OP-ED The economics of President Obama's stimulus package

Author: Robert E. Prasch

As everyone now knows, the U.S. and the world are in the grip of a tremendous financial crisis. Many banks have failed. Virtually every honest analyst and commentator understands that many of those that are still operating are actually bankrupt by any reasonable measure - all that keeps them breathing is government life support in the form of massive infusions of cash from the Federal Reserve and the U.S. Treasury. As to firms, revenues are falling, inventories are up and orders are down. The American consumer is faced with actual or threatened layoffs, debt loads that are very high by any historical standard, falling house prices, a declining stock market and tight consumer credit. Not a pretty picture. Since, in macroeconomics, aggregate demand is what determines total spending, and total spending determines our national income, we are in a bit of a pickle. As a matter of logic, if businesses and consumers will not spend, and exports show no sign of a sudden increase, then our options are to increase government spending or stand by and watch the economy go over the cliff. The choice is not enviable, but at least it is simple.

A sudden and widespread decline in the value of assets - in this case, stocks and houses - induces a reduction in aggregate spending through a mechanism known as the wealth effect. Here is how it works. Let us be optimistic. Let us suppose that American housing wealth will only decline by $6 trillion (that is about $20,000 for every man, woman and child in the U.S.). Since we are on this optimistic note, let us also say that the total wealth lost in the stock market crash will only come to $7 trillion. This decline in wealth (not income, which is another subject) will induce people to cut back on their expenditures. A plausible estimate of spending per dollar of wealth is around 5 percent. If $13 trillion of wealth has been lost then we can anticipate that consumption will decline by $650 billion per annum as a consequence of the wealth effect from declining stocks and housing alone. Again, this does not include reductions in business investment as a consequence of reduced bank lending. Additionally, we have not accounted for the reduced expenditures that will follow from the actual or anticipated loss of jobs. Stated simply, the above estimates are only partial and certainly represent a lower boundary.

Let us compare the above number to the recently enacted stimulus package. The total for the latter was $787 billion. Moreover, it is to be spent over several years. Additionally, about 40 percent of it is in the form of tax cuts, and we can anticipate that a lot of this will go into savings. As such, it will not be spent, and what the U.S. needs is spending - and it needs it now. But let us remain optimistic and suppose that all of it will be spent. Even if half of the stimulus is spent this year, a most unlikely scenario, it will not even begin to cover the (likely underestimated) losses that can be attributed to the wealth effect from losses in stocks and housing. This means that, at best, the stimulus will only check the decline in the American economy and will not stop it. That said, it is good that someone is trying to do something.

What, you may ask, of the counter-argument? What of the points raised that the ensuing deficit will cause the nation to go broke, or that government spending is largely wasteful, or that it will destroy private initiative?

The nation will not "go broke" for a very simple reason: it prints its own means of payment. Suppose, as an analogy, that I could settle my debts by printing up currency with my face on it (call them "Prasch Notes"). In such an event, I would be a perfect credit-risk. No one can doubt that I could pay my bills. As a nation with the world's leading international currency, we have this advantage. We borrow in dollars and pay our creditors in dollars. Now, there are times and places when we might not wish to over-issue currency. But the causes and consequences of inflation are another subject and, either way, a bit of inflation is never as bad as a depression. Trust me, I lived through the inflation of the '70s and my parents lived through the Great Depression - the latter was worse, a lot worse.

Can government spending be wasteful? Having served in the U.S. Army, I can assure you that I have seen waste on a scale that staggers the imagination. But is it always wasteful? I would say, compared to what? Personally, I will take roads, bridges, schools, national parks and federal water projects over more subprime loans and silly dot-coms any day, and twice a day on Sunday! Like everyone else I can list a number of projects that are wasteful - although you might not like my list - but frankly, such a conversation misses the larger point, which as summarized above is to quickly ramp up total spending. Even if we exclusively used the stimulus monies for group sing-alongs and the building of large pyramids, it would have the effect we want. It gets people on payrolls. They, in turn, will contribute to the stream of spending. That is the goal. If we find something better than sing-alongs and pyramids to spend money on, then I would say "terrific." Green energy sounds fine; so do improved infrastructure and schools. Even if the final catalog of projects is not what you or I would consider to be "optimal," something is being added to overall spending and that is the objective.

Finally, we are told that government spending will destroy private initiative. Personally, I love it when tenured economics professors at public universities make this argument. It reminds us that irony is still alive. But I digress. How much initiative is being destroyed as the unemployment rate moves ever upward? Statisticians have measured the relationship between increased unemployment and rises in divorce, drug abuse, domestic violence, etc. This does not add to initiative. Moreover, we know that businesses are cutting back and banks are not lending. Such tendencies do not present a promising environment for the launching of new ideas. The fact is that new ventures are more likely to prosper in a healthy economic environment. Businesses, banks, and even consumers are more open to new ideas, products, processes and lifestyles when they are flush.

In short, the stimulus package is a good start. It will almost certainly not be enough. It follows that we are in for a rough ride. Having graduated from university during the Reagan recession of the early 1980s, I extend my sympathies to the Class of 2009. Do, however, remember that it is not you who are responsible if you have a slow start after college; that culpability lies with the people who constructed this mess over the past decade.