As I understand them, the Republicans’ main reasons for opposing the stimulus bill (0 votes in the House, 3 in the Senate) were: (a) the bill contains too much evil government spending, (b) it doesn’t spend money fast enough to affect the economy, and (c) it’s too big. There are really no grounds for bipartisan agreement on (c), especially since many Democratic economists believe the stimulus is too small given the yawning output gap. But even conceding for a moment that (a) and (b) are valid concerns, I’m still baffled by the reduction of state aid from $79 billion to $40 billion. (See the New York Times comparison here.)

According to the Center on Budget and Policy Priorities, states are facing new budget shortfalls of $51 billion this fiscal year (ends June 30) and at least $94 billion for next fiscal year. Direct federal government aid to states will do no more than partially fill those budget gaps and enable state and local governments to keep people employed instead of firing them – teachers, firefighters, etc. While one might have concerns about whether the government can spend money on new programs efficiently, in this case the money will go to basic services that the government is already providing. This is only wasteful if you take the extreme view that all government spending in general is wasteful and any excuse to reduce it is a good one (the old “starve the beast” argument). The money can be spent quickly, because all the mechanisms needed to spend it already exist. Even if it is spent over several months (because people earn their salaries over the year), it will still have an immediate stimulative effect, because people who have jobs spend a lot more than people who don’t have jobs. It will have a high multiplier, because every dollar of government payrolls counts as one dollar of GDP, so the multiplier on government salaries is roughly the multiplier on tax cuts plus one. And it will even save a little money in unemployment benefits.

There are a lot of things one can argue about in the Senate version of the stimulus, but this I just don’t understand at all.

With mainstream and not-so-mainstream economists (including us) tripping over themselves talking about the need for a stimulus plan (and how the current one may actually be too small), and having just written an article saying the U.S. can probably absorb some more national debt before things go haywire (so did Simon), I thought it was only fair to point to the counterargument.

William Buiter at the FT argues that the U.S. cannot afford a major fiscal stimulus because the government (by which I think he means the entire political system, not just the Obama Administration) has no deficit-fighting credibility. If people do not believe that the government will raise taxes in the future to generate positive balances (I’m sorry to inform Congressional Republicans that cutting spending is not really an option, given the growth of entitlement commitments in the future and our increasing military needs, although cutting the growth rate of spending might be possible), they will conclude that the debt can only be paid off by inflating it away, which will drive interest rates up, the dollar down, and inflation up. Buiter spells this argument here and more recently here where he adds the U.S. is behaving like an emerging market economy in crisis (something with which we would agree).

The argument is plausible – yes, it is true that people could start dumping Treasuries and other dollar-denominated assets because of fear of the U.S. national debt – but not necessarily conclusive – on the other hand, they might not. Buiter recognizes the first objection to his argument: in fact, people’s behavior shows that they are not worried.

It is true that . . .  recent observations on government bond yields don’t indicate any major US Treasury debt aversion, either through an increase in nominal or real longer-term risk-free rates or through increases in default risk premia. . . .

In a world where all securities, private and public, are mistrusted, the US sovereign debt is, for the moment, mistrusted less than almost all other financial instruments (Bunds [German government debt] are a possible exception).

But . . .

But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expected inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia.

The US is helped by the absence of ‘original sin’ – its ability to borrow abroad in securities denominated in its own currency – and the closely related status of the US dollar as the world’s leading reserve currency.  But this elastic cannot be stretched indefinitely.

And as a result . . .

The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the ’sudden stop’ – the cessation of capital inflows to both the private and public sectors.  . . . But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world’s leading reserve currency.  A large fiscal stimulus from a government without fiscal credibility could be the trigger for a ’sudden stop’.

Buiter’s argument is essentially a tipping-point argument. Yes, the markets seem unconcerned about U.S. government debt, but pass that stimulus bill and all of a sudden – or shortly thereafter – they will panic. As I said, it’s possible. But the markets should already be anticipating that stimulus bill passing. (I find it hard to believe that with unemployment up to 7.6% the Republicans will block it; their better percentage is to go along reluctantly, say they are doing it to support President Obama, and turn on him when the economy does not respond immediately.) So all the information Buiter is basing his analysis on is already out in the market, and the market has shrugged it off.

More generally, though, we just don’t know. National debt of 60-70% of GDP in private hands (a rough post-crisis estimate) might be too much for Ecuador or Argentina, but what about for the world’s largest and most central economy? There just isn’t any data. Arguably debt incurred in World War II finished off the British Empire (I believe Niall Ferguson discusses this at the end of Empire), but the U.S. was already the world’s economic superpower by a wide margin. The U.S. was able to bring down debt from well over 100% of GDP after World War II. And we had debt (in private hands) of 49% of GDP as late as 1995, with the same tax-averse political culture we have now (this is after the Gingrich Revolution of 1994), yet the Clinton Administration was able to engineer low interest rates.

Maybe there is a tipping point somewhere. But no one knows where, and there isn’t much useful evidence. So do we forego the stimulus package because we’re afraid of the unproven tipping point? Maybe if, like Buiter, you think we are at the edge of the cliff and most people just don’t see it yet (although they have the same information you do), and you think the potential costs are huge.

In any case, I recommend reading at least one of Buiter’s posts.

The US has the opportunity – and perhaps the responsibility – to immediately retake a leadership role in global economic policy thinking, with the pressing priority of preventing the world’s recession from becoming something more serious.  But what should be Mr Obama’s priorities in this regard, for example in the run-up to the G20 summit in early April – which, given the timetable for these things, will have an unofficial dry run of sorts at the Davos meetings next week?

The obvious message could be: a large US fiscal stimulus is coming, but the rest of the world needs to do more.  In this option, Mr Obama could devote considerable effort to encouraging others to expand their government spending and/or cut taxes.

While worldwide cooperation of this form may have been a constructive thought last year at Davos, when the idea was first broached publicly by the IMF, a joint global fiscal stimulus is a glorious idea whose time has for now passed.

Much of Europe is facing impending fiscal pressures that mount by the day.  The issue there is not fiscal stimulus but “fiscal capacity,” meaning the ability of governments to take banks’ (bad) assets onto the public balance sheet, and the danger is that not all European governments will feel able to even let their “automatic stabilizers” work fully (i.e., government spending goes up and tax revenue goes down in recession, without any discretionary change in fiscal policy.)  There is currently hot debate on and around this issue at the European Commission.

Most emerging markets are similarly facing the prospect of difficulties in rolling over their sovereign debt – at least that part which is not placed directly with the domestic banking system.  And the global social safety net that wants to give them some general reassurance and specific fiscal encouragement in this situation – the IMF – looks sorely frayed.  Governments in middle income countries sensibly feel it is wiser to keep their fiscal powder dry.  If you think they are overly worried, look at the latest data from Singapore today – 16.9% decline in GDP (a subscription link, but the summary data are in the free part) at an annualized rate in the 4th quarter of 2008 compared with the 3rd quarter; think of Singapore as a bellweather for international trade in goods and services at this time.

The exception of course is China, where there is long-standing scope for a stimulus. But the Chinese economy is only about 6% of world GDP and their effective additional stimulus per year is likely to be around 3% of GDP.  3% of 6% is essentially the rounding error in measuring the world’s economy, and you are unlikely to notice the effects of China’s stimulus globally – although it might just keep oil prices higher than they would be otherwise.

So what should Mr Obama emphasize?  Given the latest economic and financial developments, three potential priorities stand out:

First, a world system-wide plan for recapitalizing banks and removing any toxic assets.  This has to be implemented country-by-country and of course plans should vary according to circumstances, but the cross-border nature of banking calls out for a more coordinated approach.  The US has always been a taste-setter in terms of what constitutes responsible economic policy, and Mr Obama should help persuade other leaders to adopt plans that broadly mirror his.  And if they don’t follow suit, their domestic financial situations may well become more complicated.

Second, in the global bank clean up, some countries will find themselves short of cash, particularly foreign currency.  Rather than risking more Iceland-type situations, the US should help arrange financial assistance where appropriate. This could be through the IMF but if there are historical objections (e.g., from Asia), alternatives can be arranged.  The use of regional arrangements – including in Asia – should be encouraged, rather than discouraged; this would be a major departure for US policy.

Third, the world needs to avoid deflation.  Moving the US to an explicit inflation target would help, particularly if the announcement is strongly supported (and explained) by the White House at the same time as there is dramatic further monetary easing among leading central banks.  The point would be to demonstrate that the US can and will keep its inflation rate above zero without depreciating the dollar – and thus without exacerbating the difficulties of our trading partners.  Remember that if countries do not want to cooperate with this approach, they risk appreciation of their currencies – this fear should concentrate minds in the eurozone.

This constitutes a major agenda with many difficult tasks.  President Obama not only can do it, but he should.  The alternative is a much deeper global recession with greater risks of further sovereign collapse – and many more American job losses.

We know there is going to be a large fiscal surge in the US (the latest estimate is a stimulus of $675-775bn, which is a bit lower than numbers previously floated).  This will likely arrive as the US recession deepens and fears of deflation take hold. 

The precise outcomes for 2009 are, of course, hard to know yet – this depends primarily on the resilience of US consumer spending and whether large international shocks materialize.  But we can have a sense of what happens after the fiscal stimulus has played out (or its precise consequences become clear).   There are two main potential scenarios.

First, the fiscal strategy works.  In this case, the US pulls out of recession reasonably quickly (perhaps by the second half of 2009).  Once this seems likely, the Federal Reserve will want to cut back on its quantitative easing and perhaps even think about raising interest rates.  But this will be hard to do for political reasons – the Fed will feel pressed not to quash an incipient recovery, so it will err on the side of keeping interest rates low and credit available on generous terms.  At the same time, a great deal of the fiscal stimulus will be working its way through the pipeline for at least two years.  The net effect is inflation and presumably a weakening of the dollar (although the latter of course depends on what others are doing around the world.)

Second, the fiscal strategy does not work.  In this case, the US recession deepens and we head into a serious global slump.  Some more fiscal stimulus might be offered, but faith in its effectiveness will decline sharply.  The next policy move in this case is even more quantitative easing (i.e., essentially issuing even more money).  This would not usually be appealing, but the global depression would be fed by and feed into serious deflation, and the consensus will shift from “avoid inflation over 2%” to “any inflation is preferable to deflation”.  The net effect is again inflation, at least in the US and probably more broadly.

Of course, there are other possibilities.  The fiscal stimulus could reflate the economy just enough, i.e., so that growth returns to potential (whatever that is after a crisis of this nature), but not “too much” – so that prices increase but annual inflation never rises significantly above 2%.  This scenario seems rather too ideal, and to require too many things to go right, to be high probability.

It is also possible that in a global depression/deflation scenario even the Fed could not make inflation positive.  But this also seems to be quite a remote possibility.

So inflation seems hard to avoid, irrespective of how the upcoming fiscal moves play out.

The usual grounds for optimism these days is the fact that the Obama Administration is clearly going to propose a big fiscal package with two components: a large conventional stimulus (spending plus tax cuts); and a big housing refinance scheme, in which the Treasury will potentially become the largest-ever intermediary for mortgages.

These ideas are appealing under the circumstances, but this Fiscal First approach also has definite limitations, for both domestic and foreign reasons. 

Most obviously, Congress will reasonably want to impose constraints on the amount of government debt that is issued, particularly absent a longer-term solution for Social Security and Medicare. 

In addition, the Administration’s big deficit push relies critically on an “easy enough” monetary policy which, at the same time, precludes ”too much money, too soon.”  They need long interest rates to remain low, particularly for the housing scheme to make sense – rates have to come down for borrowers, at the same time as there is sufficient margin to cover credit losses, so it only works if the 10-year Treasury rate is roughly at current levels. 

If the Fed eases “too much,” then actual or expected inflation will jump.  This would reduce real debt burdens and could help reflate the US and global economy more broadly, but the higher interest rates would compromise the fiscal/housing strategy.  (If the Fed holds down long rates in the face of sharply rising inflation expectations, then will we will have a crazy credit boom that makes all other bubbles seem relatively sensible.)

On the foreign side, all other governments have an incentive to free-ride on the US fiscal policy.  The dollar will tend to appreciate, on top of any strengthening due to safe haven-related developments.  Both Europe and leading emerging markets can, in this scenario, hope to recover based on their exports.  Sure, they like to criticize the US for its role in placing everyone on fragile growth paths with increasingly hard-to-sustain debt paths, but almost everyone would like – in the short-term – to go right back there.

Again, if the US approach were more slanted towards expansionary monetary policy, this would tend to cause dollar depreciation and it would force the hand of other governments.  Either they would ease their own interest rates and potentially increase their supply of money, or their export sectors and growth would suffer further. 

Most countries around the world have limited capacity for fiscal expansion, but almost all could engage in a more expansionary monetary policy.  This, of course, runs counter to 20 years of orthodoxy in central banking, but nothing is without risks.  And that includes the first set of fiscal moves by the Obama Administration in their global economic chess game.

Finally, the global economic policy ship begins to turn.  We are now seeing fiscal stimulus package announcements every week, if not every day.  And packages that we previously knew about are re-announced for emphasis and with an expanded mandate.  In all likelihood, we are looking at a fiscal stimulus in the order of 1-2 percent of world GDP, which is exactly what the IMF has been calling for.  Is this a modern miracle of international policy coordination?

The problem is – the IMF started calling for this in January 2008 when, with the benefit of hindsight, it would really have made a difference.  Fiscal policy is slow.  Even when everyone wants to move fast, when you can get the legislation through right away, and when there are “ready to go” projects, infrastructure spending will take at least 6-9 months to have perceptible effects in most economies. 

In the US we have some additional ways to boost spending, most notably as support to local and state governments, extending food stamps and the like (see my recent testimony to the Senate Budget Committee for further illustrations), and in most other countries that kind of government activity comes by way of “automatic stabilizers,” i.e., it happens without discretionary packages of the kinds that make headlines.  Still, the general point holds – the big fiscal stimulus package you put in place today is a bet on how the economy will be doing in a year or so.  And a year ago would have been a good time to start – remember that the NBER has just determined that the US recession actually started in December 2007 (but they were able to make the call only now, demonstrating how hard it is to forecast the present, let alone the future.)

My concern today, however, is not about the appropriateness of the overall package in the US, China or other emerging markets – in a crisis, erring on the side of “too much, too late” is better than “too little, too little.”  The problem is that in Europe we need not just a general fiscal stimulus (and more interest rate cuts), but also specific targeted measures that will provide appropriate, largely unconditional support to governments with weaker balance sheets (read: Greece, Ireland, Italy, but don’t exclude others from consideration). 

Monetary policy was consolidated in Europe (i.e., there is one currency for the eurozone) but fiscal policy substantially was not.  This imbalance is going to be addressed, one way or another, and perhaps under great stress.  Much progress has been made towards sensible policies in the US and some parts of Europe over the past two months, and calamity can still be avoided.  Let us not fall at the final hurdle.

Update: I talked with Madeleine Brand of NPR about some of these issues earlier today; audio recording and transcript are here.

Wednesday morning, starting at 10am, I’m on a panel testifying to the Senate Budget Committee about the need for a fiscal stimulus.  The other witnesses are Mark Zandi and John Taylor.

I’ll post my written testimony after the hearing. I expect to make three main points in my verbal remarks:

1) We are heading into a serious global recession, caused by and in turn causing a process of global leveraging (i.e., reduction in lending and borrowing).  We have never seen this kind of deleveraging – synchronized around the world, fast-moving, and with an unknowable destination.

2) I do not think we can prevent this deleveraging from happening.  Nor do I think we should even try to keep asset prices high (or at any particular level).  But in the United States we have the ability to mitigate some of the short-run effects and to lay the groundwork for a sustainable, strong recovery.  One sensible tool to use in this context is fiscal policy.  I lean towards smart spending programs, but as the economy continues to worsen, I think some kind of temporary tax cut could also help – it can potentially have relatively quick effects.  (Note: contrary to those who think that if tax cuts are saved by consumers, they are somehow “wasted,” I would point out that anything that improves consumers’ balance sheets is both good for them and for the financial institutions that lend to them.)

3) But there is a real limit to how far we can go with fiscal policy (and with other policy measures).  Irresponsible budget policies would not be a good idea – we need to continue a process of fiscal consolidation; it is most vital that people around the world remain confident in the U.S. government’s balance sheet.  Some of the highest numbers now being proposed for a fiscal stimulus are probably too high and a mega-stimulus could be counterproductive if it undermines confidence.

I’m proposing a fiscal stimulus of roughly 3% of GDP, to be spent over several years.  Given the uncertainties involved, this seems like reasonable middle ground – it’s enough to make a difference, but doesn’t promise a miracle; it can be spent sensibly and at an appropriate speed; and it will not undermine our ability to consolidate the U.S. fiscal position (i.e., bring government debt onto a sustainable path) over the medium-term.

What exactly is on the table for the G20 heads of government meeting in Washington at the end of this week?  One possibility is some sort of synchronized or joint fiscal policy stimulus in most G20 member countries.  (Yes, I know that the communique from this weekend’s meeting of finance ministers and central bank governors was somewhat on the vague side.)

How likely is such a cross-country stimulus?  Well, the IMF’s revised forecast for global growth, released last Thursday, has been widely interpreted as merely confirming that the world economy is slowing down (and fast – it is remarkable to knock nearly a percentage point off the global growth projection, just a month after the last forecast went final.)  But the forecast can also be read as a reflection of the Fund’s exhortation to fiscal expansion and, in some parts, as an indication of where some parts of the G20 may be headed. For example, China’s growth for 2009 is now projected at 8.5%, which struck me as too high when the forecast came out.  Lucky for me that I dawdled in writing a critique, because China’s fiscal stimulus, announced over the weekend, makes higher growth somewhat more plausible.

The IMF is allowed, by its own rules, to include in the forecast fiscal (and other) policy moves that it knows to be “in the bag,” even if they have not yet been publicly announced.  But it can’t base the forecast on just probable or potential policy changes.  If the IMF knew about China’s package (as it almost surely did 3 days in advance), then this is built into the forecast.

So what else can we infer about imminent policy changes from the forecast, if we read it sort-of backwards in this fashion?  The thing that really struck me was what the forecast says about Europe, particularly France.

According to the forecast, headline growth in 2009 will be roughly the same in the U.S. and the Eurozone (minus 0.8 vs. minus 0.7).  But the IMF’s headline numbers are annual average growth rates, which are more affected by what happens at the beginning of a year (and actually, if you care about technicalities, by what happens at the end of the previous year).  To see the Fund’s view on economic dynamics within a year, you need to look at 4th quarter over 4th quarter projections, which are in the last two columns of their Table 1.1.

These show that the U.S. will decline by 0.5% in 2009, but the Eurozone will be flat (“–” in IMF table parlance means zero; I worked at the Fund for nearly 4 out of the past 5 years, but I could never get a straight answer on why they don’t write the rather more obvious “0.0″.)  This says that the Eurozone will recover faster than the US, which – given the problems with European banks, consumer confidence, housing and (most important) exposure to the ever-vulnerable East/Central Europe - is not so very obvious.

Furthermore, of the four major Eurozone economies, the forecast shows declines for three: Germany, Spain, and Italy (by the way, for Italy this Q4 on Q4 forecast for 2009 definitely looks too high).  So who saves the day?  According to the forecast, it is France, with growth of plus 0.2% Q4 on Q4.  (Perhaps helped by Belgium and the Netherlands, but this is hard to believe, given the state of their banks.)

Such a positive statement about France is striking and more than a little at odds with where things are currently going (e.g., the IMF is projecting minus 0.4% for France in 2008, Q4 on Q4).

But it would make sense if France has tipped its fiscal hand, and is indicating something big and bold is in the works (the European rules against big budget deficits have, in case you didn’t notice, now been effectively waived).  Perhaps it is something that will be announced in the run-up to the G20 meeting?  Could it be a fiscal package that will capture the imagination of the world, develop further the friendship with China, put pressure on the outgoing Bush administration, be warmly welcomed by newly elected Democrats, somewhat eclipse Gordon Brown, and (try to) make it clear that France has the credibility needed to dominate the international economic policy agenda?