Can the US Stimulus Plan Save American Economy?

Orginal Published in IslamOnline, March 4, 2009

On Tuesday Feb 17, U.S. President Barack Obama signed into law $787 billion stimulus package, a measure he described as, “the most sweeping economic recovery package in our history.” Almost 38 percent of spending bill contains various tax-cuts to individuals and businesses with the remaining 62 percent mostly in the form of spending (although direct spending is a smaller 40 percent of the overall package). Figure 1 breaks down the percentage spending in the bill by major categories.

Governments use economic stimulus to boost its economy by spending on infrastructure, which in turn can lead to new job creation. Tax cuts encourage short-term spending. While spending related to energy is intended to provide a one-time jolt with the goal of making energy costs cheaper in the long-run. Similar arguments can be made about the portion of the stimulus plan related to health care.

But what lead to this massive spending stimulus? Current GDP numbers show the U.S. economy shrinking at an annual rate of 3.6 percent. Adding to the grim news is the finding that U.S. manufacturing activity fell to its lowest level in nearly three decades. Compounding the worry is the concomitant fall in global manufacturing.

The U.S. unemployment rate now stands at 7.6 percent, the highest level in the past fifteen years and is expected to go up as high as 8 or 9 percent by the end of this year. In 2008, 2.6 million Americans lost their jobs, the highest number in over half a century. This has lead to the spending slow down in the private sector leaving the U.S. government as the only entity that can borrow and spend. Borrowing will inevitably lead to more debt and deficit. However, the expectation is that this sort of deficit spending will ease unemployment and stimulate a slowing economy. The thinking here is a return to Keynesian economics, which believes that it is the government’s job to smooth out the dips in a business cycle by interventions in the form of infrastructure spending and tax breaks.

But can such spending program actually work? No one can provide a definitive answer. The best one can do is learn from past history. This economic downturn is beginning to a lot like the Great Depression of the 1930s. By the time President Franklin D. Roosevelt took office in 1993, the U.S. unemployment rate was a staggering 25 percent. Acting on his campaign promise of a “new deal” for Americans, FDR passed banking reform laws and enacted work relief programs. Figure 2 shows the impact of FDR’s New Deal on the U.S. economy. Not only did GDP rise but also by 1939 FDR was able to cut the unemployment rate by half of what he had inherited. President Obama expects this history is to repeat itself. However, there are already gathering concerns about the efficacy of the current stimulus plan.

For starters, the scale of the plan is much lower than comparable stimulus plans being offered by China, which in November 2008 announced a $586 billion (4 trillion yuan) spending package. The Chinese plan amounts to 20 percent of China’s GDP while in contrast the Obama plan is about 8 percent of U.S. GDP.

The next concern stems from the type of stimulus dollars. According to a study by Moody’s Economy.com tax cuts have the least impact on stimulating a sagging economy. Things like food stamp or infrastructure spending provide the most bang for the buck. The Obama stimulus plan devotes almost 4 out of every 10 dollars to tax cuts. This is a serious shortcoming of the bill. The inclusion of tax cuts was a necessary compromise in order to get the minimal Republican support needed to pass the bill in the U.S. Congress (only 3 Republican Senators voted for the bill).

Another concern about the bill is its “buy American” clause that requires materials purchased with funds from the bill to be U.S. made. To mitigate the obvious protectionist tendency of this clause, the bill requires that the “buy American” clause be implemented in a manner that is consistent with U.S. international trade obligations. Proponents say that the current provision is similar to the 1982 highway bill that called for federal highway projects to use only American steel. Given that all of the stimulus money will have to be borrowed, lawmakers were looking to get the biggest bang for their buck by keeping the stimulus money circulating in the U.S. economy as much as possible. The fear is that this provision could lead to trade wars, making a bad recession even worse. Stephen Harper, prime minister of America’s biggest trading partner Canada said, “We want to avoid protectionism in this economic slowdown.” During his recent visit to Canada, President Obama tried his best to reassure Canada and the rest of the world that the US would comply with all its international trade related treaty obligations.

The fact that all of the stimulus bill will have to be paid using borrowed dollars is a grave concern. It will add more debt to the ever growing national debt. Although the U.S. remains the largest economy of the world with a GDP of over 14.3 trillion dollars, it is also reeling from record national debt of 10.8 trillion dollars with 28 percent of that debt being held by foreigners namely Japan, China, U.K., Brazil and the oil exporting countries of Saudi Arabia, UAE, Qatar, etc. In addition, the U.S. budget deficit, which is the difference between what the U.S. government brings in through taxes and what it spends, stands at nearly 455 billion dollars and is expected to be over one trillion dollars (some estimates projecting 2 trillion) in 2009. Increases in international borrowing brings with it the small but not insignificant prospect that the United States could default on its international debt, triggering a global financial meltdown. Some economists believe that it is this fear that made President Obama limit the size of the stimulus plan to under $1 trillion. Nobel Prize winning economist Paul Krugman believes that the stimulus plan leaves a nearly $1.2 trillion dollar spending gap.

A CNN poll shows that 53 percent of Americans think that the stimulus will improve economic conditions, while 44 percent think it will not. The stimulus package is not the only massive spending program being enacted by the Obama administration. The Treasury Department and Federal Reserve has committed more than $1 trillion in financing for loan purchases aimed at injecting financial stability into a jittery financial sector. On Friday, Feb 20, the Dow Jones Industrial Average hit a near 11-year low of 7,365. In addition, President Barack Obama introduced a $275 billion homeowner relief program to stem the foreclosure crisis and prop-up a sagging housing sector.

It will be years before anyone can definitively say if these massive government interventions worked. Will Keynesian economics rescue us? Or are we witnessing the beginning of an epic economic upheaval? Concerns about the economy has replaced all other fears. America’s new intelligence chief Dennis Blair said that the global economic crisis could topple governments, trigger waves of refugees and undermine global security. The current economic crisis shows how the fate of different communities and societies are increasingly dependent on the well being of others. In an increasingly globalized world, it is hard to separate the happiness of one group from that of others. The current economic crisis is certainly dangerous but like the Chinese symbol for risk the economic crisis also provides an opportunity to forge new alliances and develop a more multi-lateral framework towards addressing global challenges from climate change to economic perils. If nations and societies seize this opportunity then out the ashes of this economic crisis could emerge a new economic order that is more equitable and sustainable for all people. That is a hope we can all believe in.