Government Spending to Boost Demand

In an opinion piece entitled “Obama Should Devote Final Years to Changing Economic Conversation” http://tinyurl.com/lschb9o economist Dean Baker of the Center for Economic and Policy Research argues that during recessions the federal government should increase spending to stabilize the economy.

Dean explains that the economy went into recession in 2008 because of “an enormous shortfall in demand created by the collapse of the housing bubble”.  The loss in demand resulted in a decrease in spending on everything from homes to vacations to consumer goods.  Almost every sector of the economy was adversely affected from building contractors to retail stores to hotels to the auto industry.  The sharp drop in consumer demand hurt almost all of us.  People lost their jobs.  People lost their savings.  People lost their homes.  It was bad.

And economists and politicians brainstormed to find a remedy.  From tax cuts to stimulus spending to bailouts to quantitative easing to changes in regulations, there wasn’t any idea that wasn’t proposed.

Dean Baker’s remedy is for the government “to fill the gap in demand with spending of its own.”  The spending, Baker adds, should be financed through debt.  “[T]the country has nothing to fear from higher debt,” writes Baker. He says that the government can easily continue to borrow and borrow and borrow and borrow.  Dean argues that increased government spending to the tune of hundreds of billions of dollars a year  or even over a trillion dollars a year (in addition to current deficits) would make up for the slack in demand and provide jobs for the unemployed.

My question is whether the government should be doing this.  Should the government borrow hundreds of billions of dollars a year to spend money to boost the economy and increase jobs?  Should the government engage in activities to manipulate the economy like this?

There is no question that the government does act to manipulate the economy.  The mortgage interest deduction in the Internal Revenue Code was designed to encourage people to buy houses.  The Federal Reserve manipulates the value of the dollar and interest rates.  Interest rates were lowered in the early 00s during a mild recession to encourage people to borrow and spend.  Auto loans could be obtained for less than 2 percent.  Loans to students are guaranteed by the government and offered at a lower than market interest rate to encourage people to further their education.

Should the government be doing this?  The mortgage interest deduction does encourage people to buy houses and acts as a subsidy to housing for everyone.  The lower interest rates did and do encourage people to take on debt to buy things like cars and houses.  And student loans do encourage people to spend for further education.  But the end result is that people are put further and further into debt.  The government has encouraged people to go into debt just so they’ll spend more to stimulate the economy.  This has been going on for decades, and in the interest of pushing up GDP, the nation has gone from the world’s largest creditor to the world’s largest debtor in just three decades as people and the government have gone deeper and deeper into debt.

And the nation experienced prosperity that had never been seen before in the history of the world, and it was all supported by consumer spending through debt accumulation encouraged by government programs.  Everything seemed fine, and the economy kept rolling right along, until the party ended.

So Baker suggests that the federal government increase its debt to finance spending to boost the economy because consumers lack the ability.  He argues that the debt accumulation poses no threat to us.  Baker basis his conclusion that additional debt accumulation poses no threat is based solely on the fact that people are willing to continue to buy bonds.  If people are willing to loan us money at low interest rates, then everything must be ok.  He misses the fact that making loans to people with bad credit during the build-up of the housing bubble didn’t render those people able to make the payments.

As an economist, Baker may not have taken a chemistry class or paid rapt attention when he did.  Consider water.  As water gets cooler, what happens?  When the temperature of water goes from 80 degrees to 50 degrees, what happens?  Nothing.  When it goes from 50 degrees to 45 degrees, what happens?  Nothing.  When it goes from 45 degrees to 40 degrees, what happens?  40 degrees to 35 degrees?  Still nothing.  So based on this data, one would conclude that reducing the temperature of water has no effect on its character.  The only problem is that at some point, 32 degrees, the water turns to ice.

This is similar to what happened with the build-up of consumer debt.  As people borrowed to buy things, maxed out their credit cards, obtained auto loans, obtained mortgages, etc. things were going smoothly.  There was no danger.  But then it reached a tipping point.  Like the straw that broke the camel’s back.  It eventually crashed.

And Baker’s promise that the country has nothing to fear from higher debt will be of little consolation in the event that it does all come crashing down.