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Issue 4/25 February 2009

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Today’s Issue Includes:

1) The economic implications of Barack Obama’s fiscal stumulus. By Ben Martin

(This is a revised version of Ben Martin's essay which was judged the winner of the St Paul's Economics prize by Professor Tim Besley, Kuwait Professor of Economics and Political Science, Director of STICERD at London School of Economics & Political Science and member of the Bank of England's Monetary Policy Committee.)

Before his inauguration as the 44th President of the United States of America, Barack Obama had repeatedly indicated that he felt that a large fiscal boost was necessary to prop up the American economy. Having consulted with economists and Republican senators, he finally pushed a $789bn stimulus package, named the 'American Recovery and Reinvestment Act' through the federal legislature. The stimulus package mostly consisted of tax credits and increased expenditure on public works. The Federal Funds Target Rate is at 0.25%; but the divergence between the real and nominal interest rates means that interest rates are effectively zero. This severely limits the capacity of the Federal Reserve to stimulate economic growth; interest rates cannot go much further without becoming negative and thereby encouraging savers to remove their money from banks with disastrous consequences for the economy. The economic consensus is that a fiscal stimulus similar to the American Recovery and Renivestment Act is required to cushion the recession. The US is suffering from a classic case of Keynesian demand deficiency; consumer spending has slowed and many state governments are cutting spending. By giving tax credits to individuals the fiscal stimulus will boost consumption and by increasing funding for state governments it will boost government spending.

The most obvious debate seems to be occurring over the size of the package; many economists are concerned over whether $819bn will be enough to close the output gap. The natural rate of unemployment in the United States is around 5%, and forecasts suggest that unemployment may top 8%. Paul Krugman, an economist who has influenced Obama significantly, has used Okun’s Law to calculate that this will lead to an output gap of around 6-9% of GDP, which is between $450bn and $675bn. This would suggest that Obama’s stimulus should be more than adequate, assuming a moderately decent multiplier effect occurs. Individuals will receive tax credits, which will lead to an increase in real incomes, boosting consumption. Likewise, the confidence of consumers will rise as they see that their government is taking an active role in helping them out. This will further increase their consumption. Increased spending on public works will increase aggregate demand, and those employed by the government to work on such public investment projects will spend their incomes, which will lead to a multiplier effect, which states that any increase in consumption leads to an even greater increase in national income.
However, historical analysis presents a much bleaker picture. A study by Harvard economist Kenneth Rogoff and Carmen Reihart has focussed on financial crises in the last century as a guide to predicting the effects of the current one, and has found that financial crises tend to increase unemployment by 7%. An average increase in unemployment of 7% would take the output gap closer to 14% of GDP, which is well over $1tn dollars. If such a collapse were to occur, Obama’s plan would look flimsy at best. Furthermore, that is only an average increase; given the extraordinary nature of the current crisis, it would not be surprising for it to result in a greater than average increase in unemployment. Let us therefore assume an output gap of near to $1tn dollars, which is what economists like Martin Wolf believe is closer to what is needed in terms of a fiscal stimulus. The proposed value of the stimulus appears to be too small – it will not boost America out of a recession.

The structure of Obama’s stimulus is important. Estimates suggest that $300bn will be given out in tax credits and $475bn will be spent on infrastructure projects. The $300bn will be given out in the form of a $500 tax credit to individuals on the first $8100 of wages earned. They should then spend this money, leading to an increase in aggregate demand. The benefits of tax credits as a form of stimulus tend to be concentrated on timing. Unlike infrastructure projects, which require planning and need to be put through legal vetting, the money can be spent instantly, providing a quick boost to the economy. The increased government spending will also increase aggregate demand. The benefits of increased government spending include better prospects for long-term growth because of better infrastructure, better provision of public goods and the certainty that money will be spent.

However, there are a number of problems with the structure of Obama’s stimulus. Firstly, tax credits are only worthwhile if people actually spend them. Consumption is linked to confidence, which is in turn influenced by asset prices, which may fall by up to 32% according to Deutsche Bank AG. If such a fall occurs, people will hoard extra income as insurance, negating the stimulating effects of any tax credits. Likewise, there are significant problems associated with increased public spending. Firstly, to have a strong effect, there needs to be a substantial multiplier effect, but if consumer confidence is low this is unlikely. This is one weakness to Obama’s plan. The other significant flaw in the stimulus plan is that Obama intends to increase spending on renewable energy projects; this would only provide significant employment for engineers and scientists: people who are unlikely to be made unemployed because of the recession.

It is also necessary to analyse the stimulus plan in the context of alternative solutions to the recession. Manipulation of interest rates is no longer possible; the only obvious alternative is for the Federal Reserve to engage in ‘quantitative easing’ by purchasing assets and commercial paper. This would have two principal effects. The first is that there would be an increase in the money supply. This would lead to an increase in aggregate demand as individuals have more money with which to purchase goods and services. It would also lead to a fall in real interest rates; if the central bank purchases commercial paper, it improves the liquidity of banks and removes toxic assets from their balance sheets. This increases the confidence and the lending ability of banks, which will then offer more credit, encouraging growth.

However, there is a significant downside to turning on the printing presses; the threat of inflation. If there is an increase in the money supply, then demand for goods and services across the economy will rise, leading to an increase in the prices of those goods and services and an increase in the overall price level. Furthermore, if people hear that the central bank is printing money, this can lead to an inflationary attitude sinking in, whereby people bring future spending forward to insulate themselves from inflation, and hence bring about the inflation that they so feared. Whilst the economic consensus suggests that there is a greater risk of deflation due to falling energy and labour costs as well as low demand, it remains difficult to quantify how much money to print without causing very high levels of inflation, which can cripple an economy, and therefore this does not seem to be a viable alternative.

There are two other significant economic implications to Obama’s stimulus plan: an increased budget deficit and an increased current account deficit. Firstly, the budget deficit; the Bush administration engaged in pro-cyclical deficit spending that has pushed the budget deficit to $455bn (6% of GDP). With Obama spending over $800bn on his fiscal stimulus, one might expect the annual budget deficit as a percentage of GDP to soar into double-figures. There are two problems with such huge budget deficits. Firstly, such high levels of government borrowing can deprive the private sector of much needed capital that is crowded out. Secondly, they necessitate future tax increases in order to pay off the debt – this can act as a brake on long-term growth and may prevent Obama from implementing some his more expensive promises, such as universal healthcare. The international effects are also significant. As U.S. consumers gain tax credits, they will spend a certain portion of their increased income on imports, so that much of the extra demand within the economy benefits other countries, increasing the current account deficit. Indeed, the foreign capital that has been flowing into America as a result of this deficit encouraged banks to engage in the risky lending that precipitated the current financial crisis. Obama’s plan will bolster the very capital flows that created this crisis and could prevent important healthcare reforms. That’s hardly change we can believe in.

Keep up with the daily changes in the economy by visiting Nigel’s econoblog at


2) What is happening to the Indian Economy by Peter Newton-Lewis in Mumbai.

Peter is the one on the right .

Why is the Indian economy still growing (although at a rate that is slowing) whilst the rest of the major world economies are in recession? Is it because the “R” word doesn’t feature in the Indian press and expectations are geared for 5%+ growth?

Certainly the recession in the West effectively started early in 2008 and it may yet turn into the “D” – “Depression” - if Western media maintains the gloom and doom.
The Indian economy is growing more slowly now (2009) than the 9% recorded rate for last year. If Economics is at all a rational, logical subject and economic agents like investors and consumers can behave to an expected pattern, then the economy here will avoid recession – indeed one report (21st. February ) suggested that the slowdown has now been reversed. My “hunch” is that this straw in the wind is a bit optimistic (an Indian sign?) and that the Indian economy may experience even slower growth than forecast during 2009 – before the expected turn-round in 2010. It is of course very difficult to predict and much will depend upon external events. Will the rest of the major economies talk themselves into an even bigger recession than expected? This scenario has parallels with the Paradox of Thrift – save more, spend less and the economy shrinks so that people can afford to save even less. There is a view in India that this is part of “kharma” – where one reaps what one sows and that this is a payback to the West for recent extravagancies / mismanagement of economies. To be honest it seems so accurate a reflection – but one that will be denied by politicians.

So what is going on in India?

From my perspective in Mumbai (the financial, business heart of India) there is still confidence, investment and high spending – partly based on rising real incomes. Contacts in Bangalore suggest that the picture is very different – Bangalore is the I.T. “engine” of India. This area in the south is much more closely connected to the micro and macro changes taking place internationally and there are apparently a lot of lay-offs and postponements to investment decisions – the “risk-averse” behaviour expected from sectors at the sharp-end of economic life. It is important to appreciate that there are many different India’s not just regionally but socially. My impression is that 90% of Indians will only be marginally affected by current global gloomy conditions. Indeed, my employer – the Reliance Company – the biggest private sector business – is expected to maintain its investment plans irrespective of world events, confident as it is in the long-term wisdom of its policies.

So, what are the negatives for India?

There are many indicators suggesting that the slow-down will gain pace over the next few months. Stock market values have fallen bringing down many people’s personal asset wealth and their savings plans for the future. Exports have declined as world demand has fallen, whilst remittances from 30 million Indians working abroad – representing 60% of invisible earnings or 3% of GDP – have also reduced sharply as foreign workers are the first to be laid –off. Lower company profits and lower domestic and MNC investment spending have also contributed to a reduction in aggregate demand – only partially off-set by higher government spending and rising consumption spending. There are no shortages of really good economists writing about what is happening and one of them, Rohini Malkani, writing in the superb Times of India economics page recently warned of the “tail winds” that could destabilise the good ship India!

The positives may only finely balance the negatives. Falling oil, food and commodity prices are helping to keep domestic consumption spending at high levels. More oil finds recently and the relatively strong dollar are also increasing money flows. There have been two significant Keynesian fiscal “stimuli” with a lot more money available for investment, infrastructure spending and agricultural production. There is reportedly a good harvest of most crops to come in shortly and tourism receipts are actually up – here to see a happier economic environment – and to get away from the “R” word?

So – what have I learned from an economics perspective during my eight months in India?

Agriculture is still the single biggest and most important industry – and there appears to me to be an abundance of good quality cheap food available. The rapid decline in inflation from 12% last summer to the current 5% and the forecasted much lower figure to come suggests a volatile, dynamic and flexible economy that seems able to cope with external shocks. I understand – possibly wrongly – that there are only 20,000 credit cards in use in the whole of India (although millions of debit cards!). This ought to mean no credit crunch here then! Property values have fallen but given the fact that there are relatively few mortgages – there is little prospect of negative equity. For many, many people their properties have little financial value anyway – government slum clearance programmes represent a bigger threat! The Indian economy as a whole is on a different economic cycle and evidently is still responding to the opportunities created by the economic liberalisation programmes of the 1990”s when the economy entered a “transition” stage. There may still be a time-lag because India is responding to the world economy rather than leading it (although that perspective will be worth reviewing in the near future). India is still a domestic-driven economy growing organically from change within the country. It is still unwinding from last summer’s energy and food price shocks – some of which were favourable. High food prices last year may have helped the economy through export earnings and higher farm incomes. Lower inflation recently will work through to lower interest rates – which will complement the expansionary fiscal policy now in evidence. An interesting underlying feature of the economic picture is that there are national elections due in the Spring – possibly explaining the fiscal easing and increased public spending?

It’s been a great place for an economist to be over the last eight months and to share the experience of an economy that is so different to the U.K’s. From here I have been able to witness from a distance what has been apparently a self-inflicted plight. My feeling about the economy in India for 2009 is that despite predictions of a slow-down to 5%, there are still significant “down-side risks” (to quote Bank of England phraseology). The economy will experience asymmetric changes – for different types of people in different parts of the country – and this is perhaps an even more interesting study in itself. I am very sceptical about all data published about the Indian economy. How can inflation be measured accurately when most prices can be haggled over (as is the case in China)? How accurate are the unemployment figures when the informal economy is so extensive and so many people are under – or even only marginally employed? How can GDP be measured if government taxation data only records those formally employed or in registered businesses? There is reportedly a lot of corruption in economic activity ( not least when rickshaw drivers want to charge me too much! ). The economy has done remarkably well in recent years but for perhaps 400 million residents this progress has barely affected them. So why should a slow-down?


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