March 23, 2009
With an eye popping 333-0 vote, with none of the Republicans in Congress voting in favor, the American Recovery and Reinvestment Act, aka the Stimulus Package, designed to jumpstart the rapidly fading US economy, was signed by President Obama on February 17, 2009. Is this a good bill that will help create, as the new administration believes, millions of jobs and help re-energize the economy? Or is this the latest example of pork laden bill passed by politicians, on the back of the taxpayer, to achieve their narrow ambitions? A few lessons from economic history may help us answer these questions.
In the 1930s during the Great Depression as the average citizen on the Main Street suffered from the extreme hangover in Wall Street from the decade long speculative binge, economists were at a loss in explaining the cause of the crisis, and in offering solutions to officials. In 1930s, economists did not understand the workings of the business cycle well enough. The existing models of the economy predicted that a prolonged and deep recession from overproduction cannot happen.
The conventional wisdom based on a hundred year old theory called “Say’s Law,” preached that supply creates its own demand. In other words, during the process of production, the economy creates enough income to support the necessary demand to buy the newly produced goods and services. As a result, the economy would not experience a state of generalized overproduction from excessive savings – something that would lead to inventories to pile up and firms to cut back on production. This view called the Classical model held that the economy may be derailed by temporary disruptions to demand, but the resilient economy eventually returns to a happy state of full-employment. These widely used equilibrium models offered no real solutions for a moribund economy afflicted by a prolonged recession. The model recommended no interventions since the economy is always expected to rebound on its own.
From across the Atlantic, the distinguished British economist, John Maynard Keynes, a Cambridge University professor and a high level government servant eventually solved the puzzle and presented breakthrough ideas on dealing with a recession in his 1936 book, The General Theory of Income, Employment and Money. 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 that needed no intervention. He wrote, “(The) Long run is a misleading guide to current affairs. In the long run we are all dead.”
The Keynesian model of the economy could explain economic slowdowns, and offered fresh solutions on how to recover from recessions. According to Keynes, the slowdown is usually caused by insufficient demand in the economy from an external shock or consumers and producers stepping back from spending. Further, once derailed, the economy often fails to automatically return to full-employment due to inefficiencies such as sticky wages and prices that are built into the economy. Additionally, psychology (animal spirits) plays an important role in the decision of entrepreneurs and businesses to invest or not, he argued. Keynes noted that insufficient demand often plagues the economy, and prescribed as solution, increased demand through a combination of expansionary monetary (credit, interest rate) and fiscal (tax and spending) policies.
Among the policy options, monetary policy has a few advantages. It can be implemented rapidly since interest rate decisions are made by the Federal Reserve Bank and not the Congress; second, changes in credit and liquidity work through the private economy. Unfortunately, at times monetary policy is not a good option. For example, if interest rates are driven to very low levels, as is the case today, investors expect interest rates to rebound and bond prices to fall, and therefore they shun bonds. This scenario is aptly described as a “liquidity trap” since in this situation monetary policy loses its potency. With the Fed’s arsenal exhausted, the only effective policy option available to the state to deal with a recession is to stimulate demand by either cutting taxes or increasing spending, or use a combination.
The economy can be re-invigorated through increased government spending financed by borrowing from the public or the Central Bank, and/or a tax reduction that will also reduced revenues and result in a budget deficit. Keynes showed that direct government spending was the most effective (fiscal) stimulus, since all of it is spent, whereas a tax cut increases disposable income a portion of which is used saved. This “leakage” from the spending stream results in a smaller bang for the buck (tax multiplier is smaller than the spending multiplier).
With interest rates at historically low levels today, increasing liquidity and cutting interest rates will not be effective in lifting the economy. The frozen credit markets make it even more difficult to depend on monetary policy as an anti-recessionary strategy. This leaves a tax cut (favored by the Republicans) or an increase in spending as the only viable options. President Obama’s advisors believed that the spending can be used more rapidly and targeted to achieve some of the goals on the President’s agenda. However, nodding to the Republican attachment to tax cuts, a rather large tax cut for the low-income households in the Stimulus Package was included to the initial version. Unfortunately, this failed to sway the Republicans. Most of them argued for a tax cut only, largely ignoring that President Bush had implemented a hefty tax cut only stimulus in early 2008, without much success. Others argued, incorrectly, that doing nothing would be better than a flawed intervention. However, most economists agree that even though there are some risks in government stimulus, given the fast deteriorating state of the economy, the positives far outweigh the negatives.
Munir Quddus is a Professor of Economics and Dean of the Business School at Prairie View A&M University, Texas. He writes on economics and related subjects. He can be reached at