Stimulus, tax-cuts, debts, deficits and Quantitative Easing

With impending presidential elections, there are divergent economic viewpoints (I would not call them ideologies because they are not all that different from each other) on how to best create jobs and lower unemployment. One viewpoint (republican) emphasizes cutting taxes and easing regulations while another (democratic) emphasizes raising taxes and government stimulus to create jobs. There is yet another approach (the Federal reserve) that involves printing money and providing easy credit to businesses and individuals to spur demand and hence employment.

Let's try to understand the three approaches with the simple village scenario in mind and we will do this again without involving the concept of money. Our village, if we have not already seen it, is operating on free-market principles with government oversight and government provided services.

The village has been humming along with Wesley the wise, Henry the hunter, Taylor the tailor, Fannie the farmer, Billy the builder and Debbie the designer. Here, we have to understand that Henry, Taylor, Fannie, Billy and Debbie are all paying "taxes" in the form of paying Wesley with grain, clothes, shelter, meat and footwear in exchange for his administrative services (policing, resolution of disputes, enactment and enforcement of laws and regulations etc. etc.). Also, the economy has matured in the sense that food supply is guaranteed. I.e. The village does not and will not experience recession with lack of food as the underlying reason. Does this mean that the village can never experience a recession? Not really, as we will see.

Before moving on, we will take a look at some of the regulations/law that Wesley had laid out for the village. The regulations are the original "ten commandments" along with an eleventh arbitrary one:

   11. Thou shalt not cross the river.

Now, we come to the recession bit. As luck would have it, the weather's improved considerably over the years and Billy's shelters and Debbie's footwear are lasting much longer than expected. People no longer feel the need to have Billy rebuild their shelter and Debbie replace their footwear on a regular basis. I.e. the demand for Billy and Debbie's products has gone down. Henry, Fannie and Taylor would rather save their grains, meat and clothes for later rather than barter them for shelter and footwear now. Billy and Debbie find themselves underemployed and with little means to pay for food and clothes. They will have to rely on their fellow villagers' charity.

Wesley the wise, however, decides to tackle it differently. The options available to him are:

1. Raise taxes on Henry, Fannie and Taylor by making them give up the extra grain, meat and clothes and put Debbie and Billy on "welfare" by giving them the food and clothes needed to survive.
2. Raise taxes on Henry, Fannie and Taylor and put Debbie and Billy to work on specific projects that he thinks will help the village and grow the economy in the future. This is what we would call "stimulus".
3. Put Billy and Debbie on "welfare" after handing Henry, Fannie and Taylor GOUs (Government Owes You) for their grain, meat and clothes, that they can use to exchange in the future for some goods of value. The GOUs are what we would call "government debt". Creation of "government debt" was Wesley's way to tackle the "deficit" problem where he needed to spend more (on Billy's and Debbie's "welfare") than he was getting in "taxes". Of course, paying off the GOUs will require increased tax revenues in the future but that's for later.
4. "Stimulate" the economy by employing Billy and Debbie and creating a "deficit". Tackle the "deficit" by printing and handing Henry, Fannie and Taylor GOUs and raising "government debt" instead of raising taxes.
5. "Stimulate" the economy by printing and handing Debbie and Billy GOUs (provided that they can pay it back in the future with interest - i.e. Wesley exchanges GOUs for Debbie and Billy's IOUs) that they can use to "buy" food and clothes for themselves. This is what we would call "Quantitative Easing".
6. "Stimulate" the economy by cutting regulations, not raising taxes and making it easier for Fannie, Taylor and Henry to employ Billy and Debbie.
7. "Stimulate" the economy by cutting both regulations and taxes and thus creating incentives for Fannie, Taylor and Henry to use the extra money to employ Billy and Debbie. How does Wesley "cut taxes"? Instead of simply providing Fannie, Taylor and Henry with administrative services in exchange for food and cloth he gives them additional "GOUs" for their goods. Effectively, Fannie, Taylor and Henry would have paid no taxes since they have the "GOUs" that they can essentially use in the future to retrieve their goods back.

Obviously, nobody wants options 1 and 3 to continue forever because nobody wants "moochers" in the society. Therefore, the viable options open to Wesley are:

1. Government stimulus via raising taxes (option 2 above)
2. Government stimulus via raising government debt (option 4 above)
3. Stimulus via Quantitative Easing (option 5 above)
4. Stimulus via cutting regulations (option 6 above)
5. Combination of one or more of the above

In the specific scenario mentioned here, Wesley can:

1. Remove the regulation of "Thou shalt not cross the river" and employ Billy to build a bridge across the river ("stimulus") while keeping Debbie on "welfare". In this case, the village will own the bridge.
2. Remove the regulation and provide a loan to Billy, while keeping Debbie on "welfare", hoping that Billy will have the wisdom to build a bridge himself ("QE"). In this case, Billy will own the bridge while paying the government off from revenues he might generate from operating the bridge.
3. Remove the regulation and hope that Fannie/Henry/Taylor will employ Billy to build that bridge ("tax-cuts") while keeping Debbie on "welfare". In this case, Fannie/Henry/Taylor will own the bridge and profit from their investment into Billy.

What would this do? Building the bridge will open access to precious and scenic land on the other side of the river and who knows, maybe, Billy will get the idea of building and operating a gated community of beautiful villas on the other side of the river that people will want to own. This will give Debbie the chance to change her vocation and gain employment by becoming a property manager in the gated community. Maybe, Fannie will find more nutrient rich land to raise silk worms or better quality of cotton to generate even more luxuriant cloth for Taylor thus raising the standard of living for everyone.

However, on the flip side, it's quite possible that the arbitrary regulation was not so arbitrary after all. Crossing the river might open the village to attacks from the neighboring village and endanger the current way of life. Blind cutting of regulations might not be the universal answer to economic recession.

As you can see, even in such a small village, there is no single approach that one can point to that is guaranteed to work while the others fail. If we extend the argument to an entire country employing millions of people in "services" what is to say which approach will work and which will not.

The important takeaways from this post are:

1. In the current economy, most of the people are employed via exchanging "services" with each other.
2. In a services based economy with guaranteed supply of basic amenities, recession is only possible when demand for certain kinds of services dries up. Economy can pick up again if out-of-demand services can be replaced by new services that catch people's fancy and generate new demand for those services. I.e. a new want can be created where none existed before.
3. The government can create new demand by loosening corporate credit that will allow companies to invest in new R&D or by loosening consumer credit that will allow consumers to borrow and spend, thus creating a new wave of demand. However, if loosening credit does not spur the economy the government might have to step in and create employment to restore consumer confidence and create fresh demand.
4. In the current economy, it is quite possible to have half the society on welfare while the other half works to provide all the basic necessities for the entire society. However, this is not acceptable to anybody believing in "free market".
5. There is no single recipe for stimulating the economy. Republicans touting small government, tax-cuts and easing regulations as the universal recipe do not possess that magic bullet. Nor do democrats when they are touting government stimulus, tax-hikes and more regulations as their answer to the current economic recession. What will work and what will not will depend on specificity of the situation. If you look carefully, both democratic and republican approaches raise "debt" and create "deficits". The differences between democratic and republican approaches are in:
1. Who makes the investment decisions? The government or private individuals? It all depends on who the wiser people are at the moment. If Wesley was not wise, then it makes more sense to let Fannie, Taylor and Henry make the call on making the right investment. After all, they are the only ones doing well in the bad economy.
2. Who benefits from the approaches? In the current economy, both approaches have the potential to increase GDP and raise the standard of living. However, with the republican approach the wealth gets concentrated in the hands of the already-haves.
6. Most probably, what will work is a mix of all three approaches ("stimulus", "tax-cuts" and "QE") because in such a large society as ours there are bound to be people who will be able to make use of "QE" to start new businesses, people who will require the government to provide them with employment that makes use of their current skills, people who will have to go on welfare and finally, people who will start new businesses if restrictive regulations are lifted.