The Closet Moderate: Fiscal stimulus for dummies

Saturday, January 24, 2009

Fiscal stimulus for dummies

I wrote this to explain the reasoning behind deficit-funded fiscal stimulus to my teenage cousin, but I felt it might be of interest to the general public as well. I'm condensing a long-raging debate in an area that is pretty far afield of my modest expertise, so reader beware:

To be fairly reductionist about it, the reason for doing deficit-funded stimulus spending is that economic crises can create vicious cycles that, left on their own, get worse and worse. There are all sorts of rules that people follow that make sense in normal times, but which can really backfire in a crisis when everyone tries to do them at once.

A classic example of this is a deflationary spiral. Something scary happens that makes people less willing to buy stuff; frequently, this is because a lot of people become a lot poorer because the price of houses or stocks drop suddenly. Firms react to this lower demand by some combination of cutting prices and making less stuff. If a firm cuts prices, it also needs to cut wages in order to make a profit, and its hard to quickly cut wages both for legal reasons (you may have a contract with a fixed wage) and for morale reasons (people don't like pay cuts). So firms end up firing a bunch of people. If a firm makes less stuff, it needs fewer people to make things and so it fires a bunch of people. Either way, people are now less employed, and thus less willing to buy things. So firms react to this yet-lower demand by some combination of cutting prices and making less stuff. And so on and so forth, until we aren't making anything and we all starve to death.

A fiscal stimulus can help a situation like this by either directly giving people more money so they don't stop spending in the first place, or by providing the people who get fired with jobs to try to keep the problem from spiraling. This may increase our deficit in the short run, but in the long run our deficit would end up being much worse if everyone was unemployed.

Another way to think about it is that people, both individually and in aggregate, like consuming stuff pretty evenly over time. Most people would prefer a life consisting of 70 years of reasonable comfort to 35 years of extravagance combined with 35 years of poverty; this is why people borrow and save. So when someone loses their job, they don't immediately start eating dogfood: instead, they spend some of their savings, or if they don't have any savings, they borrow. Typically, in a time of recession, the government encourages people to borrow by making it easier for banks to lend; this is monetary stimulus, and since the Depression its been the main way the government deals with recessions. However, right now the government has done about all it can to encourage banks to lend, but the banks still don't appear to be lending. So then the government essentially borrows a bunch of money on everyone's behalf.

At any rate, my personal views are that something does need to be done by the government, and the government is reasonably good at borrowing money and spending money and changing tax rates as compared to some of the more zany suggestions out there. The deficit is a problem that needs to be dealt with, but it'll be a lot harder to deal with if the economy stops growing for ten years.


Silent Cal said...

The Economist has been pushing for creation of a "bad bank," like Sweden did in the 90s, that is, a new entity chartered by Congress to take all the non-performing loans and other bad shit that banks have. If this happened, banks certainly would lend again, because they wouldn't be worried about saving money to make up for all the bad loans they'd made.

Moral hazard? Yes. Swedish welfare-state? Yes. But, as you say, the good rules go out the window when you're trying to avoid a depression.

shmuel421 said...

Thanks for this explanation! I'm going to use it to explain deficit spending to my 11th grade U.S. History class tomorrow...