Plain Sense Economics

In our macroeconomics class yesterday we were talking about the relative effectiveness of different stimulus strategies. When we get to fiscal policy and Keynesian policies we will explore how an increase in government spending can, in theory, result in increases in GDP by several multiples. Also in this theoretical discussion we’ll see how tax cuts also have a multiplied impact, although not quite as high as a change in government spending.

The key to both of these impacts is an assumption that new money (coming as either increased work hours on a government-funded project or as a tax rebate check) will be both spent and saved. We generally assume that these increments to normal income will mostly be spent – perhaps 80% of it. The balance will be saved – which in addition to actual saving can also mean paying down debt.

Now, we leave theory at the door and try and see how it is applied in real life. The most recent cases in point were the tax rebate checks given out in 2001, and then again in 2008. The results of these two tax payback programs were different, but neither generated the kind of economic stimulus that the President and Congress wanted. Among other things people used their windfall checks to pay off credit card and other debt, and did only modest amounts of spending.

This article in the January 26, 2009 edition of The New Yorker, explores the dynamics of these stimulus efforts. The author, James Surowiecki, notes Milton Friedman’s assertion that people change spending habits only with a permanent change in income. He also describes works of behavior economists, such as Richard Thaler.

Here’s the introductory paragraph. I recommend reading the entire (short by The New Yorker standards) article here.

Cutting taxes is usually a surefire political winner. Yet Barack Obama’s plan to include more than a hundred billion dollars in individual tax rebates in his stimulus package has earned him criticism from both ends of the political spectrum. Critics in his own party think the rebate, which Obama wants to distribute by reducing people’s withholding payments, will be too small to make a difference—the equivalent of an extra forty dollars or so a month. Naysayers from the right maintain that, because the tax rebate is a onetime event rather than a permanent reduction in tax rates, it will have only a negligible effect. Skeptics on both sides worry that most people will save the rebate rather than spend it.