Following the American Psychological Association’s Guidelines
Recessions and Recovery Strategies
Economies are alive organizations which sometimes gets problems similar to our bodies. As we grow up and develop, we catch some sicknesses and similar to us, economies also grows up and sometimes they face some crisis and recessions. During recessions, consumption level and income level of people decreases and economy slows down. In a slow economy, investors do not prefer to make new investments and even during a severe recession, they might stop their all investments in the economy. As we know, economies have a cycle and when it slows down all parts in the economy slows down. This situation is not desired by the public, because they suffer unemployment, lower level of income, and other individual problems pertaining to surviving.
Government is responsible to produce and implement recovery strategies. Each crisis has a distinct characteristics and depending on them, professionals can prepare a recipe for the economy. If economy is suffering a recession, then a set of policies should be designed and implemented government to stimulate the economy.
Deficit spending is one of the policies for recovery suggested by John Maynar Keynes during the great depression years. According to this policy, government should increase its spending to stimulate the economy. When government spends more, the industries and the people receiving payments from the government will start producing more and more. These companies and people will spend their money to get other goods and services in the economy, therefore other companies and people will receive some income and they will spend their income also. That cycling effect will continue and the economy will start running again.
Deficit Spending as a Recovery Tool
Deficit spending is an powerful tool to stimulate an economy during a recession time, because basically this tool means injecting money into economy and economy responds to this more quickly relative to other monetary and fiscal policy tools. Government spending goes to some companies and some people and they receive some income and they spend it also. A cycle of spendings in the economy by the agents will help economy recover. However, to make companies and individuals spend more and more, government should build a trust for itself, thus when people observe that government spends more, they believe that recession will end soon. If people trust their government, then economy starts working after deficit spending which is called “multiplier effect”.
Government increases to use this tool and a finance is required to cover this extra spending. Tax is a saving for governments, however, mostly governments use all the taxes they collect every year and they do not have a reserve. Thus financing the extra government spending cannot be financed through government savings and government has to borrow some resources or increase taxes. Depending on how extra spending is financed, the influence of deficit spending tool on economy may vary.
Pros & Cons of Deficit Spending Depending on How it is Financed
Decision how to finance government spending is very important determinant of the deficit spending influence on economy. Government has some options; 1) Increase tax ratios and collect higher tax from people, 2) Borrow money from people for a short term, or 3) Get long run loans from an international institution.
Increasing taxing ratios just after implementing deficit spending tool will cause an inefficiency and economy might not recover from recession. Multiplier effect theory tells us that even financing deficit spending by increasing taxes will help economy, however, the influence on economy will be very small. Also it might make people think that government is not trustable.
Borrowing money from public is one of the easiest way to finance government spending, however, it is one of the most harmful one also. When government ask money from people by selling some government papers to people, people accepts that request if only if government offers them a higher interest rate. That means the general interest rate in the economy will rise. As we know, higher interest rate means less consumption and investment expenditures in economy. Deficit spending's stimulating influence will be lower because of higher interest rates. That situation is called “Crowding-out effect”. Continuing to finance through short term borrowings from people might increase the influence of Crowding-out effect and that might mean that deficit spending does not give us desired stimulation in economy.
Getting long term loans from the international institutions such as IMF or World Bank is truly hard, however, these loans have lower interest rates. Financing deficit budget from international funds is more meaningful than borrowing money from people for short term. Because getting loans from international institutions will not affect the interest rate in the country, thus we do not expect any Crowding-out effect.
Result
Deficit spending is a powerful fiscal policy tool to stimulate the economy. Policy makers should use this tool carefully, if it is implemented for a long time, it might create an addiction among people and they will be expecting more and more spending from government. That cannot be sustained for long time. For a certain time, it should be used and right messages should be conveyed to people, thus people can comprehend that economy will recover and after a while government will decrease its spending back to previous level.
It is important how to finance deficit spending, and there are two important criteria; 1) It should not influence other important economic variables, expecially interest rates, and 2) Cost of financing should be low, thus it does cause a big burden on government in the long run. The best way to finance it get long term loans with lower interest rate from the international institutions.
Deficit spending helps economy start running again, however, if it is implemented as a long term tool, it might create negative influence on economy and it might create an inefficiency in economy like laziness. Each time economy faces a small crisis or a slow down, they start expecting deficit spending from the government. This tool should be used only for severe economic crisis.
References
Krugman, P. (2001). The Fear Economy. New York Times Sunday Magazine, October.
http://www.pkarchive.org/economy/FearEconomy.html
Taylor, J. B. (1980). Aggregate Dynamics and Staggered Contracts. Journal of Political Economy, 88(1), 1-23.
http://userwww.service.emory.edu/~skrause/E711/PartI/Taylor-1979.pdf
Woodford, M. (1996). Control of the Public Debt: A Requirement for Price Stability?. NBER working paper No. 5684.
http://www.nber.org/papers/w5684
Woodford, M. (2001). Fiscal Requirements for Price Stability. Journal of Money, Credit and Banking, 33, 669-728.
http://www.columbia.edu/~mw2230/jmcb.pdf
