In my last post I explained that an unhealthy economy essentially means that for whatever reason there is not enough money circulating around; either people do not have the money or they are not spending it. In this two-part post I want to examine the two most common responses governments and central banks have to the problem of an unhealthy economy, stimulus and austerity.
Stimulus is pretty straightforward and really only has one purpose, to get the economy moving again. Each stimulus package is different but the general idea behind them all is to inject more cash into the economy. Remember that an unhealthy economy is one with too little cash in circulation. When a patient is low on blood they are given extra in the form of a blood transfusion; a stimulus is a cash transfusion and the patient is the national economy. Scholarships and small business loans are essentially personal stimulus packages. You need money in order to make a greater amount of money in the future so you get a scholarship, to go to college, to get a good job, to make the money; or you get a loan, to start a business, to make the money.
The most basic stimulus package takes the from of, the government greatly increasing the amount of money it is spending. Perhaps the most famous stimulus package was FDR’s New Deal. The New Deal did many things including create social security but what concerns us is how it worked as a stimulus package. Under the New Deal, the federal government spent massive amounts of money in a short period of time on huge infrastructure projects such as highways, bridges, dams, and power grids. These are all useful things and we reap the benefit of them still today but they were not considered necessary at the time they were simply things for the government to spend money on in order to stimulate the economy.
The way it worked was that the government awarded massive contracts to construction companies who then took that money and hired armies of previously unemployed men to build these things. This raised those men and their families out of poverty (at least by the standards of the time) and in doing so, gave them purchasing power. They were then able to buy goods such as shoes. The shoe store would then need to hire more employees and purchase more shoes from the factory to keep up with demand. The factory would hire more employees and purchase more leather from the leather company which would in turn hire more employees. A perfect stimulus package would be the exact reversal of the vicious spiral of layoffs and closures that an ailing economy goes through. However, no stimulus is perfect.
Things did get better after the New Deal but the economy was still in pretty bad shape and by 1937, several years into the new deal, unemployment reached 19%. Eventually the economy did recover but the New Deal had some help; the US entered the second world war and Prohibition was repealed. The alcohol industry was huge just 15 years before and so the infrastructure was still in place for massive production, sales, and distribution as soon as Prohibition ended; the industry just had to hire the people to do it.
During WWII, the ranks of the military grew by the millions. These men were now employed and those who had been employed before left behind open jobs to be filled by someone else. The war had another effect; it created massive demand for both equipment and for the development of new technologies, both of which the government paid handsomely for. The point is that even if the New Deal itself did not get America out of the Great Depression; the repeal of Prohibition, the second world war, and other similar things were themselves stimuli. They were not purpose built to get the economy moving again like the New Deal was but they worked in the exact same way; they injected more cash into the economy and it got other cash circulating.
Stimulus packages sound great but they have one flaw; the money has to come from somewhere. There are three possible places where the government can get the money for a stimulus; thin air, loans, and taxes. Governments can print more money out of thin air and this is occasionally used as a stimulus. This is the quickest way for the government to devalue its currency and so printing money out of thin air is almost always a bad idea. This is because the currency becomes so devalued, inflation rates go so high, that the next time the bills are due the value of the currency that the government is holding is simply not enough. They are often forced to print more currency to cover the costs of basic services which then causes even more inflation. By this point another vicious cycle has begun. Loans and taxes never sounded so good.
Loans are probably the most common way for governments to finance stimulus packages. The idea being that loans inject cash immediately and defer payment until after the stimulus has had its effect, growing the economy and leading to higher tax revenues. The government takes out a loan which it can’t really afford now (because the economy is in the tank and tax revenue is low), expecting to be able to pay it off later (after the same loan has stimulated the economy and lead to higher tax revenues). This sounds risky but it is the exact same thing as student loans; an 18 year old high school senior can’t have any hope of paying off a $70,000 dollar loan but a 22 year old engineer can expect to pay it off in just a few years. The risk of course is that the economy may not pick up enough to raise the tax revenue to pay off the loans. Another risk with loans is that the credit rating agency may determine that the risk of the government not being able to pay off its loans is significant enough to lower their credit rating. This would cause the interest rates on those loans to go up and thus make it more difficult for the government to make the payments. In this way changing a government’s credit score can be a self fulfilling prophecy; there is a chance they will not be able to make the payments, therefore the interest rate is higher, therefore they cannot make the payments. Taxes never sounded so good.
Taxes are the final way that a government can finance a stimulus package. Taxes are always unpopular unless someone else is paying them. They are especially unpopular when the economy is down and people are already struggling financially. For this reason raising taxes is not a very common method for financing and stimulus package. That is not to say that it is not a viable option; remember the stimulus that was World War II? It was financed by a combination of loans (in the form of war bonds) and taxes. During the war taxes were extremely high, the top personal income tax bracket was 94%! Such high taxes have two effects; first the government takes that cash and spends it, second those wealthy individuals who want to preserve their personal fortune do so by reinvesting money in their companies rather than taking it out as personal income. Both effects mean more cash is circulating in the economy. Despite the fact that taxes can work and that they lack the risks associated with loans, their general unpopularity and the fact that governments can often borrow more than they can tax means they are seldom used for financing stimulus packages.
So a healthy economy is one in which lots of cash is circulating and stimulus packages in all their various forms can have that effect. However, stimulus comes with the risks of the government losing its credit rating, defaulting on its loans, and runaway inflation. In my next post I’ll look at the alternative, austerity and compare it with stimulus.