Stimulus Arithmetic

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Dean Baker
July 13, 2009, The Guardian Unlimited

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When her husband was in the oval office Laura Bush launched an initiative to promote literacy across the country. Unfortunately, there was no comparable effort to promote numeracy in our nation’s capital. This has been evident in the discussion of the stimulus among politicians and commentators in the week since the June job numbers were released.

Republicans were anxious to pronounce the stimulus a failure, while Democrats insisted that the package just needed more time, pointing out that most of the money had not yet been spent. Neither assertion can withstand the test of third grade arithmetic.

The basic story is that the stimulus was too small, pure and simple. It would have been too small even if the Obama’s administration’s projections for the severity of the recession had proven accurate. However, since the downturn is considerably steeper than they had projected, the inadequacy of the stimulus is even greater.

Here are the numbers. The unemployment rate is currently 9.5 percent and virtually certain to cross 10.0 percent by the end of the summer. It is likely to hit 11.0 percent early next year, but we’ll just work off the 10.0 percent figure.

The target for unemployment should be no higher than 5.0 percent. (The year-round average for unemployment in 2000 was 4.0 percent.) This leaves a gap between actual unemployment and our employment target of 5 percentage points. As a rule of thumb, it takes a 2 percentage points increase in GDP to reduce the unemployment rate by 1 percentage point. This means that in order to reach our target of 5 percent unemployment, we would have to increase GDP by 10 percent, or $1.5 trillion.

Different types of stimulus have different multiplier effects. One dollar of addition spending is generally estimated to have a multiplier effect in the neighborhood of 1.5, meaning that for every dollar we spend on a government project, we increase GDP by $1.50 as the people we hire go out and spend their paychecks, creating new demand.

The multiplier effect on tax cuts is generally estimated as being in the neighborhood of 0.9, or less. This means that $1 of tax cuts will end up increasing GDP by about 90 cents. Unlike spending on things like road construction or health care, a tax cut does not directly generate demand. It only generates demand when people go out and spend their tax cuts. Since much of any tax cut will be saved, the stimulus effect of tax cuts is almost always less than the effect of direct spending.

Okay, if we have an annual GDP shortfall of $1.5 trillion and we decided to fill it by spending, then we would need approximately $1 trillion per year of additional spending. Alternatively, if we tried to fill the gap with tax cuts, we would need $1.65 trillion per year in tax cuts. After pulling out spending for later years, and the alternative minimum tax fix, the Obama package provides about $300 billion a year in stimulus. This is obviously inadequate.

When the Republicans jump on the June jobs numbers and say that stimulus doesn’t work, it is like the obese person complaining that dieting and exercise don’t work because he is still overweight after passing up dessert and taking a walk around the block. There is a question of magnitude here that they seem to have missed.

The “give it time” crew don’t fare too much better. While only about 15 percent of the stimulus has gone out the door thus far, it is the rate of spending that matters.

To put this point simply, suppose that we would spend the $600 billion 2-year stimulus at the rate of $25 billion a month. Assume that we have ramped up to this spending rate, so that by May we have reached the $25 billion rate of monthly spending. While it may be true that at the end of June that we have only spent 15 percent of the stimulus, the rate of spending will not be increasing substantially from current levels. This means that whatever boost to monthly consumption and output we expect from the stimulus, we are now currently seeing. This boost will continue through 2010, but we will not get an additional boost from the stimulus further down the road.

The actual story of stimulus spending is somewhat more complicated, but this simple story captures the basic picture. The additional boost from new projects that are yet to be started will not make a big dent in the economic picture.

In short, we badly need another very big dose of stimulus. Unfortunately, the politicians and pundits in Washington are either too ignorant, dishonest, or scared to talk about the $2 plus trillion stimulus that this economy needs. As a result, tens of millions of people will lose their jobs and/or their homes because of continued economic mismanagement. In economic policy circles, mismanagement is a job qualification, not a fault.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.