Tuesday, September 27, 2011

The Tale of the Too-Small Stimulus and the Demand-Side Prince

A good question from a conservative Twitter friend...
I think there is a common misunderstanding that stimulus goes on forever.  It doesn't.  It has a finite life that is intended to "stimulate" the demand-side of the economy.

Let's take a quick look at the most common formula used to measure GDP: The Expenditure Approach.  It's not the only one, but it's the one you'll see most often in the financial press. GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M).

Y = C + I + G + (X − M)
  • Y = Gross Domestic Product
  • C = Consumption, normally the largest component of GDP it includes expenditures in the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing
  • I = Investment, includes business investment in equipments for example and does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment
  • G = Government,the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
  • X = Gross exports
  • M = Gross imports
So now that we have the formula, we can see that demand can be driven from several vectors, including the government.  This is what the stimulus is intended to do, create government demand in a situation where the C is low (as in a recession) and demand has slumped.  The government may not create "wealth," but it can surely create "demand."  And it can create a lot of demand when needed.  Whether that dollar comes from an individual or from the government, it's still a dollar that's "in play" in the economy and flowing into private business in the form of demand.
The Flow of the Economy

Normally, when we have a recession it is driven by a demand slump in C.  It looks like this.
When the demand curve shifts from AD1 to AD2, GDP drops (YP to Yrec) resulting in what's known as a recessionary gap.  Theoretically prices should drop as well, but prices are generally more "sticky" than demand so they don't move exactly the same way. (to be fair, I'm still learning about this part)

We also see unemployment rise and interest rates drop.  And this is where we are now.  Unemployment is officially at 9% (although by some measures it's as high as 17% because of the way the "official" unemployment figures are calculated) and interest rates are hovering right around 1%.

So what should happen?  Considering that the money is essentially free right now (1% interest), the government should launch a massive borrowing exercise to funnel the money into the economy in ways that will drive unemployment down.  When consumers and business aren't spending, the government should.  This countercyclical approach is the only thing that will have an impact on the economy now.  It's unlikely that any additional monetary stimulus (QE3) or further tax cuts will have a significant impact.

A significant contributor to our current situation is that the initial stimulus, while it worked as intended, was far smaller than it should have been.  Most economists believed it should have been $2.1trillion or so to cover the gap caused by the 2008 recession.

I think a lot of people don't realize that how different the macroeconomy is from the microeconomy.  The government has levers it can pull to steer the ship that businesses don't have.

So more as I learn it... To be Continued!

1 comment:

  1. In order for the government to increase its spending it has to get the money from somewhere.What can they do? Either raise taxes, which seems counterproductive to me as they simply remove some of the ability for people to (I)nvest or (C)onsume, or they can borrow. I understand people are sitting on capital and this is the Gov's way of forcing the issue. Borrowing is supposed to be done with the intention of paying it back and is akin to treating the symptom vice the problem, which as I see it is more going out than coming in. My concern are as follows, "Why aren't people investing,borrowing,lending"? Why don't they have faith in the markets?
    Id probably be at least partially on board with the economic policies you prefer if it wasn't for one thing, human nature. I see human nature, the desire for power and greed as a reason to spread power and minimize gov. Our gov is also terribly inefficient since there is no incentive to be efficient. Perfect example: The fiscal year for the Gov starts on Oct 1. EVERY YEAR as Sept winds down military commands and Gov agencies scramble to spend as much as they can from the previous year's budget.Money slated for building maint is quickly spent on a plane full of rubber dog crap so that we can justify asking for the same amount or more in the next FY. This happens in every branch of the Fed gov.

    I appreciate the time you took to lay this out, I still feel like stimulus spending and raising taxes are kicking the can so to speak. Quantitative easing strikes me as the most insane of all gov solutions as it crushes the value of our currency. Eventually I think economics strays into morality,philosophy,and religion. It becomes a matter of what should we do, whats they right thing, and who should pay for it.