Since the stimulus package passed last night, there needs to be some time for everyone to understand the particular economics behind this. As NetRightNation has pointed out this has been pointed out rightly that it is full of pork. This is logical from the politicians because they are trying to win votes. If their constituents feel as if they are not being taken care of during this time of crisis they will surely be voted out. Most non-Economist do not completely understand every aspect of this plan but they feel it is wrong. So what is the “fiscal stimulus” and what are the theories and counter theories in Economics about it?
This of course starts with our good friend John Maynard Keynes. Keynes worked on a way for us to get out of recessions with government in mind. He worked on a concept called “the marginal propensity to consume.” It was hard to find a chart but above is the consumption and income for 1935-36. As you can see consumption is very close to income. The marginal propensity to consume is how much a person will spend if you give them a dollar. If it is .9 then they will spend 90 cents on the dollar. So for simplistic terms this means that it is a multiplier and important to note for injecting money into an economy. The basic idea is that the increase of government spending on the economy will multiply rising people’s incomes throughout the economy, which will make the initial demand boost. The Keynesian economist (KE) says that it is the loss in demand that has caused the recession. The KE would also believe that businesses would have a coordination problem and they need government to ensure demand will always be there so they can invest. So what is the solution? The government.
Basically, Milton Friedman and other monetarist came along and believed that this was wrong and that in fact you must use monetary policy to shift the aggregate demand, which is everyone’s demand added together. This includes interest rates and the monetary base. So now we have two schools of thought basically arguing over how to increase demand.
So what are the problems with these? First, the problem is even if we assume this can work, there is a huge lag. As in the economy is already in recovery by the time the fiscal stimulus effects everyone, government will not get data that we are out of the recession until a couple of months after the fact. This is why monetary policy is preferred until recently. It is much quicker and requires no legislation. Second, if people expect the tax cuts to only be temporary they will not respond in the way that they would if the tax cut was permanent. The expiration of the Bush tax cuts could be a culprit to the current crisis. The third problem, is called crowding out. This is when we increase fiscal debt which leads to higher interest rates. That will then lower the demand in the private sector and then these would counteract each other. This is why adjusting the interest rate has been the governments favor plan. Of course, if you will notice then interest rate is the lowest it has ever been and loans aren’t coming out. This is because the central bank cannot control the real rate of interest.
What is the real solution then? First, we must eliminate the capital gains tax for good. This is important to make permanent as I mention the lag problem before. We also must deregulate banks and allow them to invest in more than just small business loans and mortgages. Whenever someone invests into the stock market, one of the first tips you will hear is diversify. We do it but we do not allow banks to do it. The Federal Reserve must work on targeting inflation and not creating it. There will be a downward pressure on prices but this will be due to a readjustment period and not because people are burning their money. We should adopt a balance budget. This will not happen over night but it will ensure prosperity for the future of America. We reduce spending and extend the Bush tax cuts. These all will allow for more investment. We do not need to be obsessed with Americans spending money. If they take their extra earnings from these tax cuts and elimination of the capital gain tax then we will encourage investments. This will allow for these bad assets to be bought up.