What Economic Policies Should Government Pursue During the Recovery?

Last Updated May 14, 2010 5:27 PM EDT

Now that the economy appears to be turning around, how should the government react? What types of policies are needed for the recovery period?

1. Things look better now. Almost all economic indicators are beginning to point upward, but we don't know yet if the recovery will be strong or weak, or if we might be headed for a double dip. For that reason, don't pull back on monetary and fiscal stimulus too soon. It will be tempting to listen to the deficit and inflation hawks as things start to improve, but it's important that the stimulus not be withdrawn before the economy can stand on its own.

2. If the recovery seems to be very slow or stagnating, don't be afraid to give the economy the additional help it needs. Output is starting to grow, but labor markets are lagging behind. It's not yet clear if the lag will be as large as in the previous two recessions, but it's certainly something to keep an eye on.

3. Similarly, there is a huge jobs backlog -- millions and millions of people have lost jobs during this recession -- and it will take a considerable amount of time to reemploy these workers even under strong labor market conditions. Workers will still need unemployment compensation, help with health care, and other social services until they can find work. They are not lazy or playing the system, it's just that the applicant to jobs ratio will remain high until the backlog is cleared, so don't cut them off too soon.

4. If the government does try to take an active rather than a passive role in the recovery, try to anticipate what the post-recession economy will look like and help with the adjustment. For example, there is lots of structural unemployment due to the scaling down of the housing and financial industries. Where will these workers go and what can the government do to help them get there? Will we need to rely upon exports to a greater degree than before the recession in order to maintain robust growth? If so, what can the government do to help this sector to develop? I don't mean the the government should try to manage the economy with a heavy handed industrial policy approach, but when it's clear that change is coming to a particular sector, then the government should do what it can to help (or at least get out of the way).

5. As the economy recovers, it will be easy to forget about the problems we had and what caused them. Don't let exuberance over the recovery get in the way of making the changes that need to be made to try to prevent this from happening again. All of the promises to do better that are made when things are really bad are easily forgotten once things improve.

6. When the time comes -- but not a moment before that -- policy must be reversed. The fiscal policy measures involving both government spending and tax cuts were sold as "targeted, timely, and temporary." We could have done better at the targeted and timely part, but it's not too late to make it temporary. It will be difficult to cut the stimulus once it's clear that the economy has recovered, there will be an outcry about the jobs that will be lost, the decline in growth, etc., but it's important that we do it. First, there are theoretical reasons to believe that temporary fiscal policy has a much larger effect than permanent changes within modern, New Keynesian structures. Second, we may need fiscal policy again someday. If we don't keep out promises and reverse the spending and tax cuts, the next time fiscal policy is needed nobody will believe that will actually be temporary no matter what is promised, and that will make it much more difficult to pursue the policy that is needed.

Update: 7. State and local governments are still having trouble, and are likely to continue to struggle at least through the next fiscal year. If they don't get more help, this create a big drag on the recovery.

This is surely incomplete. What else should be on the list?