Fiscal Stimulus: Too Late or Just in Time?

CONVENTIONAL WISDOM SUGGESTS that it’s a mistake to move forward with major fiscal stimulus late in an economic cycle, when the economy is near full employment and monetary policy is already shifting toward reining in activity to prevent overheating. In this view, given the limited capacity of the economy to grow, the stimulus would simply be offset by additional monetary tightening to ward off the hastened return of inflation. Implicit in this analysis is a Keynesian perspective that the stimulus adds to demand without impacting the supply side of the economy.

The idea is reinforced by the belief that the United States economy is mired in an era of “secular stagnation,” an indefinite period of subpar economic growth dictated by labor force and productivity growth rates well below historical norms. That means stimulating demand with fiscal measures when growth is already above its potential level would hasten the onset of inflation, restrictive monetary policy and an eventual recession. From both the short-term cyclical perspective and this longer-term view, adding demand late in an economic expansion is bad policy.

Conventional, but maybe not correct?

While this seems to be the view of most mainstream economists, it depends on certain assumptions that we believe are not necessarily correct. First, there is the belief in secular stagnation. While slower labor force growth can reduce potential economic growth, it can also create market forces for stronger productivity growth, which add to gross domestic product (GDP) potential. Take the 1950s, for example, when despite comparably slow labor force growth, stronger productivity kept U.S. GDP growth consistently near or above its historical average of just over 3%.

Productivity Upside May Be Ahead

History has shown low productivity in the U.S. has been followed by years of consistent growth 

Key to the more mainstream view is a presumption that productivity will not improve from its abnormally weak performance of the past decade. This is where the supply-side elements of fiscal stimulus enter the equation. The details of fiscal expansion make a difference. In particular, there are significant differences between stimulus from tax cuts and that from spending increases. The major corporate tax cuts included in the 2017 tax bill are much different in their supply-demand impact from the spending increases that directly raise demand without helping to boost production. The latter are more directly inflationary compared with the former, which help boost productivity and thereby add to supply and the potential growth rate.

The conventional wisdom tends to minimize the supply-side impact of the tax cuts. In this view, while there may be some positive effects on productivity, they are likely to be front-loaded and relatively muted over the longer run. So, for example, the Federal Reserve’s policy-making committee added only a bit to its growth outlook for the next few years as a result of the recent fiscal reforms.

Will the future be productive?

Whether the conventional wisdom is correct is essentially an empirical question about the future course of productivity. There are good reasons to believe the poor productivity performance of the U.S. over the past decade is not a harbinger for the future. The decade of secular stagnation stands out for its low productivity compared with previous experience (see “Productivity Upside May Be Ahead” above). In fact, the “stagflation” period of the late 1970s to 1980s is the only era since World War II with consistent productivity growth under 1%.

Notably, these periods are associated with the two worst recessions since the 1930s. Academic research¹ finds that severe financial crises tend to require about a decade before growth returns to normal, which is about how long it’s been since the 2008 crisis. There are a number of economic forces that boost productivity that are embodied in the dotted line in the chart, and that have been healing over the past decade, pointing to a resumption of stronger productivity growth ahead. The recession of the early 1980s and the one from 2007 to 2009 coincided with very weak productivity fundamentals that eventually proved transitory. Take into account the increased capital spending over the past year as regulatory and tax measures provided supply-side incentives for investment, and there is reason to expect the weak productivity of the secular stagnation era will prove just as fleeting. If so, the conventional wisdom will have to adjust to a more optimistic “new normal.” The main result would be a longer expansion with stronger growth before inflation becomes a game changer.

Stronger productivity growth from enhanced business investment incentives is one part of the supply-side impetus ignored by purely demand-focused analysis. Lower individual tax rates also boost the potential growth rate to the extent that they bring workers back into the labor force. The prime-age labor force participation rate (for those 25 to 54 years old), which had fallen to a generational low point in 2015, has picked up as the labor force has tightened, pressuring wage gains higher. Lower tax rates add to the after-tax value of these wage gains to workers and induce some who are on the fence back into the labor force. More workers and greater productivity mean a higher potential rate of output growth to satisfy the increased demand from the recent fiscal stimulus.

At the end of the day, the impact of the fiscal stimulus on demand versus its effect on supply will be revealed by the mix of real growth versus inflation. Faster real growth with limited inflation would be evidence that the supply-side effects are greater than conventional wisdom expects.