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Tuesday Feb 16, 2010

Fix the Recession then fix the Budget Deficits

Bill has been feeling under the weather lately. I hope that he gets well soon. I offered a friendly operation to help him, for reasons that aren't clear, he declined. ;-)

More on the budget and deficits. On Monday I discussed deficit peacocks (folks who talk about balancing the budget but vote for big ticket budget items). On Tuesday, I showed you a graph on budget deficits dating back to 1931. Today I'd like to talk a little bit about the recession and why we needed the stimulus package. I'm going to use an example that Paul Krugman uses in his book, The Return of Depression Economics. The example was originally used in an article entitled, "Monetary Theory and the Great Capitol Hill Babysitting Co-Op Crisis," by Joan and Richard Sweeney.

Over last two years, I wrote and read a lot about economics. I'm a lot smarter than I was then but I'm still no economics professor. What happens in a recession? Now, as I understand it, a lot of things happen in a recession. The end result is the loss of jobs. Let's use this babysitting co-op as an example - let's say approximately 150 couples get together and decide that they will babysit for each other when necessary. They come up with a system so that everything is fair for everyone. They will use coupons. Each coupon is worth one hour of babysitting. The only other thing that I think is important is that couples that join the co-op are given a certain number of coupons and every couple that leaves the co-op must turn in the coupons. Therefore, the currency is stable.

Several couples in this co-op turned out to be extremely frugal and somewhat homebodies. They wanted to accumulate coupons. This led to couples that went out relatively frequently, depleting their coupon supply. They looked for opportunities to babysit but with several couples staying at home, these opportunities were hard to find. This led more and more couples to stay home to accumulate coupons rather than dwindling their supply. As coupons become more and more scarce, and babysitting opportunities became extremely rare, the babysitting co-op was now experiencing a recession.

The problem in the system, the recession, was caused by the imbalance between too much supply (people wanting to babysit) and not enough demand (nobody wanting to go out). How do you fix this problem? The co-op could pass a law and require that couples go out a certain number of times per month. This would cause people to spend their coupons. It would also prevent people from hoarding coupons. That would be one solution. The other solution would be to increase the supply. With couples having an increased supply of coupons, there was no reason to hoard. More couples started to go out and the crisis was resolved.

So, back to the real world. The Obama administration was facing a recession that some thought could turn into a depression if there wasn't quick action. The Federal Reserve had already infused cash into the system. The Bush administration injected a small amount of cash right before he left office. Think of it as a mini stimulus plan. So Barack Obama and his economic advisers faced rising unemployment, increased foreclosure rates on home mortgages and a GDP that was falling or stagnant. They decided on a stimulus package. The question is how big should the stimulus package have been? Bush signed a $152 billion rebate plan (Economic Stimulus Act of 2008). There's very little evidence that that did anything. Our GDP is worth somewhere over $14.2 trillion. Bush's stimulus plan was somewhere around 1% of the Gross Domestic Product. Economists were saying somewhere between three and five percent was necessary truly to stimulate the economy and turn around this recession. The Democrats and the Obama administration settled on $800 billion for political reasons. They really could not get Congress to authorize more money. Remember, we just bailed out the banks. We just bought up toxic assets. The U.S. Treasury was hemorrhaging money. This does not include money that the U.S. Treasury directly infused into our economy (and foreign markets).

The bottom line is that you have to spend your way out of a recession. Once the recession has passed, then we can concentrate on balancing the budget. You can't balance the budget then stimulate the economy because there would be no economy to stimulate. One of the reasons that the Great Depression lasted so long was because deficit hawks hounded President Roosevelt after it looked like the economy was turning around. He tried to balance the budget too soon and this prolonged the recession/depression. In the State of the Union, you could hear Barack Obama walk the tightrope between fiscal responsibility and the necessity of spending money until the recession is officially over.

Notice that President Obama said almost exactly the same thing while answering questions from Republicans last Friday.

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Posted by Errington Thompson on Feb 16, 2010 email post email Spotlight / / You are in Economy