Opinion and Economic Analysis and Banking & Finance

HICKS: To spend or cut taxes, that is the question

July 17, 2010

We are at a point in the economy where two truths collide. The first is that the size of federal government debt is so enormous as to seriously dampen a generation of economic growth. The second is that immediate steps to reduce the debt (spending cuts and tax increases) will dramatically slow the economy. What to do?

I recommend taking a deep breath. The polemics about the size of the debt and the poor state of the economy are both wrong. The debt is huge and the economy bad, but we’ve handled much worse of both situations in living memory and without catastrophe. After that, it is helpful to review recent policy.

We’ve been through more than a year and a half of effectively zero interest rates without a burst of credit activity. Clearly, borrowers and lenders are scared of the future. The stimulus and array of bailouts have thus far done little to boost the economy. Neither is there good evidence they kept things from getting worse. I say this with anguish and disappointment since I endorsed a smaller version of the stimulus.

A caveat regarding the effect of the stimulus is that most of it is still unspent. Sadly, the federal government reports the money as spent as soon as a check is cut to a state or local government, university or not-for-profit entity. That does not mean it has led to any new hiring.

I think few of my fellow economists and even fewer in federal policy circles have any understanding of the Sisyphean task of translating federal spending into a new job. Neither do they appreciate the time lag of employment from these programs. While the tax cuts are already spent, I do not believe even half the stimulus will have hit the streets until this time next year. Most recent economic research on this matter supports this argument. This still doesn’t tell us what to do now.

A tax increase or spending cut in the next 18 months will slow the economy. Yet the looming debt grows, slowing the economy and perpetuating the uncertainty that has gripped the country for two years. It is noteworthy that nations that have shown an appetite for fiscal austerity have rebounded more robustly than those without the political resolve to address their budgets. It is here where the crux of the problem lies.

Right now, the relatively slow recovery is a problem and, until the economy recovers more fully, it is the whole problem. At the other end, the debt, in and of itself, is not an immediate problem. It is uncertainty about federal policy that accompanies that debt that cripples growth.

This stagnation can be kept at bay if, and only if, there is that rare combination of a “stay the course” fiscal policy in the short run combined with an expectation of fiscal responsibility in the long run. That takes something not included in economic models: leadership and trust. Until we have more of both, we must expect further disquieting news.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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