Launch a Pre-Emptive Strike Against Recession
President Trump was right to set aside premature plans for fiscal stimulus last month. Based on the current economic situation, stimulus isn't yet warranted—but it may be soon. Given the uncertainty, Congress should pass a law immediately that would automatically trigger stimulus if the labor market deteriorates, with unemployment rising rapidly. The package should include not only tax cuts but also relief for states, as well as extra help for people most hurt by recessions. The legislation should be permanent, the measures lasting as long as needed in the next downturn and set to trigger in future ones as well.
The US macroeconomy is in good shape. Labor data is the most reliable gauge for the real economy, and it remains very strong with above-average job growth and an unemployment rate below 4 percent. Growth in gross domestic product is slowing with marked weakness in business investment, and it seems likely to stabilize at a little below 2 percent, the rate many economists say is natural and sustainable. Yet a slowdown is occurring world-wide, and US trade policy is increasingly erratic. Rising short-term bond rates are a warning bell that shouldn't be ignored.
While monetary policy is more nimble and should be our first line of defense, it may not be as potent as it has been in the past. Unlike in past downturns, monetary policy won't be able to accomplish much. In previous recessions the Federal Reserve has cut interest rates by an average of six percentage points, but today it has only about a third as much room to maneuver.
At the onset of a downturn, monetary policy already is supplemented by automatic changes in taxes and spending. Tax collections fall as individuals and companies recede to lower brackets, while spending on programs like nutrition assistance and unemployment insurance goes up. Yet these automatic stabilizers are relatively weak in the United States compared with other advanced economies. That makes the need for fiscal stimulus even greater—and the robust international market for US bonds enables the borrowing that makes stimulus possible.
Economists often don't realize a recession is under way until six months or more after it starts. One reliable early signal of recession is the Sahm Rule: A downturn is probably occurring if the three-month average of the unemployment rate has risen by at least 0.5 percentage point above its low point in the previous 12 months. This rule, discerned by economist Claudia Sahm, has signaled every recession since 1970 with virtually no false positives. Congress should adopt Ms. Sahm's idea of a trigger for stimulus payments to households. The most equitable and efficient payment would be a flat sum that phased out at higher incomes, but a payroll-tax cut would be a decent alternative.
One obstacle to effective stimulus is balanced-budget rules in state government, which trigger spending cuts and tax increases right when local economies are in dire need of cash. Congress should offset cuts in health-care spending by automatically expanding the federal match for Medicaid in states with high unemployment rates, as I recently proposed with Matthew Fiedler of the Brookings Institution and Wilson Powell of the Harvard Kennedy School. Presidents George W. Bush and Barack Obama took similar but temporary steps. This proposal would make increased matching a permanent feature that would trigger automatically as needed.
Finally, the social safety net should be reconfigured to respond adequately to recessions. Take unemployment insurance. The 26-week limit is meant to protect a recipient's standard of living without discouraging him from seeking a new job. Yet the relative importance of these two goals shifts when unemployment rises, making it efficient for unemployment insurance to be more generous and last longer. Congress has done that on a discretionary basis eight times since 1950. Lawmakers should provide for the automatic extension of unemployment benefits during recessions, and do the same for nutritional assistance and other aid for vulnerable households.
Passing these measures now would reduce uncertainty about the future, and thereby support business investment. It would also foster financial stability because a fiscal expansion would reduce overreliance on interest-rate cuts and other monetary interventions.
With the right benchmarks in place, an approach to fiscal stimulus that is comprehensive and permanent would be far superior to the usual temporary, narrow and ad hoc responses. These economic interventions would occur only when needed, unlike the needless stimulus from tax cuts and spending increases in 2018. They would also last as long as needed, unlike the stimulus that was cut off prematurely in 2012 despite an unemployment rate still at 8 percent. Finally, a fixed stimulus regime would permanently improve America's economic resilience, helping to make up for the heightened challenge of navigating an economy with lower interest rates.