Fiscal stimulus in ancient Greece
There is nothing new about the idea of a fiscal stimulus, where a government responds to high unemployment by increasing spending, thereby creating government jobs and/or private sector jobs dependent on government spending. In one of the longest dictatorships in ancient Greece, Periander was said to have, "solved a crisis of unemployment by undertaking great public works."(D1) A stimulus can create or repair public goods like roads and canals, or it can simply give money directly to the people, in hopes they will spend the money quickly and help the economy get back on track.
Fiscal stimulus and the MV=PQ equation
In previous videos we introduced the MV = PQ equation, also called the Quantity Theory of Money, which we used to illustrate how [electronically] printing money and destroying money impacts the economy in the short- and long-run. The Federal Reserve created an enormous amount of money to help bail out investment banks during the 2008 Financial Crisis. As a previous video showed, Ben Bernanke's research on the Great Depression instilled in him a great fear of what would happen if the financial sector was harmed. He wanted to make sure the crisis did not turn into another Great Depression, and to do this was willing to print an unprecedented amount of money.
Congress and the President were just as concerned about the economy as Bernanke, and while they cannot create money, they can raise money through taxes and borrowing, and that is what they did. In 2008, President Bush and the Congress enacted a 0.157 trillion dollar "stimulus", where they borrowed money and gave it to taxpayers in the form of a tax cut. After Bush handed the presidency to Obama, a much larger stimulus of 0.902 trillion dollars was passed, where this amount of money was borrowed and then given to U.S. citizens in the form of tax cuts and direct government purchases.
Confidence in the economy wanes
To understand how a fiscal stimulus works, let us revisit the Quantity Theory of Money, described in the formula below.
[equation 1a] (Money Supply)(Money Velocity) = (Price Level of Representative Basket of Goods)(Income, or number of those baskets people consume)
or
[equation 1b] MV = PQ
The 2008 Financial crisis causes spending to fall, which can be depicted by a decrease in V. The amount of money didn't really change, but fearing a loss of income in the future, ordinary citizens were more likely to leave cash sitting in their wallets and money in their checking accounts. Spending by businesses also fell, as it was more difficult for them to acquire loans.
Let us view the consequence of a decrease in V from the viewpoint of a Democrat or liberal, who tend to believe that prices do not change in the short-run. If this is true, the impact of a smaller V is felt entirely by Q (see equation 2). A fall in V causes a fall in Q. Remember, Q is income. Once Q falls, then we have a recession. Those who fear the fall in V will be especially large and also believe prices are very "sticky" in the short-run is then very gloomy about future economic conditions, and will be more eager to combat this fear with government action.
(Note: you may not see the arrows if you are not using Internet Explorer)
[equation 2] (M)(↓V)=(P)(↓Q)
How a fiscal stimulus works
The theory behind a fiscal stimulus is incredibly simple. If a recession occurs because people are spending less, then perhaps government should make-up for this lack of spending by spending lots of money itself. It could invest in assets like highways, or simply pay people for nothing, like unemployment benefits. It could pay for the spending by raising taxes or borrowing money—usually the latter. As government spending increases the velocity of money also increases, and again, if prices remain relatively constant this works to increase Q, which means higher incomes and lower unemployment. If the theory is correct, then the impact of a fiscal is given by the red arrows below.
[Equation 2] (M)(↓↑V)=(P)(↓↑Q)
If the stimulus works perfectly, the red and blue arrows will offset each other and both incomes and the unemployment rate will return to its normal level.
Liberals who support the use of fiscal stimuli generally believe governments should run budget deficits during recessions to fund fiscal stimuli but run surpluses in normal times to pay back the money borrowed in the last recession. Of course, what happens is that governments use this approval of government spending to run continuous deficits.
Does the stimulus work?
If government spending can increase incomes so easily, why doesn't it spend more and more all the time, regardless of whether the economy is in a recession? The answer is that the theory relies on prices remaining constant, when in reality prices do change, even over short time periods. In a recession, where businesses are struggling to maintain business, firms are reluctant to raise prices because that deters consumers. However, in normal times when business is brisk a firm will quickly raise their prices in response to an increase in consumer demand. Thus, even the most liberal economist doesn't wish to run a fiscal stimulus unless an economy is in a recession.
For reasons not entirely clear, economists often believe firms are reluctant to lower prices in bad times. This is why some economists say prices are "sticky" in the short-run.
There are many reasons why the stimulus theory may not work, but they usually boil down to something like this. For the government to spend money it must first take money out of the economy, through taxes or borrowing. It can't print money, like the Fed does. If government must take money out of the economy before it can inject it into the economy, then why would we say that will increase spending? If a family was planning on spending $100 on food but the government takes that money and spends it on roads instead, why would that increase V? If an investor was planning on spending $100,000 to invest in private companies, but she lends it to the government instead, why would that increase V? If a family saves $2,000 to protect against hard times ahead and the government takes that $2,000 in taxes to fund a stimulus, might the family simply replenish the $2,000 by cutting their own spending on other things? Too often, fiscal stimuli is depicted as an injection of new spending, when it is nothing of the sort.
What do the data say?
It would be nice if economists could simply study the effect of past fiscal stimuli to determine if it was good for the economy. Indeed, many studies have pursued this noble goal, but they draw no conclusions. In the end, all an honest economist can say is that a fiscal stimuli may work and it may not, and the odds of both are roughly the same.(R1)
So why don't you see economists saying, "I don't know," on TV? Because that makes for bad TV. Instead, viewers prefer to see liberals and conservatives yell at each other about whether a fiscal stimulus is good. As one might suspect, conservatives dislike stimuli, while liberals love it. They both love yelling and attention on TV, so regardless of what the science says about a fiscal stimulus, you will always see people confidently arguing both sides.
Fiscal stimuli in the public spotlight
To see how debates about the fiscal stimuli take place in the media, consider the following clip from the very, very liberal Rachel Maddow. Now, her depiction of Herbert Hoover is completely wrong, and she shows little sign of really understanding a fiscal stimuli, but she does do an apt job of depicting how liberals describe and defend ramping up government spending during recessions.
Video 1—Rachel Maddow Supporting A Fiscal Stimulus During Recessions
(must use Internet Explorer)
References
(D1) Durant, Will. 1939. The Life of Greece. Simon and Schuster: NY, NY. Page 90.
(R1) Ramey, Valerie [guest]. October 24, 2011. "Ramey on Stimulus and Multipliers." Econtalk.org [podcast]. Roberts, Russel [host]. Accessed January 27, 2013 at http://www.econtalk.org/archives/2011/10/ramey_on_stimul.html
