Why fiscal stimulus makes sense
Imagine an economy where all prices were fluid, changing minute-by-minute, and there were no stable long-term relationships between economic agents. Imagine that “John Q.’s labour-power” was a commodity traded on an exchange just like “Light sweet crude.” Instead of having a job, John Q. has a little widget on his computer screen that tells him who is the current top bidder for his labour-power. If he wants, he can instantly go out and start working for that bidder, for as long or as short as the two of them find it mutually beneficial.
If a source of demand disappeared from this economy — such as by the bursting of a real estate bubble, say — there would be no recession and no significant increase in unemployment. All that would happen is that some people would be worse off, some people would be better off, some prices would be higher and some lower. But the overall level of economic activity would not change.
But that is a crazy fantasy economy. In the real-world economy, prices do not change instantly, behaviour does not change instantly in response to circumstances, and so on. John Q. does not have a “labour ticker” on his computer screen, he has a steady job. It is very difficult to reduce his wage at this job — partially for reasons of contract, labour unions, and regulations, but mostly for reasons of human psychology.
This creates the possibility of something called a “recession.” This happens when a source of demand disappears from the economy — such as the collapse of a housing bubble. Because prices are “sticky,” the economy does not instantly adjust. Perfectly employable people lose their jobs. Perfectly useful productive resources lie unused. This reduces the level of demand in the economy, in a vicious circle known as the multiplier effect.
So in the real world, what do functioning first world governments do when confronted with a recession? The normal response to a recession is essentially printing money and distributing it to large banks. Make sure the banks have lots of money available, they go looking for investment opportunities, and this causes people and resources to become, once again, employed.
But in particularly severe recessions, this doesn’t necessarily work. If the hole in the economy is big enough, you may not be able to fill the hole in the customary way, by loosening up credit to the banks. It may be that the people who control this “monetary policy” are simply unwilling to loosen up credit far enough. It may be that they are simply unable to do so, due to exceptional conditions known as the “zero lower bound” and the “liquidity trap.” What happens then?
In this case, you can have the government act like a bank, and make large public investments itself, such as building bridges, or schools, or scientific instruments, or monuments, or military weapons, or any number of other things. The government can even just hand out money to families directly — whether in the form of a tax cut, a tax credit, or a grant. This is called “fiscal stimulus.” Fiscal stimulus adds demand to the economy. It also operates using the “multiplier effect” mentioned above; by spending $1, the government may actually add $1.50 or more to the total demand in the economy.
But wait! Doesn’t the money have to come from somewhere? If the government borrows money, that must mean that someone else doesn’t get access to that money. If the government prints money, that dilutes the value of everyone else’s money (because more money is chasing the same amount of productive resources.) Right?
No. In a deep recession, potentially loanable money is not getting loaned out. Potentially productive resources are not being used for production. Fiscal stimulus does not divert resources from the private sector; it mobilizes resources which were previously idle. It increases the overall level of economic activity. That is why it is sometimes a very good idea.