Viscous circles, Virtuous Cycles, and the Stimulus

The US House passed a $813 billion dollar stimulus package spending bill yesterday. The vote went along party lines, with the Republicans, in a remarkable show of party unity, voting 100% opposed. It will now proceed on to the Senate.

There has been a steady drumbeat of bad economic news in the last few weeks, with a number of major companies, from Alcoa to Starbucks, announcing major job cuts. Both consumer and business confidence are at low ebbs. So I think a stimulus package is probably a good thing at this point. But I think there hasn’t been much discussion about the purpose behind the stimulus. Put another way, what is the stimulus intended to accomplish?

Most of the rhetoric has been about job creation. The debate has been couched in terms of what puts people back to work faster, spending or tax cuts. My perspective is that the emphasis on job creation is misplaced. As a conservative, I would argue that the purpose of government is not to guarantee everybody a job (an impossible task in any case). The major purpose of government is to safeguard our liberties, with a minor in promote the general welfare.

The purpose of the stimulus should be to create an inflection point in the general trend line of the economy. To do that, we need to break up the current negative feedback loop driving decision making.

I can see my mother now, saying “What the Hell does that mean?”

First, let’s talk about inflection points. Anytime you look at a graph, the line is trending downward over time, or it is trending upwards over time. If you have a graph that shows both, the spot where the trend changes from down to up or up to down is the inflection point. The economy is trending down right now, and from the news, it is trending down pretty steeply. What the stimulus should do is reverse that trend, to get the economy growing again. That will be difficult because the downward trend is being fed by a negative feedback loop.

Here is the mechanism at work: demand is soft, so companies layoff workers. Once they are laid off, those workers cut back on their spending. Since they are not spending, demand for products and services drops further. With lower demand, more companies announce layoffs, leading to another round of reduced spending, lower demand, and more layoffs. The cycle feeds on itself. Another term for a negative feedback loop is a viscous circle.

Adding to the problem are the effects of fear. People who haven’t lost their jobs yet say “I could be next,” and cut back on their spending as well to conserve cash. This is perfectly natural (by which I mean I’m doing it too), but it steepens the decline.

In a growing economy, as demand increases, businesses hire more employees. Those new employees start spending more, increasing demand, leading to more hiring, driving spending higher, and so on. This is a positive feedback loop, also known a virtuous cycle. Once businesses increase in confidence, they start investing in capital. Capital investment both drives the cycle higher and leads to productivity improvement, bringing higher standards of living as well as more jobs.

The emphasis on turning the economy around versus merely creating jobs is critical. A goal of job creation will lead to an expansion of government payrolls. The easiest way to make sure everyone has a job is to keep hiring. But once you add government positions, it is hard to remove them. You end up with higher government costs for the long term.

An emphasis on a short term surge to kick start the private sector leaves the long term heavy lifting to the private sector. And it is the private sector which will develop the productivity improvements that will raise living standards in the long run.