Utopia, you are standing in it!

Eugene Fama argues that government bailouts and stimulus plans seem attractive when there are idle resources – when there is unemployment such as in a recession or depression including in the 1930s.

Fama counters that:

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

Fama noted that there was just one valid negative comment in response to this argument  that appears  to be valid which was made by Brad DeLong.

Fama thinks Delong’s point about involuntary inventory accumulation is consistent with Fama’s initial arguments about the need for the stimulus to work through moving resources to higher value uses.

For me, the notion that a fiscal stimulus is a negative productivity shock is a good starting point for analysis. The method of financing the stimulus is important too.

Economic agents know that a temporary expenditure program has no lasting effect on employment but has lasting effect on disposable income and taxes. Indeed, massive public interventions to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead to a depression.

In Australia,  there was a  massive fiscal contraction from late 1930 onwards called the Premiers’ Plan. In 1931, unemployment rates was 25% or more.

• The Premiers’ Plan required the federal and state governments to cut spending by 20%, including cuts to wages and pensions and was to be accompanied by tax increases, reductions in interest on bank deposits and a 22.5% reduction in the interest the government paid on internal loans.
• The Premiers’ Plan was complementary to the Arbitration Court’s 10 per cent nominal wage cut in January 1931 and the devaluation of the Australian pound. Most countries had abandoned the gold standard by 1931 and 1932 and devalued by about 10% including the UK. These competitive devaluations were called currency wars. Most countries below started to recovery before they left the gold standard, a year or two before they left the cross of gold.

Maclaren (1936) dated the Australian economic recovery from the last months of 1932. It was to take another three years before unemployment rates fell below 10 per cent — the rate it had been during most of the 1920s.

The June 1931 Premiers’ Plan of fiscal consolidation had time by late 1932 to become credible and take hold given the usual leads and lag on fiscal policy. Unemployment data  for the time show a rapid fall in the high twenties unemployment rate in 1932 to be below 10 per cent by 1937.