188.8.131.52 Stimulating the Economy To Avoid Recession
Governments can smooth out the effects of the economic cycle by stimulating the economy to avoid recession, and then cooling it down later
There is an economic cycle – a tendency for economies to fluctuate between periods of higher and lower growth – which is partly a global phenomenon. 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 by intervening to speed up the economy when necessary, by using fiscal policy – increasing their spending or cutting taxes.
John Maynard Keynes helped to end the Great Depression in the 1930s by using fiscal policy: increasing spend as a stimulus and then paying back the resulting debt later by increased taxation. As described above (184.108.40.206), a prudent government could 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.
A Keynesian spend stimulus is a temporary increase in government spending which affects the economy in various ways:
● 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. For example, Barack Obama initiated an increase in government spending 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”.
● As described earlier (220.127.116.11), government investments in infrastructure or research can deliver future benefits, in increased productivity, but it is difficult to launch them quickly: it takes time to obtain and adjudicate bids for a road-building programme, for example,
● Increased government spending can make use of spare economic capacity – keeping people in work – if no other work is available.
● Keynes argued that government spending stimulates the economy by more than its face value: 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).
An alternative form of stimulus is to cut taxes, so that consumers have more money to spend:
● Tax cuts reduce a government’s tax revenue in the short term, but they might subsequently pay for themselves if they generate enough growth. Ronald Reagan’s tax cuts broadly met that test, at least initially, but Donald Trump’s “law paid for about a fifth of itself, according to an estimate from the Congressional Budget Office” according to Bloomberg.
● Tax cuts are only an appropriate stimulus in certain circumstances. When new Prime Minister Liz Truss and her new chancellor Kwasi Kwarteng introduced a ‘mini-budget’ in September 2022, they did not have the advantage of having a strong currency. As The Economist explained, Liz Truss’s selective Reaganomics won’t work.
● A tax cut is a more effective stimulus to the economy if the benefits go to the people who spend the extra money immediately – the middle class and the poor – rather than to the rich, who might just save the money or speculate with it. With Donald Trump’s tax cuts, though: “according to figures from the Joint Committee on Taxation, most of the benefits will go to the rich. Reagan’s reform did the opposite” according to The Economist. The British tax cuts referred to above also favoured the rich.
Both these ways of stimulating the economy to avoid recession are temporary fixes. Governments must rein in their routine spending to avoid having a structural deficit, as described above (18.104.22.168), and tax cuts usually need to be reversed later to stabilise the economy – as was the case in America: “By 1993 Congress had raised taxes by almost as much as it had cut them in 1981”, as reported by The Economist. Economic stability depends upon a government normally raising enough in taxation to meet its spending commitments, and it must pay back any debts that it has incurred when applying a stimulus.
Governments sometimes make recessions worse, for political reasons, by imposing 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 in 2015, against the advice of the IMF among others – as reviewed in a blog post on this website: Greeks Need Relief, not Grexit.
Such actions can inflict irrecoverable damage to the economy, permanently losing some otherwise viable businesses and losing people from the workforce if they find it difficult to return after they have been unemployed for a long time.
This page is intended to form part of Edition 4 of the Patterns of Power series of books. An archived copy of it is held at https://www.patternsofpower.org/edition04/3382b.htm