The Importance of Automatic Stabilizers to the Economy

Last Updated Jan 25, 2010 12:52 PM EST

Automatic stabilizers are a key factor in easing the consequences of negative economic shocks. What are automatic stabilizers and how do they work? In an earlier post on this topic, Social Insurance and the Severity of Recessions, I wrote that:
The question of how bad would economic conditions be right now if there had been no stimulus package and no financial bailout is receiving considerable attention. There's no way to know for sure, but I believe the economy would have been much worse off without these two policy interventions. ... But one thing I am fairly certain of, and something I don't think is getting enough attention, is the effect that automatic stabilizers have had in helping to ease the impact of the recession.
What are automatic stabilizers? Automatic stabilizers are taxes and transfers such as unemployment compensation and food stamps that automatically change with changes in economic conditions in a way that dampens economic cycles. For example, when the economy turns downward, the amount spent on food stamps automatically goes up as more people apply or eligibility rules are eased. The extra spending the food stamps generates helps to soften the downturn for the individuals receiving the help, and also benefits the businesses and employees where the money is spent (and the multiplier process spreads the benefits more widely). Similarly, unemployment compensation, which obviously rises as jobs are eliminated, goes up when conditions deteriorate and this also provides a boost to demand. There are other factors too...

I don't think there can be any doubt about the importance and effectiveness of social insurance in helping to limit the impact of economic downturns. ...
Yet, despite their importance in smoothing the impact of economic shocks, very little discussion of the recent crisis has been devoted to whether the automatic stabilizers we have in place have been adequate. Why have these stabilizers received so little attention? One reason is that they are automatic and hence largely outside the political process, this is one of their advantages, and it's only when programs such as unemployment compensation threaten to come to an end that they catch our attention.

As just noted, in addition to their effectiveness at reducing the severity of economic shocks, automatic stabilizers have an additional advantage of being outside the political process. One of the difficulties in using fiscal policy to combat recessions is getting Congress to agree on what measures to implement. Agreeing on tax cuts versus spending, who should get the tax cuts, how money should be spent, etc., is difficult if not impossible, and the delays and compromises involved in passing legislation undermine the effectiveness of the policy. Automatic stabilizers bypass this difficulty by doing exactly what their name implies, they kick in automatically without the need for Congressional action.

However, while automatic stabilization policies bypass the political process once they are operative, the political challenges of putting automatic stabilizers in place to begin with are just as great, perhaps even greater in some ways, as they are for implementing fiscal policy on the fly once a recession hits. But the difference is that negotiations over automatic stabilizers can be carried out when the economy is doing well and delay isn't as costly, and the negotiations only have to be carried out once instead of in each and every downturn.

Of course, the motivation for implementing new and improved stabilization policy will be lower during good economic times, we tend to forget and move on to other things. That's why it's important to begin the assessment of the automatic stabilizers we presently have in place right now, while the need for them is still fresh in our minds.

We need to do a careful and thorough assessment of the strengths and weaknesses of existing automatic stabilizers, to identify missing pieces and extraneous parts, and we need to design new stabilizers that can improve our ability to smooth fluctuations in the economy (e.g. payroll taxes that decline automatically when conditions deteriorate, investment tax credits that vary countercyclically, or a continuously updated list of infrastructure projects that can be started ahead of schedule or brought online anew if the economy goes into recession). Then we need to begin the difficult political process of getting the needed change through Congress and signed into law before the next crisis hits.

The lags in the effects of policy and the existing political atmosphere mean it's too late to do much more to help the economy this time around, but we should be as prepared as we can the next time this happens.
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    Mark Thoma is a macroeconomist and time-series econometrician at the University of Oregon. His research focuses on how monetary policy affects the economy, and he has also worked on political business cycle models. Mark is currently a fellow at The Century Foundation.