US President-elect Barack Obama’s decision to devote 40% of his stimulus plan to tax cuts should help to secure bipartisan support in Congress. It should also reduce the plan’s unproductive public spending element.
Combined with negative real interest rates and a zooming money supply, this may result in a short-term boost to the US economy. Even so, the inflation and deficit hangover from the overall package may be nasty.
The stimulus package is currently expected to total around $775 billion (Rs37.7 trillion), 5% of US gross domestic product, spread over two years. That’s much larger than the spending proposals Obama produced during the campaign, which totalled only around $200-250 billion annually.
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Further, some of those proposals, notably in the health field, would be impossible to implement quickly since they require very careful design and widespread consultation. Hence, much of a rapidly implemented package devoted only to spending would be prone to pork-barrel waste.
In a really deep depression, in which demand stagnated far below equilibrium, John Maynard Keynes proposed that the unemployed should be put to work digging holes and filling them.
The US is not currently in such a situation, so wasteful spending would be economically counterproductive, diverting resources from the private sector.
Moreover, Obama’s tax cuts appear sensibly targeted, focusing on small business, which suffers particularly from banking system risk aversion, on employment creation and on lower-paid individuals whose living standards have been badly eroded in recent years.
However, his hope that the proceeds from tax cuts for individuals will be spent is misguided. That may be a good thing: If they improve consumer balance sheets and raise the abysmal US savings rate, they would do more long-term good.
The economic danger arises because this stimulus comes on top of an exceptionally rapid money supply expansion. Should the combination produce an economic “bounce”, it will be essential to raise interest rates sharply to prevent an explosive resurgence of inflation.
Given the US Federal Reserve’s long-standing reluctance to raise rates and Congress’ notorious reluctance to tighten fiscal policy, the US could find itself with a huge budget deficit and rapidly rising prices, a combination from which recovery would be extremely difficult, painful and prolonged.