Mark Thoma

Keeping the stimulus argument alive

September 7, 2011: 12:30 PM ET

Some economists have a solution for the economy's woes: Spend on stimulus and keep the deficit under control. Is it more than wishful thinking?

FORTUNE – During the depths of the financial crisis, the U.S. spent hundreds of billions of dollars to save the economy from collapse. Now, as Europe's debt crisis rattles investors worldwide, the call for stimulus in the U.S. has all but grown faint. Even with a slow recovery that many now say could move even slower, the cry for austerity is growing ever louder as Washington lawmakers worry that escalating debts and deficits could be the nation's next big financial risk.

But there's a way to beef up government spending without adding to America's fiscal woes, say economists urging the need for another large-scale stimulus package to get the economy out of its rut. In The New Republic last week, Yale University economist Robert Shiller wrote that if government raises taxes by the same amount it increases spending on everything from infrastructure projects to research grants, the nation could very well stimulate the economy without having to widen the deficit.

Shiller explains it this way: Say the government raises taxes to give the unemployed jobs. Once they have jobs, they'll likely spend what they earn since they've been strapped for so long and feel better about their financial prospects. And even though those who already have jobs will have to pay higher taxes, they likely won't spend much less because they've grown so accustomed to a certain lifestyle that they'll simply dig deeper into savings.

In a blog post last week, University of Oregon economist Mark Thoma offered another example: Suppose the government spends $100 on a project intended to stimulate the economy. This would be financed by a $100 increase in taxes. Intuitively, both seem to offset each other, but going by what economists call the "balanced budget multiplier," they actually won't. It's true that households faced with a higher tax bill would naturally spend less but they'll also pay part of the higher costs by dipping into their savings.

As Thoma notes, let's say a household covered $80 of its new tax bill by clamping down spending on things such as a pair of new shoes or dinners out. They'll probably pay the rest of the bill by taking some – say, $20 from savings. That means there's about $20 left for spending – much less than the $100 bump the government spent to stimulate the economy, but that's better than nothing.

Indeed, the scenarios sound pretty neat and clear, but it's hard not to wonder if they would really pan out as economists describe. Households may spend the extra money that trickles from Washington, but that could depend on how inclined they are to save rather than spend.

To be sure, personal savings as a percentage of disposable income has fallen slightly after surging in the months following the financial crisis. In July, it was at 5%, down from 5.9% during the same month last year, the Commerce Department reported last week. It remains to be seen if and by how much the trend downward could continue. After all, households – many having racked up overwhelming debt in the face of falling home and equity prices – still have a ways to go before achieving clean balance sheets. Household debt as a percentage of disposable income has steadily fallen since the latest recession. In 2007, U.S. household debt to income ratio peaked at 140%. It has fallen to about 120% today, but that's still far from the 100% level seen in 2000.

Beyond economics, there's also the political obstacle. Many doubt Obama's speech this week will include any big stimulus package, which isn't much of a surprise especially given the stalemate we saw in Congress recently over negotiations to raise the federal debt limit.

Shiller and other economists, who themselves acknowledge the political climate, could remind lawmakers that stimulus spending doesn't necessarily have to lead to deficit spending. However, a majority of Americans appear more worried about the deficit than giving the economy an extra boost, according to results of an August Wall Street Journal/NBC News poll.

No doubt pulling in the reins on government spending in a big way could slow the U.S. economy further. For several months now, cash-strapped municipalities seeing less financial help from Washington have been shedding hundreds of thousands of jobs. More job cuts in the public sector are expected in the coming months. This certainly won't help the U.S. unemployment rate, which hovers at a high 9.1%.

And yet, however economists try to sell more stimulus, the case for more stimulus still seems far from reach.

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