Jan 31 2008

Fiscal policy and the “vicious” business cycle

Alice Su, an AP Econ student, asked a very good question in class today during our discussion of the business cycle, which illustrates the tendency of national economies to fluctuate between periods of expansion and recession. Karen wanted to know what a government could possibly do to try and avoid the dismal prospect of repeated recessions on and on into the future that the business cycle seems to suggest is the fate of any economy.

To answer Alice’s question, we can look at the United States right now, where the Bush administration and the Democratic led Congress have teamed up to approve a fiscal stimulus package aimed at boosting consumer spending and business investment, thus putting the economy back on the path of expansion and economic growth.

A government can only try to stimulate aggregate demand and/or aggregate supply in times of recession. The tools at the government’s disposal include changing tax policies and increasing or decreasing government spending. In times of recession, tax cuts should encourage businesses and households to spend more, increasing GDP. Likewise, new government spending increases GDP directly. The current stimulus package approved by the White House and Congress focuses on the tax side. Listen to the excerpt from a recent episode of WBUR Boston’s OnPoint radio show.

Tax rebates (which will appear as checks in the mail to most households earning under $75,000 per individual or $150,000 per working couple) will increase households’ disposable income. More disposable income should increase the overall level of consumption by households (and investment by firms who also will receive rebates), stimulating new spending and shifting the economy towards a recovery. Under Congress’s plan the government will issue tax rebates of up to $600 for working individuals, $1200 for working couples, plus $300 for each child.

Missing from Congress’s plan, however, are increases in government spending. It is not uncommon for stimulus packages to include both tax cuts and new government spending.

How would changes in government spending affect overall output (and thus income) in the economy? The columnist in the podcast makes a couple of suggestions that may have contributed to the stimulus resulting from the $146 billion tax rebate. He says the government should consider, “extending unemployment benefits or increasing food stamp spending”.

The White House’s bill, however, included no such increases in spending. In the podcast, the columnist explains the absence of new government spending: “If you increase spending on a temporary basis, you can’t undue it, because you can be accused of being harsh, because you’re going to cut food stamps in the future.” In other words, the tax rebate is a one time shot; everyone gets a check in the mail and everyone’s happy. Increased spending on welfare and unemployment benefits, while enjoyed by those suffering from the economic slowdown, will be politically almost impossible to roll back once the economy is in better shape. (For those of you in my class, this should remind you of the “mommy” vs. “daddy” conversation we had today!)

Should the stimulus package have gone further? In addition to tax cuts, should Congress be extending a helping hand to workers and families who suffer from the economic downturn?

The tax rebate “stimulates short-term spending”. Is it enough to put America back on the expansionary path of its business cycle?

These are tough questions, although most economists tend to believe that a rebate equal to around 1% of total GDP is far from enough to assure a solid recovery. This may not be the government’s intention, however. What the government is trying to do is “avoid a vicious cycle where bad news begets more bad news… if you can avoid that then in the long run we’re a lot better off.” The “vicious” cycle the columnist refers to is, of course, the business cycle.

Perhaps Congress knows from history that business cycles are unavoidable, and the current stimulus package is not meant to propel the US economy to new heights of economic growth, rather to slightly offset the negative effects of a recession that may in fact be an unavoidable side effect of our ever-fluctuating economy.

Or, as the columnist says, “Why put more medicine in now than is necessary?” What do you think? Should the government put more medicine in than the seemingly minuscule dosage equaling merely 1% of GDP?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

5 responses so far

5 Responses to “Fiscal policy and the “vicious” business cycle”

  1. Leanne Tomassoon 30 Nov 1999 at 1:00 am

    Bob and Jason,

  2. optional.xuon 11 Feb 2008 at 4:21 pm

    I feel like a big reason for this recession is overspending by the government in such areas as the Iraq war where its spending billions. If perhaps this money was allocated to alleviating the economy, then maybe the "medicine" put on this economic disease would be more effective.

    While government spending does increase overall GDP, the spending on military is using up the government budget and causing an overspending and depreciation of the dollar. Areas that need to be reformed like Social Security and even moreso the general receding economy cannot be adequately funded.

  3. Richard T.on 11 Feb 2008 at 6:58 pm

    Instead of responding to the question, "why put more medicine in now than is necessary?" I think, this problem wouldnt be issued or lets say so severe, if the government allocates the money efficiently and not waste it on meaningless pride or events, as previously mentioned.

  4. Alice Suon 12 Feb 2008 at 7:22 pm

    It seems to me that this tax rebate is not truly addressing the problem of recession–undoubtedly, it does, as Nancy Pelosi said, "put money in the hands of hardworking Americans", and this looks like a nice act done under a bipartisan agreement that makes lots of citizens feel better. But only in the short run. Offering a one-time tax rebate like this is like trying to stick a band-aid on a bullet wound. So the question isn't "Why put more medicine in now than is necessary?" but rather, "Does this medicine actually do anything to help?" It looks like all it does is temporarily reassure Americans, maybe make the recession a little more cushioned and make the government able to say "LOOK we're cutting back on taxes! Don't you love us", but it won't actually do anything that will feasibly fight against the "vicious cycle." So does this mean that recessions are inevitable there really is nothing you can do to fight them except.. wait for it to get better? In the podcast they mentioned something about fine-tuning interest rates and such to prevent occurrences like the Great Depression. How does that actually work though? And how is the government supposed to know how they should "fine-tune" taxes and interest rates and government spending if they're in a period of growth/peak? They won't know what's needed until they've entered the recession, and by then it seems like it's too late to stop it and all they can do is try methods like the tax rebate in this blog post to just "slightly offset the negative effects."

  5. Michael Dailyon 13 Feb 2008 at 10:04 pm

    Wow…Alice's comment. But anyways I think the government should have just picked one of the extremes: either include government spending in the package and actually give the economy a significant boost, or just scrap the plan all together. I'm leaning towards forgetting the plan because it seems as if the government is aiming to just get the US out of this recession as quickly as possible rather than slowly digging out of it. Rather than having a tax rebate that just stimulates "short-term spending" it would be better if a measure was placed to help the US in the long run so it would be harder to enter a recession all over again. Ultimately though the stimulus package will help the US economy in its current situation, but I'm not sure if it will truly help America avoid future falls back into a recession.