Let me return to the idea raised in Fiscal Stimulus – Part 1, namely the theory of the second best. This theory offers a guide that is widely applicable to many different situations. It says that policy interventions by government will be most efficient, and therefore work most effectively, if they are targeted most directly at the source of the current problems. Thus, we can ask, in terms of the current financial crisis, what are the problems and what types of solutions target the problems directly?

First, the crisis emanates in the financial sector. Overextension in the housing market lowered home prices leading to a wave of defaults and the eventual insolvency of many financial institutions. The US FED and Treasury acted quickly last year by lowering interest rates and injecting substantial money into the financial system. When a snowballing effect of financial meltdowns occurred in September, and as confidence in the financial system plummeted, the FED/TREAS sought Congressional funding and began to implement the Targeted Asset Relief Program. (TARP). Initially, the intention was to buy up the so-called “toxic” assets, primarily bad mortgages bundled up in mortgage backed securities (MBS) whose values were greatly uncertain. This action was appropriately “targeted” at the source of the immediate problem. Financial institutions had become extremely reluctant to lend to each other and this threatened to bring down the whole financial system, largely because no one knew who was safe and who not.

That uncertainty and the infection quickly spread to the non-financial, or real, sector, as manufacturing firms could no longer easily borrow, which then affected the stock market as financial managers began a flight to safer assets. The drop in the stock market coupled with the failure of some major institutions infected consumers who have responded by cutting back spending.

The current government stimulus plan is intended to substitute for the drop in consumer spending. There are two ways to do this, first by raising spending and second by cutting taxes. One could argue that this plan targets the problem of insufficient demand, however, it is not the most direct target since it doesn’t get to the source of insufficient demand, which presumably is the loss of consumer confidence. That loss of confidence, in turn, stems from the drop in asset values and the fear of insolvency among both business and households. At best the proposed stimulus package addresses a symptom of the economic problem.

There are a few ways for government intervention to get closer to the problems at hand. First, government money would be better directed to restore confidence in the financial sector. TARP-like proposals, such as the carving out of “bad” banks from goods ones with the bad ones run like the resolution trust company during the S&L crisis seem to be appropriate targets. Such a program might require much more than the current allocation of $750 billion, but it will be hard to add to this once the fiscal stimulus plan goes through. Second, supplemental and temporary government assistance to those who suffer a job loss would help ease the adjustment to those most directly affected. This is a better way to stimulate spending than tax cuts since many tax cuts will be to relatively more secure households who will save the refunds rather than spend them. Relatively insecure households are more likely to spend the extra cash. Thus general tax cuts are too blunt an instrument, not targeted enough at the source of the problem whereas additional benefits to the newly unemployed more directly targets and relieves one source of the fear.

Finally, one big problem with the fiscal stimulus plan is that it may substantially change the priorities of the economy from those chosen by the private sector to those mandated by the government. For example, there will be substantial increases in R&D spending for new energy technologies. Rest assured that every alternative energy company will be trying to get their hands on this money. Some companies may do good work in the end, but many undoubtedly will waste the money away. Since the decisions as to who will get the funding will be made politically, there is more reason to worry that those companies, or the technologies chosen will not be the most efficient way forward. Real competition assures that the most efficient and effective technologies will arise; government directives make it more likely that “influence” will determine the outcomes.

Also, although new spending initiatives will stimulate demand in some industries, it is not assured that the skills needed, say to produce solar energy, are the same set of skills among those workers recently laid off. Thus, while it seems reasonable that new jobs in new technologies industries will be created to offset the lost jobs elsewhere, it may not stimulate demand for the right types of workers. If a mismatch like this occurs, unemployment would not fall much (Circuit City employees will remain unemployed) while the workers who have the requisite skills (e.g., solar energy engineers) will see their relative wages rise.

In summary, there is much that can go wrong with the current stimulus proposal. It is unlikely to be the silver bullet that solves the problems at hand. Indeed, it is conceivable that the package makes things worse rather than better, largely because the lack of focus of the program may reduce the size of the more appropriate targeted interventions, and if the economy continues to stagnate will further reduce overall confidence.

This situation really is analogous to the Iraq war. In the case of Iraq it was argued (rightly or wrongly) that deposing Saddam Hussein was necessary to preserve the safety and security of the US. At the same time, the incursion into Iraq helped to promote other goals, like the spread of democracy. However, once Hussein was deposed it turned out that the long-term consequences were much harder to manage than was expected.

In a similar vein perhaps, today’s massive stimulus package is argued to be absolutely necessary to preserve the economic security of the country. At the same time the extra spending will help to promote other desired goals, like R&D into energy efficiency and infrastructure development. Nonetheless once the full effect of the spending occurs, we may well discover that the long-term consequences are much harder to mange than is being anticipated today.