As it is becoming more obvious the economy is in a recession, the federal government is taking steps to try to ease the economic pain. But how is the government doing this, and what are the possible pitfalls and costs?
The federal government has two broad strategies at its disposal to try to steer the economic ship. One, controlled by the Federal Reserve, is to manage the availability and cost of credit. The Fed uses this power to “lean against the economic wind” and promote steady economic growth with modest inflation.
This means that when the economy is booming and higher inflation is a threat, the Fed will increase the cost of credit — the interest rate — and strive to reduce lending and slow consumer spending. The purpose is not to decrease prosperity. Rather, the objective is to increase prosperity at a consistent, sustained rate.
The Fed moves in the opposite direction when the economy is slumping. Here the Fed lowers interest rates and increases the amount of money available for loans. The goal is to motivate consumers and businesses to borrow and spend more.
Can these actions work? They can, but there are some issues. A big one is that the Fed’s actions take time to gain traction — six to 18 months. Also, even if credit is available and cheap, people and businesses still have to want to borrow. To borrow, they have to have confidence about the economy. The Fed can’t necessarily create this confidence.
There’s also a possible cost of the Fed’s policies, particularly those designed to fight a recession. If credit is made too easy and too cheap, excessive borrowing can lead to higher inflation or to an investment “bubble,” as with technology stocks in the 1990s and residential housing this decade.
The other arm of the government’s economic policy is controlled by the president and Congress and operated through the spending and tax policies of the federal budget. The tactics are simple. To fight a recession, the government tries to put more money in people’s hands by cutting taxes and increasing public spending. Conversely, to subdue a boom, taxes are increased and spending curtailed.
An obvious question is where the government gets its money when it reduces taxes but increases spending. The answer: It borrows the money. In recent years, half the borrowing has come from domestic sources, and half from foreign sources. In the original conception of this policy, the borrowing would be paid off when the government eventually increased taxes and decreased spending during an economic boom. But it hasn’t worked out this way. So, running up the national debt is a cost of this strategy.
Beyond this cost, there is some question whether temporary changes in government taxes and spending work any magic. Some analysis indicates the government actions might give the economy a temporary push or pull, but if businesses and consumers know the changes aren’t lasting, they will modestly alter their behavior.
There’s also a concern, and some evidence to back it up, that increased government borrowing and spending simply substitutes for, or “crowds out,” private borrowing and spending, thereby leaving no net gain for the economy.
The federal government is using both strategies to fight the expanding recession. The Fed has lowered interest rates and increased credit. The government also has spent more money via a stimulus plan, while another stimulus shot is being discussed.
But so far, the economy hasn’t revived. Does this mean the government’s policies have failed? Or, would the economy be much worse without the policies? Or, as some well-regarded economists have argued, have the government’s actions to steer a steady course in the economy actually resulted in a choppier ride? The debate will continue long after this recession is over.
Michael L. Walden is a William Neal Reynolds distinguished professor at North Carolina State University.