A Clearer Understanding

I’d like to launch this site with a discussion of fiscal stimulus. With the US economy confronting anemic growth and high unemployment, recent efforts to prop up aggregate demand has made this, perhaps, the most noteworthy debate in macroeconomics (and politics) today. China’s 586 billion dollar spending package revealed in late 2008, and the US’s 787 billion dollar bill passed in 2009 are two of the most ambitious programs of this type in years.

So when President Obama outlined his jobs proposal last night in a speech to congress, many commentators not surprisingly called it a stimulus. Whether the plan really is one is up to interpretation because, as Mr. Obama noted, it doesn’t increase the deficit. It did, nevertheless, bring about similar comments and criticisms heard during earlier stimulus legislation.

Paul Krugman from the New York Times, although supportive, stated, “It’s not nearly as bold as the plan I’d want in an ideal world.” While Dan Danner of the National Federation of Independent Business wrote in the Washington Times, “Rather than the retread failed ideas we heard…..we want government to get out of the way to let us do what we do best: create jobs.”

In order to accurately consider these arguments, I think a clear understanding of their theoretical underpinnings is necessary. On that thought I’d like to post the best summaries I’ve found describing the benefits and drawbacks of a fiscal stimulus. And, they happen to be from the same book, Crisis Economics, by Nouriel Roubini, professor at NYU’s Stern School of Business.

On page 160, Roubini describes the rationale for stimulus as first championed by the British economist John Maynard Keynes in the 1930’s;

“…..in an economic downturn, the total demand for goods and services falls far below the supply, triggering unemployment and a drop in production. Writing in the shadow of the Great Depression, Keynes concluded that this cycle, if permitted to go unchecked, could feed on itself. If the crisis got bad enough, the ‘animal spirits’ of the economy would perish, and fearful entrepreneurs and consumers would curtail spending more than was justified by weakened incomes and economic woes. Despite a surplus of desperate workers and idle factories, a vicious cycle of ever falling demand, employment, production, and prices would grip the economy in a deflationary spiral and result in a permanent state of stagnation.
Keynes believed that the economy would not emerge from the doldrums on its own. Only if the government stepped into the breach and directly or indirectly picked up the slack in demand relative to the glut of excess supply and idle supply could the economy stabilize itself, let alone return to prosperity.”

Two pages later Roubini continues by discussing the drawbacks of Keynes’s idea;

“…..a few words of caution are in order. For starters, fiscal policy isn’t a free lunch: if a government increases spending and cuts taxes – and does so during a recession when tax revenues decline – the budget deficit will soar. The government will have to issue more debt, which it will eventually have to pay. If it doesn’t pay the debt, and the deficits grow larger every year, then it will have to entice investors to buy more debt by raising interest rates. Those higher returns will then compete with interest rates on other investments – mortgages, consumer credit, corporate bonds, and auto loans – and can drive up the cost of borrowing for everyone else, thus reducing debt-financed capital spending by firms and consumption spending by households.”

Rather than fuel an ideological divide, Roubini demonstrates that fiscal policy needs to be fluid and tailored to a specific situation. In the US’s case, borrowing is cheap because interest rates on federal treasury bonds are low. Therefore, it’s as good a time as any to upgrade the country’s weathered public infrastructure, not to mention provide jobs for many of the unemployed.

Two questions remain, however. First, can a government afford to prop up demand if a recovery lasts years; at what point will the debt be too much to service in the future? And finally, will public borrowing draw capital away from important private sector projects as gun-shy banks happily move their money to the security of government bonds?