Thursday, June 11, 2009

Government policies to reduce the severity of recessions and reverse economic declines

The government has two broad options for managing the overall economy: monetary policy and fiscal policy.

In the United States, expansionary monetary policy is the Federal Reserve system´s use of the money supply, interest rates, and the banking system to encourage commercial banks to lend more money to the public in the hope that this will increase overall spending on newly produced U.S. goods and services. The collapse of credit markets in 2008 reduced most types of lending and will require a restoration of confidence (perhaps by improved oversight and regulation) before monetary policy can assist in economy recovery (by lending more money to encourage more overall spending).

Fiscal policy is taxation and government spending. The logic of using tax cuts to counter a recession is that if the government takes less money from individuals and businesses, they will have more money to spend. Remember the cause of the U.S. economic downturn is insufficient overall spending on newly produced American goods and services. In this regard, tax cuts are essentially identical to the federal government handing out money. The goal is to put more money in the hands of individuals and businesses in the hope that they will spend it on products that are newly made by U.S. workers. Many debates about tax cuts are essentially decisions about to whom the government should be giving money. Tax cuts and other increases in government handouts are relatively quick ways to inject purchasing power into the economy and increase the potential for increases in aggregate demand. There is no way to guarantee that these income supplements will result in purchases of newly made U.S. products, however. For example, much of the increased disposable income caused by the tax cuts of 2001 and 2003 resulted in paying down consumer debt rather than increased consumer spending. And even when spent, if the products purchased are not American-made there is limited benefit to the U.S. economy and its workers. Even though tax cuts or other government handouts can be done quickly, they may be poor choices if they do not significantly increase overall spending on newly produced U.S. goods and services.

An alternative fiscal policy to counteract economic declines is an increase in government purchases. The primary benefit of this choice is that government procurement policies can ensure that this increased spending goes to U.S. businesses that employ American workers. A difficulty with this approach, however, is that it may be difficult to spend sufficient quantities of money quickly enough on projects of long-term benefit. Infrastructure projects can take long periods of time to complete and thus may not inject additional income into the economy quickly enough. Similar arguments can be made for proposals to improve energy efficiency, develop alternative fuel sources, or reform the health care industry. Projects that can be quickly implemented, however, may be of questionable long-term benefit. Yet, if the result is increased purchases of new products made by U.S. workers and suppliers, they still may be preferable to tax cuts (if the tax cuts are used to pay down debt or buy used or foreign products).

Tax cuts and increases in government spending both increase budget deficits and the national debt. Criticisms of stimulus proposals on the basis of reluctance to increase public borrowing apply equally to tax reductions and increased spending programs. Running deficits is not always bad, however. For example, many students borrow substantial sums of money in order to attend college. This indebtedness is easily justified, however, because it leads to a college degree that increases earnings potential for the remainder of one´s career. Similarly, it can be reasonable for a society to borrow money from future generations if the funds are spent wisely on things that increase the productive ability of the economy and improve future living standards. Future generations may not mind if money is borrowed from them to develop alternative energy sources that result in less environmental degradation. It is less arguable to accumulate massive public debt based on willful ignorance, selfishness, or simple reluctance to pay one´s way. The 2001 and 2003 tax cuts were the first wartime tax decreases in U.S. history. Previous generations were willing to make sacrifices for causes they believed in.

Tax decreases are popular and are undoubtedly of short-term benefit to those allowed to pay less in tax. The dramatic increases in U.S. budget deficits and public debt since 1980 have been of great short-term benefit to many sectors of the economy. But they have done substantial harm to the long-term benefit of the U.S. and global economies (for many of the reasons cited by critics of current stimulus proposals). It is akin to allowing large numbers of people to go to the mall, stuff shopping bags with items, and walk out without paying. It is of great short-term benefit to those who get away with it. But these strategies are not sustainable in the long-term. Selfish and misguided choices over the previous three decades have left American policymakers with few, if any, desirable options. The more important question may be how long will it take before U.S. citizens become willing to make the sacrifices and tough choices necessary to correct the abuses of the past and demand more honest, reasoned leadership.

See also "Recessions & Depressions: Questions & Answers."

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