Options for Responding to Short-Term Economic Weakness

Source: Robert Dennis, Douglas Hamilton, Kim Kowalewski, John Peterson, and Thomas Woodward, Congressional Budget Office, January 2008

Effective stimulus does not necessarily require addressing the source of economic weakness directly; instead, it requires strengthening aggregate demand. Although much of the current economic weakness can be traced to the housing and mortgage markets, other factors, such as the high price of oil, have played an important role. If policymakers choose to address problems in the housing and mortgage markets, possible actions should therefore be evaluated primarily with regard to their effectiveness in correcting identifiable failures in those markets–and not necessarily with regard to their value in counteracting economic weakness. Policy actions affecting the housing and financial markets may, however, help the economy by reducing the risks of a self-reinforcing spiral (of less lending, lower house prices, more foreclosures, even less lending, and so on) that could further impair economic activity and potentially turn a mild recession into a long and deep recession.

The paper first reviews the economic situation, including how the monetary and regulatory authorities have already responded. The next section assesses different fiscal approaches to giving a temporary boost to aggregate demand in the economy. A final section examines policy options geared specifically toward the housing and mortgage markets.

The Congressional Budget Office (CBO) finds the following:

■ 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.

■ 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.

■ A variety of options are available for helping people who have been adversely affected by turmoil in the mortgage market. In evaluating the options, it is important to strike a balance between helping financially distressed families meet their basic needs, being fair to other families, and not rewarding imprudent behavior that might create additional costs in the future. In addition, further declines in housing prices are probably necessary to correct imbalances in the economy, and policies that attempt to prevent market prices from correcting could make the situation worse.

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