House Speaker Nancy Pelosi (D-CA) announced yesterday that Democrats are moving forward with an economic stimulus package. Although she remains vague about such a proposal, Pelosi indicated that it would be targeted to low- and middle-income individuals.

A press release at her website says that the package will "assist hard-hit families by promoting consumer confidence, economic growth, and job creation" and will be designed to provide "economic security for those with the greatest economic hardships..."

On Friday of last week (January 4), the Bureau of Labor Statistics released December employment data showing that the unemployment rate had jumped from 4.7 percent to 5.0 percent, causing many economists to predict a higher probability of recession in the coming quarters. Attention is now focused on policy makers in anticipation of an offering of some sort fiscal policy response.

This series will lay out the basic mechanics of fiscal policy in response to economic downturns.

When economic growth slows considerably, or even contracts, firms respond by cutting back production of goods and services. And since less labor is required by these firms to maintain the new level of output, firms will either reduce the size of their labor pool by laying off workers (or by reducing the number of hours of paid work or some combination of both). In short, many people will see a reduction in income during economic downturns.

The federal government can ease the hardship of unemployment and lower incomes through fiscal policy - that is by changing rates of taxation or the amount of money spent by the federal government. The purpose of this fiscal policy response response is to cushion the blow of a slumping economy along two dimensions: 1) the duration of a recession and 2) the magnitude of the hardship faced by families who experience job loss or a significant decreases in income.

The second dimension is affected simply by putting money into the hands of the people who are hit hardest by the economic downturn. A reduction in taxes or increasing spending through, say, unemployment insurance or food stamps allows individuals to continue buying food, housing, and medicine. And the more effective fiscal policy is at meeting objective (2), the more successful it will be in meeting objective (1).

In Part 2 of this series I will discuss The Multiplier Process.

According to the CBO Budget Review, released yesterday:

The federal budget deficit was about $107 billion in the first quarter of fiscal year 2008, CBO estimates—about $27 billion more than in the same period last year. Outlays have risen by 9 percent compared with their level in the first three months of [fiscal year] 2007, whereas revenues have grown by about 6 percent.

The deficit increase is attributed to:

• a "drop in corporate profits": the deceleration in the growth of of overall revenue receipts on a year-on-year basis from roughly 7.5 to 5.6 percent and the five percent decrease in corporate tax receipts "probably reflects a drop in corporate profits that has occurred over the past year"
• a jump in government outlays of 8.9 percent across the board: total spending rose by about eight percent; "net interest on the public debt increased by 17 percent." Medicaid spending in the first quarter was up nearly 11 percent over the program's outlays in the first three months of 2007.

These figures represent the first sign that the national economic slowdown is having an impact on the federal deficit. And it is even having an impact on President Bush.

On December 29, he said:

... even with high oil prices and softness in the housing market, we're still growing. In November, our economy added jobs for the 51st straight month, making this the longest period of uninterrupted job growth on record. Unemployment is a low 4.7 percent. Exports are up. And the fundamentals of our economy are strong.

Yesterday, Bush said:

Last Friday we learned ... that our jobs are growing at a slower pace and that the unemployment rate ticked up to 5 percent. A mixed report only reinforces the need for sound policies in Washington, which do not create more regulation and more lawsuits... The smartest thing we can do is to keep taxes low.

The current condition of the economy, and Bush's likely response to it (in unison: tax cuts!) can be expected to exacerbate the federal budget imbalance and add still more to the nation's $9 trillion debt.

Joseph Stiglitz sees stagflation on the horizon. If it does hit, what's a fiscal policy wonk to do?

For those who think that a well-managed globalisation has the potential to benefit both developed and developing countries, and who believe in global social justice and the importance of democracy (and the vibrant middle class that supports it), all of this is bad news. Economic adjustments of this magnitude are always painful, but the economic pain is greater today because the winners are less prone to spend.

Indeed, the flip side of "a world awash with liquidity" is a world facing depressed aggregate demand. For the past seven years, America's unbridled spending filled the gap. Now both US household and government spending is likely to be curbed, as both parties' presidential candidates promise a return to fiscal responsibility. After seven years in which America has seen its national debt rise from $5.6tn to $9tn, this should be welcome news - but the timing couldn't be worse.

Stiglitz is more or less advocating a deficit-financed fiscal stimulus that targets the middle and lower class. People as different as Robert Reich, Larry Summers and Martin Feldstein have shown that they're open to a fiscal stimulus package, should the need arise.

Question: when was the last time this country's leaders seriously considered offering a truly Keynsian stimulus package, one that was deficit financed and tried to raise aggregate demand by increasing the purchasing power of the lower and middle class? The Reagan and Bush stimulus packages targeted the wealthy, and as far as I know, Clinton wasn't in to deficits.

Brookings is having an event in a couple days where fiscal stimulus will be discussed by some heavyweights in the economics world (with the notable exception, as is customary in discussions of macroeconomic policy, of anyone that can be credibly identified with the left). Should be interesting to see what possibilities they entertain and rule out.

The Bush administration has consistently tried to make the war in Iraq seem like a costless effort. But we pay for every dollar spent in Iraq, particularly in terms of opportunity costs. Every dollar spent in Iraq is lost potential spending in domestic programs.

This is one reason it's important that John Edwards, a Democratic candidate for president, today promised to all but end the US presence in Iraq in less than a year if elected. Ballpark estimate of the fiscal consequences of doing this: it'd save $100 billion a year, which could and should free up money to put towards domestic priorities. Other candidates have made similar pledges.

The money is badly needed. According to the Wall Street Journal ($) today, allowing the Bush tax cuts for the very rich to expire would only bring in about $50 billion a year. Other proposals for closing tax loopholes and enforcing tax laws better would help, too, but I'm skeptical that we're talking about an increase in revenue that would finance the many new spending projects Democratic candidates have proposed. And Congress still doesn't want to touch tax rate increases with a ten-foot poll.

Of course, deficit-financing new spending is a viable way to put programs in action, but there's only so much of that be done in a sustainable way. Reduced war spending opens up new opportunities for domestic spending on top of what can be borrowed.

War spending is a trade-off, like any other kind of spending. Whoever's president will probably have to take significant resources out of the Iraq war to pay for new domestic spending. And the more money that's not being spent in Iraq, the more that could be spent here.