Monetary Policy
The first solution is expansionary monetary policy from the Federal Reserve. It's powerful, quick, and effective. Lower interest rates make it easier for families to borrow what they need. That includes expensive items like cars, homes, and consumer electronics. It stimulates enough demand to put the economy back on track. Low interest rates also allow businesses to borrow for less. That gives them the financial capital to hire enough workers to meet rising demand.
Fiscal Policy
If the recession is really severe, then monetary policy might not be enough on its own. That's when fiscal policy is needed. The government must either cut taxes or increase spending to stimulate the economy. An expansionary fiscal policy is slower than monetary policy to get started. It takes time for Congress and the president to agree on the next steps. But it can be more effective once executed. It also provides much-needed confidence that the government will turn things around. Confidence is crucial for convincing people to spend now for a better future.
Cutting taxes works like lowering interest rates. Both give businesses and consumers more money to spend. That increases demand. It gives businesses more cash to invest and hire more workers.
Government spending usually takes the form of jobs programs. The government hires employees directly. It also contracts with companies to build things and provide services. It provides consumers with the cash they need to buy more products.
The Most Cost-Effective Solution
Dollar for dollar, what's the best investment that creates the most jobs? A University of Massachusetts/Amherst study found that building mass transit is the most cost-effective solution. One billion dollars spent on public transportation creates 19,795 construction jobs.
The next is unemployment benefits. Every $1 billion spent on unemployment benefits creates 19,000 jobs, according to a Congressional Budget Office study. The unemployed are most likely to spend every dime they get. They buy basics like groceries, clothing, and housing. As a result, every dollar spent on unemployment benefits stimulates $1.64 in demand.
How can $1 create $1.64? It does it through the ripple effect. For example, a dollar spent at the grocery store pays for the food. It also helps pay the clerk's salary, the truckers who haul the food, and even the farmers who grow it. The clerks, truckers, and farmers then buy groceries. This ripple effect keeps demand strong, creating added benefit. Stores keep their employees to supply the goods and services the unemployed need. Without these benefits, demand would drop. Then retailers would need to lay off their workers, increasing unemployment rates.
Unemployment benefits work fast. The government writes a check that goes directly into the economy. Public works projects take longer to get implemented. The plans must be updated, workers hired, and supplies delivered.
During the final quarter of 2008, unemployment programs paid $34.9 billion in benefits to 8 million unemployed workers. That boosted economic growth by $57 billion. Every month in extended benefits cost taxpayers $10 billion. But at the same time, it generated $16.4 billion in economic growth.
The third-best unemployment solution is funding education. One billion dollars spent hiring teachers adds $1.3 billion to the economy. Better-educated people can get higher-paying jobs. They can buy more things with the higher wages they earn. Each billion also creates 17,687 jobs. That's much better than defense spending. It only creates 8,555 jobs for the same investment. Defense is more capital-intensive. Modern defense relies more on drones, F-35s, and aircraft carriers than soldiers.
The most popular fiscal stimulus is across-the-board income tax cuts. That's not the most cost-effective, according to the UMass/Amherst study. One billion dollars in cuts creates 10,779 jobs. Workers only spend half the money, which in this case is only $505 million.
As a result, reductions in the tax rate damage the economy. Every dollar in lost tax revenue only creates 59 cents in economic growth. Most people don't realize they are getting a break until tax time. The tax cut means they pay less in taxes, but they still have to pay. Psychologically, they are less likely to spend anything extra. It just doesn't feel like a bonus. As a result, people are more liable to save anything they get or use it to pay down other debts.
A more effective tax cut is in businesses payroll taxes. One billion dollars in payroll tax cuts created 13,000 new jobs. The best place to give business tax relief is with small businesses. They produce 65 percent of all new jobs.
Fiscal Policy Risks
The downside of fiscal policy is it adds to the budget deficit. That creates more government debt. As debt approaches 100 percent of the economy's total output, it slows economic growth. Investors could lose the desire for that government's debt. This makes interest rates rise, increasing the cost of borrowing.
Advocates of supply-side economics say that, over time, tax cuts boost the economy enough to replace any lost tax revenue. But according to the Laffer Curve, that's only true if taxes are more than 50 percent to start with.
