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The Case for an Even Bolder
Economic Stimulus

Hendrik van den Berg
UNL Professor of Economics

There’s no question that the U.S. economy needs a large fiscal stimulus. Official unemployment reached 7.6 percent in January, and labor economists estimate that the true percentage of people who would like a job but don’t have one is probably double that — at 14 or 15 percent of the working-age population. And as a whole, the economy continues its downward spiral as more firms announce layoffs and consumer demand continues to shrink. Worst of all, the same thing is happening in every other country of the world (which means that there isn’t another large economy to pull us out of recession). The downward spiral will have to be reversed by our own economic policies.

And a fiscal stimulus is, realistically, our only option.

Yes, it’s true that, in general, government has three options for dealing with rising unemployment and falling incomes: (1) fiscal stimulus, (2) monetary expansion (‘easy money’ credit policies), and (3) doing nothing in the hope that the economy eventually fixes itself. Once the economy begins contracting and unemployment rises to high levels, however, the latter course is no longer really viable, as plummeting economies do not reverse themselves very easily. And, monetary expansion is also inadequate in a financial collapse like the one we find ourselves in today. The U.S. Department of the Treasury and the Federal Reserve (not to mention foreign governments in most other countries) have already spent enormous amounts of debt-financed money trying to fix our broken financial sector — so far to no avail.

The Financial Origins of the Current Recession

This is not to say that we should not fix the financial sector. After all, that’s where the current recession originally started. The first signs of the current economic downturn appeared two years ago, in early 2007, when falling housing prices set off a massive reevaluation of the profit/loss balance sheets in the financial sector. Most commercial banks, investment banks, insurance companies and hedge funds held a substantial portion of their assets in the form of financial instruments that were based on the value of mortgages issued during the ‘housing bubble’ of the early 2000s. It is now well known that this housing bubble (with its inflated mortgage values) was fueled by the expansionary monetary policy of the U.S. Federal Reserve Bank — allegedly to help the economy recover from the popped ‘stock market bubble’ of 2000 that the Federal Reserve had in turn encouraged with its expansionary monetary policy during the economic boom of the 1990s.

On top of the Federal Reserve’s over-expansion of the money supply, the rapid growth of the global market for what’s now known as ‘securitized’ and ‘structured’ financial instruments further fueled the housing bubble by letting banks issue many more mortgages than they ordinarily could have afforded. Banks essentially issued mortgages to whoever walked in the front door, and then had an investment bank bundle them up into a new security that could be sold on to other investors and banks throughout the world. The income from the sale of the security enabled the original banks to turn around and make even more loans to willing home buyers, whose mortgages were again bundled into yet another new security, and so on. Some clever financial manipulation and faulty (read: corrupt) ratings techniques made many of the securitized bundles of mortgages seem safer than they actually were, and banks, pension funds, hedge funds and insurance companies throughout the world naively purchased them — which of course only encouraged mortgage lenders to use the available money and do the whole thing all over again. With every repetition of this cycle, however, the bubble in the housing market grew both larger and more precarious.

This financial expansion came to an end when housing prices began falling from their unsustainable levels in 2006, and the securitized mortgages — often bundled together with other securities — had to be downgraded to reflect their diminished value. Many banks and other financial institutions began scrambling to shore up their balance sheets and to avoid violating banking regulations and regulatory guidelines. The market for securitized bundles of mortgages and other debt quickly dried up, greatly reducing financing for housing and other loans. Borrowing costs accordingly rose and building and investment activity slowed sharply.

The Recession Began More than a Year Ago

It is now estimated that the current recession actually began at the end of 2007, even though the widespread news reports of the failures of major financial institutions like Bear Stearns, Lehman Brothers and AIG only began to make headlines in mid-2008. The media really missed the story on this one, but looking back, the warning signs of recession were certainly there, beginning with the collapse of the municipal bond market. In 2007, the so-called ‘monolines’ (the insurance firms that traditionally insure such bonds) had their investment ratings downgraded because — for the first time ever — they’d diluted their insurance portfolios of municipal bonds by adding what they assumed were equally-safe mortgage securities. That same year, however, the Treasury Department explicitly ruled out any moves to shore up the municipal bond market. The ensuing collapse of state and local projects contributed directly to the economic slowdown. The only upside to this has been that Lancaster County has not yet been able to float a bond to build its new jail.

By 2008, however, the Treasury Department and the Federal Reserve realized they had a brewing crisis on their hands and they began to assist banks in cleaning up their balance sheets by lending them treasury bonds and bills — using as collateral those very same securitized financial products whose real market values were deteriorating rapidly. The Federal Reserve also began pumping large amounts of money into the banking system in the hope of reversing the sharp decline in lending that was beginning to choke economic activity. On top of the $2 trillion already provided to the financial industry through these measures, Congress, in the fall of 2008, approved President Bush’s request for $700 billion in additional funds for the secretary of the Treasury to acquire questionable bank assets so that banks would again begin lending. To date, these measures have had little effect, and unemployment continues to grow.

It’s a Fiscal Expansion, Stupid!

John Maynard Keynes in his 1936 General Theory of Employment, Interest, and Money explained that — in a deep recession — the economy is caught in a ‘liquidity trap,’ where no amount of available money will make investors want to borrow funds for new projects, or make banks want to lend to borrowers who are unlikely to be able to repay their loans. The recent collapse of the bloated market for securitized products and the still-shaky balance sheets of most financial institutions make the current liquidity trap even harder to work out of. Hence, expansion of the money supply has little or no real effect, and we are left with only fiscal policy (an economic stimulus) to resuscitate the economy.

Stimulative fiscal policy consists of some combination of tax cuts and government expenditures, both intended to increase demand for goods and services and, thus, raise employment and income. Tax cuts work by leaving people or businesses with more money in their hands, which they then hopefully spend. Increased government expenditures have a more direct effect on demand for goods and services — provided the government can actually spend the budgeted money quickly. In either case — taxes cuts or direct government expenditures — the increased expenditures generate income which is then later spent, generating a second increase in demand, which in turn causes further income growth, which is also spent... It’s a tried and true method for spurring the economy into recovery. The effectiveness of a fiscal stimulus in reversing a downward spiral and starting an upward one, however, depends on how fast and how much demand increases from the initial expenditures and — in subsequent rounds — on income receipts and expenditures.

It was interesting these past weeks to listen to pundits and Republican partisans complaining that the fiscal stimulus plan had deteriorated into nothing more than a program of tax breaks and more government spending. Well, duh! It’s a fiscal stimulus plan. That’s what it’s designed to do. Of course, everyone really knew this. That was just the usual political jockeying… But the carping does serve to drive home the point that the nature, the scale and the duration of the Obama Administration’s fiscal stimulus strategy will ultimately come down to politics.

The Politics of Fiscal Stimulus

A fiscal stimulus plan affects the future size of government. Those who want to limit the role of government in the economy tend to favor tax cuts. Proponents of an enhanced role for government favor new government programs and expenditures. Also, there will be further political arguments about which taxes to cut or which government expenditures to make. In short, any final package of fiscal measures to expand demand for the economy’s goods and services will inevitably be a mixture of tax cuts and a wide variety of new government expenditures that no one is happy with. Bipartisanship, such as we so often see arise when it comes to voting on going to war, is nearly impossible to achieve when it comes to a fiscal stimulus bill.

President Obama tried to appeal to nationalism and patriotism when he stumped for the stimulus bill — reaching across the political aisle for needed Republican support. But the normally patriotic Republicans refused to budge, because they saw the sharp increases in government expenditures as running counter to their economic philosophy of privatization, low taxes and reduced social spending. F.D.R., by contrast, was able to shift government policy as much as he did without catering to the Republicans because he enjoyed huge majorities in both houses of Congress.

What about the Financial Bailout?

It is a fact of life that a modern economy cannot function without a healthy financial sector. We thus have no choice but to restore our banks, insurance companies and financial markets to a healthy state. However, this does not mean we need to spend the massive amounts of money currently being proposed, since those sums are based on the assumption that we will return to a system similar to what we had. The failure of that system and its direct role in fueling excessive expenditures and debt over the past 25 years (including the questionable and likely fraudulent activities that caused the recent stock market and housing bubbles) argues that we in fact should not go back to the financial system that we had. Given the cozy relationship the financial industry has with so many of our politicians, it’s entirely possible of course that we’ll wind up doing exactly that. Hopefully saner minds will eventually prevail, however, and take us back to a simpler, more transparent, and better-regulated financial system — one that serves the interests of the real economy, instead of the present arrangement in which the real economy serves the interests of the financial system. Even under the best of circumstances, however, fixing the financial system is going to be a lengthy process. And in the meantime, we will need an expansionary fiscal policy if we are to have any chance of avoiding a prolonged and costly period of high unemployment.

We Will Need More Fiscal Stimulus

Given the huge demand deficit the global economy currently faces, we will probably need further fiscal stimuli beyond what the recent fiscal stimulus package offers. Never afraid to rewrite history, many conservatives argue that fiscal expansion did not work during the Great Depression, as evidenced by the persistence of the Depression throughout the 1930s. In point of fact, however, the problem was not that F.D.R. was too bold — but that his efforts to stimulate the economy were too timid. After his initial expansion of government expenditures in 1933, F.D.R. raised taxes and cut expenditures in 1936 in response to claims by bankers and fiscal conservatives that government debt was becoming too great a burden. The economy immediately collapsed again in 1937, just as the Keynesian economic model predicts would happen. It was not until that enormous fiscal stimulus known as World War II that the U.S. economy was able to recover from the Great Depression. The U.S. economy, it turns out, was able to handle government debt greater than 100 percent of annual GDP (we’re only at 70 percent now). The debt was gradually worked off during the 1950s and 1960s, the period when the U.S. economy achieved rates of income growth that, since then, no amount of privatization, tax cuts and reduced government have been able to achieve.

I do not bring up World War II’s fiscal stimulus in order to suggest that we should resort to war to solve our economic problems. To the contrary, we peace activists must be prepared to challenge and thwart the inevitable attempts to use the current recession to justify more war and increased military expenditures. The just-enacted stimulus package is largely free of new military expenditures — but recent lobbying by the military-industrial complex suggests that the economic recession will be actively used to justify bloating this year’s military appropriations with unnecessary programs. Proponents of questionable arms programs, like the F-22 fighter slated for extinction by the Obama Administration, are already railing about the job losses cutbacks in these programs will bring.

Critics of the just-passed fiscal stimulus package often claimed that the proposed expenditures were ‘wasteful.’ Such claims were largely a diversionary tactic, of course. Proposed expenditures on condoms to avoid unwanted births and the spread of AIDS (which were taken out of the bill) are clearly much more economically stimulative and productive than tax breaks for the upper middle class (which were included in the bill). Nevertheless, for the future, there will be a continued need to focus on the long-term benefits of increased government expenditures for productive, non-military projects and programs.

With the U.S. already accounting for half of the world’s military expenditures, nothing more clearly fits the definition of ‘wasteful’ than additional military spending. There are enough needs for peaceful and effective expenditures on education, basic infrastructure, alternative energy, repairing government services, improving the social safety net, and providing universal healthcare to fit whatever amount of fiscal stimulus our economic decline requires. Over the next two years in particular, members of Nebraskans for Peace will need to be vigilant about opposing any attempts in Congress to use the economic crisis to promote military spending and further our already overblown capacity to wage war.