Is Stimulus Still Necessary?

Have stimulus packages brought the world’s traumatized economies back to life? Or have they set the scene for inflation and big future debt burdens? The answer is that they may have done both. The key question now concerns the order in which these outcomes occur.

The theory behind the massive economic stimulus efforts that many governments have undertaken rests on the notion of the “output gap.” This is the difference between an economy’s actual output and its potential output. If actual output is below potential output, this means that total spending is insufficient to buy what the economy can produce.

A stimulus is a government-engineered boost to total spending. Government can either spend more money itself, or try to stimulate private spending by cutting taxes or lowering interest rates. This will raise actual output to the level of potential output, thereby closing the output gap.

Some economists – admittedly a diminishing number – deny that there can ever be an output gap. The economy, they argue, is always at full employment. If there are less people working today than yesterday, it is because more people have decided not to work. (By this reasoning, a lot of bankers have simply decided to take long holidays since last September’s financial meltdown.) So today’s output is what people want to produce. Attempts to stimulate it will produce only higher prices as people spend more money on the same quantity of goods and services.

A more sensible view is that today’s economy is not producing as much as it could and that there are many more people who want to work than there are jobs available. So a stimulus will boost both output and employment.

But how large must such a stimulus be? The United States Congressional Budget Office (CBO) estimates that American output will be roughly 7% below its potential in the next two years, making this the worst recession since World War II. American unemployment is projected to peak at 9.4% towards the end of 2009 or the beginning of 2010, and is expected to remain above 7% at least until the end of 2011.

The US government has pledged $787 billion in economic stimulus, or about 7% of GDP. Superficially this looks about right to close the output gap – if it is spent this year . But it is in fact a three year-program. Some $584 billion is allocated for 2009-2010, leaving perhaps $300 billion of extra money for this year. Even so, it is not clear how much of that will be spent.

This can be illustrated by a simple example. Suppose the government distributes the extra cash to its citizens. Some of it will be saved. American household saving has shot up from 0% to 5% since the start of the recession, understandably to pay off debt.

Another part of the extra money will be spent on imports, which does nothing to stimulate spending on US output. Let’s subtract 20% for these two items. The bad news, then, is that only 80% of the $300 billion, or $240 billion, will be spent initially.

The good news is that this figure is multiplied over successive rounds of spending, as one person’s spending becomes another person’s income, and so on. The value of the multiplier depends on assumptions about the size of the “gap,” “leakages” from the spending stream, and the effect of government programs on confidence.

Estimates vary from a multiplier of about two all the way down to zero. A multiplier of two would generate $480 billion of extra spending, compared to a multiplier of one, which would generate just the initial $240 billion. If the multiplier is zero, as conservative-minded economists believe, there will be no effect on output, only on prices.

A further source of stimulus is “quantitative easing,” or, more simply, printing money. By buying government securities, the central bank injects cash into the banking system. This is intended to stimulate private spending by bringing down the rate of interest at which banks lend to their customers. Extra hundreds of billions of dollars have been injected into banks worldwide by this means.

But the stimulus effect of quantitative easing is far less certain than even that of fiscal stimulus. While the policy caused credit spreads to narrow and bond market liquidity to improve, many banks have been using the extra money to rebuild their balance sheets (the equivalent of increased household savings) rather than lending it to businesses and individuals.

Several conclusions can be drawn from what admittedly are back of the envelope calculations. The first is that stimulus packages around the world arrested the slide into depression, and may have started a modest recovery.

Second, it is too early to scale down the stimulus, as Japan and the US seem ready to do. As one British official said ahead of the G-20 summit in Italy in July, “We should start to prepare exit strategies, but we should start implementing them only when [we] are sure [we] have got a recovery that is entrenched and self-sustaining, and I don’t think anyone is saying we are at that point yet.”

Third, existing policy, even if maintained, will not produce self-sustaining recovery. At best, it offers the prospect of several years more of sub-normal activity. A double round of stimulus packages is needed to counteract the real prospect of a double-dip recession.

The time to start worrying about inflation is when the recovery is entrenched. To pay back the debt without strain, we need a booming economy. Talk of government spending cuts is premature. ‘A boom not a slump is the right time for austerity at the Treasury’ said Keynes. He was right.