Wednesday, August 10, 2011

Here's why the Obama stimulus didn't work...

We need to first understand what a recession is and why it happens. A recession is simply a cutback in spending and production and usually takes place because of some event that leads to consumers and businesses holding on to the cash they have and to businesses cutting production in anticipation of a drop in demand for their products. Events can lead to recession can be wars and terrorist attacks, diseases, a drying up of credit or anything else that causes people to think that maybe things aren't going to be as nice in the future.

Left unchecked, it is possible that this initial round of cutbacks will result in even more fear, leading to businesses and consumers cutting even further their production and spending, the end result being a deeper and more severe recession.

However, if the fear can be checked, then we'll gather ourselves, pick ourselves back up, relax and start to spend and invest again.

That is where government traditionally has come in. In 'normal' recessions, governments have stepped up with spending and tax cuts that is supposed to 'stimulate' the economy. In reality, the stimulus does no such thing. What it does do is provide some amount of artificial and temporary spending and influx of cash that offsets to some degree the drop in private sector spending and investment, thus lessening the extent of the recession. It isn't so much that the 'stimulus' stimulates the economy as it lessens the drop. Sales and consumer income don't fall as much as they would without the stimulus. And once people see that the world isn't going to end, we get back to doing what we like doing... spending and investing and trying to improve our lives. And once we do that, the private sector picks up, lessening the need for any further government spending.

That is the way it is supposed to work.

But it only works if people think the stimulus is going to help (yes, it is a self-fulfilling condition). If, on the other hand, people were afraid that the stimulus would make things worse, then the stimulus, instead of causing people to keep spending, causes people to cut even further back on their spending... leading to the very problems that the stimulus was supposed to have prevented.

And that is what happened with Obama's stimulus. It was so massive (not just the amount of the 'official' stimulus, but the hundreds of billions that went into the financial sector bailout and into the car companies and so on) that it made people even more afraid of the future. We weren't talking billions of dollars, we were all of a sudden talking about trillions of dollars of spending... and we were no longer talking about a hundred billion dollar deficit, we were looking at a trillion dollar deficit... for as far as one could see.

This freaked people out. And when people get more afraid, they cut back their spending and investment even further. At best, they don't increase their spending and investment as much as they would if they weren't so scared.

Combine that with a (justified) fear that Obama and the Democrats were taking advantage of the crisis to push their agenda and to funnel money not to programs which would help the country as a whole but rather to their pet programs and supporters and it was no surprise that the huge stimulus failed to do what its authors claimed it would do.

That is why the Obama stimulus failed. And as Obama fails to recognize where he went wrong, any follow up stimulus of his would be salt in the wound of our confidence.

It isn't that a stimulus per se is doomed to fail. Done right they can (still) work. But this particular stimulus - because of its size and what it did - failed and big time.