Tuesday, March 5, 2013

GC Explains: Contractionary Policy Is Contractionary

This is one in a series of articles designed to explain complex concepts in simpler terms.

Except this one isn't.  Read on for the explanation of a simple concept in simple terms.

The federal government spends a lot of money.  This year, it will spend about $4 trillion. That's such an enormous amount of money that if you spent $100 every second, it would take you 1,268 years to spend $4 trillion.

The federal government gets this money in a lot of different ways.  A pretty significant portion of it comes from the personal income tax.  Corporate taxes make up part of it.  Excise taxes, which are taxes paid on the value of things, usually on the basis of their being sold or purchased, make up part of it.  User fees--fees that you pay to use government services, like passport application fees and patent application fees and national park entry fees, make up part of it.  The government also receives royalties on the use of federal lands for things like timbering, oil drilling, and so forth.

And the government borrows money, sometimes a lot of money, to make some of this spending possible.  The government borrows money by selling bonds, bills, and notes, which are various financial instruments that include a promise to pay them back.  Borrowed money comes from private investors (including maybe you, if you own savings bonds, or you own shares of a mutual fund that holds bonds), from institutional investors like pension funds, from sovereign wealth funds (other countries that want to put their money in a safe investment), and even from itself.  See, the government collects more in Social Security and Medicare taxes than it pays out in benefits, and the difference is loaned to the federal government.

Right now, the government can borrow money nearly for free--i.e., without having to pay much in interest at all.

Let's go back to the spending part of this.  When the government spends money, where does the money go?  Well, it goes into the hands of individuals who work as government employees, and they use it to pay their bills and buy things.  It also goes into the hands of corporations (mostly) that provide the government with things the government needs, like bombs and paper clips and cars.  Those corporations in turn spend that money on buying things, paying their employees, and paying dividends to shareholders.

We can disagree about whether it is a good idea for the government to buy the things it buys with its money, but even the money that the government "wastes" doesn't disappear.  It goes into the hands of people, ultimately, who buy things.

You may have recently heard about something called the "sequester."  The sequester is a method of keeping the government from spending quite so much money by reducing expenditures across the board.  So, some office of the government may have a budget of $1 million before the sequester, and after the sequester, its budget goes to $900,000 (these figures are just made up to illustrate).  So, instead of spending $1 million, that office will spend only $900,000.

All told, the government will reduce spending by $83 billion in the first year of the sequester.  What that means is that $83 billion less will be made available to people who do business with the government (including employees, vendors, and service providers).  Those people will have to find a way to deal with less, by reducing their own spending by $83 billion in the aggregate.  That means layoffs of government and corporate employees, and less spending by corporations and individuals on the things they need to keep going.

Why does this matter?  Well, in a booming economy, it might not matter much at all, and might even be a good thing.  But we don't live in a booming economy.  It's hard to find ways to earn enough money to maintain our standard of living.  When you reduce government spending, you reduce the spending of people who get their money by doing things for the government also, which means that the people who depend on those people--the landlords, the grocery stores, the gas stations, the electric utilities, the restaurants, the hotels, the car dealers, the appliance stores--have to get by with less, too. 

Our economy is designed to grow continuously in the sense that each quarter and each year we expect more and more economic activity.  The economy needs to grow at some level because our population is increasing.  When the economy shrinks instead of growing, we're going in the opposite direction from where we need to be, which is called contraction.  If we go two quarters (half a year) with contraction, it's called a recession, which is a term that most people know but a lot of people don't understand. 

We can't do a whole lot to get people to spend their own money in a weak (contractionary) economy.  Everybody makes their own decisions, and when times are tough, people are concerned that they need to conserve their money because it will be harder to replace it when needed.

But we can spend money through the government.  Even if tax revenues aren't high enough to support more spending, the government can borrow money and spend it.  The idea is that when the government spends extra money, the fact that more money than usual is flowing to people who do business with the government causes those people to loosen the purse strings a bit and buy things.  In other words, the government spending stimulates other spending, which causes the economy to expand again.

When we do the opposite--reduce the money the government spends--then people react in the opposite way. They reduce their spending, worried that tough times are ahead.  When the government reduces its spending as a matter of policy, that is a "contractionary" policy.

These concepts are well understood by economists, so well understood that there is very little debate over them.

And when you implement a contractionary policy, the result is going to be contraction--i.e., the economy will get smaller, not bigger.  Contractionary policy is contractionary, and we shouldn't be surprised by it.

Now, I get that we need to get wasteful spending out of the government.  I'm all in favor of doing that.  But we're not talking about wasteful spending.  We're talking about all kinds of spending, wasteful or not.  You can stop wasteful spending and still spend that money on something else that's not wasteful.  There are a lot of things that we really need, that would benefit a lot of people and lay the groundwork for future growth in the economy.

Fundamentally, the question is this:  Do you want the economy to grow or contract?  If you want it to contract, we should cut government spending.  If you want it to grow, we should do the opposite.

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