The Importance of Automatic Stabilizers in the Next Recession

Traders work on the floor of the New York Stock Exchange on December 19, 2018, in New York City, when U.S. stocks fell after the Federal Reserve raised interest rates for the fourth time in 2018.

The United States is experiencing one of the longest periods of economic expansion in its history, but downturns are difficult to predict, giving policymakers reason to worry about whether the country is prepared for the next recession. Automatic stabilizers—policy features that automatically expand spending or reduce tax receipts during economic downturns in order to inject stimulus—helped reduce the severity of the Great Recession a decade ago. In order to improve the U.S. economy’s resilience against future recessions, policymakers must strengthen automatic stabilizers. Otherwise, families could be left struggling to keep a roof over their heads and put food on the table as Congress takes time to act.

This column offers a brief explanation of automatic stabilizers, their role in mitigating a recession, and how they can be improved for the future.

What are automatic stabilizers?

Automatic stabilizers are features of the federal government’s budget that automatically inject funds into the economy through transfer payments or tax reductions when the economy goes into recession or otherwise slumps. They are “automatic” because they do not require action by Congress; in other words, they are built into already enacted policies. Many government policies serve as automatic stabilizers simply by their nature. For example, when many workers lose their jobs around the same time, the unemployment insurance program receives more claims and pays out more in benefits. The progressive income tax system also serves as an automatic stabilizer because when people’s incomes fall, they pay less in taxes. Some programs could have additional features built into them that would react when certain macroeconomic indicators were triggered. (see Table 1)

Automatic stabilizers help cushion the impact of recessions on people, helping them stay afloat if they lose their jobs or if their businesses suffer. They also play a vital macroeconomic role by boosting aggregate demand when it lags, helping make downturns shorter and less severe than they otherwise would be. Although the United States currently has automatic stabilizers in place, there is room for improvement. If policymakers do not implement changes to these features to make them larger, more automatic, and—if necessary—more prolonged, they are likely to have a more limited macroeconomic effect than 10 years ago.

The increased importance of automatic stabilizers

The role of automatic stabilizers will be more important than ever when the next recession strikes. The Federal Reserve’s first policy response to a recession is typically a reduction in the federal funds rate. Many structural factors, however, have contributed to depressed long-term interest and inflation rates and, currently, a low federal funds rate. Thus, during the next downturn, the Fed will have a limited ability to reduce the rate of interest—which affects firm behavior—since the rate is already low. If a recession were to happen tomorrow, this would leave the Fed with nearly half of the federal funds rate cut that it was able to use in the last recession before it must revert to alternative forms of monetary policy. As a result, automatic stabilizers may play a larger role in mitigating future business cycle shocks.

Additionally, it takes time for policymakers and analysts to recognize that a recession is underway. For example, the last business cycle peak preceding the Great Recession was not announced until a year later, when the recession was well underway. When Congress does decide on a fiscal stimulus package, it then takes even longer for people to see tangible results. Automatic stabilizers reduce or eliminate that time lag—so long as triggers are effectively tied to economic indicators.

The effectiveness of automatic stabilizers

A textbook example of an automatic stabilizer is unemployment insurance (UI). UI helps jobless workers meet their basic needs. In order to qualify for benefits, the worker must have a sufficient earnings history and be looking for a job. This program not only stabilizes families’ incomes, but it also has positive macroeconomic effects. Individuals can continue to spend and therefore boost demand, preventing further job loss and helping stabilize output. From 2008 to 2012, UI prevented approximately 1.4 million foreclosures by boosting demand—avoiding an additional 18 percent shortfall in gross domestic product (GDP). In an estimate by Mark Zandi, a $1 increase in UI generates $1.64 in GDP during hard economic times. It is important that during a downturn, these benefits are timely, strengthened, and extended and that a mechanism is in place to trigger these features automatically. Other estimates confirm this and prioritize social insurance programs—including UI—as the most effective tools for stabilizing aggregate output.

Nearly all states are required by law to balance their budgets every year; this means that state governments are constrained from providing fiscal stimuli when recessions hit. This creates problems with programs that are partially funded by the states, such as education and Medicaid, as they are unable to expand to adapt to increased need at the very moment it is most critical. In fact, states often react to declining revenues during recessions by cutting programs—especially education. These annual state budget requirements mean that federal fiscal policy—especially strong automatic stabilizers that substantially increase state fiscal relief—is even more important to combat an economic downturn.

Emergency UI benefits and emergency unemployment compensation (EUC)—such as those which extend the amount of time individuals have to collect UI while looking for work—are federally funded. They are usually enacted by the federal government with broad bipartisan support during times of high unemployment, making them good candidates for a more automated process.

Importantly, the federal government must also provide sufficient automatic funding for state programs prior to the next recession. States must maintain funding for certain programs at prespecified levels from before a downturn in order to receive federal grants. These are called maintenance of effort (MOE) provisions, and they make explicit a cost-sharing obligation and prevent a moral hazard problem wherein states use federal aid to replace their program obligations rather than to expand programs. During a recession, this behavior creates a drag on federal efforts to raise demand through program expansion in order to stabilize output. It is imperative that states receive a large enough fiscal stimulus to expand these programs as more people need them and that this be done through an automated process. State aid was far too small during the last recession and resulted in states relying most heavily on spending cuts to fill budget gaps.

How automatic stabilizers should work

It is crucial that Congress update existing automatic stabilizers using both academic studies of previous efforts and policy professionals’ experience in implementation gleaned during the Great Recession. Several guidelines should be implemented in existing policies to create an instant response that would bolster the United States’ economic stability without the need for legislative action in a potentially gridlocked Congress. These principles should underlie almost any automatic stabilization policy:

  1. Ensure that policymakers can increase and extend the benefits of automatic programs and that they are not tightened before all demographic groups and regions have recovered.
  2. When appropriate, tie the triggers to activate automatic stabilizers to economic indicators such as unemployment, GDP, and business cycle indices.
  3. Make federal fiscal relief to states substantial, automatic, and prolonged so that states do not engage in austerity measures—policies that contract the economy by cutting government programs and/or raising taxes—before the economy has recovered.
  4. Require strong MOE provisions during downturns so that states do not use federal funds to simply replace their own.

Conclusion

A recession response should generally have a two-pronged fiscal policy approach: automatic stabilizers and a congressional process. Automatic stabilizers should be in place long before the economy starts to contract so that Congress has time to take the second step of crafting temporary fiscal policies. A two-part approach ensures that people are not left to suffer from an inevitably lagged fiscal response that both houses of Congress must pass and that the president must sign. Time for deliberation is an important part of the congressional process, but if there are no preemptive updates to automatic stabilizers to work in conjunction with a temporary fiscal stimulus, half the battle will be lost.

Table 1 shows a series of existing, new, and modified policies that serve or can serve as automatic stabilizers.

Sara Estep is a research assistant for Economic Policy at the Center for American Progress. Olugbenga Ajilore is a senior economist at the Center. Michael Madowitz is an economist at the Center.