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Why Does Government Provide Economic Stimulus

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This evening I was asked why government supplies deficit financed economic stimulus during recessionary periods of low revenue. The questioner said that when his wages decreased he had to cut expenses to avoid deficit spending. So, he asked, why shouldn’t government do likewise. Here is my response.

The lack of current demand, i.e. consumer and business purchases, has kept economic activity down as the private sector (mainly families) deleverage. Rogoff and Reinhart wrote and maintain that it takes up to 10 years for this deleveraging process to complete following a major financially caused recession. You can see in the chart attached that this recession, because of the steps taken by the new Obama Admin and Bernanke’s Fed, shows a steeper incline upwards from previous financial recessions when no federal economic stimulus was applied to the economy.

US Systemic Banking Crisis Recoveries Over a Hundred Years

But here’s the main point specific to your question. As a household you reduce spending to meet lowered income to avoid going into debt. Businesses during a recession do the same thing. So everyone spends less. That lowered spending causes unemployment increases as no one is buying so employees are not needed for the lower demand. That works fine for household but not so well for businesses. Without demand, businesses go under.

So, here is where macro-economics depart from household (micro) economics. With no one buying while the deleveraging process continues, there is only one entity left to increase demand: government. Governmental spending increases demand that currently fails to exist. With that increased demand, businesses can hire or maintain workers. More people are put to work which will increase business revenues in surrounding businesses which will cause even more workers to be hired. A virtuous cycle that increases employment, business revenues, and governmental revenues.

On the other hand, if government cuts back when demand is low as it has been for the last 4 years, then there is no spender of last resort. If families, businesses, and government cut back on spending, business revenues are reduced which consequently increases unemployment. That circumstance causes less tax revenue for government which means government has to cut back even more which means even less spending…and so on. It’s called a debt trap. Less governmental spending during a develeraging, low demand period causes more unemployment that further reduces governmental revenues. Lower revenues then cause even less spending which further increases unemployment, causing lower revenues. And so on. A non-virtuous cycle that increases unemployment and debt.

The whole idea is that when demand is low, government should spend more to increase demand which leads to more business revenues which lowers unemployment and increases tax revenues. Then when demand picks up to normal levels, government cuts back on spending allowing the private sector, businesses, to assume the difference in spending. Once demand is normal, governmental help is no longer needed and can then focus on reducing increased debt levels and eliminate deficits.

What the GOP has been advocating for the last four years is a debt trap. While this lowering of spending to meet revenues is good for households (the micro-economy), it is a disaster for the macro-economy.


Written by Valerie Curl

October 18, 2012 at 9:48 AM

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