The U.S. economy has been in recession for at least a year.  The Federal Reserve has lowered the federal funds rate to just a hair above 0%, which leaves monetary policy essentially powerless to help the economy out of recession.  So now the nation expects Congress and the incoming Obama administration to provide a massive fiscal stimulus to jump start the economy.  Congress should not spend $800 billion lightly.  To help in the deliberation, I’ve provided a list of some dos and don’ts Congress should consider in order to get the best bang for the stimulus buck.

DO: Spend the money on investment.  GDP consists of four items: consumption (consumer and business spending on goods and services), investment (business spending on plant and equipment), government spending, and net exports. The government, just like households and businesses, can choose to spend money on public consumption or public investment. Investment spending purchases tools that workers can use to produce more goods and services. It’s like a two-for-one deal; buy investment and get consumption for free.  

DON’T: Spend the money on consumption. Some economists use the idea of a Keynesian consumption multiplier to justify an increase in consumption spending. An increase in spending from a government stimulus should increase total spending on consumption by a multiple (the inverse of the savings rate) of the initial amount. For example, suppose the savings rate is 20%. If the government spends $100,000 on new fighter planes, then Boeing has $80,000 to spend on guidance systems, and Intel has $64,000 to spend on silicon for new chips, and so on. Add up the total amount of new spending that follows from that initial increase and you will find that $100,000 of government spending stimulated $500,000 in total spending in the economy. However, this strategy depends on consumers and business spending all of their money instead of saving it.   Unfortunately, with most Americans heavily indebted already, the government should encourage saving (more on that later).

DON’T: Give a lump sum payment, such as a tax rebate. The first round of tax rebates in early 2008 were a dismal failure. Consumers, worried about difficult times to come, smartly saved the rebate for a rainy day. This is about the worst thing the government can do; it transfers money from some people to others with no real economic benefit.

DO: Cut income tax rates. Consumers will only start spending again once they feel their income stream is secure.  Cutting income taxes increases consumers’ current take-home pay, just like a rebate program, but it also increases their future take-home pay.

DO: Cut capital gains tax rates.  Just as the government should look to purchase capital, it should encourage saving by cutting the capital gains tax rate.  Increased savings will lower the interest rate and encourage business to finance more capital investment. 

DO: Invest in public transportation.  Population trends show more Americans moving to metropolitan areas.  The cities are the natural location for the information jobs of the new economy.  Most middle class workers who can afford to do so choose to live in the suburbs and exurbs and commute to work.  Unfortunately, there is a physical limit to how many people and cars can fit into a crowded downtown business district.  The congestion from a traffic jam at rush hour imposes a cost on everyone stuck in a car wasting time.  Expanding the current light rail and rapid transit in America’s most congested cities would provide commuters with a viable alternative to driving that would take cars off the road and decrease traffic delays.

DON’T: Invest in new roads and bridges.  If we want to build roads, improving the roads around metropolitan areas to reduce traffic gives us the best value per stimulus dollar.  But mass transit systems in these areas will produce an even greater return.  We don’t need to improve the highway system, as most open roads in between cities are still free of congestion.  Let’s try other stimulating other transportation possibilities first, like railways for freight shipping, and leave building roads to the New Deal.  

DO: Invest in broadband Internet access.  If information technology is the future of the American economy, we need to create the modern-day equivalent of the Interstate Highway System.  Currently, the United States rank 16th in broadband Internet access per capita.  Increasing access to the Internet will open up new online business opportunities.  The fact that certain people can make an honest living playing online games such as Second Life shows that online access can create new jobs and even new industries.  To compound the benefits, spending should go to help cities create large wi-fi networks, eliminating the costly need to lay cables and providing access to anyone, anywhere.

DO: Resupply and refurbish the military.  After two wars in Iraq and Afghanistan, the American military is worn out.  Maintaining our defense capability should be a no-brainer.

DO: Invest in research and development for energy-efficient technologies.  R&D provides another two-for-one benefit: the initial spending creates jobs while those jobs create technologies that reduce the cost of business across the economy.  Energy is still a major factor of production.  Sharp increases in the price of oil or other forms of energy can still raise the operating costs of every business, and therefore the prices of every consumer good.  Increasing energy efficiency will not only insulate businesses and households from fluctuations in the supply of and demand for energy, it will also lower the fixed costs of production and increase real GDP.

DON’T: Forget to trim spending once the economy recovers.  Politicians usually forget the second half of the Keynesian prescription: the government should run a surplus during the good economic times.  This means cutting back the emergency spending programs once the emergency has passed, not incorporating them into the baseline CBO projection for spending.  In this post, I’ve advocated spending money on public capital, which has a lasting benefit long after the stimulus spending has stopped.  Social welfare programs and direct job creation by the government require continued spending in order to maintain their effects.  With a projected budget deficit of $1.1 trillion for FY 2009 and an additional $3.1 trillion over the following ten years, we can’t continue to spend money indefinitely.

DON’T: Rush to push a stimulus through Congress. A quickly passed bill or series of bills will ensure that stimulus money goes to the groups with the best political connections instead of the groups with the most productive projects. If future generations are ever to pay off the massive debt generated by this stimulus, they need to have the ability to make money above and beyond the interest payments on the debt. Yes the economy is in a rough spot now, but a little patience will ensure that the stimulus money is not wasted and this recession will not continue indefinitely.  

And last but not least, DO: Remember we don’t have to spend the money.  It’s better to do nothing than to waste $800 billion.