Time for Stimulus 2.0? The Debate Gains New Urgency

With the Federal Reserve adopting a more a pessimistic view of the economic outlook, the revival has been swift in calls for the federal government to do more to help spur growth. But what can it do, and would it be counterproductive?

The Federal Open Market Committee, which sets the Fed's interest rates, issued a downbeat assessment of the economy at its meeting Tuesday, saying "the pace of recovery in output and employment has slowed in recent months."

While it left the Fed's key benchmark rate unchanged -- at between 0% and 0.25%, it can't go any lower -- the FOMC announced that the Fed would take the mildly stimulative step of using the proceeds of maturing mortgage bonds in the Fed's portfolio to buy Treasury bonds. That move is aimed at keeping interest rates low and encouraging banks to lend to customers.

In addition to the Fed's glum assessment, more bad news landed on Wednesday. The Commerce Department reported that the U.S. trade deficit widened to $49.9 billion in June from $42 billion in May. That data, along with downbeat financial reports from China and Britain, helped send world stock prices plunging.

Point, Counterpoint

The first U.S. stimulus package was launched in February 2009, when President Obama signed into law a $787 billion stimulus bill that included tax cuts, infrastructure spending and other measures to spur the economy. In addition, Congress on July 23 passed a $34 billion measure to extend unemployment benefits. And on Tuesday, it passed legislation giving $26 billion to the states for teachers and Medicaid assistance, both likely to help boost spending.

But the recent litany of bad tidings has renewed the debate about whether further stimulus spending is necessary to reinvigorate the economy. And not surprisingly, economists are split in their answers.

Nobel Prize-winning economist Robert M. Solow published an appeal to the government on the Daily Beast website to "get our economy moving again, and soon." He said the federal government could give the economy a push by either increasing public spending or through "carefully targeted" tax reductions.

But Robert Rubin, who served as Treasury Secretary under President Bill Clinton, came out against another round of fiscal stimulus. Speaking on CNN, Rubin said a major new spending would create more uncertainty and undermine confidence.

Government Spending as a Gap-Filler

Augustine Faucher, director of macroeconomics at Moody's economy.com, says the economy would benefit from another $50 billion in aid to states and localities to keep more government employees from being laid off. "We're still going to see substantial layoffs at the state and local level," Faucher says.

Jon Shure, director of the state fiscal project at the Center on Budget and Policy Priorities in Washington, D.C., says the stimulus package adopted in 2009 was the right medicine and needed to be extended.

"It's safe to say that states are going to continue to have problems meeting peoples' needs for the foreseeable future, and it's appropriate for the federal government to be thinking about the role it can play," Shure says. " With the private sector faltering the way it is today, state and local government spending is a huge driver of the national economy."

In addition to more state aid, Faucher says he'd like to see the federal government continue spending on infrastructure projects because of the huge unemployment problem in the construction sector. He also recommends that all of the Bush tax cuts, which are due to expire in January, should be extended for a period of years, including the cuts aimed at the top tax brackets of people earning more than $200,000 a year.

Says Faucher: "Given the fragility of the economy, you don't want to take the risk that higher taxes could upset the people who account for the bulk of spending." However, Treasury Secretary Timothy Geithner says the administration opposes continuing the tax cuts for the wealthy.

More Debt Means Less Growth

Increased federal spending has raised concerns among some economists about the impact on the federal deficit.

In a study published Wednesday, Kenneth Rogoff, a professor of economics at Harvard, and Carmen M. Reinhart, an economics professor at the University of Maryland, examined spending data from 44 countries over 200 years. They found, for example, that public sector debt in the U.S. has reached 117% of GDP in the first quarter of 2010, the highest it's been since reaching 119% of GDP in 1945.

Rogoff and Reinhart concluded that two centuries of statistics show conclusively that "high levels of debt dampen growth." They say that means the bigger the deficit we run today, even in the short term, the longer it will be before economic growth returns to healthy levels and can lift the economy out of the doldrums.

Still, don't expect that to be the last word in the newly refueled stimulus debate.