduled to be brought up until May – a full 4 months after
the Fed’s first action on the economy.

we have to wait for the implemented policies to have their ultimate effect
on the private economy – the “outside lag” as mentioned above. On this
point there is still a bit of debate as to how long it takes for policy
to have its ultimate impact the economy. Most would put the main effect
of a interest rate shift anywhere from 6 to 18 months after enactment.
Fiscal policy probably takes longer.

Because of these
lags, it looks like monetary policy is the way to go.

Can fiscal
policy be improved?

Being aware of
the policy lags mentioned above, most economists would agree that if non-automatic**,
or “active,” counter-cyclical policy is to be used at all, then we should
rely primarily on monetary policy – except in the most extreme cases (e.g.
liquidity traps). 

However, this
view is predicated largely on the long lags associated with the decision
making process of Fiscal Policy. If those lags could be reduced then there
may be more of a role for active Fiscal policy. Perhaps we could develop
a “anti-recession fund” – say a reserve account that could be used to fund
tax cuts in the case where GDP growth falls below a certain amount, or
some other trigger is pulled. 

It seems like
this would be a good time to fund such an account given the current climate
of surpluses in Washington. 

In the opinion of most economists, under “usual” circumstances, and subject
to a variety of caveats. There is, however, some debate over the strength
of the tools, the length of the lags involved; and there are also people
who argue against the use of any active, discretionary, stabilization policy
for a variety of reasons. 

We currently have a number of Fiscal policies that can be called “automatic
stabilizers” – namely policies that automatically increase spending or
decrease taxes in the case of a recession. For example, unemployment insurance
payments rise in a recession since there are more unemployed people; and
income tax receipts fall as total income falls since we pay a fraction
of our incomes in taxes.

Filed under: Economics