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 US Congressional Budget Office (CBO) estimates that American output will be roughly 7 percent below its potential in the next two years, making this the worst recession since World War II. US unemployment is projected to peak at 9.4 percent toward the end of this year or the beginning of next year, and is expected to remain above 7 percent at least until the end of 2011.
The US government has pledged US$787 billion in economic stimulus, or about 7 percent 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 US$584 billion is allocated for this year to next year, leaving perhaps US$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. US household saving has shot up from zero percent to 5 percent 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 percent for these two items. The bad news, then, is that only 80 percent of the US$300 billion, or US$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.
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