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What is an Economic Stimulus?

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What is an Economic Stimulus?

Old 01-25-2009, 10:07 AM
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Default What is an Economic Stimulus?

Does Stimulus Stimulate?
Bruce Bartlett, 01.23.09, 12:01 AM EST
The role of government in economic recovery.

In a few weeks, Congress will likely enact the largest fiscal stimulus legislation in history. Surprisingly, the whole idea of such a stimulus is much more controversial among A-list economists than I would have expected, given the depth and breadth of the economic malaise. Although the debate is rather technical, it's important to try to understand it because much is at stake.

Eighty years ago, the conventional view among economists was that government had nothing to do with business cycles--it neither caused them nor was there anything it could do about them. They were like the weather; you just coped the best you could.


Eventually, economists came to understand that vast numbers of individuals and businesses throughout the economy don't make exactly the same mistakes simultaneously unless something has changed the rules of the game. Government isn't always responsible--bubbles can occur on their own, as they have over the centuries--but systemic errors usually result from government policy.

The Federal Reserve, our nation's central bank, is the institution mainly responsible for altering the terms of trade. That is because it has the power to change the value of the currency, which is the intermediary in every single economic transaction, and also to alter the terms of every intertemporal transaction--those between the present and future, such as saving today to consume tomorrow--by raising or lowering the interest rate.

No one today believes that the Great Depression just happened or dragged on as long as it did because the private sector kept making mistake after mistake after mistake. It only made them and continued to do so because government interfered with the normal operations of the market and prevented readjustment from taking place.

The Great Depression resulted from a confluence of governmental errors--the Fed was too easy for too long in the 1920s, tightened too much in 1928-29 and then failed to fix its mistake, thus bringing on a general deflation that was very difficult to arrest once downward momentum had set in. Herbert Hoover compounded the problem by signing into law the Smoot-Hawley Tariff and sharply raising taxes in 1932.

Unfortunately, Franklin D. Roosevelt misunderstood the nature of the economy's problem and tried to fix prices to keep them from falling--thus preventing the very readjustment that would have brought about recovery. (See this paper by UCLA economists Harold Cole and Lee Ohanian.) He doesn't seem to have ever understood the critical role of Fed policy and mistakenly thought that arbitrarily raising the price of gold would make money easier.



Then, in 1937, just as the economy was starting to build some upward momentum, Roosevelt decided to raise taxes and cut spending, and the Fed suddenly concluded that inflation, rather than deflation, was the main problem and tightened monetary policy. (Note: According to the National Bureau of Economic Research, the Great Depression was basically two severe recessions--one from August 1929 to March 1933, and another from May 1937 to June 1938--not a continuous downturn.)




The result was an economic setback that didn't really end until both monetary and fiscal policy became expansive with the onset of World War II. At that point, no one worried any more about budget deficits, and the Fed pegged interest rates to ensure that they stayed low, increasing the money supply as necessary to achieve this goal.

It was then and only then that the Great Depression truly ended. As a consequence, economists concluded that an expansive monetary and fiscal policy, which had been advocated by economist John Maynard Keynes throughout the 1930s, was the key to getting out of a depression.

Keynes was right, but many of his followers weren't. They thought that budget deficits would stimulate growth under all circumstances, not just those of a deflationary depression. When this medicine was applied inappropriately, as it was in the 1960s and 1970s, the result was inflation.

Economists then concluded that it was a mistake to pursue countercyclical fiscal policy, and the idea of "fine-tuning" became a derogatory term. Even those who continued to believe it was theoretically possible to counter recessions with public works or government jobs programs were eventually forced to concede that it was impossibly difficult to make them work in a timely manner.

In the 1980s and 1990s, economists came around to the view that only monetary policy could act quickly enough to reverse or moderate a recession. But they never really came to grips with the Fed's responsibility for causing recessions in the first place. It always tightened a little too much when inflation was the problem and eased too much when slow growth was the problem.

For a time, a cult grew up around Fed Chairman Alan Greenspan. Many who should have known better convinced themselves that the "Maestro," as journalist Bob Woodward called him, would fix everything. Investors began seriously talking about a "Greenspan put"--the idea that the Fed would always protect them from a severe decline in the market. Nitwits wrote and bought books predicting astronomical levels for the stock market because Greenspan had permanently reduced the level of risk.

As we have seen, the Fed could not prevent the greatest financial downturn the world has seen since 1929. This has revived the idea that fiscal policy must be the engine that pulls us out.

Somewhat surprisingly, there has been rather heated opposition to the very principle of fiscal stimulus--a return to pre-Keynesian economics. And among those expressing dissent are some of the leading lights of economic theory over the last 40 years.

To be sure, the idea that fiscal policy was impotent never entirely disappeared. In 1969, economist Milton Friedman argued strenuously that only monetary policy really matters and that fiscal policy has no meaningful effect. Said Friedman, "In my opinion, the state of the budget by itself has no significant effect on the course of nominal income, on inflation, on deflation or on cyclical fluctuations."

Yet at the same time, monetarists argued that monetary policy had no lasting effect on the same economic variables. In the long run, they said, monetary policy could only affect nominal incomes, not real incomes. Real incomes were a function of things like growth of the labor force and productivity per work hour.

This led to a renewed emphasis on fiscal policy, but on the tax side rather than the spending side, as Keynesians tend to focus. Supply-siders argued that certain changes in tax policy--lowering marginal tax rates, reducing taxes on entrepreneurial income--were especially powerful, economically. Keynesians think that just putting dollars in peoples' pockets in order to stimulate consumption is the key to growth.

We have now had several tests of the Keynesian idea--most recently with last year's $300 tax rebate, which was supposed to prevent a recession. According to a new paper by University of Michigan economists Matthew Shapiro and Joel Slemrod, only a third of the money was spent, thus providing very little "bang for the buck."

The failure of rebates has shifted the focus to public works and other direct spending measures as a means of stimulating aggregate spending. A study by Obama administration economists Christina Romer and Jared Bernstein predicts that the stimulus plan being debated in Congress will raise the gross domestic product by $1.57 for every $1 spent.

Such a multiplier effect has been heavily criticized by a number of top economists, including John Taylor of Stanford, Gary Becker and Eugene Fama of the University of Chicago and Greg Mankiw and Robert Barro of Harvard. The gist of their argument is that the government cannot expand the economy through deficit spending because it has to borrow the funds in the first place, thus displacing other economic activities. In the end, the government has simply moved around economic activity without increasing it in the aggregate.

Other reputable economists have criticized this position as being no different from the pre-Keynesian view that helped make the Great Depression so long and deep. Paul Krugman of Princeton, Brad DeLong of the University of California at Berkeley and Mark Thoma of the University of Oregon have been outspoken in their belief that theory and experience show that government spending can expand the economy under conditions such as we are experiencing today.

I think the critics of an activist fiscal policy are forgetting the essential role of monetary policy as it relates to fiscal policy. As Keynes was very clear about, the whole point of fiscal stimulus is to mobilize monetary policy and inject liquidity into the economy. This is necessary when nominal interest rates get very low, as they are now, because Fed policy becomes impotent. Keynes called this a liquidity trap, and I think there is strong evidence that we are in one right now.

The problem is that fiscal stimulus needs to be injected right now to counter the liquidity trap. If that were the case, I think we might well get a very high multiplier effect this year. But if much of the stimulus doesn't come online until next year, when we are likely to be past the worst of the slowdown, then crowding out will greatly diminish the effectiveness of the stimulus, just as the critics argue. According to the Congressional Budget Office, only a fraction of proposed infrastructure spending can be spent before October of next year; the bulk would come long after.

Thus the argument really boils down to a question of timing. In the short run, the case for stimulus is overwhelming. But in the longer run, we can't enrich ourselves by borrowing and printing money. That just causes inflation.

The trick is to front-load the stimulus as much as possible while putting in place policies that will tighten both fiscal and monetary policy next year. As terrible as our economic crisis is right now, we don't want to repeat the errors of the past and set off a new round of stagflation.

For this reason, I think there is a better case for stimulating the economy through tax policy than has been made. Congress can change incentives instantly by, for example, saying that new investments in machinery and equipment made after today would qualify for a 10% Investment Tax Credit, and this measure would be in effect only for investments largely completed this year. Businesses will start placing orders tomorrow. By contrast, it will take many months before spending on public works begins to flow through the economy, and it is very hard to stop it when the economy turns around.

Stimulus based on private investment also has the added virtue of establishing a foundation for future growth, whereas consumption spending does not. As economist Hal Varian of the University of California at Berkeley recently put it, "Private investment is what makes possible future increases in production and consumption. Investment tax credits or other subsidies for private sector investment are not as politically appealing as tax cuts for consumers or increases in government expenditure. But if private investment doesn't increase, where will the extra consumption come from in the future?"

Bruce Bartlett is a former Treasury Department economist and the author of Reaganomics: Supply-Side Economics in Actionand Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy. He writes a weekly column for Forbes.com.
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Old 01-25-2009, 10:25 AM
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Interesting article and I agree that a strong case for stimulus can be made. Unfortunately, I don't think stimulating the pre-failure market model without meaningful reform is going to have sustainable benefit.
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Old 01-25-2009, 01:38 PM
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This article is pretty consistent with what I hear from economists on NPR. The latter is a somewhat left of center, and I am aware of that- but not by far. The tax break idea is probably the best one for helping the economy but it has to be the right deal so the money hits the markets and doesn't get stuck in places it doesn't help. I make bizjets and we are getting hit like a tornado right now. Companies still want to buy bizjets but can't get financed because all the TARP money is being hoarded by frightened lenders. As fiscal policy it serves no purpose. When the next policy option is tabled it must get into the markets immediately or it will do no good.
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Old 01-25-2009, 08:53 PM
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More waste and fraud from the "0"
WSJ
That $355 billion in spending isn't about the economy.
Article


The stimulus bill currently steaming through Congress looks like a legislative freight train, but given last week's analysis by the Congressional Budget Office, it is more accurate to think of it as a time machine. That may be the only way to explain how spending on public works in 2011 and beyond will help the economy today.

According to Congressional Budget Office estimates, a mere $26 billion of the House stimulus bill's $355 billion in new spending would actually be spent in the current fiscal year, and just $110 billion would be spent by the end of 2010. This is highly embarrassing given that Congress's justification for passing this bill so urgently is to help the economy right now, if not sooner.

And the red Congressional faces must be very red indeed, because CBO's analysis has since vanished into thin air after having been posted early last week on the Appropriations Committee Web site. Officially, the committee says this is because the estimates have been superseded as the legislation has moved through committee. No doubt.


AP
David Obey.
In addition to suppressing the CBO analysis, Democrats have derided it. Appropriations Chairman David Obey (D., Wis.) called it "off the wall," never mind that CBO is now run by Democrats. Mr. Obey also suggested that it would be a mistake to debate the stimulus "until the cows come home." We'd settle for a month or two, so at least the voters can inspect the various Congressional cattle they're buying with that $355 billion.

The stimulus bill is also a time machine in the sense that it's based on an old, and largely discredited, economic theory. As Harvard economist Robert Barro pointed out on these pages last Thursday, the "stimulus" claim is based on something called the Keynesian "multiplier," which is that each $1 of spending the government "injects" into the economy yields 1.5 times that in greater output. There's little evidence to support this theory, but you have to admire its beauty because it assumes the government can create wealth out of thin air. If it were true, the government should spend $10 trillion and we'd all live in paradise.

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The problem is that the money for this spending boom has to come from somewhere, which means it is removed from the private sector as higher taxes or borrowing. For every $1 the government "injects," it must take $1 away from someone else -- either in taxes or by issuing a bond. In either case this leaves $1 less available for private investment or consumption. Mr. Barro wrote about this way back in 1974 in his classic article, "Are Government Bonds Net Wealth?", in the Journal of Political Economy. Larry Summers and Paul Krugman must have missed it.

The government spending will be a net stimulus only if its $1 goes to more productive purposes than those to which private investors would have put that same $1. There are some ways we may want the government to spend money -- on national defense, say -- but that doesn't mean it's a stimulus.

A similar analysis applies to the tax cuts that are part of President Obama's proposal. In contrast to the spending, at least the tax cuts will take effect immediately. But the problem is that Mr. Obama wants them to be temporary, which means taxpayers realize they will see no permanent increase in their after-tax incomes. Not being fools, Americans may either save or spend the money but they aren't likely to change their behavior in ways that will spur growth. For Exhibit A, consider the failure of last February's tax rebate stimulus, which was a bipartisan production of George W. Bush and Mr. Summers, who is now advising Mr. Obama.

To be genuinely stimulating, tax cuts need to be immediate, permanent and on the "margin," meaning that they apply to the next dollar of income that an individual or business earns. This was the principle behind the Kennedy tax cuts of 1964, as well as the Reagan tax cuts of 1981, which finally took full effect on January 1, 1983.

If the Obama Democrats can't abide this because it's a "tax cut for the rich," as an alternative they could slash the corporate tax to spur business incentives. The revenue cost of eliminating the corporate tax wouldn't be any more than their proposed $355 billion in new spending, and we guarantee its "multiplier" effects on growth would be far greater. Research by Mr. Obama's own White House chief economist, Christina Romer, has shown that every $1 in tax cuts can increase output by as much as $3.

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REVIEW & OUTLOOK
States of Distress

TODAY'S COMMENTARY
Information Age: Bad News Is Better Than No News
– L. Gordon Crovitz
The Americas: Drug Gangs Have Mexico on the Ropes
– Mary Anastasia O'Grady

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How Modern Law Makes Us Powerless
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Geithner Is Exactly Wrong on China Trade
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Watch Out for Stimulus 'Leaks'
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Congress Needs to Help the Economy Fast
– John Kerry and Kent Conrad
As for all of that new spending, CBO will release an updated analysis this week. And we anticipate that the budget analysts will in the interim have discovered that much more of that $355 billion will somehow find its way to "shovel-ready" projects that the Obama Administration can start building before the crocuses bloom. But in the real world, the CBO's first estimate is likely to prove closer to the truth.

The spending portion of the stimulus, in short, isn't really about the economy. It's about promoting long-time Democratic policy goals, such as subsidizing health care for the middle class and promoting alternative energy. The "stimulus" is merely the mother of all political excuses to pack as much of this spending agenda as possible into a single bill when Mr. Obama is at his political zenith.

Apart from the inevitable waste, the Democrats are taking a big political gamble here. Congress and Mr. Obama are promoting this stimulus as the key to economic revival. Americans who know nothing about multipliers or neo-Keynesians expect it to work. The Federal Reserve is pushing trillions of dollars of monetary stimulus into the economy, and perhaps that along with a better bank rescue strategy will make the difference. But if spring and then summer arrive, and the economy is still in recession, Americans are going to start asking what they bought for that $355 billion.
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Old 01-26-2009, 04:42 AM
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Originally Posted by jungle View Post

I think the critics of an activist fiscal policy are forgetting the essential role of monetary policy as it relates to fiscal policy. As Keynes was very clear about, the whole point of fiscal stimulus is to mobilize monetary policy and inject liquidity into the economy. This is necessary when nominal interest rates get very low, as they are now, because Fed policy becomes impotent. Keynes called this a liquidity trap, and I think there is strong evidence that we are in one right now.
This is presupposing a Keynesian cause and a Keynesian solution. A liquidity trap is implied by deflation. The government just can't sit around and not do anything... they have to do something (even if that is the wrong thing).

I think Keynes said is best himself:

Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually the slaves of some defunct economist.
Madmen in authority, who hear voices in the air, are distilling
their frenzy from some academic scribbler of a few years back.

- John Maynard Keynes


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Old 01-26-2009, 04:54 AM
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And how well did the last stimulus deal work ?
We have a spending mindset and not a saving mindset and that in my opinion is what will catch up to us as ppl start to hit retirement.
Throwing good money after bad never work's but then again I could be wrong.
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Old 01-26-2009, 07:15 AM
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This is the wrong thing,its a monetary bone to blocs that support the Dhims and designed to institutionalize new constituencies for the "0"

Consider consumer spending. The proposed remedy is the "economic stimulus" plan. This seems sensible. If government doesn't offset declines in consumer and other private spending, the economy might spiral down for several years. Last week, House committees considered an $825 billion package, split between $550 billion in additional spending and $275 billion in tax cuts.

But in practice, the stimulus could disappoint. Parts of the House package look like a giant political slush fund, with money sprinkled to dozens of programs. There's $50 million for the National Endowment for the Arts, $200 million for the Teacher Incentive Fund and $15.6 billion for increased Pell Grants to college students. Some of these proposals, whatever their other merits, won't produce many new jobs.

Another problem: Construction spending -- for schools, clinics, roads -- may start so slowly that there will be little immediate economic boost. The Congressional Budget Office examined $356 billion in spending proposals and concluded that only 7 percent would be spent in 2009 and 31 percent in 2010.

How about this gem from the dingbat by the bay

Speaker of the House Nancy Pelosi boldly defended a move to add birth control funding to the new economic "stimulus" package, claiming "contraception will reduce costs to the states and to the federal government."

Pelosi, the mother of 5 children and 6 grandchildren, who once said, "Nothing in my life will ever, ever compare to being a mom," seemed to imply babies are somehow a burden on the treasury.

Do something wrong, indeed.
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Old 01-27-2009, 04:14 AM
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When 43 took office, we had surplus. Now, we have the biggest deficit in the history of this country. The writing is on the wall fellas. Take a good look around you. People are losing and have lost homes, jobs, and businesses in historic proportion. Not to mention their minds & their lives......and it's going to get worse before it gets better.

The good ole boys of "trickle down economics", as I refer to them as, raped and pillaged this country over the last few years. Economists state that the likes of the state of the economy have not been seen since the days of the Depression. It took govenment intervention then and it will certainly take government intervention now.



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Old 01-27-2009, 04:39 AM
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Originally Posted by atpwannabe View Post
When 43 took office, we had surplus. Now, we have the biggest deficit in the history of this country. The writing is on the wall fellas. Take a good look around you. People are losing and have lost homes, jobs, and businesses in historic proportion. Not to mention their minds & their lives......and it's going to get worse before it gets better.

The good ole boys of "trickle down economics", as I refer to them as, raped and pillaged this country over the last few years. Economists state that the likes of the state of the economy have not been seen since the days of the Depression. It took govenment intervention then and it will certainly take government intervention now.



atp
You need to make sure that they are correct. Your post is filled with factual innaccuracies and the sort of conventional wisdom pap served up in the editorial pages of the USA Today.

I respect the right you have to your opinions, but this is not Hangar Talk. Check your facts before you post here.

WW
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Old 01-27-2009, 06:55 AM
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Originally Posted by atpwannabe View Post
When 43 took office, we had surplus. Now, we have the biggest deficit in the history of this country. The writing is on the wall fellas. Take a good look around you. People are losing and have lost homes, jobs, and businesses in historic proportion. Not to mention their minds & their lives......and it's going to get worse before it gets better.

The good ole boys of "trickle down economics", as I refer to them as, raped and pillaged this country over the last few years. Economists state that the likes of the state of the economy have not been seen since the days of the Depression. It took govenment intervention then and it will certainly take government intervention now.



atp
Another pearl of wisdom from the spiked hair, backpack toting, ipod wearing crowd.
You believe everything you read and see on the boob tube too? Only have to go back 25-30 years for it to be alot worse than now, not the great depression. You know why they call it the Great depression? Because government intervention actually made things worse; don't worry your tax hike is a coming, but then you are a student pilot so you will see a tax cut, bourne on the backs of the rest of us who make too much money.
I can see why you like socialism...
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