Understanding the Case for and Against Stimulus

Following news coverage can be easy. Understanding some of the terms it uses, less so. In our Flashcard series, The Atlantic explains ideas you may read about but never see spelled out. In this installment, we dig into the case for (and against) stimulus.

The News

In the twilight of a global recession, the world is sending a message: deficits matter, again. From the G20 announcement that the world's leading economies will begin removing fiscal stimulus, to Washington's revolt against the newest "jobs bill," we are entering a period where politicians are more concerned about tending to healthy-looking budgets than reviving their weak economies at all costs.

The Gist

Recessions lead to deficits for two main reasons. First, tax revenues fall when workers lose jobs and the taxable income that comes with jobs. Second, governments put policies in place to spend more when its businesses cut back. When families earn less money, they spend less money, which means lower profits for firms, which can spiral into even more jobless families. To stimulate the wilting economy, the government spends money -- infrastructure projects, state relief, unemployment aid -- that families cannot. Much of this spending comes on top of what the government is earning in taxes. So countries borrow money by selling bonds to investors and promising to pay them back with interest later when the economy has recovered.

The government cannot spend significantly more than it earns forever. Borrowing and spending through a downturn is sustainable only as long as investors believe that you will pay them back, in full and on time. When they lose that confidence, countries have to offer higher interest rates and financing the debt can become unaffordable. Think of it this way: when interest rates are low, short-term deficits replace the engine for growth. When interest rates spike, the engine feels heavier and heavier, until it eventually becomes an anchor.

The Debate

Liberals in the United States have argued for more than a year that the Obama administration's $800 billion Recovery Act was insufficient to meet the shortfall in demand. One piece of evidence that bolsters the liberal claim is that state revenues have fallen much faster than the administration anticipated. As a result, states are cutting back even faster than the federal government is spending, sapping the effectiveness of that stimulus.

Conservatives counter that Obama's stimulus was much better at growing the deficit than growing jobs. That some of the $800 billion Recovery Act might have been spent better is a truism. But the jobs criticism is unfair. Most of the early stimulus money went to shouldering the states' Medicaid burden and stabilizing their budgets, freeing up cash to keep up public payrolls, which in turn propped up spending. Independent analysis by Goldman Sachs economists estimate the Recovery Act added up to two percentage points to GDP growth by the end of 2009.

In the end, a dash of humility is required on both sides of the debate. While the rationale for stimulus spending is sound and dates back to John Maynard Keynes and the Great Depression, it's also unevenly tested. Historic recessions are historically rare, by definition, which leaves policy makers with limited options. It's difficult to know for sure what stimulus measures are the most effective (money for the cash-poor? relief for states? infrastructure projects?) or downright wasteful. But until economics and history conspire to produce better evidence that short-term deficit spending hurts economic production, politicians will always conclude that they can't afford to not spend the money.

For more Flashcard posts:

The Value-Added Tax

The Contagion Effect

Deficit Spending (Stimulus)

The Oil Spill Liability Cap

Carbon Pricing