Hello Fiscal Stimulus, Goodbye Monetary Policy

Economists have two types of policy actions available to stimulate economic development--fiscal policy and monetary policy. Fiscal policy can stimulate the US economy by lowering taxes or increasing government expenditures. Monetary policy can stimulate an economy by lowering interest rates and making capital more available to the markets.

With the Federal Reserve lowering interest rates to near zero, faith has not been restored in the financial markets. Business are afraid to borrow and are now beginning massive layoffs after failing to increase profitability through shortened hours. Over half a million jobs were cut in the U.S. in December 2008. Unemployment now stands at 7.2% is predicted to rise to over 8.0% by mid summer 2009. So much for lowering interest rates sharply since last summer in response to the collapsing housing market. This monetary policy approach of lowering interest rates was effective in all of the previous recessions. Strike one!

That leaves the fiscal policy option. At the latest meeting of the AEA (American Economics Assn.), most economists argued for more government regulation of markets--a total reversal of previous economists' sentiment for many decades. If the government lowers taxes, presumably consumers and businesses will spend the extra cash and increase consumption (which is about 70% of GDP.) However, given the weakness of the financial markets, consumers and businesses may save the tax cut, or spend it on imports, neither of which would help the economy grow. So the government must now play the public government spending wildcard to help save the economy. By spending more public monies, the government can create jobs and increase worker productivity (if some of the money is spend on training the workforce or improving technologies). The fiscal stimulus package is expected to have a much larger impact on impacting GDP growth than the lackluster monetary stimulus that we witnessed in the last six months of 2008.

So Obama needs to spend, spend, spend. Budget deficits can grow temporarily while the economy creates jobs and gets the workers back to work and off of the government unemployment roles. Workers mean more tax revenue for the government. After the recession is fixed, the government budget deficit will improve by default.