Unemployment: Why Stimulus 2.0 Might Backfire

What can government do to crank up America's creaky job machine? We'll be arguing ferociously about that in coming months, and the answer, frankly, isn't clear. Diehard Keynesians insist that only more government spending and tax cuts will accelerate job growth. But many other economists fear that exploding federal debt—incurred partly to pay for more spending and tax cuts—could trigger a new crisis that would destroy jobs.

Almost everyone agrees that the outlook is bleak. Since the recession's start in December 2007, about 8 million payroll jobs have disappeared. More will go. With the labor force expanding by more than 1 million workers annually, economists Joseph Seneca and James Hughes of Rutgers estimate that even the job growth of the 1990s (2.4 million a year) wouldn't reduce today's 9.8 percent un-employment to 5 percent until 2017. Ugh.

The Keynesian solution (after economist John Maynard Keynes, who died in 1946) holds that government activism can generate more jobs. That's the theory behind the $787 billion "economic stimulus" passed in February. Many ideas are circulating for Stimulus 2.0, though the controversy over Stimulus 1.0 suggests it will be relabeled.

Larry Mishel of the liberal Economic Policy Institute wants more aid to state governments, a further extension of unemployment insurance (now up to 79 weeks), and a tax credit for companies that create new jobs. One proposal would give employers a $7,000 credit for each additional worker hired (over some base period). Timothy Bartik of the W.E. Upjohn Institute for Employment Research thinks such a credit might create 2 million jobs. The budgetary cost could be $40 billion or higher. One drawback: two thirds of the credit's cost might go to firms that would have hired anyway.

The rap on Stimulus 1.0 is that it hasn't yet—as promised—reduced unemployment. Boosters retort that unemployment would have been worse without it, and more than half hasn't even been spent. Detractors argue that the benefits of "stimulus" packages are overrated. Underlying this dispute is an academic argument about the "multiplier": whether increased stimulus spending and tax cuts translate into large increases for the overall economy, or whether the effects are offset. Consumers might save most tax cuts, or bigger deficits might raise interest rates and crowd out private borrowing.

In truth, there is no "right" answer; the multiplier will vary depending on economic circumstances. In this case, the Obama administration is more plausible than its critics. In early 2009 consumer and business spending was collapsing. The stimulus helped stabilize the economy; it's saved jobs that otherwise would have been lost. Interest rates didn't rise. But just because the earlier stimulus was justified doesn't mean that another would be, because circumstances are changing.

Government debt is now rising at unprecedented post–World War II rates. In fiscal 2009 (ending Sept. 30), the federal budget deficit was $1.4 trillion. The Congressional Budget Office predicts the same for 2010. "Right now, the world wants to lend to us, and we can carry a huge debt burden at relatively modest interest costs," says economist Kenneth Rogoff, coauthor with Carmen Reinhart of This Time Is Different: Eight Centuries of Financial Folly. "But history teaches that confidence is fickle." If rising debt frightens domestic and foreign lenders into fearing high inflation or default, interest rates could soar. A first stimulus was warranted, but now "it makes no sense to use stimulus just to postpone the reality of lower economic growth over the coming decade."

Economists Mishel and Rogoff frame the debate: the first, impatient; the second, prudent. A middle way would be to scour government for policies that discourage job creation. Consider the Environmental Protection Agency's recent proposal requiring permits for large industrial facilities emitting 25,000 tons of greenhouse gases annually. New plants or expansions would need permits demonstrating they're using "the best practices and technologies" (whatever they might be) to minimize six greenhouse gases. Permits would be granted on a case-by-case basis; the proposed rule is 416 pages of impenetrable legalese.

Could this possibly promote investment and job creation, except for lawyers and consultants? Similar employment obstacles abound. But dismantling them would require the Obama administration to choose between more jobs and many other goals—a choice it has so far avoided.