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The economic stimulus package: How does spending help?

A reader wonders why government is attempting to spend its way out of an apparent recession.

By David R. Franciscolumnist / February 4, 2008

A reader asks: "Could you please explain how a stimulus package (which creates more federal debt but puts cash into the hands of consumers) helps the economy? It is hard to understand how spending more money helps the economy. Isn't this what got us into this mess? The nation has a negative saving rate, the Republican Congress encouraged spending at the federal level and at the consumer level, housing prices became inflated, people took out mortgages that they now cannot afford (overspending)…. Isn't it better to have a good balance of spending and saving?"

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The reader is basically right, says Barry Bluestone, a dean and economist at Northeastern University, Boston. Many consumers have overspent and maxed out their credit cards. Housing prices have soared, making Americans regard them as a clever investment as well as a home. "Mischievous" mortgage brokers made a mint providing inappropriate loans on home purchases.

Paraphrasing Professor Bluestone further, he sees the United States now facing a "perfect storm" with the potential for serious inflationary pressures. Oil prices have soared toward $100 a barrel. The dollar has tumbled, making it easier for domestic businesses to raise prices and still compete with imports.

Moreover, the decline in housing prices, the subprime mortgage mess, plus approximately a 15 percent drop in stock market values since October, has left many people feeling poorer. Even if still employed, they rein in their spending. They delay building an addition to their house. They skip a vacation. They don't buy expensive furniture, and so on.

This trend raises the risk of a worsening economic slump. It needs countering with easier monetary policy and "short-term fiscal stimulus," says Bluestone. He emphasizes the words "short-term." Tax rebates or tax cuts shouldn't be permanent, he says. Putting an extra $300 or more into the pockets of consumers will prompt some of them to spend, some to reduce debts, and some to save.

"It will make people feel less poor," says Bluestone.

Yes, the tax stimulus raises federal debt. But with the economy already slowing, the nation must avoid hitting the economic brakes; rather keep it moving to slow rising unemployment and the weakening of businesses.

When the temporary tax cuts end, the economy should be moving forward again and federal revenues will rise to trim or end the federal budget deficit. That, explains Bluestone, is what happened in 1995-96 under President Clinton. And if necessary, the government could dampen a new vigorous economic expansion to trim rising inflation.

"At least we tackle that problem when the economy is growing, not declining," says Bluestone. "It's a timing problem."