News Release: Finance and Economics

Apr. 17,  2009

A Historical Look at the Power and Impact of Stimulus

From Knowledge@Emory

Will President Obama’s $787 billion stimulus package be an antidote for an economy that’s on life support—spurring spending and creating jobs? Or will it simply drive the federal debt to a record-high $1.75 trillion, prolong inefficient industry practices and reward bad choices, while saddling the country with crippling debt that guarantees higher inflation and taxes down the road?

Faculty from Emory University and its Goizueta Business School weighed in on the question, looking back at past jump-start packages and ahead at the likely effects of this one.

There’s a temptation to draw parallels between the current economy and the Great Depression—and to assume that Obama’s response is similar to the New Deal launched by then-President Franklin D. Roosevelt.

But those may be misleading comparisons, says Ray Hill, an assistant finance professor at Goizueta.

“It would be accurate to say that President Obama is following a Keynesian economic approach, trying to revive the economy through massive government expenditures,” Hill says. “But in fact Obama’s approach is very different from FDR’s.”

The assumed similarities stem, to some degree, from the buzz that both FDR’s and Obama’s plans have generated. But a closer examination exposes the differences in the strategies.

“From the beginning, Obama’s economic program has embraced a high level of federal deficit spending that is intended to serve as a stimulus,” Hill explains. “But from the time Roosevelt entered office [in 1933] until World War II, the economic stimulus provided by Roosevelt’s budget deficits was a relatively small percentage of gross domestic product. In fact his predecessor, Herbert Hoover, was responsible for more deficit spending in his last two years of office than Roosevelt’s average over the first six years of his administration, despite the characterization of Hoover as a president that took a hands-off position regarding the economy.”

That’s not the only significant difference, says Hill.

“In the 1930s, the Federal Reserve Bank adopted policies that led to a significant contraction in the money supply, which spurred deflation,” he notes. “In contrast, [Federal Reserve] chief Ben Bernanke is acting aggressively to stave off deflation, and the administration is taking steps to shore up banks—something that Roosevelt was slow to do.”

The concern now is that the Obama stimulus package may artificially prop up companies that in fact should fail, says Hill. And keeping them on life support “may keep people from adjusting to the new reality of lower prices and wages.”

Companies like General Motors Corp., whose chairman and CEO Rick Wagoner resigned March 29 at the request of the White House, will continue to lose money until its workers accept lower wages, according to Hill.

He notes that FDR impeded that kind of adjustment by suspending enforcement of anti-trust laws to pump up prices and by supporting union calls for higher wages.

“The problem was that people who worked outside of the targeted industries could not afford the higher prices,” says Hill. “As he pursues the economic stimulus program, Obama needs to be careful about propping up car companies and other industries that instead need to be massively restructured.”

Japan’s economic crisis, which started around 1990 and took more than a decade to resolve, provides an example of what happens when a country resuscitates industries instead of restructuring them, Hill notes.

“When Japan’s real estate bubble burst, the country propped up its banks and construction companies with public funds,” says Hill. “It did not let them fail and did not push them to restructure. As a consequence, Japan was mired in recession much longer than necessary. Will the U.S. suffer the same conditions? It’s still too early to tell, but the steps that Obama takes during the next few months will likely help determine the length of our recovery.”

Some of the economic policies initiated by FDR and by the Japanese government prolonged their respective economic crises, Goizueta finance professor Jeffrey A. Rosensweig notes.

“Initially, FDR cut taxes and initiated new spending, but he quickly reversed course and raised taxes, ultimately prolonging the depression,” Rosensweig says. “Similarly, although Japan increased some infrastructure spending, the government also imposed a consumption tax that was supposed to balance the budget but instead choked off any chance of a quick recovery.”

Rosensweig also faults the early Federal Reserve policies.

“During the Great Depression, the Fed pursued inconsistent policies,” he observes. “At one point it increased the availability of money and credit but at other times it irrationally feared inflation and cut the money supply, one of the worst policies that could be followed in a depression.”

Fortunately, says Rosensweig, current Fed Chairman Bernanke is “a leading scholar of the way monetary policies impacted the economy during the Great Depression, so he’s more likely to keep his foot on the pedal of the monetary accelerator.”

There is a valid concern about the long-term inflationary impact of deficit spending, Rosensweig adds, “but right now the deflationary risks outweigh inflation fears.”

“There’s been a lot of confusion over the federal stimulus package,” says Tilman Klumpp, an assistant professor at Emory’s department of economics. “For the most part, it has been developed in a thoughtful manner. The package is costly but takes an intelligent approach.”

The success of the package should not be measured by whether or not it quickly gets the country out of the recession, he says. Instead, he argues, it is aimed at changing the nation’s long-term thinking about infrastructure, science and technology in a way that leaves the U.S. in a better position.

“People tend to focus on Obama’s promises to create jobs, but they forget he also campaigned on reforming the nation’s infrastructure, and on stimulating the production of clean and renewable energy,” Klumpp adds.

But the ambitious plan carries a price.

Obama’s overall national budget, which includes the stimulus package, is projected to drive the federal debt to a record-high $1.75 trillion. The heavy borrowing could spark a new round of inflation, while paying it down could mean imposing higher taxes. But the long-term returns may be worth the risk, according to Klumpp.

“There’s nothing controversial about taking on debt for projects that have a long-term payoff,” Klumpp says. “Companies do it all the time.”

Fears of extended government involvement in the economy also may be overblown, according to Klumpp. He notes, for example, highways are built with government funds, and the space program was launched with public money. The Internet, too, was also initially developed with taxpayer funds.

“Markets can fail,” Klumpp notes. “Government interaction, wisely pursued, can help get the country to recover.”

Many people agree that some government action needs to be taken, but there's no consensus about just what to do, observes Emory economics professor Zheng Liu, who is currently on leave from the university and is conducting research at the Federal Reserve Bank of San Francisco.

“The Keynesian view is that government spending in general has a ‘multiplier effect’ that creates more jobs and more private-sector spending,” explains Liu, who notes his personal views do not necessarily reflect the views of the Federal Reserve Bank of San Francisco or the Federal Reserve System. “In contrast, the neoclassical view is that the source of the problem lies in the supply side—firms are not hiring because they can't get enough capital, and banks are not lending because of fear of excessive risks.”

Therefore Keynesian followers would think that government spending on things like infrastructure, health care, and education would tend to stimulate the economy and get it back on track.

“Those who accept the neoclassical view, however, would support targeted spending, or providing tax cuts and other targeted incentives for firms and banks,” Liu adds.

Noting that some studies contradict the Keynesian model, Liu points out that Japan tried a Keynesian-based stimulus approach when its economy tanked in late 1989, but much of the government money went to a few construction companies, while bypassing the bulk of the country’s unemployed citizens.

“I don't think massive government spending is the most effective way of bringing us out of this recession, because it may compete with resources from the private sector,” he explains. “Spending on infrastructure projects does help workers and private contractors in some sectors, but economists do not agree on the effectiveness of that kind of spending.”

Some economists estimate that each dollar the government spends eventually helps to raise the real gross domestic product by two or even three dollars, notes Liu. But he adds that others say there is no meaningful multiplier effect.

“The current administration seems to favor the more optimistic estimates of the multiplier effect,” Liu observes. “But the optimism may not be warranted.”

Len Carlson, an associate professor of economics at Emory, says that examining the effects of FDR’s policies may help in judging the likely success of Obama’s policies.

The Great Depression, which started in 1929, was “badly handled by policy makers in the Federal Reserve and in Congress, and unemployment rose steadily until 1933,” he notes.

Although a recovery began to take place after Roosevelt was inaugurated in 1933, aided by relatively modest increases in federal spending—that were partly offset by falls in state spending and steady growth in the money supply—growth in output was “pretty steady and might well have continued throughout the 1930s,” Carlson adds. “But then the Federal Reserve suddenly increased reserve requirements, or the amount of cash banks have to keep on hand.”

That squeezed lending, chopped off the recovery and spurred a recession in 1937, he says. At the same time Congress raised taxes to balance the budget while unemployment was still over 10 percent.

“These mistakes helped insure that unemployment would remain well over 10 percent until 1939,” Carlson notes.

Similarly, says Carlson, data from the Congressional Budget Office indicate that the U.S. would likely recover from the current recession even without a federal stimulus package, although he says the hope is that the stimulus will speed up that recovery.

One lesson from this, according to Carlson, “is that it is easier to prolong a recession or mess up a recovery than it is to devise policies to help the recovery.”

It is a complicated situation, agrees another expert.

“Despite fears of an economic hangover from the high-priced stimulus package, government officials may be politically boxed into making a choice like this when the country witnesses such a rise in unemployment and when further economic deterioration is likely,” says Esfandiar Maasoumi, an economics professor at Emory.

Despite that, he is not quite comfortable with the magnitude of the plan.

“Even though this stimulus package may not be the largest in history—at least relative to the size of the economy and the problems at hand—the economic catastrophe we’re in is different from the Great Depression in the U.S. and the collapse of Japan’s economy in 1989-1990,” he says. “In this case the government does not have the savings and the funds, or the faith of the credit market to spend more.”

Pointing to stock market—which nose-dived as Obama implemented his stimulus package, although it has since firmed a bit—Maasoumi notes that economists traditionally call for budget allocations to be accompanied by realistic budget restraints, which seem to have been discarded in this case.

“I believe the consequences of further debt financing will be far more catastrophic to the U.S. and beyond than any further bank failures and unemployment would be,” he says. “As they stand, the stimulus package and bank bailouts will blunt market forces from pushing out failed enterprises, will prolong the misery, and will likely have longer-term costs that have not even been considered in the current calculations.”

Some other academics may have qualms about Obama’s stimulus package, but nonetheless accept it as a necessary evil.

“If we look at Roosevelt’s New Deal as a similar stimulus package, the evidence suggests that some of the spending provisions may have had beneficial effects,” says Emory law and economics professor Paul Rubin. “But increased regulations and laws that promoted unions led to price increases that outweighed the stimulus delivered by the deficit spending.”

Rubin sees some similarities today, as Obama moves to tighten regulatory control over financial institutions, hike environmental regulations, increase tort liability for employers, and promote unionization in the workplace.

“All of these proposals will add to the cost of doing business in the United States,” says Rubin. “President Obama’s policies may not yet be as substantive as the New Deal, but they’re certainly moving in the same direction.”

The climb in the price of gold during this recession along with the stock market’s continued weakness signal fears of inflation as a result of Obama’s policies, adds Rubin. But he can also see why Obama chose the path he did.

“Aside from measures to deal with the mortgage mess and keep the financial system intact, the economy would probably recover faster if the government did nothing,” he says. “And it would be in better shape when it does recover.”


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