Economic Stimulus is Good for You

Digging Holes

There’s always much controversy on how to best help and stimulate an economy in deep recession. Let’s investigate two alternatives generally considered as most extreme and one more conventional case. It turns out that even such measures may sometimes be more sensible than the actual policies have been in Europe in recent years.

Shoveling the money away

Say we have a simple society: A village with several farmers and one smith. The farmers produce cereal. The smith makes spades and other tools for farming. The price of a spade is five gallons of wheat.

Then there comes a calamity year: Cold weather destroys most of the harvest. The farmers themselves must partly eat substitute food like tree bark and nettles as they don’t have enough wheat. Such substitutes are available in big quantities but the nutritional value is poor. With some amount of proper food most persons are able to survive up to next harvest. The farmers are not able to buy any new tools from the smith. If the smith perishes during the famine then there will not be any tools ever after.The smith could possibly sell spades on credit so that the farmer pays it with interest when next harvest is available. That would help the farmers but would not prevent the smith from starving.

Happily enough these are indigenous and wise men fully up to the challenges posed by the difficult macroeconomic situation. The wise men in the village decide to make loans easier to create and they want to have an easy system of payments: They introduce money and print a fixed number of banknotes. They distribute to each family 10 bucks with a nominal value of one gallon of wheat. Then it’s possible for the farmers to buy the spades from the smith. The smith gets money that permits him to buy food at greatly inflated prices from those lucky farmers having a little bit more of it. There is no plan to ever collect the money back: No taxation or redemption.

Persons familiar with macroeconomic blogosphere will recognize the previous as a modified version of the helicopter money plan. Milton Friedman originally wanted to mock the Keynesian requirement to add purchasing power in a depressed economy to compensate for missing demand. He proposed government helicopters flying over the cities while central bank staffers shovel money to the citizens. That should solve any lack of demand. Later on Ben Bernanke used this in his speech to celebrate the 90’th birthday of Friedman. He wanted to emphasize the readiness and capability of Fed to use unconventional means to tackle economic problems. The helicopter metaphor was likely exaggerated but Bernanke later on in practical situations demonstrated his capability of using unconventional measures. In his own words in ToFriedman_20021121 “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

An alternative in the village arrangement above is in more complicated loan deals. The point of the exercise was to demonstrate how helicopter money may come up as a simpler and yet workable solution.

It’s worth to note as an aside to the above arrangement that it’s generally difficult to come up with toy models demonstrating forced unemployment. This is due to the difficulty of having lack of purchasing power in such models. Lack of food used for payments created the unemployment in the example above.

2. Financing some public works with debt is clever policy

Simon Wren-Levis in bringing-economics-back-into-fiscal encourages to “see the state like a firm that decides to undertake these investments by borrowing when borrowing is cheap and there is plenty of spare labour to complete them”. Say, a case where the state has a plan to do specific construction in the future after five years from now, maybe motorway crossing or a bridge. The intention is to pay it with taxes to be collected at that time. If instead the job is done right now with cheaply borrowed money then there are advantages:

  • The unemployed get work

  • No need to pay unemployment benefits to them

  • The state gets more tax income

  • The wage money will circulate and expand GDP

  • The result of building is available earlier. Likely the outcome brings some calculated benefit to the society.

  • The state don’t exist for the purpose of making profits but to generate advantages for a large majority of citizens. Here it fulfills that purpose.

After five years the taxes will be collected exactly as originally planned and the debt will be paid. A company manager failing to grasp this kind of bargain should be fired.

3. Digging holes

John Maynard Keynes insisted on using government money during depressions to create more jobs and to increase purchasing power to compensate for the missing demand in the economy. The works undertaken should be as necessary and useful as possible. It is claimed, however, him to have requested that if it somehow proves out impossible to find anything useful then it’s still better to have men digging holes and filling them than to keep people idle.

Let’s say the state will finance this digging project either with new exogenous money from central bank or with endogenous money borrowed from financial world. In both cases borrowing will not cause crowding out of any alternate lending targets. The well known IMF study found out that while in a normally growing economy a decrease in state spending causes a decrease in GDP with a multiplier of the order of 0,6 then during depressed conditions that multiplier is much higher. It may have values of up to 1,6. See IMF_Multiplier. If we are increasing state spending instead of decreasing then the multiplier may have quite another value. Further on we would like to know the tail of those changes in the following years.

Anyway let’s perform that hole digging project. The wages bring income to the persons participating. Via multiplier effect it brings income to broader parts of the economy. In the following years a diminishing part of that push continues. The state pays interest on the loan to the banks. There may be some low inflation, say 1,5%. After five years the state collects taxes and pays out the loan. As it was endogenous money out of thin air that repayment will not increase anybody’s current liquidity. The money existed for some years and then disappeared again. In a depressed economy the whole value of interest and principal payments discounted to the loan start date and further on adjusted for inflation may be slightly less than original loan amount or maybe little more.

Most likely a bigger part of benefits went to worse-off people. The businesses had their share of the multiplier effects. The taxation in the end likely takes more from the wealthy than from poor citizens. It has similar redistributive properties as any taxation with progressive scales.

As a whole the operation does not appear to be a huge success but neither is there anything to label it as an actual mistake. It comes up as a better alternative to performing taxation and paying unemployment benefits right away. To leave the unemployed without any money would hurt them badly without bringing any actual benefit to the economy.

As far as is known this kind of operation has never been actually performed. Either the state just provides unemployment compensations or starts projects perceived as useful. This is good: The river dams build during the Tennessee Valley Authority project in 1930’s are still producing electricity. Present production cost must be extremely low as it consists of minor repairs and daily supervision. Another essay on this is in digging-holes-to-fill-them. Keynes actually wrote about the gold standard where the only method to generate new money is digging holes to find it. He proposed an improvement where governments buries bottles with money in the ground. That would permit faster expansion of the money stock. Our discussion above is not defending Keynes as he actually was writing but is defending a straw man that his opponents have created. It seems possible to do even that.

There are clearly limits to such hole digging activity: Large parts of any economy shall not be of this type. It is not a real perpetuum mobile. Real products, useful services and investments must be present to make the society actually perform. Obviously activity like the one described above has no place in a society having normal growth.

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