3.3.8.2 Responding to the Economic Cycle with a Stimulus

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.  The total GDP therefore rises by more than the nominal value of the increased government spend, with what is called the “multiplier” effect – as described by Samuelson and Nordhaus in chapter 24 of Economics (p. 943).

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, 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).  Raghuram C. Rajan, in his book Fault Lines, suggested that part of President Obama’s stimulus spending was misallocated for tactical political reasons:

“As an example of more egregiously directed spending, $6.5 billion was approved for cancer research to appease a particular senator [Arlen Specter, who had cancer himself]. Cancer research is unlikely to create many jobs in the short term…” [p. 98]

  • A stimulus requires increased borrowing in the short term and, like all government spending, it ultimately has to be paid for by taxation. A successful stimulus might pay for itself, though, by increasing the government’s tax revenue.
  • It should be judged on whether it delivers benefit to society as a whole, which depends upon whether there would have been any better way of using the economy’s 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 reduces a government’s tax revenue in the short term.  If it generates enough growth, though, it might subsequently pay for itself.

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.  A policy of austerity does the opposite if it involves cutting government spend when there is spare capacity in the economy: it reduces growth and increases the fiscal deficit.  Nonetheless, politicians imposed austerity – even when it was inappropriate:

  • Ha-Joon Chang’s article in March 2013, Britain: a nation in decay, suggested that Britain’s “spending cuts are not about deficits but about rolling back the welfare state”.
  • Austerity was imposed on Greece during the Eurozone crisis, against the advice of the IMF among others – as reviewed in a blog post on this website: Greeks Need Relief, not Grexit.

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