Do we really need all this stimulus?

Prior to the Depression, the conventional thinking was that economic downturns were self-correcting. A fall in consumer spending would cause businesses to cut prices to get people back in the stores. Faced with higher unemployment, workers would accept lower wages, which they could afford because prices were lower, which they would be because businesses would face lower costs now that wages were down. The system would fix itself without the heavy hand of government involvement.

The Depression showed that the process of price and wage cuts was not stabilizing, but instead led to a continued downward, deflationary spiral. Lower wages made it impossible for debtors to repay what they owed, banks collapsed, business and consumers held back spending, which caused further declines in prices, asset values continued to drop, business failures continued to rise, and the economy continued to decline.

Government stimulus in the form of interest rate cuts, government spending programs and plain old money printing were needed. Eventually, this reliance on government spending, borrowing, and money printing contributed to the double-digit inflation of the 1970s and for that and other reasons, government as the solution to economic problems fell out of favor. Now the pendulum has swung again and even the most market-oriented economists are calling out for the need for more government action.

Lost in the conversation about bailouts, infrastructure spending, and a zero percent fed funds rate is the simple fact that the government has been rapidly printing money. The money supply has increased almost 10 percent over the past year. Normally, this kind of monetary expansion would be inflationary. But in this case, we believe that there is a good chance that this will all result in a great offset – inflationary actions by the government will offset the deflationary symptoms in the private sector, producing something close to price stability. Even if the inflationary forces eventually dominate, that would not be the worst thing right now. It would make it easier for debtors to repay their loans, housing prices might stop falling, and businesses and consumers would be a little less cash-poor than they are right now. Eventually, of course, inflation is a problem that will need to be addressed, but that fight can wait for another day.

Percent Change in Money Supply vs. One Year Earlier

Source: Federal Reserve

In the meantime, fiscal policy will be as loose as we have ever seen, with Democrats and Republicans likely to agree on a combination of spending increases and tax cuts totaling perhaps $800 billion over the next two years. Factoring in the decline in tax revenues that inevitably occurs during a recession and the budget deficit will likely rise to $1.2 trillion in 2009, equal to 8.4 percent of GDP. Large as they may seem, it is not that much greater than the 6.3 percent deficit share in 1983 and the increase in the deficit will be not much greater than what happened in 2003 when the budget swung from surplus to deficit following the 2001 recession. For more on the challenges and opportunities facing the Obama administration, see our annual special focus issue.

All in all, the effect of tax cuts, spending increases, money printing, and a fed funds rate which we believe will stay near zero until the end of the year should lift the economy out of its worst downturn since at least the early 1980s. If not, it certainly will not be due to a lack of effort on the part of policy makers.