Sunday, November 14, 2010

Politics! Politics! Politics! Politics! Politics! (Part Two)

In the first part of this series, I talked about one huge economic problem that vexes politicians:  the deficit.  In this second installment, I will discuss a second thorny economic problem:  getting the economy back on track.

Technically, the American economy is no longer in a recession.  The economy is growing.  Yes, it is growing slowly.  However, it is growing.  However, if you asked the nearly 10% of the population that is out of work, they would tell you a different story.  From their point of view, we are still in a recession.  One of the talking points during the past election was that not enough was being done by our government to create jobs.  There was much debate over what the best way to do this would be.  Should we cut taxes, raise taxes, extend unemployment benefits, build bridges, send everybody a check for $1000, or something else?

To figure that out, we have to understand why recessions happen in the first place.  By definition, a recession is a reduction in economic activity:  factories closing, stores shuttering, businesses declaring bankrupcy, and so forth.  Why does this happen?  To understand this, you have to understand the economic concept known as the multiplier effect.

Consider a man who find a $100 bill on the sidewalk.  The man is so happy with his found money that he decides to use it to treat his wife to a nice dinner.  Some of that money goes to the cook, the wait staff, the busboy, the farmer who supplied the food and of course the owner of the restaurant.  The owner is so happy that he had a successful evening that he buys his wife a bouquet of flowers for his wife his way home.  The waiter uses the extra money that he got on tips to treat himself to a latte at the local coffee shop.  The farmer who supplied the food invests his extra money by paying his helper overtime to plant more seeds.  The helper, in turn, uses his extra overtime pay to buy his son a gift from the toy story.  You can imagine that this story continues to multiply until that $100 has rippled through the local economy.  Now imagine this flow of money multiplied thousands and thousands of times from all of the money that changes hands every day.  That, in a nutshell, is the multiplier effect.  It is the effect of a single transaction rippling through the economy.

Now imagine a different story.  Imagine that the man has heard on the cable news channels that banks are failing, companies are going out of business, and people are losing their job.  Now the man find that $100 bill.  The man is lucky to have his job, but because of all of the bad news he keeps hearing about, he decides that he is better off just pocketing the money in case he might need it for a rainy day.  He doesn't take his wife out to dinner.  The owner doesn't buy his wife flowers, and maybe he cuts back on purchases from the local farm.  The farmer doesn't need to plant as many seeds so he cuts back on help.  The helper, in turn, can no longer afford to buy his son toys.  That $100 that the man didn't spend doesn't filter through the economy.  Imagine this story multiplied thousands of times.  Maybe the restaurant goes out of business because everybody is looking to save $100.  Now the wait staff is unemployed.  Now the farmer can't sell as much so he lays off his employees.  And so on, and so forth.

As you can see, recessions are as much about psychology as they are economics.  If people believe that their jobs are in jeopardy, they will stop spending.  If they stop spending, businesses close.  If businesses close, their workers are unemployed.  If people are unemployed, they can't spend money.  It is a vicious negative feedback loop. 

How does cycle get broken?  One way is for the government to intervene.

There are two methods that the government can use to intervene.  First, government has the power to keep interest rates low.  How does this help the economy?  Businesses and individuals who need to borrow money can do so at a lower cost.  A couple looking to buy a home might decide to pull the trigger on their purchase if lower interest rates reduce their monthly payment.  A business looking to modernize its equipment might be more likely to do so if they can get a cheaper loan.  Of course, because of the multiplier effect, any purchase by an individual or business flows through the economy.

The problem is that interest rates are pretty much as low as they can go, and the economy is still sluggish.  This lever has already been pulled, and it won't move any further.

The second way that government can intervene is by spending money.  In effect, they fill the role of the consumers and businesses who are afraid to spend money on their own.  However, in order for this spending to have any effect on the economy, it has to be spent in a way that multiplies the effect as much as possible.  If they just give away $100 to the person who is just going to stick it in their wallet and not spend it, it doesn't have much effect on the economy at all.  On the other hand, if they spend it in a way that will cause the recipient to spend the money, then it will have more of an effect.

Here are a couple of ways in which the government can spend money:

Enhanced Unemployment Benefits:  On the one hand, there is a good chance that unemployment benefits are going to be spent.  If you are out of work, your unemployment check may be your only source of income.  Therefore, you will spend it on the necessities:  food, clothing, shelter.  You aren't in a position to save that money, since given the choice between saving and starving or spending and eating, most people would choose the second option.  This seems like a good way to make sure that the money ripples through the economy.  However, the better the unemployment benefits, the less likely somebody is to actually look for a job.  Why work when somebody is paying you not to?

Tax Cuts/Stimulus Checks:  Tax cuts and stimulus checks amount to the same thing.  Basically, the government is handing out found money to all taxpayers.  This only helps the economy if people are spending the money.  If people are just pocketing the found money and not spending it, it does little good.  Generally speaking, if you are poor, you might be more likely to spend it, since it could make the difference between eating or not eating (see above).  If your basic needs are being met, you might just save the money.

Capital Projects:  This includes spending money to build bridges, fix roads, and the like.  The good thing about this is that it guarantees that the money is going to be spent.  Building a bridge requires hiring construction workers, buying lots and lots of steel and concrete, and so forth.  Also, once the money is spent, we have something tangible to show for it.  The downside is that you can't just write a check and, poof, a bridge appears.  This type of project takes time, so the money might not flow through the economy right away.

These are just a few options for how the government can spend money to stimulate the economy.  The problem with all of them is that they are incompatible with the goal of cutting the deficit.  The money has to come from somewhere.  Most likely, it will have to be borrowed.  On the other hand, it is likely that if the economy does improve because of this spending, it will lead to more people working and thus more people able to pay taxes.  Therefore, one can think of it as an investment in the future. 

Of course, politicians will have to weight the short term effect of a stimulus on the deficit versus its longer term effect on the overall economy.  Given the fact that many members of Congress were elected by campaigning to be more "fiscally responsible", it seems possible that any additional spending will be frowned upon.  It will be interesting to see how our elected officials balance their desire to balance the budget with the impact this might have on the ability to stimulate the economy. 

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