What Can Washington Do to Fix the Economy?

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The economy has hit a bump. Does the government have any tools it can use?

If the weakness we've been seeing since April from various economic indicators hasn't been enough, last Friday we learned that the U.S. only added a measly 54,000 jobs in May. This number is disturbingly low at a time when an economic recovery should be providing at least five times that many net new hires. This morning, my colleague Derek Thompson explained why the government won't fix the economy. Let's take that question a step further: should the government act and how might it be able to do so?

Should the Government Act?

The way you answer this question probably depends in large part on how cynical you are about the government's ability to do anything right. Up to now, it doesn't have the greatest track record. The $787 billion stimulus package from early 2009 produced far weaker results than hoped (see chart below, click to enlarge). Extending the Bush tax cuts at the end of 2010 hasn't seemed to strengthen the economy much either. Both Republican and Democratic strategies have failed to help sustain an enduring recovery.

white house unem updated 2011-05 v2.PNGThere could be a few reasons for this. Partisan politics tends to get in the way. Perhaps if Democrats had focused on a stimulus package that provided more shovel-ready, direct job creation efforts -- instead of serving as a wishlist for their allies -- then it may have had a greater impact. And perhaps if Republicans had structured the tax cuts to better aim at lower- and middle-class Americans, then they would have put more cash in the pockets of the consumers who are currently feeling pinched by high gas prices.

Or perhaps even with these changes, nothing would be different. The unemployment problemĀ  is mostly demand driven. Americans aren't rushing to buy lots of additional goods and services, so firms aren't hiring more workers. Since Washington doesn't have a mind control machine, it can't make people spend money. It might just take time for the economy to heal.

What the Government Might Be Able To Do

Unfortunately, we're impatient. Indeed, those millions of Americans who have been unemployed for a year or more have good reason to be impatient. But the political reality is such that additional government spending or tax cuts will be difficult: Washington is in the midst of a deficit-cutting strategy session. As a result, any proposals that intend to create jobs must be considered in the context of that debate. This might sound impossible, but it isn't.

A Grand Unified Debt Ceiling Compromise

The debt ceiling situation is tricky. It has to be raised, but the market will also probably look for it to include some plan for long-term deficit reduction. If any job creation measures are to be taken, they should be a part of this discussion.

For example, let's say you want to stop state and local government jobs from bleeding. Last month they shed 30,000 government jobs. Even though the government can't force the private sector to hire new workers, it can work to prevent state and local governments from firing its current workers. (See note below for how such a program might work.) Another option might be to temporarily suspend all gas taxes to reduce the price at the pump.

The problem is that the federal government has to pay for such programs. At a time when the market is worried about the U.S. deficit, that isn't a cinch. Investors might worry that additional deficit spending means that the government isn't serious about fiscal restraint after all. So if any such spending occurs, it must be accounted for in the government's longer-term plan.

For example, the long-term deficit reduction plan will just have to be a little bit more aggressive if, say, the government spends $250 billion more this summer to combat unemployment. If there's a plan in place to pay for this spending, then the market isn't as likely to object.

Creating an Environment Conducive to Jobs

Once the deficit ceiling debate has concluded, the government needs to shift into clean-up mode. In 2010, a heap of messy new regulation was thrust on the U.S. businesses. The health care law created new rules that firms must follow and financial reform created a confusing and at times burdensome set of new rules for banks and lenders to follow.

The government needs to work to provide clarity and certainty, quickly. Any questions left open in the legislation need to be answered; any challenges need to be dealt with and resolved. As soon as firms feel some permanence in their regulatory framework, they will be more comfortable hiring. They need to understand the rules of the game before they can be expected to double down.

The best part of this proposal is that it won't cost much, if anything. It would just take some regulator coordination and bipartisan work. On second thought, perhaps just asking Washington to spend other people's money would be easier. But we can hope that U.S. politics isn't completely hopeless.

Note: A plan for saving state and local government jobs: To combat these layoffs the federal government could provide some amount of funding (per capita) to each state to ensure that these jobs survive. The federal government could provide sort of pseudo-loans to these states and localities to fill their budget gaps that are contingent on a firing-freeze. If the recipient's level of employment stays level or grows each month, then it doesn't need to pay the government interest. But if net job losses occur, then it owes the government interest. At the end of five years, the federal government will forgive the loans, if the state or locality's employment has been level or has grown.

Image Credit: REUTERS/Jason Reed