January 30, 2008
Is a Trillion Dollar Stimulus Really Needed?
As Obama takes office, the biggest item on his agenda is the passage of a massive federal spending bill, called the “stimulus package”. This huge burst of government spending is being touted to America as a necessary step to avoid an economic meltdown. So what is the rationale behind this stimulus, and why does it need to be so large?
The great fear that is motivating Obama is the notion that the current economic downturn is not just a recession, but actually carries the risk of a “depression”. Recessions are natural parts of the business cycle of the economy, and usually occur as the Federal Reserve in response to rising inflation raises interest rates to choke off too rapid growth, the economy slows down, inflation falls, the Fed then lowers rates and the recession ends. Afterwards the economy makes up the lost ground and two years later things are back to normal, with the unemployment brought on by the recession mostly resolved.
A depression is a prolonged period of lowered economic output. The economy contracts just as in a recession, but it contracts much more than usual, and the rebound is very slow and tepid. Several years after the onset of the depression, the economy remains much smaller than its fully-utilized optimum. Unemployment remains elevated, and a new, lower equilibrium is established and maintained.
Every year the natural tendency of the economy is to grow. That natural growth is the result of the annual increase in the labor force and the 1-2% increase in worker productivity due to additional machinery, education, and improved management and production techniques. During a recession or depression a gap opens up between the actual output of the economy, and its natural potential. In a normal recession this output gap may reach 3-5% of GDP, but in the years after the recession ends, the economy grows very rapidly and closes the gap. For example, in 1984 the economy grew 7%, which was mostly due to closing of the output gap created by the 1982 recession.
In a depression the output gap can grow much larger, 10% or more. In the Great Depression it was over 25% of the economy, and when the economy does start growing, it does so too slowly to actually close the gap. So what causes this to happen in depressions? And why is a massive stimulus the answer?
John Maynard Keynes, the great economist of the Depression, understood what was really happening. In a massive depression a vicious circle takes hold. Because millions are unemployed and without income and purchasing power, there is a huge and persistent reduction in demand for goods and services. Businesses, already skittish about the weak economy, become very hesitant to hire and expand production as they have no confidence that anyone will buy their massive increase in production, which is the only way to close the output gap. But with no hiring, demand remains suppressed. Some economic growth occurs, but not enough to bring the unemployed labor and capital back into use, and it all sits uselessly idle year after year, as it did in the 1930’s.
Keynes insight was that in this situation, the only way to break the cycle was for government to create fresh and massive demand. It could not do this by raising taxes and spending the money, because that would only further reduce worker’s purchasing power and offset the government’s spending. Instead, the government should engage in massive spending with borrowed money, what we call deficit spending. All this spending will create fresh demand for labor and for businesses to hire and produce. As more and more people start working, their purchasing power then creates even further demand and the economy surges forward. To set off this virtual circle, it doesn’t even really matter what the government spends the stimulus on. Keynes famously remarked that you could just hire people to dig holes and then fill them back up.
How much spending is needed? The Great Depression did not really end until World War II forced the US government to run deficit spending of 20% of GDP. Normally, 2% of GDP is considered a tolerable level of deficit spending. So how much deficit spending is needed now? Many economists are suggesting a 5% or more spending spree, which amounts to 750 billion dollars on the low side.
But this just begs the question: why do we currently face a depression rather than just another recession? There are two big differences that are creating this new environment. First is that the banks themselves are in deep trouble, and without healthy banks the whole economy seizes up due to lack of credit. The banking sector collapsed due to the meltdown in the housing market, and even with the massive bailouts, the banks are still in difficulty and are not lending. Auto makers are complaining that 25% of their intended customers can’t buy cars because they can’t get an auto loan. The other big problem is that with the popping of the housing bubble and the collapse of stock prices, Americans have had their net worth seriously damaged. In response, consumers are starting to save money instead of spending it. Saving for an individual is a good thing, but when everyone starts saving, and the national savings rate goes from near zero to 5% or higher in a few months, that moves a lot of money out of spending, and further hits business and economic activity. This double whammy is creating a risk of a downward spiral that could take the economy into depression territory.
There are however critics of the stimulus proposal. Keynes was a brilliant man, but his theory is only truly useful for depressions. Problems arise when Keynes becomes a rationale for unnecessary government spending. In its fully developed mode, Keynesian economics was supposed to be “countercyclical”. Governments were to run appropriate deficits during bad times, but then run surpluses to avoid overheating the economy during good times. By doing so, one could supposedly “fine-tune” the business cycle and avoid extreme ups and downs. In reality, governments were great at running deficits during bad times, but never got around to tightening up during good times. In the 1960’s, when the economy was surging, President Johnson decided to fund both the Great Society social programs and the Vietnam War with deficit spending rather than raise taxes. These policies continued into the 70’s, and the Federal Reserve never countered them by tightening interest rates. The end result was this ongoing stimulus gradually pushed inflation from negligible in the early 60’s to 15% by the end of the 70’s. Keynesianism as a miracle cure was discredited, and a new policy of lower taxes, high interest rates, but continued high deficits took hold in the 1980’s.
Today the question is do we need a massive stimulus? The answer depends on whether the threat of depression is real or not. If we are facing merely a bad recession, then the economy will heal on its own, and the massive stimulus is wasteful and unnecessary. In fact, it may overheat the economy and leave us with a nasty burst of inflation while at the same time piling on an extra trillion dollars to our 10 trillion dollar national debt for no good reason. On the other hand, if we do face the prospect of a depression, then a massive stimulus, in the range of 5-10% of GDP, is exactly what is needed. Although Keynes is right that during a depression what you spend the stimulus on exactly is not that important (whether that be missiles that will never be fired, or worthless holes in the ground); if we are going to spend 750 billion dollars, let’s do something that gives us some long-term benefits. For that reason, we should look very carefully at how this stimulus is allocated and what it is to be spent on.
