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What Are The Key Ingredients of Fiscal Stimulus

What Does A Fiscal Stimulus Package Require?

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In late 2008 and early 2009 you could not turn on a TV or open a newspaper without hearing the term fiscal stimulus over and over again. The idea behind fiscal stimulus is a rather simple one - a reduction in consumer demand has resulted in an unusually high number of idle resources such as unemployed workers and closed factories. Becuase the private sector will not spend, government can take the place of the private sector by increasing spending, thus putting these idle resources back to work. With their newly found income these workers will be able to spend again, increase consumer demand. As well, workers who already have jobs will have increased confidence in the state of the economy and will increase their spending as well. Once consumer spending rises enough, the government can slow their spending, as they are no longer needed to pick up the slack.

The theory behind fiscal stimulus depends on three basic factors. As we will see, in practice it is difficult to have more than two of these met at any one time.

Fiscal Stimulus Factor 1 - Provide Stimulus Through Use of Idle Resources

Fiscal stimulus only works if it uses idle resources - resources that would not otherwise be used by the private sector. Using employees and equipment that would otherwise be used by the private sector is of no use; in fact it is detrimental if the private sector projects are of more value than government ones. This "crowding out" of private spending by public spending must be avoided.

To avoid crowing out, great care needs to be taken in a fiscal stimulus package to target industries and geographic areas that contain idle resources. Re-opening a closed automotive plant and re-hiring the laid off workers is an obvious way to do so, though in the real world it is difficult to target a stimulus plan so precisely.

We cannot forget that the choice of what type of fiscal stimulus is chosen by politicians, and thus is a political issue as much as it is an economic one. There is a great likelihood that a politically popular but non-stimulating package will be chosen over one that is politically less popular but more beneficial to the economy.

Fiscal Stimulus Factor 2 - Started Quickly

A recession is not a particularly long-lived phenomenon (though it often feels like one). Since World War II recessions have lasted between 6 and 18 months, with an average duration of 11 months (source). Suppose we are in a long recession of 18 months, with another 6 months of slow growth afterwards. This gives us a 24 month window in which to provide fiscal stimulus. During this period a number of things have to happen:
  1. The government has to recognize that the economy is in recession. This takes longer than one might imagine - the National Bureau of Economic Research did not recognize that the United States was in a recession until 12 months after it started.

  2. The government needs to develop a stimulus package.

  3. The stimulus bill needs to be made law and pass all the necessary checks and balances.

  4. The projects involved in the stimulus package need to be started. There may be delays in this step, particularly if the project involves the building of physical infrastructure. Environmental assessments need to be completed, private sector contractors need to bid on the project, workers need to be hired. All of this takes time.

  5. The projects, ideally, need to be completed. If they are not completed before the economy fully recovers, then we will certainly have crowding out as these employees and equipment would be of use to the private sector.
All of these items need to happen in the window of, at best, 24 months. Meeting this task seems quite difficult, if not impossible.

Fiscal Stimulus Factor 3 - Perform Reasonably Well on a Benefit-Cost Test

Ideally, we should get good value for our money - government should spend taxpayer dollars on items of real value to the taxpayer. Government spending will necessarily raise GDP, because in the calculation of GDP the value of any government project is determined by its cost, not its value. But building roads to nowhere does nothing to increase our true standard of living.

There is also the political issue here - that projects may be chosen on their political popularity or value to special interests, rather than on their merits.

Fiscal Stimulus - Meeting One Factor Is Hard; Three Is Impossible

In Fiscal Stimulus - Unlikely To Work in the Real World we will see that not only are some of these factors hard enough to meet on their own, it is nearly impossible to meet more than two of them at any one time.

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