January 28, 2009

Economics a 15 Year-Old Can Understand

Filed under: Politics — Bob Gifford @ 10:52 pm

My younger son was asking me about the stimulus package, the criticism of it, and what I thought. I walked him through some basic economics and explained what kind of stimulus we need and why. Nothing I said was profound, or innovative, or insightful. It was very basic. But I can’t help wondering how many bloggers, television commentators, and even politicians know this much. Listening to the conservative critiques of the stimulus bill, it would seem not many. So herewith, the explanation I gave to my 15 year old son.

In the 19th century the US went through a regular series of panics. Demand, for whatever reason, would dip, so production would slow and workers would be laid off. This caused everyone to start saving more and spending less, either because they were unemployed or worried they soon would be. Lower spending meant decreased demand, which lowered production, caused more workers to be laid off, and the cycle continued spiraling down.

The same thing happened in the Depression, triggered in that case by the collapse of a stock market bubble, which froze credit and caused banks to fail. People lost their savings, so they stopped spending, which lowered demand, which slowed production, put people out of work, and we were into the same old vicious cycle, but on steroids.

This is eerily similar to what we are seeing today, except that our bubble is in housing prices and investments backed by home mortgages.

Mainstream economists, following Keynes, understand that something has to break this cycle to stop a recession from becoming a depression. So the spender of last resort is the government, the one entity able to borrow lots of money and with incentives to do something to benefit the economy as a whole. Paraphrasing Lincoln, government allows us to do together what none of us can do individually. During a recession, the government spends more than it takes in, which compensates for the drop in consumer spending, prevents production from dropping and workers from being laid off, and thereby stops the vicious cycle. This is the classic Keynsian stimulus.

Cutting taxes doesn’t have the same affect as increasing spending. If you cut personal taxes, you put more money in the pockets of consumers, but in the middle of a recession they will likely save most or all of the tax cut, and hence not increase demand. Similarly, cutting business taxes puts more money in business owners’ hands, but if no one is buying, businesses can’t spend that money to expand, increase production, and hire workers.

What we need is spending, and 100% of government spending gets, well, spent.

If the government is going to spend more to stimulate the economy, then it should spend money on things that are worthwhile. Since we’re in a recession, it would be even better if government spent money on things that would boost productivity, which in the long term increases economic growth. Infrastructure. During the Depression it was dams, water projects and power lines. Today it’s much of the same, plus things like electronic medical records and high-speed rail.

But then the government debt is increasing, and that’s bad, right? Of course. During good times we should be paying down the debt, saving up for a rainy day when the government needs to engage in deficit spending. Unfortunately, Bush magically turned a budget surplus into a deficit. Instead of saving for a rainy day, we’ve been running up more debt. But now we have no choice — we are in a deep recession, and have to deficit spend to keep it from getting a lot worse. Once the economy turns around, we need to go back to fiscal responsibility — running surpluses in good times to make up for deficits in bad times.

So this is why all the mainstream economists agree on the shape of the stimulus bill. Which isn’t to say that the political process isn’t throwing some garbage into the bill. We need to hold Congress accountable for focusing spending on things we really need and that will stimulate the economy. But for the most part, the need for a bill and its general outlines are not in doubt.

Except by, apparently, Republicans.

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