The Case for Strengthening Automatic Fiscal Stabilizers

“[F]iscal stimulus should be timely, targeted and temporary.” Douglas Elmendorf and Jason Furman, “If, When, How: A Primer on Fiscal Stimulus,” The Hamilton Project, January 2008.

“Somewhere, sometime a government policy worked in a way it was intended to.” Stanley Fischer, discussing John Taylor, “The Swedish Investment Funds System as a Stabilization Policy Rule,” 1982.

 “[S]tabilizers are unlikely to pay for themselves.” Claudia Sahm, “Direct Stimulus Payments to Individuals,” in Heather Boushey, Ryan Nunn, and Jay Shambaugh (editors), Recession Ready: Fiscal Policies to Stabilize the U.S. Economy, 2019.

For decades, monetary economists viewed central banks as the “last movers.” They were relatively quick and nimble in their ability to adjust policy to stabilize the economy as signs of a slowdown arose. In contrast, discretionary fiscal policy is difficult to implement quickly, so any stimulus typically comes too late. In addition, allowing for the possibility of a constantly changing fiscal stance adds to uncertainty and raises the risk that short-run politics, rather than effective use of public resources, will drive policy. So, the ideal fiscal approach was to set policy to support long-run priorities, minimizing short-run discretionary changes that can reduce economic efficiency.

The depth of the Great Recession of 2007-09 and the weakness of the recovery have shifted perceptions. Once the Federal Reserve’s policy rates reached zero, conventional monetary policy was exhausted. While central banks have proven creative in developing a suite of unconventional tools, these suffer from all the risks associated with new therapies: we know relatively little about how they work, we are unsure of their potency and side effects, and we continue to set the dosage by trial and error. Unsurprisingly in such a circumstance, the severity of the Great Recession led to multiple, large discretionary fiscal actions. Even then, the federal government probably began to pull back far too soon (when the unemployment rate was still 9% in fiscal 2011).

Today, because conventional monetary policy continues to have little room to ease, the case for using fiscal policy as a cyclical stabilizer remains strong. According to the Federal Open Market Committee’s latest median projection, the neutral longer-run (nominal) policy rate is just 2.5%, nearly two percentage points below where it was in 2012 (see chart). However, over the past three business cycles, to blunt the recession and hasten recovery, the Fed reduced its target policy rate by about 5 percentage points. As a result, unless something changes, there is a good chance that when the next recession hits, monetary policymakers will once again find themselves stuck at the lower bound for an extended period. Since it is likely to be significantly more effective in the absence of a monetary policy offset (see, for example, Ramey and Chodorow-Reich), fiscal policy could become the stabilization tool of choice in the next recession.

FOMC projections of the longer-run policy interest rate: high, median and low, 2012-June 2019

Source: Various editions of the Summary of Economic Projections.

Source: Various editions of the Summary of Economic Projections.

Against this background, a new book from The Hamilton Project and the Washington Center for Equitable Growth, Recession Ready: Fiscal Policies to Stabilize the American Economy, makes a compelling case for strengthening automatic fiscal stabilizers. These are the tax, transfer and spending components that change with economic conditions, as the law prescribes.

In the United States, the most important automatic stabilizers are the progressive federal income tax, unemployment compensation, Medicaid (and the Children’s Health Insurance Program, CHIP), and SNAP (Supplemental Nutrition Assistance Program, formerly known as food stamps). In a recession, when incomes fall, tax payments fall even more (as people slip into lower tax brackets), helping to cushion the impact on disposable income. When unemployment rises, the federal government provides most of the additional resources for unemployment compensation. And, when recession drives more families closer to poverty, eligibility rises for Medicaid and CHIP (both jointly funded with the states), as well as SNAP. In addition to their outright effects, federal tax and transfer mechanisms cushion the impact of recession on the states and localities that face the brunt of the downturn. Put differently, through these fiscal arrangements, the nation shares the impact of geographically asymmetric shocks (both the good and the bad), with those people in areas that are doing relatively better helping out those that are doing relatively worse.

The next chart shows the Congressional Budget Office’s (CBO) estimate of the portion of the federal budget that responds automatically as output moves above or below its normal (or potential) level. Consistent with their countercyclical impact, budget surpluses arise in expansions, while deficits grow in recessions. The largest episodes of fiscal stimulus—when the automatic component of the federal deficit reached −2 to −3 percent of potential GDP—correspond to the deepest U.S. postwar downturns (in the early 1980s and 2007-2009). The slow recovery and stubbornly high unemployment following the Great Recession also resulted in a persistently large automatic deficit compared to previous cycles. Even so, Dolls, Fuest, and Peichl conclude that automatic stabilizers are significantly larger in Europe than in the United States, especially in response to increases in unemployment.

Automatic component of the federal budget balance (Percent of potential GDP), 1965-September 2018

Note: Shaded areas denote recessions. Source:  CBO .

Note: Shaded areas denote recessions. Source: CBO.

A key point of Recession Ready is that U.S. automatic stabilizers can be more “timely, targeted and temporary” than discretionary fiscal actions (see the opening citation from Elmendorf and Furman). This reminds us of much-earlier efforts to study fiscal policy rules (like John Taylor’s work on the Swedish investment funds system from the 1950s to the early 1970s) that were apparently successful at countercyclical stabilization (see the opening citation from Stanley Fischer). In the same way that monetary policy has become more rule-like over recent decades, greater reliance on automatic stabilizers (as opposed to discretionary fiscal policy) would make fiscal policy more systematic, instilling greater confidence that support will arrive when it is needed most. That itself can be a stabilizing factor. Already operating in many cases with slim buffers, households and firms would have more income certainty, while state and local governments would have to worry less about the procyclical consequences of having to balance their budgets at the height of a recession.

Some automatic stabilizers require triggers for turning them on and off. One of the clever innovations in Recession Ready is Claudia Sahm’s introduction of a simple algorithm—suitable for use in legislation—aimed at doing just that. The “Sahm indicator” measures the difference between the three-month moving average of the unemployment rate and its minimum over the prior 12 months (see chart). The use of the unemployment rate avoids the long lags (and frequent large revisions) associated with other indicators (like GDP). Since 1970, whenever the Sahm indicator crossed the threshold of 0.5%, a recession was underway―there were essentially no false signals. Moreover, the trigger occurred early in these downturns (on average within 4 months of the start). Sahm also proposes using an unemployment rate test to turn the stabilizers off. To avoid a premature return to fiscal austerity, she suggests deactivating programs when the unemployment rate falls to a level that is less than 2 percentage points above the initial trigger.

Gap between three-month average unemployment rate and its minimum over the prior 12 months, 1950-May 2019

Note: Shaded areas denote recessions. Source: FRED and authors’ calculations based on Figure 2 in Claudia Sahm, “ Direct Stimulus Payments to Individuals .”

Note: Shaded areas denote recessions. Source: FRED and authors’ calculations based on Figure 2 in Claudia Sahm, “Direct Stimulus Payments to Individuals.”

To see what this means, take the case of the Great Recession. When the unemployment rate hit 5.0% in January of 2008—the second month of the recession—Sahm’s indicator hit 0.50 percentage point, which would have triggered activation of any pre-authorized programs. The stabilizers would then have stayed in effect until November 2013, when the unemployment rate fell to 6.9%, less than 2 percentage points above the activation trigger.

Recession Ready examines a wide range of reforms that could enhance the effectiveness of U.S. automatic stabilizers. These include the introduction of direct payments to individuals and the creation of a countercyclical infrastructure investment fund, as well as mechanisms to enhance the countercyclical impact of unemployment insurance, TANF (Temporary Assistance for Needy Families), and SNAP. In general, the proposals build on existing programs or improve (and make automatic) ad hoc discretionary programs introduced in response to the Great Recession. The goal throughout is to plan for timely implementation of efficient and effective programs, while reducing reliance on the vagaries of the legislative process when a recession hits. The reasonable presumption is that preparing (and making potentially complex administrative arrangements) during an expansion will be more effective than ad hoc responses in a crisis.

To be sure, some of the proposals are more “timely, targeted and temporary” than others. One that almost surely meets the test is Fiedler, Furman and Powell’s suggestion to increase the federal component of support for Medicaid and CHIP programs in downturns, using the Sahm indicator as an automatic switch. Administratively, Medicaid and CHIP already involve state and federal burden sharing. Since states typically face balanced-budget requirements, automatically boosting the federal contribution reduces the cyclical strain on state budgets. So, not only would this simple-to-implement reform help some of the most vulnerable populations that have a relatively high propensity to consume, it would also reduce the pressure for pro-cyclical spending cuts in a range of activities (like education and infrastructure) where state and local spending dominates.

Of course, the key problem with greater reliance on fiscal policy is that the U.S. federal budget already is on an unsustainable path. (See our primer on fiscal sustainability.) According to the CBO, federal debt held by the public is now 78% of GDP (up from 35% in 2007), and is headed far higher (150% of GDP by 2049) in the absence of a fiscal tightening. Moreover, countercyclical measures are unlikely to pay for themselves (see the opening citation from Sahm). Consequently, over time, fiscal policymakers will have to pay for additional automatic stabilizers through some mix of higher taxes and lower (secular) spending elsewhere. Unfortunately, we see little evidence that the U.S. Congress is prepared to make such adjustments. Instead, under the current Administration, federal tax and spending policy has been more pro-cyclical than at any time since the latter half of the 1960s (see here).

The bottom line: with the limited scope for conventional monetary policy easing, the benefits of countercyclical fiscal policy in the next recession will be greater than in downturns prior to the Great Recession. It would be far better to plan for a more systematic fiscal policy response now than to wait for the ad hoc one that is likely to arise when a recession hits. Strengthening the existing automatic stabilizers seems like a natural approach.