The dangers of the Obama stimulus plan

Obama’s stimulus package, expected to be around $500 billion (around Rs24.8 trillion), will increase the federal deficit, which was already expected to near $1 trillion for 2009

Fiscal stimulus packages, such as the one discussed by US President-elect Barack Obama on 6 December, aren’t necessarily economically stimulating because they must be financed. Stimulus works best when the money is carefully directed and the cost doesn’t add to a large budget deficit. If it crowds out private investment, such stimulus will produce higher unemployment, faster inflation or both.

Obama used the analogy of a blood transfusion to describe his approach. But in a transfusion, blood is injected from outside, not siphoned from elsewhere in the body. Obama’s stimulus package, expected to be around $500 billion (around Rs24.8 trillion), will increase the federal deficit, which was already expected to near $1 trillion for 2009. Pure stimulus—Keynes’ “digging holes and filling them in”—can help in an economy suffering from under-consumption and underinvestment. The availability of financing then greatly exceeds demand. The US is not in this situation. Financing is unavailable because of the destruction of bank balance sheets and high levels of investor risk aversion. If the government takes an additional $500 billion of the meagre credit available, it leaves that much less for private borrowers. Of course, the government can print money to finance its additional borrowing, but that will stoke inflation.
Occasionally, stimulus may produce more growth than it destroys. The Tennessee Valley Authority power projects made electricity available in areas the private sector would have ignored, and together with agricultural education programmes, created regional economic growth. But examples today of new large-scale infrastructure projects are scarce. Fiscal stimulus risks prolonging a recession and making recovery sluggish. It should be used with great caution.