We probably should not be surprised that the debate over the stimulus package has brought with it strange economic reasoning. Economist John Maynard Keynes proposed that government spending, even while incurring debt, would help support an economy in the throes of a severe economic downturn. He came to that conclusion at a time when financial institutions were very different, the population was not only less skilled but also less mobile, and the economy was less robust. With that in mind, his work was so important that he is the primary source for economic analysis worldwide to this day. His contribution went well beyond theory and led to the establishment of a body of economic statistics that allows us to explore the impacts of economic activity.
I am about to do a disservice to his great work by simplifying it. Basically, Keynesian economists analyze four major influences to determine the path of the economy — consumption, investment, government spending and foreign trade. Each influence has been dissected over time and through economic models to explain how the behavior of each influence is generated as new insights are surmised and/or gleaned from the data. The result is a plethora of models and explanations of how the economy functions and what the impact of economic policy will be.
What is consistent throughout this analysis is that the equations used to explain each of the influences have their own set of variables, some unique and some not, and that the estimation of the importance of these variables is left to statistical analysis that assigns coefficients to the variables that are re-estimated with new data and new assumptions. The bottom line is that a series of very complex equations are brought together in a systematic manner that allows organizations and government agencies the ability to estimate the path the economy will take given current and expected activity — such as the stimulus.
One of the four influences, government spending in all its forms related to the gross domestic product, is less complex than the others to estimate. Analysts look at budgets and projected revenues to estimate expenditures and guess the estimated impacts on each industry based upon historic and intended spending patterns.
More complex is foreign trade, since it depends on trade agreements, exchange rates, relative buying power of each trading partner, interest rates, terms of trade and political issues. The price of oil has resulted in recent net trade balance swings, and the influence of declining world economies also has had a severe and perhaps longer-term impact on net foreign trade.
Still more complex is investment, since it captures behavior of both consumers and business. Residential construction depends on a host of factors, as we have seen recently. Some of the demand is based on consumer income. Business investment depends on assumptions about future demand for products as well as the replacement of aging facilities, the introduction of new technology and changes in regulations.
The most complex factor and most important for our economy is the consumer influence. Among the models attempting to explain consumption are income-based, expectations-based and substitution-based ones, which are very complex and all prone to variances over time.
Quoting a friend of mine, “To state that a stimulus dollar dropped into the economy anywhere will have the same impact over time is not only absurd but a very dangerous basis for political decisions. We have many problems all at once, but underlying all of them is a deep mistrust of most institutions, both private and government. That's why this package should make sense to people…to help rebuild trust in government.”