Testimony on Options for Responding to Short-Term Economic Weakness - The Diigo Meta page

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• 10 Apr 08
  

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  • CBO
    TESTIMONY

     

    Statement of
     Peter R. Orszag
     Director 

     

    Options for Responding to
    Short-Term Economic Weakness

     

    before the
     Committee on Finance
    United States Senate

     

    January 22, 2008
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    ■	There is a strong possibility of at least a few quarters of very slow growth. Although the economy may avoid a recession in 2008, the risk of a recession has risen.

     

     

     

           

    ■	The Federal Reserve has powerful tools to keep the economy growing, but there is no guarantee that it will be able to keep the economy from entering a recession.

     

     

     

           

    ■	The system of automatic stabilizers built into the federal budget will act to stimulate the economy in a period of economic sluggishness, helping to mitigate any economic downturn.

     

     

     

           

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    If additional fiscal stimulus is deemed necessary, it would be desirable to make sure that the actions take effect when stimulus is most likely needed and are designed to increase economic activity as much as possible for a given budgetary cost. Such well-designed stimulus can help bolster an economy suffering from weak aggregate demand and thereby help reduce the risk and severity of a recession.

     

     

     

         

    ■	The most effective types of fiscal stimulus (delivered either through tax cuts or increased spending on transfer payments) are those that direct money to people who are most likely to quickly spend the bulk of any additional funds provided to them.
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  • The Congressional Budget Office (CBO) estimates that, since 1968, automatic stabilizers have added between 1 percent and 2.5 percent of gross domestic product (GDP) to the deficit during recessions, which translates to about $140 billion to $350 billion in today’s economy, and thereby helped mitigate past economic downturns. The automatic stabilizers already built into current law will partially offset any further weakening of the economy.
  • Fiscal stimulus may increase demand directly, as in the case of direct government spending on goods and services, or it may do so indirectly, by increasing household consumption or business investment. Consumption by households is generally stimulated when either after-tax income or expected lifetime wealth rises (which can occur because of a reduction in taxes or an increase in transfer payments from the government). Investment by businesses can be stimulated directly by boosting the after-tax return on capital (for example, through a reduction in taxes) sufficiently to make additional investment profitable. Also, any policy that succeeds in increasing the overall level of economic activity (even if it is directed at consumers) is likely to increase business investment (because it would raise the expected pretax return on capital).

  • Principles for an Effective Fiscal Stimulus

      

    The most effective fiscal stimulus policies share two common features:

      

    ■	They focus on the time period when stimulus is most likely to be needed, and

      

    ■	They are designed to increase economic activity as much as possible for a given budgetary cost.
  • During a period of economic weakness, the key constraint on economic growth is demand for the goods and services that firms could produce with existing resources. In that context, additional spending (by households, businesses, or governments) created by a stimulus policy can engage some unemployed resources, and that new activity has further effects. In particular, households whose income increases as a result of the stimulus subsequently consume more, adding to demand. That process, by which an initial stimulus sets in motion further bouts of consumption, is referred to as a "multiplier" effect. Furthermore, some of the firms that supply goods to satisfy the additional demand are encouraged to invest to add to their capacity, further increasing demand.
  • Timing. The timing of fiscal stimulus is critical. If the policies do not generate additional spending when the economy is in a phase of very slow growth or a recession, they will provide little help to the economy when it is needed. (Over the long term, the key constraint to economic growth is the rate at which the capacity of firms to produce goods and services is expanded—not aggregate demand.) Poorly timed policies may do harm by aggravating inflationary pressures and needlessly increasing federal debt if they stimulate the economy after it has already started to recover.

  • Lump-Sum Rebate

      

    A lump-sum rebate of taxes puts cash directly in consumers’ wallets. As a matter of nomenclature, a true rebate is limited to what a household has already paid in taxes. In practice, however, rebates may be larger than the household’s tax liability. In those cases, the "rebates" are actually transfers administered through the tax system.

      

    Rebates can be designed and implemented in a variety of ways. For example, they may be the same for all recipients (or subject to a ceiling), or they may vary in amount according to the size of the tax liability. In addition, they may be based on income tax returns or on some other tax, such as payroll taxes.

  • Approaches to Providing Incentives for Businesses

      

    Tax cuts for businesses may also take two forms. They may be general, such as reducing the corporate tax rate, or they may apply only to new investment, such as the investment tax credit. That distinction materially influences the effectiveness of the proposed approaches. Although a general business tax cut may leave a corporation with higher cash flow, which can affect investment decisions in some cases, its stimulative effect comes principally from how much it increases the attractiveness of new investment. Because a general tax cut applies to income generated from a firm’s productive assets regardless of when they are placed in service, only part of the cut affects a firm’s decision to undertake new investment.

      

    Even business tax reductions focused on new investment, however, may have only a limited effect on decisions to invest. For one thing, they may apply to investment that would have been undertaken anyway. In addition, like general business tax cuts, their stimulative effect depends on firms’ having tax liability in the first place; without such liability, tax cuts generate no cost reductions for firms. The portion of investment by firms with no tax liability varies, but it is significant. By one measure, the share of investment among firms subject to the corporate income tax ranged over the past few years from a little less than 30 percent to more than 45 percent. Moreover, the efficacy of some types of investment stimulus (such as accelerated depreciation) may be muted by the corporate alternative minimum tax, which can effectively undo cuts in regular corporate taxes.

  • Cut in Corporate Tax Rates

      

    The most common form of a general cut in business taxes is a reduction in the corporate tax rate. This approach, however, is not a particularly cost-effective method of stimulating business spending: Increasing the after-tax income of businesses typically does not create an incentive for them to spend more on labor or to produce more, because production depends on the ability to sell output.

      

    But because taxes on business income essentially lower the return that firms earn from capital investment, reducing such taxes can increase firms’ willingness to acquire more capital—that is, to invest. As a result, the principal influence of taxes on a firm’s decision about investing depends on the prospective profits from its new investments, not on current profits made from old investments. However, a substantial effect of reducing current corporate tax rates is to increase the returns from past investments rather than increase the attractiveness of new investments.

  • Proposals for Home Mortgage Markets

      

    Because problems in the housing and home mortgage markets have contributed to weaker economic activity and concerns about a recession, some current actions and proposals to address economic weakness are tied specifically to the housing market³⁴ Effective stimulus need not be directed specifically at the source of economic weakness, however. Indeed, actions and proposals to bolster housing and financial markets are not fiscal stimulus in the traditional sense as discussed above. They do not directly affect large numbers of consumers and businesses, nor do they involve sums of money that would probably be necessary to push the economy out of recession should it enter one. Nevertheless, by addressing specific problems in those markets that private participants might find difficult to resolve, they could play an important role in reducing the severity of a potential recession.
  • The end of the housing boom in 2005 has led to declining house prices and the reduced availability of mortgage credit. As house prices began to soften and fall, delinquencies and foreclosures on subprime adjustable-rate mortgage loans (ARMs), which were 6.6 percent of total residential mortgages at the end of 2006, began to increase unexpectedly, a consequence of the lax credit standards, weaker house prices, and higher interest rates on ARMs whose interest rates had reset to higher rates as scheduled in the terms of their loan contracts. The unexpected losses on subprime mortgages have created considerable uncertainty about the eventual size of the losses. Lenders with exposure to losses on subprime mortgages, held either directly or indirectly in mortgage-backed securities, have tightened their lending standards and pulled back from subprime lending, preferring to conserve capital and hold less risky assets.³⁵
  • Consequently, some homeowners facing higher interest rates on their subprime ARMs and lower house prices are having trouble refinancing into more affordable loans. With about 1.7 million subprime ARMs worth $367 billion facing their first interest rate reset during 2008 and 2009, analysts are concerned that mortgage foreclosures will climb significantly higher and, along with falling housing prices, overwhelm the ability of mortgage markets to restructure or refinance loans for creditworthy borrowers.³⁶ In the worst case, a breakdown of mortgage markets could put the economy on a self-reinforcing downward spiral of less lending, weaker economic activity, lower house prices, more foreclosures, even less lending, and so on, either causing or significantly worsening a recession.³⁷
  • Promote the Restructuring of Mortgage Loans. This approach is embodied in the "moral suasion" efforts of federal agencies that regulate banks, thrifts, and credit unions to encourage financial institutions to work with homeowners whose mortgages they hold and who are unable to make their mortgage payments. The goal is to facilitate as many restructurings as possible within the bounds of the terms of the loan contracts. Promoting loan restructuring by mandating changes in loan terms through legislation could create the appearance of abrogating existing contracts. The adverse consequences for financial markets of such a policy could be severe.

  • Expanding Opportunities to Refinance Subprime Mortgages

      

    The effects of securitization in complicating the ability of lenders to negotiate loan modifications suggests that policymakers might more fruitfully focus on creating favorable opportunities for borrowers to refinance. That is, borrowers may be able to avoid default by paying off existing mortgages with the proceeds from new, more affordable loans. Policies to do so quickly might focus on making increased use of existing federal credit programs and the housing government-sponsored enterprises (GSEs). Alternatively, the Congress could consider new or expanded programs to increase federal assistance to community-based organizations that provide services, counseling, and foreclosure protection to households. The Administration has also recommended that the Congress pass legislation that would allow state and local governments to issue tax-exempt bonds to help troubled borrowers.
  • Adopting these proposals could increase the supply of subprime mortgages (including refinance loans) and could lower mortgage interest rates. However, the proposals also raise concerns about an increase in risk to the financial system (and perhaps implicitly to the federal budget) from further concentrating mortgage holdings in enterprises that have experienced problems with financial controls and accounting. Using a federal agency such as FHA, rather than the for-profit housing GSEs, would allow the government to determine the assistance given to borrowers.⁴⁸

  • Government Purchases of Subprime Mortgages

      

    Efforts to encourage the restructuring and refinancing of subprime mortgages may be insufficient to stabilize this mortgage market, and the market may not begin to function effectively again until some of the current uncertainty about the value of subprime mortgages has been dispelled. Some analysts have therefore proposed that the federal government buy subprime mortgages.⁵¹ Under such proposals, the federal government would create or empower an agency to establish a schedule of prices for different tiers of loans. The prices would be steep discounts from the estimated values of the loans in the tiers. The agency would evaluate and classify the loans it was asked to buy. Proponents believe that such a program would put a floor on the prices of subprime mortgages and allow market participants to price the assets of financial institutions. The agency would aim to sell the mortgages at higher prices when financial markets were better able to price them and were more amenable to undertaking the risk.
  • Even if the individual options have small effects, some of the options taken together may help the economy by reducing the risks of a self-reinforcing downward spiral (of less lending, weaker economic activity, lower house prices, more foreclosures, even less lending, and so on). Such a spiral could further impair economic activity and potentially turn a mild recession into a long and deep recession. Consequently, some of the options may therefore lessen the load now being placed on monetary policy to relieve the stresses in the financial system from the subprime turmoil and reduce the chance of recession.

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• 03 Feb 08
  

  RDRutherford Rutherford

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