3.3.8.2 Responding to the Economic Cycle with a Stimulus

(This is a current page, from the Patterns of Power Edition 3 book contents.  An archived copy of this page is held at http://www.patternsofpower.org/edition03/3382.htm)

There is an economic cycle – a tendency for economies to fluctuate between periods of higher and lower growth – which is partly a global phenomenon.  A prudent government would be able to reduce its debt in good years, when there is high GDP growth, but it might have to borrow at low points in the economic cycle when growth slows down.

Recessions, defined as two successive quarters of negative growth, cause unemployment and its consequences: personal hardship and wasted productive capacity.  Governments can mitigate these effects, either by increasing spending or by cutting taxes, in a so-called ‘Keynesian stimulus’.

Keynes argued that government spending is worth more than its face value because the amount spent is itself an increase in GDP, but the people employed on these programmes are then able to spend more as individuals elsewhere in the economy – so the total GDP rises by more than the nominal value of the increased government spend, with what is called the “multiplier” effect.[1]

As an example of applying a Keynesian stimulus, Barack Obama initiated an increase in government spending on infrastructure in December 2008.  A New York Times article on 22 Feb 2014, entitled What the stimulus accomplished, claimed that “It raised the nation’s economic output by 2 to 3 percent from 2009 to 2011”.

There are potential drawbacks:

  • It is difficult to apply such stimuli quickly enough. When launching a road-building programme, for example, it takes time to obtain and adjudicate bids for the work.
  • When approving stimulus spending, individual politicians may demand tactical measures to benefit their own constituencies –without regard to the broader economic impact (3.3.7.1). It was alleged that this happened with President Obama’s stimulus package.[2]
  • Like all government spending, it ultimately has to be paid for by taxation; a stimulus requires increased borrowing in the short term.
  • A spending stimulus should be judged on whether it delivers benefit to society as a whole, which depends upon whether there would have been any more beneficial way of using the economy’s capacity.[3]

If the stimulus spending is merely bringing forward government expenditure which would have been necessary in later years it can have a counter-cyclical effect, smoothing the fluctuations in the economic cycle, without contributing to a structural deficit.

An alternative form of stimulus is to cut taxes, so that consumers have more money to spend, but this also increases the need for borrowing in the short term.

Government spending (unlike household spending) can be allowed to increase if it is taking up spare capacity.  If a stimulus avoids job losses it results in higher tax revenues, so it reduces the fiscal deficit.  Many people, and some governments, don’t realise that austerity hurts growth and increases the fiscal deficit.[4]

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[1] Samuelson and Nordhaus describe the multiplier in Economics, chap.  24, p.453.

[2] In his book Fault Lines, Raghuram C. Rajan pointed out the risk of stimulus spending being hijacked for tactical political manipulation, citing the example of $6.5 billion being approved for cancer research – which is not the most effective way of creating jobs (p.  99).

He had taken this example from Elizabeth Drew’s article Thirty Days of Barack Obama which appeared in the New York Review of Books on 26 March 2009 and which was available in April 2018 at www.nybooks.com/articles/22450.  The senator who had demanded the funding for cancer research was Arlen Specter, who had cancer himself.

[3] Frédéric Bastiat, in an essay What Is Seen and What Is Not Seen, refuted the argument that breaking a window is economically beneficial by creating work for glazier: it just diverts the owner’s money away from something else that might have been more beneficial.  The article was available in April 2018 at http://www.econlib.org/library/Bastiat/basEss1.html.

[4] Some governments tried to reduce their debts after the economic crisis in 2007-8 by imposing austerity, but they may have been following bad economic advice.  Debt is caused by low economic growth, not the other way round, as recent studies have made clear; for example, on 30 May 2013 Mark Gongloff wrote an article entitled Reinhart And Rogoff’s Pro-Austerity Research Now Even More Thoroughly Debunked By Studies, which was available in April 2018 at http://www.huffingtonpost.com/2013/05/30/reinhart-rogoff-debunked_n_3361299.html.

Politicians may have been genuinely misled by bad advice, or they may have been capitalising on the public’s economic ignorance in order to achieve their own political ends by imposing austerity – as was alleged by Ha-Joon Chang, when he wrote that Britain’s “spending cuts are not about deficits but about rolling back the welfare state” in an article entitled Britain: a nation in decay, which was published 0n 8 March 2013; it was available in April 2018 at http://www.theguardian.com/commentisfree/2013/mar/08/britain-economy-long-term-fix.

As Paul Krugman pointed out on 13 August 2013, in an article entitled What People (Don’t) Know About The Deficit, Americans seem to be unaware of President Obama’s success in reducing the US deficit by applying a large financial stimulus.  The annual deficit was then below its pre-crisis level.  This article was available in April 2018 at http://krugman.blogs.nytimes.com/2013/08/13/what-people-dont-know-about-the-deficit/.