The proponents of the stimulus packages have justified their action by claiming that the new income offered to the people would help them to raise consumption. The increase in consumption will, in turn, raise the demand for goods and services.
The producers are then expected to respond to the increased demand by increasing the production. It would finally help the economy to come out of the feared recession.
These economic stimulus packages are based on the economic philosophy propounded by John Maynard Keynes in 1936 in a book titled ‘General Theory of Employment, Interest and Money’. This philosophy that prescribed the governmental action through deficit budgets was very popular in almost all the countries in the subsequent four decades or so. Accordingly, it gave rise to the popular economic policy action that ‘governments should finance economic activities’ of a country.
This Keynesian philosophy assumes that an economy cannot perform at its potential level due to a deficiency in the effective demand caused by a corresponding deficiency in consumption. Hence, the solution to the problem is the increase in the demand by whatever the means. Since the private sector cannot be expected to act promptly, governments were advised to pump funds to raise the demand in the economy.The recovery of the economy through government’s funding takes place as follows:
When people receive new income, they spend it on consumption.
The additional consumption will raise the demand for goods and services.
To satisfy the increased demand, producers will raise production by engaging resources, both physical and human.
It will put the economy back to the long term growth path.
The basic assumption here is that people, when they receive a new income, would immediately spend it on consumption. For instance if a person gets an additional 100 rupees, he would use the entirety of his new income or a significant portion of it, for increased consumption. Keynes believed that people have a tendency to spend a lesser amount out of an increase in income.
He called it marginal propensity to consume with a value of less than one because only a part of the new income is consumed, while the balance is saved. This consumed part is an expenditure for the person, but an income for another person in the economy.
For instance, if a person buys a loaf of bread, it is an expenditure for the buyer, but an income for the seller.
In a second round, the seller would spend it on consumption according to his marginal propensity to consume. It thus gives rise to a series of income and expenditure, but at a dwindling rate, because everybody spends less than what he or she got as income. This will continue until the consumption force of the originally created new income is fully exhausted by spenders and income recipients.
But, in the process, Keynes believed that a new output and income are created in multiple terms, driving the economy out of the economic depression.
Hence, according to Keynes, for an economy to have continuous economic growth, maintaining a high consumption is essential. Similarly, to get an economy out of depression, a higher portion, almost closer to the full amount, of new income should be spent on consumption. Since consumption is based on the absolute income, he called it absolute income hypothesis.
However, after Keynes, many economists have come up with different formulations about people’s consumption behaviour.
Milton Friedman, a Nobel Laureate in economics, said that people base their consumption on what they perceive as permanent income. Accordingly, any income received as temporary income is not considered when they plan and execute their consumption decisions. He called this ‘permanent income hypothesis’.
Since, stimulus packages offer temporary income increases, according to Friedman’s argument, they do not contribute to raising consumption and demand.
James Dusenberry, an economist attached to Harvard University in USA, said that consumption is based, not on the absolute income that one receives, but on how he is placed among others in the society. Hence, consumption decisions are made by looking at how one’s neighbours have performed with respect to earning incomes.
If one’s new income is higher than the income of neighbours, then, he would get a feeling of higher well-being and be induced to increase his consumption. Since consumption is based on relative income, he called this ‘relative income hypothesis’.
Franco Modigliani presented a completely different argument relating to consumption. According to him, the total income and total consumption of a person during his life cycle are equal to each other.
During the mid-ages when a person is productive, his consumption is less than the income and he saves; during the young age and old age, his consumption is higher than the income because he uses his past savings or bequests he has got from him parents. Hence, temporary incomes cause higher consumption only when such incomes are paid to old people.
It, therefore, shows that there is a significant body of economic knowledge that raises doubts about the ability of temporary incomes to raise consumption, demand and finally rescue economies out of recession.
There are some other weaknesses in stimulus packages that arise from how funds are sourced for such packages.
If funds are raised by taxing people, the income which they could spend on consumption (or disposable income) will decline as a result of new taxation. To that extent, consumption too will fall. When the money income rises due to the stimulus, consumption is expected to rise, but as shown previously, it may not take place at all. In such a situation, the economy would recede to a still lower level. The way out of this problem is to increase incomes permanently by continuous stimulus packages, but that may not be feasible to implement due to scarcity of resources.
The same situation would arise if funds are raised by borrowing. The lenders to the government would do so by cutting their consumption and, therefore, the overall consumption would fall. When the borrowings are recycled through the stimulus, whether the consumption would rise or not will depend on how far it is considered as an increase in permanent income by people.
If the stimulus package is financed by printing new money, the situation becomes much more alarming. This is because the ultimate money supply increase is much more than the initial printing due to commercial banks’ use of printed money as seed money to create multiple deposits and credit.
If the economy is already going through a high inflation phase, the increase in the aggregate demand will worsen the existing inflationary situation. If inflation becomes uncontrollable, the economy would become weaker and beyond redemption.
Even if the current inflation is mild and under control, the use of inflation to stimulate an economy may not be the proper option, since the inflationary growth, at the end, would become a ‘lose’ situation for the government and a ‘lose’ situation for the people.
What this shows is that stimulus packages aiming at rescuing ailing economies by increasing consumption will not deliver the expected results.
If the governments know that stimulus packages do not work, then, why do they introduce such packages? First, they would do so to build confidence of people in the economy and marshal their collective action to raise economic activities.
Second, it is necessary to convince the public that the government is doing something to rescue the economy. Third, as some economists have argued, governments may be tempted to support the sections that have supported them in elections.
In countries which are highly dependent on imports, stimulus packages may lead to an unwarranted problem in the form of increased imports and consequential balance of payments problems. The loss of reserves would put pressure on the exchange rates to depreciate, a requirement to correct the persistent balance of payments deficits.
Economists point out that countries with persistent deficit financing in their budgetary operations have implemented permanent stimulus packages. This occurs when the governments consume more than their revenue and make available new incomes to people continuously. However, there has been no evidence that economic growth in such countries has accelerated to an impressive level on a permanent basis.
The long term experience in such countries has been the high inflation and low economic growth. Sri Lanka offers one of the best examples to amplify this point.
During the entire post-independence period except in 1954 and 1955, Sri Lanka had a budget deficit which sometimes remained between 7-10 percent of its GDP. Its result was the elevation of the country to a high inflation regime coupled with moderate economic growth.
Accordingly, during the three decades from 1977, its inflation on average stood at 11 percent per annum and growth rate barely at 5 percent.
If the stimulus packages do not work, how could an economy be rescued?
Economic growth depends on continuous high investment and innovations leading to improvement in productivity. Hence, governments should have stimulus packages to induce investments and raise productivity and not for temporary increases in consumption. It should facilitate the private sector to invest more and have policies to make people work harder.
This was practised by Singapore during the whole of its post independence period. The result was dramatic and Singapore could elevate itself to the status of a developed country within a quarter of a century.
In all other circumstances, stimulus packages would simply be a waste of resources.