Economic Stimulus

What Is Economic Stimulus?

Economic stimulus is action by the government to encourage private sector economic activity by engaging in targeted, expansionary monetary or fiscal policy based on the ideas of Keynesian economics. The term economic stimulus is based on an analogy to the biological process of stimulus and response, with the intention of using government policy as a stimulus to elicit a response from the private sector economy.

Economic stimulus is commonly employed during times of recession. Policy tools often used to implement economic stimulus include lowering interest rates, increasing government spending, and quantitative easing, to name a few.

Understanding Economic Stimulus

The concept of economic stimulus is mostly associated with the theories of 20th-century economist John Maynard Keynes, and his student Richard Kahn’s concept of the fiscal multiplier.

A recession, according to Keynesian economics, is a persistent deficiency of aggregate demand, where the economy will not self-correct and instead can reach a new equilibrium at a higher rate of unemployment, lower output, and/or slower growth rates. Under this theory, in order to combat recession, the government should engage in expansionary fiscal policy (or in the variant of Keynesianism known as Monetarism, monetary policy) to make up for shortfalls in private sector consumption and business investment spending in order to restore aggregate demand and full employment.

Fiscal stimulus differs from expansionary monetary and fiscal policy more generally, in that it is a more specifically targeted and conservative approach to policy. Instead of using monetary and fiscal policy to replace private sector spending, economic stimulus is supposed to direct government deficit spending, tax cuts, lowered interest rates, or new credit creation toward specific key sectors of the economy to take advantage of powerful multiplier effects that will indirectly increase private sector consumption and investment spending.

This increased private sector spending will then boost the economy out of recession, at least according to the theory. The goal of economic stimulus is to achieve this stimulus-response effect so that the private sector economy can do most of the work to fight the recession and to avoid the various risks that might come with massive government deficits or extreme monetary policy. Such risks might include hyperinflation, government defaults, or the (presumably unintentional) nationalization of industry.

By stimulating private sector growth, stimulus deficit spending could, allegedly, even pay for itself through higher tax revenues resulting from faster growth.

The CARES (Coronavirus Aid, Relief, and Economic Security) Act, signed into law by the president on March 27, 2020, pushes the boundaries of economic stimulus in that it aims to directly replace large swaths of private-sector spending, albeit on a temporary basis (one hopes), that have been destroyed by the coronavirus.

Over the course of a normal business cycle, governments try to influence the pace and composition of economic growth using various tools at their disposal. Central governments, including the U.S. federal government, utilize fiscal and monetary policy tools to stimulate growth. Similarly, state and local governments can also engage in projects or enacting policies that stimulate private sector investment.

Fiscal stimulus refers to policy measures undertaken by a government that typically reduce taxes or regulations — or increase government spending — in order to boost economic activity. Monetary stimulus, on the other hand, refers to central bank actions, such as lowering interest rates or purchasing securities in the market, in order to make it easier or cheaper to borrow and invest. A stimulus package is a coordinated combination of fiscal and monetary measures put together by a government to stimulate a floundering economy.

Potential Risks of Economic Stimulus Spending

There are several counter-arguments to Keynes, including the concept of “Ricardian equivalence”, the crowding out of private investment, and the idea that economic stimulus can actually delay or prevent private sector recovery from the actual cause of a recession. 

Ricardian equivalence and crowding out

Ricardian equivalence, named for David Ricardo’s work dating back to the early 1800s, suggests that consumers internalize government spending decisions in a way that counterbalances current stimulus measures. In other words, Ricardo argued that consumers would spend less today if they believed they would pay higher future taxes to cover government deficits. Although empirical evidence for the Ricardian equivalence is not clear, it remains an important consideration in policy decisions.

The crowding-out critique suggests that government deficit spending will reduce private investment in two ways. First, the rising demand for labor will increase wages, which hurts business profits. Second, deficits must be funded in the short run by debt, which will cause a marginal increase in interest rates, making it more costly for businesses to obtain financing necessary for their own investments.

Both Ricardian equivalence and the crowding-out effect essentially revolve around the idea that people respond to economic incentives. Because of this, consumers and businesses will adjust their behavior in ways that offset and cancel out the stimulus policy. The response to the stimulus will not be a simple multiplier effect, but will also include these offsetting behaviors. 

Preventing economic adjustment and recovery

Other economic theories that devote attention to the specific causes of recessions also dispute the usefulness of economic stimulus policy. In Real Business Cycle Theory a recession is a process of market adjustment and recovery from a major negative economic shock, and in Austrian Business Cycle Theory a recession is a process of liquidating mistaken investments initiated under prior distorted market conditions and reallocating the involved resources in line with true economic fundamentals — described by the famous Austrian economist Joseph Schumpeter as the “process of creative destruction." In both cases, economic stimulus can be counterproductive to the necessary process of adjustment and healing in markets. 

This is especially a problem when, as is often the case, the economic stimulus spending is targeted at boosting the industries of sectors that are hardest hit by the recession. These are precisely the areas of the economy that may need to be cut back or liquidated in order to adjust to real economic conditions according to these theories. Stimulus spending that props them up runs the risk of dragging out a recession by creating economic zombie businesses and industries that continue to consume and waste society's scarce resources as long as they continue to operate. This means that not only will economic stimulus not help the economy get out of recession, but it can make matters even worse. 

Other arguments

Additional arguments against stimulus spending recognize that while some forms of stimulus may be beneficial on a theoretical basis, using them faces practical challenges. For example, stimulus spending may occur at the wrong time due to delays in identifying and allocating funds. Second, central governments are arguably less efficient at allocating capital to its most useful purpose, leading to wasteful projects that have a low return.