How stimulus packages can lead to growth
“Today, investors are reluctant to lend to risky firms …"
The world today is in a state of perpetual déjà vu. The current global recession has already been compared countless times in the press to the Great Depression of the 1930s, so much so that both commentators and the public are beginning to think of the two events as one and the same.
Many aspects of the current economic crisis certainly do evoke memories of the other major recession in world history; sharp plunges in personal and corporate incomes, widespread export slumps, record-high unemployment rates and a troubled stock market are symptoms all too familiar to scholars of economic history.
The parallels between the current situation and that of the 1930s solidified even further at the end of 2008 when governments around the world began to launch fiscal stimulus packages of historical dimensions.
Fiscal stimulus around the globe
Fiscal stimulus is a common economic tool used in times of recession to prop up falling aggregate demand through a combination of tax cuts and government spending. The size and content of these packages, however, have varied greatly among different countries.
European stimulus plans have thus far been relatively small due to the existence of built-in social security programmes in most European states. From September 2008 to January 2009, the 13 largest EU economies announced stimulus packages equalling only about 90 billion euros, or 0.78% of their total combined GDP.
Countries in other regions of the world have had to take more drastic measures. The Indian stimulus plan, launched in December 2008, is valued at approximately US$ 8 billion and specifically targets consumer spending through petroleum price subsidies and tax cuts on various consumer goods such as automobiles, cement and textiles. The Chinese stimulus package, on the other hand, costs a hefty US$ 825 billion and focuses on the development of roads and infrastructure.
The stimulus controversy
By far the most controversial stimulus package is undoubtedly the national plan that American President Barack Obama launched in early 2009 to help revive demand and lower unemployment in the United States. Costing a total of approximately US$ 775 billion, Obama’s fiscal stimulus plan involves a combination of government-funded public works projects to create jobs, individual and household tax cuts to encourage consumption and increased public spending on unemployment benefits, education and health care.
Since its announcement, the stimulus plan has become the centre of a storm of criticism from the nation’s conservatives, who warn that further stimulus spending would drive up inflation, destabilize the dollar and cause the national deficit to grow to gigantic proportions.
Most importantly, critics of the US stimulus plan are sceptical that it would lead to economic recovery, in terms of GDP growth and job creation, of a scale that would justify its extremely high costs. Conservative commentators have time and again expressed their frustration that the measures implemented as part of the stimulus package seem to have simply transferred money without improving the state of the economy as a whole.
Even amidst the storm, other influential voices have chimed in support of the plan. New York Times columnist Paul Krugman, for instance, hails Congress’s biggest Keynesian intervention in decades as a necessary step to keep the American economy afloat and on the right path to recovery.
“We must not make the same mistake that the FDR government made in 1937, when they withdrew stimulus prematurely and prolonged the recession as a result,” says Krugman in response to conservative demands to start scaling back stimulus spending now that the economy has begun to crawl back to its feet.
“Rising GDP doesn’t necessarily signal permanent economic recovery. Often, these figures are statistical illusions resulting from an ‘inventory bounce’ in which companies slash production to get rid of excess stocks, and then temporarily increase their production once the excess is gone,” Krugman writes.
“Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, also pick up.” Ultimately, Krugman insists, this won’t happen without the help of second and third rounds of continued stimulus spending.
Smarter ways to implement fiscal stimulus
The fierce debate in Washington on whether or not Congress should increase or decrease stimulus spending has raised other, more compelling, questions about the way in which policymakers could improve the design of fiscal stimulus proposals in order to better maximize their effectiveness. The main problem with the New Deal-type provisions in the current American stimulus plan is that it focuses too heavily on boosting consumer spending and does not provide any specific incentives to increase investment.
In a commentary recently published in the Wall Street Journal, Harvard economist Alberto Alesina and University of Chicago finance expert Luigi Zingales point out that what distinguishes the current recession is that it is being driven by a lack of investment, not by a lack of household spending.
“Today, investors are reluctant to lend to risky firms,” say Alesina and Zingales. “This reluctance is making it difficult for these firms to refinance their debt, forcing them to default on their credit, which further validates investors’ fear. Thus, the problem is how to increase investors’ willingness to take risk. It’s unclear how the proposed stimulus package would inspire investors to do so.”
Alesina and Zingales advocate specific stimulus measures to encourage investment, including the temporary elimination of the capital gains tax as well as
"Often, these figures are statistical illusions resulting from an ‘inventory bounce’ in which companies slash production to get rid of excess stocks, and then temporarily increase their production once the excess is gone …"
additional tax cuts on capital expenditures and on investments in corporate research and development. Besides giving an immediate boost to aggregate demand, measures that specifically target investment could also promote long-term economic growth.
Say Alesina and Zingales, “A large temporary tax incentive may be just enough to jolt investors from their current paralysis to take action. A temporary capital gains tax cut, for instance, will motivate people to move their savings from money-market funds to stocks, thereby increasing valuations, investments and confidence.”
Alesina and Zingales’ commentary makes the further point that stimulus packages must be adapted to tackle individual recessions at their source, rather than following a formulaic one-size-fits-all approach. Policy reactions to the current recession must consider its origin and cannot simply mimic the ones that were taken in the 1930s.
“This particular recession is unique not in its dimensions, but in its sources,” say Alesina and Zingales. “The current stagnation did not originate in the labor market, but in the credit market, thus necessitating a stimulus strategy based on promoting investment.”
The international dimensions
In addition to keeping confidence levels high at home, the American government must also keep reassuring their peers in Europe and Asia that the stimulus plan would have a positive impact on global markets as well.
Commodity shares all over the world from Hong Kong to Paris increased immediately following the launch of the American stimulus package, causing much celebration and renewed investor confidence in these countries.
In the long run, however, a more coordinated international effort is needed to turn American stimulus into “global stimulus”. Despite the temporary revival of some financial markets following the stimulus, America’s major trading partners such as Japan and China have continued to experience drastic declines in their economy due to the export slump.
Meanwhile, certain protectionist clauses in Obama’s original stimulus proposal – such as the “buy American” clause attached to consumer tax cuts and infrastructure projects – have soured relations between the US and the European Union. The leaders of many EU countries, reluctant to upgrade their own stimulus packages, had been hoping that the American stimulus bill would provide valuable trade and contracting opportunities that would help lift their own economies out of the GDP hole.
As the world eagerly watches the impacts of the American stimulus plan unfold in the hopes that it would revive international trade and the US demand for foreign goods, the stage remains open for further international cooperation on global stimulus initiatives.
Article by Karin Sun
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