America’s economic crisis is like no other the country has faced since the Great Depression. With millions unemployed, a failing financial system and the burst of the housing bubble, extraordinary actions must be taken to revitalize the slowing economy.
The Federal Reserve’s traditional method of lowering interest rates will not be enough to stimulate the economy. Lowering interest rates reduces the rate at which banks receive money from the Fed, expanding the money supply and increasing access to credit. Businesses can expand and individuals can take out loans for houses and cars. If the interest rate is left too low for too long, unexpected inflation and economic bubbles can grow, such as the recent housing bubble.
That bubble — along with the failure of new unregulated financial banking systems over the last 25 years — led to a freezing of the financial system.
Interest rates were lowered to help bring the U.S. out of the 2001 recession. However, unemployment continued afterward. The Fed finally took corrective action, but by then the housing bubble was in full swing. As the housing and financial systems collapsed, the Fed was forced to cut already low interest rates to .25 percent — not enough to encourage the financial system to lend.
Economist John Keynes, considered by many to be the father of modern economics, called this situation a “liquidity trap.” With interest rates at practically 0 percent, no one is willing to lend or borrow money out of fear of an uncertain future.
In recessions, consumer and business spending decrease, causing more people to lose their jobs as businesses fail to make a profit. Because of the liquidity trap, no options are left but government fiscal policies — government spending and tax cuts. These policies work through a multiplier.
The multiplier works like this: A person finds $100 on the ground and spends it on a $95 haircut. This increases spending in the economy by $95 and increases the barber’s income by $95. The barber then buys some clothes for $85, increasing the spending in the economy and also the retailer’s income. The original $100 of spending has now stimulated the economy by a number far larger than $100.
The multiplier effect works the other way as well. If, instead of spending the money, the initial person saves it, businesses lose profits and the economy loses any benefits of the multiplier.
This is what’s happening now. Consumers are unsure about the future of the economy and their jobs. Because of this, they are saving money and reducing spending amid a credit system in which no one is willing to borrow or lend.
This is why necessary government fiscal policies — such as the $787 billion stimulus package — are being implemented. The package is made up of two-thirds spending and one-third tax cuts. The reason for this ratio is that spending has been shown to have a greater multiplier effect than tax cuts.
The problem with tax cuts is that individuals see them as temporary and use them mostly to save or to reduce their debt. The National Bureau of Economic Research Digest published this month shows that around 80 percent of the 2008 tax rebate stimulus was spent on debt or saved.
Government spending can go directly toward infrastructure, education and other necessary projects — all of which give people jobs. This, along with the resources purchased for such projects, is why government spending has a larger multiplier.
Additional spending is necessary to return millions to work and ease the suffering of millions more. Extraordinary action is needed.
Kalvin Southwell is a sophomore majoring in economics and political science.