What Stimulates the Economy?
"Economic stimulation" is the phrase of the day. Amid mounting fears of a U.S. recession, Congress and the White House have announced a deal on stimulating legislation that would give most U.S. tax filers refunds of $600 to $1,200--more for those who have children.
Of course, when the economy starts to slide, it's natural to look for ways to stimulate it. The trick is coming up with the right strategy. Fortunately, the world is full of economists ready to give you advice. Unfortunately, they rarely agree with each other, so you'll have to choose from their competing theories. Here a quick review of three fiscal policy ideas you could adopt--if you decide to run for office.
Idea #1: Create Jobs
That's what British economist John Maynard Keynes thought. Keynes learned classical economics, which held that market forces alone could produce full employment and a robust economy. Yet he worked during the Great Depression, when it looked like high unemployment might never go away.
It was a vicious circle. High unemployment meant low demand, since fewer consumers were drawing a good salary. And once production outstripped demand, businesses cut costs by laying off even more workers.
Keynes's solution: create jobs. Governments can spend revenue on public works projects, artificially creating jobs for the unemployed. That will increase their buying power and lift consumer demand. Once businesses see this increase in demand, they will ramp up production, hire new workers, and eliminate the need for the government spending.
Idea #2: Cut Taxes
As Congress and the president would tell you today, the economic rationale for cutting taxes is straightforward: tax cuts can put more money in people's pockets. Like government spending to create jobs, they can increase consumers' buying power and lift consumer demand.
"Supply-siders" go further, arguing that it's not just about increasing consumer demand. They point out that high taxes can reduce people's incentive to work and invest--that you're less likely to try to make a buck if the IRS takes 70 cents than if the IRS takes 35.
So, they say, cutting taxes--especially high taxes that distort people's choices--can make markets work more efficiently and spur overall economic growth. Some even argue that cutting taxes can increase tax revenues, as the tax cuts will have such a stimulating effect on the economy that tax revenues will actually rise despite the lower rates.
Idea #3: Go on Vacation
Economists like to talk about "three lags" that hamstring efforts to stimulate the economy: the time it takes for policymakers to realize there are problems, the time it takes for them to do something about it, and the time it takes for their efforts to have a measurable effect.
By the time these three lags have run their course, the economy might well have changed direction--and your stimulus policy could do more harm than good. So, some economists think that the best stimulus is no stimulus at all: take a break, leave the economy alone, and you can be sure at least that you won't make things worse.
What's the Fed Got to Do with It?
"Okay," you say, "but you haven't even mentioned the Fed. Its rate cut this week made big news. How does that work?"
The Federal Reserve System is America's central bank. Created by Congress in 1913, it consists of a Board of Governors in Washington, DC, 12 regional Federal Reserve Banks in big cities from Boston to San Francisco, and 25 branches in other big cities.
The Board of Governors gives the Fed its marching orders. But the individual Reserve Banks maintain significant control over their day-to-day operations, including:
- Holding the cash reserves of other banks and loaning money to them
- Putting new currency into circulation and taking old currency out (every dollar is a "Federal Reserve Note")
- Providing checking accounts for the U.S. Treasury and acting as the U.S. government's "fiscal agent"
- Collecting and processing millions of checks each day
Essentially, the Fed provides banking services to America's banks and to Uncle Sam. That's the nitty-gritty part of its job. On the more glamorous side, it also develops and implements the nation's monetary policy--and in the process influences interest rates.
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