Stimulus Package, Part II

In my last post I argued that the proposed stimulus package approved by the US House would be ineffective. First, it would do nothing to solve the structural problem in the housing and financial services industries. That problem is that falling house prices have put a large number of subprime borrowers underwater on their loans, just as those loans start to reset from their original teaser rates up to higher market rates. Lowering interest rates, as the Fed has done recently, may aleviate some of the pressure on home owners, but handing out checks to households will only delay the inevitable by one or two months. If you can't afford your mortgage, getting a short term infusion of cash defers going into default, but does not make the mortgage more affordable in the long run.

I also argued that a Keynesian stimulus would not be effective when the government was already running a massive deficit. So just what is a Keynesian stimulus, and when would it be appropriate?

John Maynard Keynes was a British economist of the early 20th century. His most influential work was published in the 1920's and 1930's. From a policy perspective, his biggest contributions were in the realm of increasing total economic demand by increasing goverment spending. The idea is that during times of reduced demand, unemployment increases. Government can start deficit spending, which will increase demand. To meet increased demand, businesses will have to hire workers, who will then have money to spend, causing other businesses to hire more workers to meet that demand. This all leads to a virtuous circle of increasing economic activity.

The metaphor most commonly used to describe this process is "priming the pump." Businesses will only borrow money when they need to expand. But governments can borrow in order to smooth our the down part of the business cycle. The goal is to keep employment levels high (after all, employees are voters as well).

But right now, we are already running a massive Federal budget deficit. Also, unemplyment is still low. So if you are already providing a hyper-Keynesian stimulus, and yet economic acitivty is still dropping, you have to look somewhere else for the solution to the problem.

So in my next post I provide some of my own modest ideas of how to get the economy out of the doldrums.