February 11, 2009
As the nation debates – to stimulate or not – we can learn from economic history, and the history of economic ideas.
In the 1930s during the Great Depression as the average citizen on the Main Street suffered from the speculative excesses in Wall Street, the academic economists was at a loss in trying to explain the nature of the crisis, and offer solutions. Economists did not understand the workings of the business cycle well enough.
The conventional wisdom based on a theory called “Say’s Law,” held that supply creates its own demand. In other words, the economy should not experience overproduction, where inventories pile up because of insufficient demand. This view sometimes called the Classical model held that temporary disruptions in demand may exist but eventually the economy returns to a state of full-employment, a happy state. The existing model had no solution to offer in jumpstarting the moribund economy.
From across the Atlantic, the distinguished British economist, John Maynard Keynes, a Cambridge University professor, a high level government servant, and an author par excellence eventually came with a few breakthrough ideas on rebooting a sick economy. In his book, The General Theory of Income, Employment and Money, published in 1936, Keynes persuasively made the case for immediate government intervention to reenergize the economy in a recession. He dismissed the mantra of an eventually self-correcting economy. “(The) Long run is a misleading guide to current affairs. In the long run we are all dead.”
Keynes built a new model of the economy that could explain economic slowdowns, and offered fresh solutions. According to the new model, once derailed the economy often fails to return to a state of full-employment on its own due to the built in inefficiencies such as sticky wages and prices. Psychology plays an important role in the decision of entrepreneurs and businesses to invest or not, he argued. Keynes argued that insufficient demand often plagues the economy, and the solution is to increase demand through a combination of expansionary monetary and fiscal policies.
Fiscal policies to stimulate the economy could be increased government spending financed by borrowing from the public or the Central Bank, and/or a tax reduction that will also result in a budget deficit. Keynes believed that direct government spending was the most effective stimulus, since it is spent directly whereas a tax break can result in higher saving. With interest rates at historically low levels, increasing liquidity and cutting interest rates typically are not effective during a deep recession. He coined the term “liquidity trap” to describe the situation as we have today when monetary tools lose their potency. Derided as a socialist, Keynes believed that he was prescribing a solution to manage business cycles and strengthen capitalism.
Today, in America we face a ferocious economic retrenchment. The statistics are not in dispute. The U.S. economy is in a free fall shedding 598,000 jobs in just one month, January 2009. The national unemployment rate is a record 7.6%, one of the highest in the past three decades. Drilling down we find the unemployment rate to be 12% for African Americans, and a whopping 21% for the young people just entering the labor force. A distressing 15 % of the unemployed have a college degree. What a waste of precious national resources, and what a tragedy for those impacted.
The total economic pie or the Gross Domestic Product contracted a stunning 3.8% in the 4th quarter of 2008. Warren Buffet, the world’s most famous investor recently described the situation as “an economic Pearl Harbor.”
What happened? How did we get here? This current economic malaise originated in the collapse of a massive housing bubble; the subsequent meltdown in the bloated financial sector, the resulting freezing of the credit markets. The cumulative impact of greed and excesses in Wall Street was a delayed deleterious impact on the Main Street. Pretty soon, despite a massive bailout of the banks, the economy was fast spinning out of control.
The crisis in the US economy quickly spread throughout the global economy, infecting one nation after another. One has to go all the way back to 1930s to find a crisis of similar depth and dimensions; the Great Depression was also caused by the collapse of an overly extended economy and stock market from excessive destabilizing speculation that eventually spread to shutter down thousands of banks sending the economy into a tailspin.
The billion dollar question is, should we wait for the economy to self-correct, or should we urgently act prudently? If our economic decline continues at this pace, unemployment rate could be at double digits by summer of 2009. For a $14.3 trillion economy, each month the economy is hemorrhaging, the potential income lost is roughly $46,000,000,000 and $550 billion annually.
Fortunately, this does not have to be the case. It is unnecessary that the American workers and businesses suffer through years of a painful recession that will further erode our competitive position in the global economy. Most economists agree on what ails the economy and time tested remedies are available. A stimulus in the form of a combination of direct government expenditure and tax cuts should jolt the economy back to path to full recovery. Like bitter medicine given to a sick patient, for the stimulus to work may take some time, and there may be some unpleasant side effects, but it should work.
Senator McCain said, “This is not a stimulus bill; it is a spending bill.” By definition, a stimulus package is also a spending package. It is meant to be. In a famous passage, Keynes used a metaphor to make a point – suppose the government would use its resources to have workers dig ditches and then fill these up, even though wasteful this stimulus would help the sagging economy through a process of spending and re-spending called the fiscal multiplier. Just imagine if the end product is a lasting improvement in our physical and digital infrastructure and in our schools and the education of the young – these are not consumption or wasteful expenditures, they are an investment in the future of the nation.
Yes, it is the entrepreneurs and the small businesses whose ingenuity and hard work create most of the jobs, but even the entrepreneur needs help such as a healthy banking system, availability of credit, and customer confidence. Both the House and the Senate versions of the Stimulus bill include payroll tax cuts for consumers to have higher disposable income to spend.
Tax cuts are seldom a cure-all for a slowing economy. consider the $168 billion Bush tax rebate introduced in February 2008 as part of the $300 billion Bush stimulus package. Its impact was minimal. Most economists believe that tax cuts have a smaller bang for the buck due to our propensity to save a chunk of the tax check. Further, the supply side benefits of a tax cut popularized by A. Laffer have been found to be wanting.
Jesse H. Jones, the legendary Houston banker appointed as the Federal Loan Administrator by President Roosevelt, wrote, “Old and deliberate methods, dear to many, were necessarily brushed aside in order the people may have food, clothing and shelter, and that their homes and savings may not be taken from them. Fighting a depression is no different than from fighting a war. In either case the entire resources of a nation must be used in necessary.”
There is a clear and present danger that the nation’s economy could get much worse. By supporting a bold stimulus package in a bipartisan way, our representatives in Washington have an opportunity to send a strong message to the rest of the world that America is united not only to defeat terrorism, but united also in bridging our ideological differences to rebuild a strong economy.
Munir Quddus is a Professor of Economics and Dean of the Business School at Prairie View A&M University, Texas. He writes on the history of economic ideas. He can be reached at e-mail: email@example.com.