I’m sure gorillas could be taught to use shotguns. That would teach the poachers!
In my last two posts I examined fist what an unhealthy economy really means and then one way governments try to deal with it, namely stimulus packages. In this post I will look at the other way a government might try to deal with an unhealthy economy, austerity measures.
Austerity measures, unlike stimulus packages have two purposes. Like stimulus, austerity can be used to get the economy moving again but it can also be a way to protect the government incase the economy does not improve as expected. When a government adopts austerity measures it basically means that the government cuts back on its spending. Usually this is done by reducing or eliminating basic services and by canceling or postponing large contracts. In the wake of a failed stimulus package or in the case of a government which has grown very large and expensive during good economic times, austerity measures can be a way for a government to keep from defaulting on its loans or from having its credit rating lowered. This is exactly what is happening in Greece and many other EU member countries right now.
Greece’s government grew to be a very large portion of the country’s total economy during good economic times and on borrowed money; money it could only afford to borrow because wealthier countries like Germany were essentially co-signing on the loans. Now that the economy is bad, interest rates are going up and tax revenues are going down and Germany is having to pay Greece’s debts but is requiring Greece to adopt austerity measures to ensure that it does not happen again. This situation is repeating itself all over Europe.
The second purpose of austerity is to actually get the economy moving again; which at first sounds strange considering that austerity is in many ways the opposite of stimulus, but they also share a few things in common. If a government is in relatively good financial shape and not at risk of defaulting on its loans then it can adopt austerity measures in which it couples a reduction in spending with a reduction in taxation. This acts similar to a stimulus package in that people are suddenly able to spend more money and thus to get more cash circulating in the economy. This is what happens when there are sales tax holidays; people go shopping and buy more than they ordinarily would because they do not have to pay taxes on it. This also happens after people receive their income tax refunds. Unfortunately governments are rarely in this kind of shape financially and so austerity is usually not met with reduced taxes or the economic boost they may give.
Tax cuts are still often advocated as a way to stimulate the economy and they often work but not when coupled with austerity measures. If the government cuts taxes by the same amount that it cuts spending then the two actions cancel each other out as far as circulating cash in the economy is concerned. In such a scenario, the outcome would likely be worse economic disaster while the various companies adapt to the loss of government contracts, even if similar contracts could be picked up later in the private sector. Instead, tax cuts are usually adopted along with government loans, this is what happened with the Bush tax cuts; the tax rate went down and the government was financed to a greater extent by debt.
So to compare stimulus and austerity, stimulus is strictly to grow the economy at the risk of the government defaulting on its loans if the economy does not pick up quickly enough while austerity is a way to protect the government from the risk of defaulting on its loans and collapsing. In this way, stimulus is a higher risk and more radical move while austerity is lower risk more conservative move and more focused on riding out the storm than overcoming it.
One last note, the economy is largely dependent on how the people feel. If they think the future looks bright then they spend more and risk more and the economy tends to do well if they think the future looks grim then they conserve more spend less and the economy does not do as well. This means that a crucial aspect of the success of any economic program is how the people react to it. If during a stimulus program the people feel that the program is unsustainable and that taxes are inevitably going to go up, then the future looks bleak to them and they conserve and spend less. Even if a country suffers during austerity measures but the people feel good about future stability then they will risk more and spend more and the economy will probably recover. This is one reason why I feel that the New Deal had as much success as it did; people saw the grand projects that boggle the mind and were inspired to believe that the future was bright.
In my last post I explained that an unhealthy economy essentially means that for whatever reason there is not enough money circulating around; either people do not have the money or they are not spending it. In this two-part post I want to examine the two most common responses governments and central banks have to the problem of an unhealthy economy, stimulus and austerity.
Stimulus is pretty straightforward and really only has one purpose, to get the economy moving again. Each stimulus package is different but the general idea behind them all is to inject more cash into the economy. Remember that an unhealthy economy is one with too little cash in circulation. When a patient is low on blood they are given extra in the form of a blood transfusion; a stimulus is a cash transfusion and the patient is the national economy. Scholarships and small business loans are essentially personal stimulus packages. You need money in order to make a greater amount of money in the future so you get a scholarship, to go to college, to get a good job, to make the money; or you get a loan, to start a business, to make the money.
The most basic stimulus package takes the from of, the government greatly increasing the amount of money it is spending. Perhaps the most famous stimulus package was FDR’s New Deal. The New Deal did many things including create social security but what concerns us is how it worked as a stimulus package. Under the New Deal, the federal government spent massive amounts of money in a short period of time on huge infrastructure projects such as highways, bridges, dams, and power grids. These are all useful things and we reap the benefit of them still today but they were not considered necessary at the time they were simply things for the government to spend money on in order to stimulate the economy.
The way it worked was that the government awarded massive contracts to construction companies who then took that money and hired armies of previously unemployed men to build these things. This raised those men and their families out of poverty (at least by the standards of the time) and in doing so, gave them purchasing power. They were then able to buy goods such as shoes. The shoe store would then need to hire more employees and purchase more shoes from the factory to keep up with demand. The factory would hire more employees and purchase more leather from the leather company which would in turn hire more employees. A perfect stimulus package would be the exact reversal of the vicious spiral of layoffs and closures that an ailing economy goes through. However, no stimulus is perfect.
Things did get better after the New Deal but the economy was still in pretty bad shape and by 1937, several years into the new deal, unemployment reached 19%. Eventually the economy did recover but the New Deal had some help; the US entered the second world war and Prohibition was repealed. The alcohol industry was huge just 15 years before and so the infrastructure was still in place for massive production, sales, and distribution as soon as Prohibition ended; the industry just had to hire the people to do it.
During WWII, the ranks of the military grew by the millions. These men were now employed and those who had been employed before left behind open jobs to be filled by someone else. The war had another effect; it created massive demand for both equipment and for the development of new technologies, both of which the government paid handsomely for. The point is that even if the New Deal itself did not get America out of the Great Depression; the repeal of Prohibition, the second world war, and other similar things were themselves stimuli. They were not purpose built to get the economy moving again like the New Deal was but they worked in the exact same way; they injected more cash into the economy and it got other cash circulating.
Stimulus packages sound great but they have one flaw; the money has to come from somewhere. There are three possible places where the government can get the money for a stimulus; thin air, loans, and taxes. Governments can print more money out of thin air and this is occasionally used as a stimulus. This is the quickest way for the government to devalue its currency and so printing money out of thin air is almost always a bad idea. This is because the currency becomes so devalued, inflation rates go so high, that the next time the bills are due the value of the currency that the government is holding is simply not enough. They are often forced to print more currency to cover the costs of basic services which then causes even more inflation. By this point another vicious cycle has begun. Loans and taxes never sounded so good.
Loans are probably the most common way for governments to finance stimulus packages. The idea being that loans inject cash immediately and defer payment until after the stimulus has had its effect, growing the economy and leading to higher tax revenues. The government takes out a loan which it can’t really afford now (because the economy is in the tank and tax revenue is low), expecting to be able to pay it off later (after the same loan has stimulated the economy and lead to higher tax revenues). This sounds risky but it is the exact same thing as student loans; an 18 year old high school senior can’t have any hope of paying off a $70,000 dollar loan but a 22 year old engineer can expect to pay it off in just a few years. The risk of course is that the economy may not pick up enough to raise the tax revenue to pay off the loans. Another risk with loans is that the credit rating agency may determine that the risk of the government not being able to pay off its loans is significant enough to lower their credit rating. This would cause the interest rates on those loans to go up and thus make it more difficult for the government to make the payments. In this way changing a government’s credit score can be a self fulfilling prophecy; there is a chance they will not be able to make the payments, therefore the interest rate is higher, therefore they cannot make the payments. Taxes never sounded so good.
Taxes are the final way that a government can finance a stimulus package. Taxes are always unpopular unless someone else is paying them. They are especially unpopular when the economy is down and people are already struggling financially. For this reason raising taxes is not a very common method for financing and stimulus package. That is not to say that it is not a viable option; remember the stimulus that was World War II? It was financed by a combination of loans (in the form of war bonds) and taxes. During the war taxes were extremely high, the top personal income tax bracket was 94%! Such high taxes have two effects; first the government takes that cash and spends it, second those wealthy individuals who want to preserve their personal fortune do so by reinvesting money in their companies rather than taking it out as personal income. Both effects mean more cash is circulating in the economy. Despite the fact that taxes can work and that they lack the risks associated with loans, their general unpopularity and the fact that governments can often borrow more than they can tax means they are seldom used for financing stimulus packages.
So a healthy economy is one in which lots of cash is circulating and stimulus packages in all their various forms can have that effect. However, stimulus comes with the risks of the government losing its credit rating, defaulting on its loans, and runaway inflation. In my next post I’ll look at the alternative, austerity and compare it with stimulus.