It is now almost a year since the world economy teetered on the edge of calamity. In the span of three days, Sept. 15-17, 2008, Lehman Brothers filed for bankruptcy, the mega-insurance company AIG was taken over by the US government and the failing Wall Street icon Merrill Lynch was absorbed by Bank of America in a deal brokered and financed by the US government.
Panic ensued and credit stopped circulating. Non-financial companies could not get working capital, much less funding for long-term investments. A depression seemed possible.
Today, the storm has broken. Months of emergency action by the world’s leading central banks prevented financial markets from crashing. When banks stopped providing short-term liquidity to other banks and industrial companies, central banks filled the gap. As a result, the major economies avoided a collapse of credit and production. The sense of panic has subsided. Banks are once again lending to each other.
Although the worst was avoided, much pain remains. The crisis culminated in a collapse of asset prices at the end of last year. Middle-class and wealthy households around the world felt poorer and therefore cut their spending sharply. Sky-high oil and food prices added to the pain, and thus to the downturn. Enterprises could not sell their output, leading to production cuts and layoffs. Rising unemployment compounded the loss of household wealth, throwing families into deep economic peril and leading to further cutbacks in consumer spending.
The big problem now is that unemployment continues to rise in the US and Europe, because growth is too slow to create enough new jobs. Dislocations are still being felt around the world.
A huge debate has ensued around so-called “stimulus spending” in the US, Europe and China. Stimulus spending aims to use higher government outlays or tax incentives to offset the decline in household consumption and business investment.
In the US, for example, roughly one-third of the US$800 billion two-year stimulus package comprises tax cuts (to stimulate consumer spending); one-third is public outlays on roads, schools, power and other infrastructure; and one-third takes the form of federal transfers to state and local governments for health care, unemployment insurance, school salaries and the like.
Stimulus packages are controversial because they increase budget deficits, and thus imply the need to cut spending or raise taxes sometime in the near future. The question is whether they successfully boost output and jobs in the short term, and if so, whether they do enough to compensate for budget problems down the road.
The true effectiveness of these packages is not clear. Suppose that the government gives a tax cut in order to increase consumers’ take-home pay. If consumers expect that their taxes will rise in the future, they may decide to save the tax cut rather than boost consumption. In that case, the stimulus will have little positive effect on household spending, but will worsen the budget deficit.
An early assessment of the stimulus packages suggests that China’s program has worked well. The sharp fall in China’s exports to the US has been compensated for by a sharp rise in the Chinese government’s spending on infrastructure — say, on subway construction in China’s biggest cities.
In the US, the verdict is less clear. The tax cut has probably been saved rather than spent. The infrastructure component has not yet been spent because of long lags in turning the US stimulus package into real construction projects. The third part — the transfer to state and local governments — almost surely has been successful in maintaining spending on schools, health and the unemployed.
RSS