The Economic Lesson of Goldilocks and the Three Bears: Overall Spending Should Not Be Too Large or Too Small

One of the most significant determinants of a country's economic well-being is overall spending on newly produced goods and services, which economists call aggregate demand (AD). Overall spending needs to be large enough to keep unemployment low, yet small enough to keep inflation low. Aggregate demand should not be too large or too small. Like the porridge, chair, and bed in the story of Goldilocks and the Three Bears, an economy's overall spending needs to be "just right."

Insufficient overall spending causes economic recessions and depressions. As aggregate demand declines, businesses sell fewer goods and services. Inventories of unsold products increase, leading to fewer factory orders for newly produced goods. Businesses lay off workers as production and sales decline. The unemployment rate increases as more workers become unemployed. The rate of economic growth, which is measured as the percentage change in output, decreases.

Excessive overall spending causes inflation, which is a general increase in the price level. During periods of inflation, the prices of most goods and services are rising. Inflation is similar to the rising prices of scalped tickets to a popular concert or sporting event. If a society tries to buy more goods and services than the economy is able to produce, the prices of most things will increase.

If society wishes to manage the natural fluctuations in economic activity, called business cycles, it needs to alter overall spending on newly produced goods and services. Thus, there can be a role for government in managing the economy when the consumption and investment actions of households and businesses fail to provide socially desirable outcomes.

When low unemployment and increasing inflation suggest the productive capacity of the economy is unable to meet the demand for goods and services, the appropriate policy is to discourage spending through contractionary monetary policy (higher interest rates, fewer bank loans, and a smaller money supply), and contractionary fiscal policy (higher taxes and reduced government purchases).

However, when unemployment is relatively high and economic growth is small (such as in the current recession), the appropriate policies to pursue are expansionary monetary policy (lower interest rates, more bank loans, and a larger money supply) and expansionary fiscal policy (lower taxes and increased government purchases).

In the current U.S. economy, monetary policy has been largely ineffective. Interest rates are about as low as they can go. (The federal funds rate is 0.25%. It is almost zero.) Because of the financial crisis, banks are reluctant to lend money. Tax cuts have been largely ineffective as well. Studies show most recipients have used the additional funds to pay down debt rather than increase purchases. So that leaves increased government spending as the most viable way to increase the aggregate demand for newly produced goods and services.

Thus, the economic justification for government spending programs to stimulate the economy is that they can increase aggregate demand when consumers and businesses and unwilling to do so.

If one's primary concern is economic recovery, then the spending should be done as quickly as possible on projects that employ workers in the production of new goods and services. However, there is a tradeoff between projects that can be done quickly, and those that provide the greatest long-term benefit. This has led to criticism of U.S. government stimulus spending. Projects that can be done quickly are criticized for lacking long-term benefit. Spending for more worthy projects is criticized because it is not helping the economy quickly enough. This is why defenders of stimulus programs argue we need to give them more time. Much of the spending was designed to help over the period of several years, not a few months.

CLICK HERE to read the story of Goldilocks and the Three Bears.

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."

Should the government do anything to prevent economic declines?

Economic declines eventually end without government intervention, but it may take an unacceptably long period of time. The British economist John Maynard Keynes popularized the idea that the government should play an active role in managing the economy. Keynes admitted that an unassisted economy may correct itself in the long run, but “in the long run we are all dead.” We may not live long enough to see the improvement in the economy.

Recessions are caused by insufficient overall spending on newly produced goods and services. Increases in unemployment reduce national income, which in turn reduces aggregate demand further. This deepens the economic decline and may lead to a depression. The length and severity of the Great Depression led most economists and public policy analysts to conclude that it is appropriate for the government to intervene in the economy to try to reduce the severity of recessions and prevent depressions.

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

What causes recessions and depressions?

Recessions and depressions are caused by insufficient overall spending on newly produced goods and services. When there is insufficient aggregate demand (AD) for new products, stores sell fewer things, causing factories to produce less output and increasing unemployment. As workers lose their jobs, their incomes are reduced, leading to further decreases in overall spending and deepening the economic downturn.

The recession that began in December 2007 was caused by collapsing housing prices, the subprime mortgage crisis, and subsequent tightening of credit markets. In 2004 and 2005, the United States experienced unusually rapid increases in housing prices, sometimes referred to as a real estate bubble. Low interest rates and insufficiently regulated lending practices fueled these unsustainable price increases. Many people increased general purchases by borrowing against their homes (with unrealistically high values). Housing prices peaked in 2006 and the subsequent declines, sometimes called the bursting of the bubble, triggered home foreclosures, the subprime mortgage crisis and reductions in loans. Thus, real estate declines led to a decrease in the aggregate demand (AD) for newly produced goods and services.

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

What is a recession and how does it differ from a depression?

A recession is a sustained decrease in economic activity that is typically accompanied by decreases in employment, national income, and the production of goods and services. An unofficial way to estimate the existence a recession is to look for at least two consecutive quarters of declines in gross domestic product (GDP). The official calculations are more complex and are conducted by the National Bureau of Economic Research (NBER).

A depression is a severe and prolonged recession.

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

Recessions & Depressions: Questions & Answers

A recession is a sustained decline in economic activity characterized by declines in national income, total output of goods and services, and employment.

A depression is an extremely severe recession.

Recessions and depressions occur when there is a prolonged decrease in overall spending on newly produced goods and services, which economists call aggregate demand (AD).

Gross domestic product (GDP) is the total value of new domestically produced final goods and services.

Aggregate Demand (AD) for Gross Domestic Product (GDP) = Consumption (mostly by households) + Investment (mostly by businesses) + Government Purchases (on newly produced goods and services) + Exports to foreign purchasers – Imports from foreign producers

AD (for newly produced U.S. goods & services) = C + I + G + X – M

Click on the questions below to link to the answers.

What is a recession and how does it differ from a depression?

What causes recessions and depressions?

Should the government do anything to prevent economic declines?

What types of government policies reduce the severity of recessions and reverse economic declines?

What about the supply-side argument that tax cuts induce businesses to increase investment and create jobs?