Tuesday, January 29, 2008

Three ways to Stimulate the Economy

What is the right strategy to stimulate the economy? Does it really need to be stimulated? Perhaps, letting it all play out is the best option.

Here are three traditional ways to jump start an economy:

#1 Create Jobs
It's classical economics, high unemployment results in low demand for goods. Unemployed people can’t buy a lot of stuff, so demand is low which forces companies to cut production and lay off more people. It’s a vicious cycle.

To combat this, governments create jobs, like public works projects. This puts money in peoples’ pockets and lifts demand. Once companies see this increase in demand, they will ramp up production, hire new workers, and eliminate the need for the government spending.

This is close, but not exactly the problem we have today. Unemployment is still relatively low. We have jobs, but a lot of them are low paying and people expect to have more stuff than ever before. Consequently, people borrow (use credit cards, home equity loans) to make purchases, increasing demand and so on. What happens if these folks can’t get credit? They stop buying, demand falls and companies cut back.

You could argue that people should spend less and live within their means. Living more frugally does help the individual, but it doesn’t help businesses grow.

#2 Cut Taxes
Another way to put more money in people’s pockets is to cut taxes. This is classical supply side economics. The tax refund proposals out there today are temporary, one time band-aids to the problem. Evidently, this is what POTUS thinks is all that this economy needs - a quick jump start and then once its running again it will become more efficient and spur more growth. Plus, it’s real popular with the people.

The big problem with this is that whenever governments cut taxes, they are also cutting revenue. To replace lost revenue, the government must issue new debt to borrow more money from foreign lenders. The credit worthiness of the US is at an all time low which translates into higher rates for loans. This ultimately contributes to the devaluation of the dollar, reducing buying power and lowering demand. Another vicious cycle.

#3 Do Nothing
There are three big time lags that typically thwart economic stimulation. First the government must recognize that there is a problem, then agree on a stimulus package and then it takes time for the “fix” to take effect. By the time all this happens, the economy may have already changed direction and played out on it's own anyway.

This approach may be just as effective as any other, but it is much more unpopular. It’s like going to the doctor and he says just wait awhile and you will start to feel better. To most people that’s not acceptable. They went to the doctor to get help and they want something, a medication, a “fix”, right then. Whether the “fix” helps or not it still makes us feel like we are doing something about the problem.

For more Personal Finance topics check out the festival of frugality carnival hosted by Mrs Micah: Finance and Life. My article: Opt-out of Mail-order Catalogs to Save $ and the Planet! was included in the carnival.

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