Monday, December 08, 2008

A Better Stimulus

John Makin, the man who most accurately predicted and best understood Japan's stagflation, has a creative response to today's crisis. Don't build roads and bridges: That takes too long. Instead: Print money and cut the payroll tax.

Interest-rate targeting has gone about as far as it can go. Although the Fed's official federal funds target is 1 percent, the effective fed funds rate on most days is merely a quarter of a percent. The reason is that the cash trapped in the banking system can only earn about ten basis points on short-term Treasury bills because households and firms are so frightened by possible insolvencies in the financial system that they seek the absolute safety of direct short-term claims on the U.S. government. Cash-stuffed banks choose to lend their funds to the Federal Reserve at a slightly higher rate—twenty-five to thirty basis points—than is currently available in the fed funds market.

The Fed needs to undertake quantitative easing, whereby it prints money and expands its balance sheet by direct purchases of longer-term Treasuries or mortgage-backed securities. The result of such quantitative easing would be to push mortgage rates down toward 4 percent from the current level of 6 percent. This would help to ease stresses in the mortgage market and thereby help to contain what is likely to be a reacceleration of the fall in house prices. Further, lower borrowing costs would help, at the margin, to stimulate spending by households that are not in acute financial distress. A broad-based quantitative Fed easing that adds directly to the liquidity of households and firms, while lowering key mortgage interest rates, would provide some systemic relief and thereby reduce the pressure for "special case" bailouts like those sought by insurance companies and automobile manufacturers.

Stimulative fiscal policy will be necessary to complement the demand stimulus that comes from quantitative easing. Tax rebates have already proven to be ineffective because nervous households, whose saving is far below desired levels, just tend to either save the rebates or use them to pay down debt. Spending measures such as public works (outlays to improve roads and bridges) do not provide the prompt income boost currently needed by distressed households and firms. Cost-effective implementation of such measures requires time, while hasty implementation entails waste of scarce resources.

The best available fiscal policy measure would be a sharp reduction in the payroll tax, which would boost household disposable income while giving firms an incentive to retain more workers on their payrolls. Total annual collections from households and firms of payroll tax levies total about $625 billion, about 7 percent of disposable personal income. A payroll tax is labeled as the primary means to finance Social Security and Medicare benefits, but those benefits are financed out of government revenues and would, of course, continue to be provided at their full level. The payroll tax is a poorly designed fiscal measure because it acts as a tax on employing labor and, in times of falling demand, a tax on retaining labor. The payroll tax is the primary tax paid by more than 60 percent of American households and so constitutes a marginal disincentive to further work.

If the payroll tax (of which households pay half directly) were suspended—say, for a year or eighteen months—households would experience an immediate 3.5 percent increase in disposable income that they could employ to sustain consumption and pay down debts. Since the payroll tax is regressive, falling more heavily on lower income households, its repeal would be progressive, while transferring a substantial increase in disposable income to the low-income households who are likely to need it most and therefore likely to spend most of it.

For firms, a reduction in their payroll tax payments would reduce their incentive to lay off workers by reducing the cost of keeping workers on the payroll. In effect, firms would be prompted to shift more toward labor as a factor of production because of a reduction in the tax on employment of labor that the payroll tax entails.

12/08 01:43 PM