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YOU DECIDE: Will the stimulus plan work?

February 06, 2009

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu


Dr. Mike Walden
Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

It looks like the $800 billion federal economic stimulus plan is on its way to approval (in fact, the president may already have signed it by the time you're reading this column). Due to so much uncertainty and fear about the economy, many are counting on the plan to turn the economy around.

But here's the big ($800 billion) question: will it?

I'll use three steps to get at this question.

First, what's the idea behind the need for a federal stimulus plan during a recession? Second, what kinds of impacts do stimulus plans have on the economy? And third, how has the debate over the stimulus boiled down to one over tax cuts versus government spending?

The theory behind a government stimulus plan is rather simple. During a recession, consumers (you and me) - who account for 70 percent of all spending in the economy - aren't spending at levels needed to keep full employment. And because consumer spending is down, businesses also curtail their buying.

Further, the lack of buying by consumers and businesses can create a vicious cycle. As consumers buy less, businesses lay off more workers, which in turn causes consumers to reduce their spending even more, and so on and so on.

One entity can break this logjam, and it's government.

The notion is that government can step in and spend more money, buying products and services directly from businesses. With their sales up, businesses will hire more workers, which in turn puts more money in consumers' pockets and motivates them to increase their spending. Once confidence in the economy has been restored, government can scale back its spending and watch the economy operate normally.

At least that's the theory.

This theory has been - and continues to be - one of the most controversial and debated in the economics profession for more than seven decades. The debate hinges on two key questions: where will the government obtain the additional money it spends, and how will consumers and businesses react to the way the government gets the money?

In most cases, the government will borrow the new money it spends. But borrow from whom?

There are three possibilities: foreign investors, domestic investors or the Federal Reserve Bank. In the latter case, the Federal Reserve effectively prints the money borrowed by the government.

A legitimate concern about this borrowing is whether it will effectively "crowd out," or replace, other spending. This could happen if the extra government borrowing caused interest rates to rise. Although the federal government will pay whatever interest rate necessary, consumers and businesses will likely reduce their borrowing and spending when interest rates jump.

If interest rates do rise, and if consumers and businesses do reduce their spending as a result, then this lower private spending could partially or fully offset the additional government spending and weaken the impact of the stimulus program.

Economists disagree about the size of this crowding out.

Some argue it is substantial and effectively complete, meaning the increase in government spending will be counteracted by a decrease in private spending, so there is no extra kick to the economy. Others claim that during recessions - especially severe ones - there are so many "idle resources" available that interest rates rise very little and all the stimulus spending is really extra spending to the economy.

Yet even if it is agreed the federal government needs to come to the aid of the economy with a stimulus plan, there can be a clash over exactly how: spending or tax cuts? The budgetary effects of the two are really the same. In both cases the government has to borrow money to fund either the tax cut or the new spending.

The real difference is in who controls the money.

In the case of tax cuts, households and businesses receiving the cuts decide how to spend the funds; in the case of government spending, public officials make those calls. Economists may also quibble over the effectiveness of the two alternatives, in terms of which gives the biggest economic bang for the buck, but once again opinions are all across the board.

So is there an overwhelming consensus among economists that the new federal fiscal stimulus will help end the recession?

No. But there's also no consensus it won't!

Perhaps the best economists can do in this case is highlight the issues and points of disagreements and let policymakers, and you, decide.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at February 6, 2009 08:31 AM