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AP Micro Econs
Current Events article

             Former Treasurer Prescribes Fiscal Policy to Prevent Recession

I. Summary of Article
       Former Treasury Secretary (and Harvard University President) Lawrence Summers advocates
a $50 to $75 billion federal tax cut and spending package to head off a possible recession in 2008.
“’Insufficient action to contain recessionary forces has much more serious consequences than
excessive action to contain recessionary forces,’ Mr. Summers said in an interview ahead of a
speech today at the Brookings Institution.” Mr. Summers, who in the article also advocates more
aggressive action by the Federal Reserve to ensure consumers benefit from recent interest-rate
cuts, is more pessimistic than most economists about the prospect of a recession in the coming
year. As the article points out, while the current consensus is that the new year will bring with it
an increased likelihood of slower GDP growth and less-than-50% chance of a recession, Mr.
Summers thinks that “slow growth is a near certainty, that a recession is more than a 50%
chance, and that there's a distinct possibility of a more serious recession that will lead to the
worst economic performance since the late 1970s and early 1980s."

II. Related Microeconomic Topic, Theory, or Principle
        This article relates to the federal government’s ability to use fiscal policy to stabilize, or to
prevent a potential downturn in, overall economic activity. In the article, former Secretary
Summers suggests that the federal government use both levers of fiscal policy, government
spending and tax cuts, to stimulate economic activity and prevent the highly-likely occurrence of a
recession (in his opinion) in the near future.

III. Analysis
         Although GDP growth has been remarkably strong in recent quarters (3.8 and 4.9 percent in
the second and third quarters of 2007, respectively), the severe downturn in the housing market,
aided by falling housing prices and rising mortgage costs (largely due to many adjustable-rate loans
coming to the end of their initial low-rate periods) has many economists concerned that a recession
is on the horizon (as indicated on pp. 214-215 in the text, two consecutive calendar quarters of
falling real GDP is generally viewed by officials as the technical definition of a recession). Thus, a
fiscal stimulus, such as the one advocated by Secretary Summers, might be warranted at this point.
         However, even if the federal government heeded the advice of Secretary Summers, it is
uncertain what impact this fiscal policy would have on GDP. If we assume a marginal propensity to
consume of 0.6, which implies a spending multiplier of 2.5, a $75 billion fiscal stimulus package
could potentially increase nominal GDP by almost $200 billion, or about 1.5 percent of nominal
GDP (which is currently at about $13.6 trillion). Yet, this assumes the fiscal stimulus would not
“crowd out” private investment as a result of the increased spending putting upward pressure on
interest rates. If that occurred, then the impact on nominal GDP would be less than 1.5 percent.
         In the current climate of reduced interest rates (engineered by the Federal Reserve),
crowding out would not seem to be a significant concern. However, another uncertainty of the
impact of a stimulating fiscal policy is how it would be perceived by consumers. If consumers did
not believe the tax cut to be permanent, it may not cause them to increase spending (which is the
primary purpose of the tax cut) and therefore the policy would be largely ineffective. On the other
hand, if there is a sizeable lag between when Congress would implement such a tax-cut and when
the policy would have an effect on the broader economy (via the multiplier effect), the economy
may already be recovering from a slowdown or recession at the time the policy is having the
intended effect. In that case, the fiscal policy may turn out to have been unnecessary or, in the worst
case, to over-stimulate the economy and create conditions conducive to general price inflation.
        From his comments in the article (see above), former Secretary Summers seems less
concerned about these consequences than those from a policy of doing little or nothing. For some,
his views in this regard are perhaps more debatable than his prediction for the performance of the
economy in 2008, which is why Congress may not agree to implement his economic prescription
even if it generally agrees with his prognosis of future economic conditions.

Source: Phillips, Michael M., “Ex-Treasury Secretary Calls for Tax Cut, Spending Plan,” The Wall
Street Journal (12/19/07), accessed online 12/19/07, at:

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