(The latest version of this page is at Pattern Descriptions. An archived copy of this page is held at https://www.patternsofpower.org/edition02/3382.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 due to a multiplier effect because people who are employed can spend more and fuel economic growth.[1] As an example of applying a Keynesian stimulus, Barack Obama pledged an increase in government spending on infrastructure in December 2008,[2] but there are potential drawbacks:
· It is difficult to apply such stimuli quickly enough it was thought that less than half his road programme would feed into the economy within 4 years.[3] More than 4 years have now elapsed, so results should be visible but there are other factors which need to be taken into account; the US economy recovered better than the UK, which had cut government spending in an 'austerity' programme, but the US also benefited from less exposure to the European recession and a more aggressive easing of credit.[4]
· 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.[5]
· Like all government spending, it ultimately has to be paid for by taxation which is a drag on the rest of the economy (3.2.4.6); 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,[6] which depends upon whether there would have been any more beneficial way of using the economys capacity.
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.
If a stimulus avoids job losses and wasted capacity, it can soon result in higher tax revenues so it reduces the deficit. This is counter-intuitive: people might think that the deficit would be increased by cutting rates of tax or by increasing government spending but, unlike household budgets, national budgets are elastic when the economic capacity of the country is being under-used. Austerity hurts growth and increases the fiscal deficit.[7]
© PatternsofPower.org, 2014
[1] The use of government spending programmes as a stimulus is quantitatively very effective due to the 'Keynesian multiplier': 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. Samuelson and Nordhaus describe the multiplier in Economics, chap. 24, p.453.
Although the concept may seem counterintuitive, it should be remembered that each wealth creation activity results in money being available for consumers to spend and that creates demand for other wealth creation activities (after a time delay). The application of the theory is assuming that there is unemployed labour in the economy and that the effect of the stimulus is to put this labour to productive use. The additional wealth is not the effect of magic but of making use of unemployed labour to create wealth that otherwise would not have been produced not only for those directly involved in the stimulus activity but also those who benefit from the increased consumer demand. The stimulus will only work if there is sufficient unemployed labour in the economy. Otherwise it will merely displace other wealth creation activities. When looking at the model of the economy (3.1.2) one can also see that there will be an increase in imports, in savings, and in tax receipts as a result of the additional wealth creation activity.
[2] As reported, for example, on Bloomberg available in April 2014 at http://www.bloomberg.com/apps/news?pid=20601070&refer=home&sid=ao_8cZPMC0cE.
[3] An article Much in Obama stimulus bill won't hit economy soon by Andrew Johnson (AP) was widely published, as in the Chicago Sun-Times for example on 20 Jan 2009. It quoted the Congressional Budget Office:
Less than half of the $30 billion in highway construction funds detailed by House Democrats would be released into the economy over the next four years, concludes the analysis by the Congressional Budget Office. Less than $4 billion in highway construction money would reach the economy by September 2010.
A copy of the article was available in April 2014 at http://gregmankiw.blogspot.co.uk/2009/01/long-lags-of-fiscal-policy.html.
[4] On 14 November 2012, the Financial Times published an article entitled Why is the UK recovery weaker than the US?, which was available in April 2014 at http://blogs.ft.com/gavyndavies/2012/11/14/why-is-the-uk-recovery-weaker-than-the-us/. The article referred to a detailed study of the output gap of 4.8 per cent of GDP between the UK and the US which had concluded that "fiscal consolidation" (i.e. cutting government spending) accounted for about half the difference in performance between the UK and the US, in recovering from the recession in 2007-8.
[5] 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 Barrack Obama which appeared in the New York Review of Books on 26 March 2009 and which was available in April 2014 at www.nybooks.com/articles/22450. The senator who had demanded the funding for cancer research was Arlen Specter, who had cancer himself.
[6] For example, recovery from the Japanese earthquake in March 2011 could not sensibly be seen as economically beneficial as had been suggested because it inflicted damage on the population and reduced Japans economic capacity. Russ Roberts made this point on the Cafe Hayek blog on 11 March 2011, in a posting entitled I dont understand the logic, which was available in April 2014 at http://cafehayek.com/2011/03/i-dont-understand-the-logic.html.
He referenced Frédéric Bastiats essay What Is Seen and What Is Not Seen, which refuted the argument that breaking a window is economically beneficial by creating work for glaziers (it just diverts the owners money away from something else that might have been more beneficial).
[7] 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 2014 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 Britains 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 2014 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 (Dont) 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 2014 at http://krugman.blogs.nytimes.com/2013/08/13/what-people-dont-know-about-the-deficit/.