Thursday, December 11, 2008

How to Get Out of Quicksand, Part II

So, as I indicated last time, this second installment of the Readers' Manual on How To Get Out of Economic Quicksand will answer the question of why, when we're facing such a dramatic economic crisis, the government should engage in an expansionary fiscal policy instead of a contractionary policy or a more moderate expansionary fiscal policy.

Here's where things get complicated, and where many economists disagree with one another. It's also, truth be told, where I get a little lost without doing some more serious research, so I'll admit that my explanations might be oversimplifying things a bit.

Proponents of an aggressive fiscal policy in this dire economic situation concentrate on gross domestic product and unemployment as the centerpieces to solving our economic troubles. Gross domestic product (GDP) is the sum of a country's consumption, investment, government spending and the value of the country's exports less imports, and it is generally considered the principal measure of an economy's health.

Normally, the Federal Reserve can influence GDP by lowering interest rates because by doing so, as I discussed last time, investment goes up. However, when the Fed can no longer lower interest rates then investment goes down or remains static and downward pressure is exerted on GDP and unemployment increases. To avoid this scenario, the government needs to spend a lot of dollars. Spending has the ability to do two things (which are related): stimulate consumption and create jobs. By stimulating consumption, GDP goes up. And by creating jobs, people get paid salaries, which in turn increases consumption, which in turn increases GDP and creates more jobs.

In a normal economic environment, too much government spending creates the risk that the government will just start printing money at will, leading to high inflation. However, inflation is typically curbed by raising interest rates (because raising interest rates reduced the available money supply). When the Fed is starting with interest rates hovering around zero, the sky's the limit on its ability to raise interest rates. So, if the government overshoots its spending policy then the Fed can simply counteract that by raising interest rates.

Conversely, if the government takes a cautious approach to fiscal policy and falls shorts of its GDP goals, the Fed can't do anything to remedy the problem. It can't raise interest rates because that will just keep the economy stagnant when there's no need to curb inflation, and it can't lower interest rates because interest rates are already around zero.

Though the arguments in favor of an aggressive fiscal policy are compelling, such a policy is difficult to implement in reality. The news from today that the auto industry bailout faltered in the Senate demonstrates that politics combined with Congress's reticence in setting economic policy will affect the choice of medicines that we are ultimately told to swallow in order to revive our ailing economy. Drastic times call for drastic measures, but a more cautious approach may ultimately win the day.