The stimulus package would thus fill less than half of the hole in GDP caused by the decline in household wealth and housing construction, with the remaining demand shortfall of $450 billion in each of the next two years causing serious second-round effects. As demand falls, businesses will reduce production, leading to lower employment and incomes, which in turn will lead to further cuts in consumer spending.
To be sure, an improvement in the currently dysfunctional financial system will allow banks and other financial institutions to start lending to borrowers who want to spend but cannot get credit today. This will help, but it is unlikely to be enough to achieve positive GDP growth.
A second fiscal stimulus package is therefore likely. However, it will need to be much better targeted at increasing demand in order to avoid adding more to the national debt than the rise in domestic spending. Similarly, the tax changes in such a stimulus package should provide incentives to increase spending by households and businesses.
Although long-term government interest rates are now very low, they are beginning to rise in response to the outlook for a sharply rising national debt. The national debt held by US and foreign investors totaled about 40% of GDP at the end of 2008. It is likely to rise to more than 60% of GDP by the end of 2010, with the debt-to-GDP ratio continuing to increase. The resulting increase in real long-term interest rates will reduce all forms of interest-sensitive spending, adding further to the economy’s weakness.
So it is not clear what will occur to reverse the decline in GDP and end the economic downturn.