Fiscal Policy

8 Basic Lessons in Economics #3

So, I'm a computer consultant who finds himself between clients. At the moment, I'm still receiving paychecks from my boss, but that is not something I expect to continue for long. So, because of the uncertainty in my career right now, my wife and I have cut back on our spending. Way back. We are actively worsening the recession.

There's no denying that cutting back on spending during perilous economic times is a natural reaction. For many recessions, the loss in confidence can do more harm to the economy than whatever event caused the downturn in the first place. In Naked Economics, Wheelan puts it this way ...

Indeed, if we all believe the economy will get worse, then it will get worse ... Franklin Delano Roosevelt's admonition that we have "nothing to fear but fear itself" was both excellent leadership and good economics.

So, if consumer spending is down, consumer confidence is down. If consumer confidence is down, the recession will deepen. How can we avoid this trap?

There are two tools that the government can use to smooth the business cycle and bring a recession to a close: monetary policy and fiscal policy. The current interest rate from the Fed is already near zero (known as a liquidity trap) which reduces the ability of the Fed to fix the economy using monetary policy. While most economists agree that monetary policy is the best tool to use, it is simply not available for this crisis. This leaves fiscal policy.

Fiscal policy, the key of Keynesian economic theory, is the ability for government to bring a recession to a close through the use of government spending or tax cuts or perhaps a combination of the two. For fiscal policy to work, the amount of spending or tax cuts must be appropriate and the money must enter the economy as quickly as possible. Many economists believe that government spending is preferable to tax cuts because people are more likely to save than spend until confidence has been restored. (Wheelan states no preference in Naked Economics.) World War II was the largest spending project in the nation's history and it ushered in a long period of shared economic prosperity.)

The political reality of the day is that fiscal policy will consist of both government spending and tax cuts. The Stimulus Package passed earlier this year is a combination of both approaches. Let's hope the money gets into the economy as quickly as possible and makes the current recession a fading memory as soon as possible. Don't hold your breath.