Fri May 18, 2012
Brian Werner
The Stimulus Needs more Stimulus
By Brian Werner, Missouri – November 2010
As we approach the midterm elections, voters are understandably frustrated about the seemingly intractable problem of unemployment and the lack of growth in the economy. The views political candidates are touting in their campaign promises are either we’ll balance the budget now or balance the budget later. The problem is that neither of those options will bring us out of this recession.
Balancing the budget would mean the government would have to collect more in taxes than it spends. More taxes than spending means that money would be sucked out of the private sector. It would be like trying to get a car moving by siphoning out the gas. What we need right now is a substantial increase in spending to stimulate consumer demand.
A recession is a slowdown in economic activity. As a whole we produce fewer goods and services, even though we still have the ability to produce them. Why is this the case?
Businesses function to make a profit and they aren’t going to keep making goods that will sit unsold in warehouses and on store shelves. So what if the local car dealer sees his sales go down and cuts his orders for the next quarter? With fewer orders the auto plant decides not to go through with an expansion and instead cuts a shift, eliminating 1000 workers. Suppliers of tires and other car components are forced to make similar cutbacks. Those unemployed workers don’t have the salary to spend at the department stores and restaurants. When the managers in those stores see sales go down, they might decide to cut back on labor too.
Because business investment pays the wages that workers spend, decisions to cut back in one sector may ripple throughout the entire system. While it makes sense for the individual business to cut costs (often through cutting hours or laying off workers), it can have disastrous consequences when all businesses do the same thing. This same reasoning holds true with savings. It’s good for individual households to save, but if all households save too much, economic activity slows down.
Our ability to make cars hasn’t gone away, but we don’t have the money to buy them. This is what economists call a lack of effective demand. Eventually businesses will invest and hire again, but it’s a slow process that (as we’re seeing) can take years.
How does this relate to the current recession? Contrary to what you hear on the news, the financial crisis wasn’t the primary cause of the recession. Even though we bailed out the big banks and the financial system stabilized, banks haven’t started making loans. That’s because banks make loans for people to buy houses and businesses to invest and expand – activities we aren’t seeing a lot of right now.
The root of the problem was the collapse of the massive housing bubble. Over the last decade or so, housing prices in the U.S. rose at unprecedented rates, a pace that couldn’t be explained by any fundamental forces. People bought houses based on the belief that prices would swiftly rise every year – which they did for some time. The bubble was financed through debt and fed by a huge wave of fraud in mortgage lending. Spending was high (because of debt) even though wages weren’t going up. Foreclosures were extremely low, not because the lenders were doing high-quality underwriting (they weren’t), but because in a rising market, if you can’t pay the mortgage you just sell the house for a profit.
As hidden balloon payments on mortgages kicked in, defaults started to rise. People who were able to sell did so, pushing prices into a downward spiral. This rocked the financial world because most large financial institutions were heavily invested in mortgage debt. Everyone scrambled to sell off their “toxic assets.” Trust and lending dried up because no one knew how much other banks were exposed.
The housing bubble itself had grown to around $8 trillion dollars. When consumers saw the value of their homes and retirement accounts go into free-fall, they cut back on spending, and businesses started laying people off. At the same time housing construction, which had been driving economic activity, plummeted.
The current unemployment rates shows that letting things recover on their own is a slow and painful process. The stimulus package was a step in the right direction, but just a baby step. It did prevent job losses but was way too small to make up for the loss in demand. Unless we take drastic action (a couple hundred billions dollars worth) it will likely be years more until we get back to previous levels of employment.
The fastest way to stimulate demand would be for the government to grant an immediate payroll tax holiday, which would put more money in workers’ pockets and decrease the cost of hiring for businesses. We could also create programs that would pay big returns in the long run. The government could offer a minimum wage job to anyone willing to work. These workers could be used to modernize our deficient energy infrastructure or rebuild road and bridges, investments that would benefit all aspects of the economy for decades to come.
Can we afford it? Yes. Despite how often it is repeated, the federal government is not like a household. The government can always create and spend dollars as needed. Should we worry about inflation? Not right now. Inflation is an issue of too much money chasing too few goods, the exact opposite of the situation we’re in.
Instead, we should worry about those who have lost their jobs or their homes, those who have to get by with cuts in crucial services. There is no economic necessity that says they have to suffer, only bad policy.
The size of the government deficit will not be what hinders our economic success in the future. We’ll be limited by the investments we don’t make now, in our infrastructure and technology, in educating our children, and in providing jobs and skills to our citizens.
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