As a result of the recent strong stimulatory policies employed by the US government and the Fed, most commentators are of the view that the risk of a deepening slump in the US economy on account of the COVID-19 pandemic has now receded.
Some other commentators are not so certain that the risk has declined, arguing that the economy is still heading towards difficult times ahead. These commentators are of the view that to prevent the possible economic difficulties ahead authorities should continue with easy fiscal and monetary policies until the economy safely placed on the trajectory of stable economic growth.
Most commentators are of the view that by failing to act swiftly authorities are running the risk of raising the cost of an economic slump in terms of idle or unutilized resources such as labor and capital.
This way of thinking is succinctly summarized by Ludwig von Mises,
Here, they say, are plants and farms whose capacity to produce is either not used at all or not to its full extent. Here are piles of unsalable commodities and hosts of unemployed workers. But here are also masses of people who would be lucky if they only could satisfy their wants more amply. All that is lacking is credit. Additional credit would enable the entrepreneurs to resume or to expand production. The unemployed would find jobs again and could buy the products. This reasoning seems plausible. Nonetheless it is utterly wrong.
Conventional thinking argues that boosting the overall demand for goods and services is going to strengthen the supply of these goods and services – demand creates supply.
However, why should an increase in the overall demand be followed by the increase in the production of goods and services? This requires a suitable production structure that is going to permit the increase in the production.
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CAMBRIDGE – More than a decade ago, I undertook a study, together with Graciela Kaminsky of George Washington University and Carlos Végh, now the World Bank’s chief economist for Latin America and the Caribbean, examining more than 100 countries’ fiscal policies for much of the postwar era. We concluded that advanced economies’ fiscal policies tended to be either independent of the business cycle (acyclical) or to lean in the opposite direction (countercyclical). Built-in stabilizers, like unemployment insurance, are part of the story, but government outlays also worked to smooth the economic cycle.
The benefit of countercyclical policies is that government debt as a share of GDP falls during good times. That provides fiscal space when recessions materialize, without jeopardizing long-run debt sustainability.1
By contrast, in most emerging-market economies, fiscal policy was procyclical: government spending increased when the economy was approaching full employment. This tendency leaves countries poorly positioned to inject stimulus when bad times come again. In fact, it sets the stage for dreaded austerity measures that make bad times worse.
Following its admission to the eurozone, Greece convincingly demonstrated that an advanced economy can be just as procyclical as any emerging market. During a decade of prosperity, with output close to potential most of the time, government spending outpaced growth, and government debt ballooned. Perhaps policymakers presumed that saving for a rainy day is unnecessary if this time is different and perpetual sunshine is the new normal.
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