Why We Shouldn’t Count on Fiscal Policy to Save the Economy

Mark Thoma today has an excellent (implicit) rebuttal of Larry Summers’s proposal that the US government use fiscal policy to fight impending recession.

Both fiscal and monetary policy are capable of fighting recessions, Thoma says. But the thing about monetary policy is that rates go up as well as down. On the fiscal side, by contrast, taxes are a hell of a lot easier to cut than they are to raise.

If we are going to use tax cuts as a fiscal policy tool to stabilize the economy, we have to be willing to move the tax rate in both directions, up as well as down. We are quite willing, currently, to move the tax rate down but when people like Martin Feldstein call for a temporary tax cut to stimulate the economy, if such a policy were to be enacted does anyone doubt the difficulty of raising taxes again later even with automatic expiration provisions?

Just today, we got another example of this mechanism in action, when Congress passed its annual let’s-duck-the-alternative-minimum-tax-issue bill. In theory, the AMT is going to generate enormous sums of money for the US fisc in future years; in practice, Congress looks as though it’s never going to allow that to happen.

So it looks like it really is down to the Fed to avert recession after all. They’d best get cracking: the latest InTrade odds of a recession in 2008 are 46%.

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