Financial crisis: What have we learnt a year later?

In the US, for example, roughly one-third of the $800-billion two-year stimulus package comprises tax cuts (to stimulate consumer spending); one-third is public outlays on roads, schools, power, and other infrastructure; and one-third takes the forms of federal transfers to state and local governments for health care, unemployment insurance, school salaries, and the like.

Stimulus packages are controversial, because they increase budget deficits, and thus imply the need to cut spending or raise taxes sometime in the near future.

The question is whether they successfully boost output and jobs in the short term, and, if so, whether they do enough to compensate for the inevitable budget problems down the road.

The true effectiveness of these packages is not clear.

Suppose that the government gives a tax cut in order to increase consumers’ take-home pay.

If consumers expect that their taxes will rise in the future, they may decide to save the tax cut rather than boost consumption.

In that case, the stimulus will have little positive effect on household spending, but will worsen the budget deficit.

An early assessment of the stimulus packages suggests that China’s program has worked well.

The sharp fall in China’s exports to the US has been compensated by a sharp rise in the Chinese government’s spending on infrastructure – say, on subway construction in China’s biggest cities.

In the US, the verdict is less clear. The tax cut has probably been saved rather than spent.

The infrastructure component has not yet been spent because of long lags in turning the US stimulus package into real construction projects.

The third part — the transfer to state and local governments — almost surely has been successful in maintaining spending on schools, health, and the unemployed.

In short, the US stimulus effects on spending have probably been positive but small, and without a decisive effect on the economy.

Moreover, concerns about the enormous US budget deficit, now running at $1.8 trillion (12 per cent of GNP) per year, are bound to increase, not only creating enormous uncertainties in politics and financial markets, but also dimming consumer confidence as households focus their attention on potential future budget cuts and tax increases.

The US has reached the practical limits of reliance on short-term stimulus spending, and will need to start cutting the budget deficit and fostering alternative pathways to growth.