If we aren’t going to have monetary stimulus, what would be the best (or least bad) type of fiscal stimulus? In my view the best would be cutting the employer share of the payroll tax, as that seems to be the only way to reduce real wage costs. I view sticky nominal wages as one of the major causes of unemployment during recessions. The traditional Keynesian argument against wage cuts is that it merely leads to more deflation, without reducing real wages. I recall Gauti Eggertsson discussing this problem and Paul Krugman citing his argument. But I don’t buy the argument. The Fed controls the price level.
You might ask why if the Fed determines the price level, they don’t just go ahead and raise the price level, instead of letting the fiscal authorities run up trillions in budget deficits (stimulus plus cyclical deficits). I can’t answer that; you’ll have to ask the inflation hawks at the Fed. But for whatever reason, they’ve decided we have enough NGDP, and if Congress wants more they’ll have to do it the hard (and inefficient) way.
At least Bernanke made it pretty clear that he won’t allow further disinflation. He hinted that there is a sort of ‘Bernanke put’ around 1% core inflation, roughly where we are now. If this is the case, then any nominal wage cuts become real wage cuts. For very complicated reasons it is hard to directly cut the nominal wages of workers. But you can cut the nominal labor costs to companies very easily—just reduce payroll taxes.
Now that the Keynesian fiscal stimulus has not worked, the Obama team is looking at new ideas. They are rediscovering the merits of sticky-wage theories of the business cycle, which I am one of the few economists to still adhere to (most now assume sticky-price versions of Keynesianism.)
The Washington Post reports that Obama is considering a $300,000,000,000 payroll tax cut. No details are provided, but I’d guess that would finance a 2% cut for a couple years. That would mean a 2% cut in wage costs, which should cause the recovery to speed up. Of course one always must think about the monetary policy counterfactual. The hawks may become horrified by the increased debt and tighten further. But I think Bernanke can hold the line at 1% core inflation. If so, it may be our best shot, even if it is far less efficient than monetary stimulus.
Here’s the WaPo:
With less than two months until the November elections, the White House is seriously weighing a package of business tax breaks – potentially worth hundreds of billions of dollars – to spur hiring and combat Republican charges that Democratic tax policies hurt small businesses, according to people with knowledge of the deliberations.
. . .
Permanently extending the research credit would cost roughly $100 billion over the next decade, tax analysts said. And depending on its form and duration, a payroll tax holiday could cost more than $300 billion. While significantly less than last year’s stimulus package, both ideas would be far more dramatic than anything the White House has so far acknowledged considering.
HT: Tyler Cowen