LONDON – Have stimulus packages brought the world’s traumatized economies back to life? Or have they set the scene for inflation and big future debt burdens? The answer is that they may have done both. The key question now concerns the order in which these outcomes occur.
The theory behind the massive economic stimulus efforts that many governments have undertaken rests on the notion of the “output gap.” This is the difference between an economy’s actual output and its potential output. If actual output is below potential output, this means that total spending is insufficient to buy what the economy can produce.
A stimulus is a government-engineered boost to total spending. Government can either spend more money itself, or try to stimulate private spending by cutting taxes or lowering interest rates. This will raise actual output to the level of potential output, thereby closing the output gap.
Some economists – admittedly a diminishing number – deny that there can ever be an output gap. The economy, they argue, is always at full employment. If there are less people working today than yesterday, it is because more people have decided not to work. (By this reasoning, a lot of bankers have simply decided to take long holidays since last September’s financial meltdown.) So today’s output is what people want to produce. Attempts to stimulate it will produce only higher prices as people spend more money on the same quantity of goods and services.