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Fiscal Stimulus: Wrong Policy with Declining Crude Oil Prices

By Byron A. Ellis-October 31, 2008

Economics is often viewed as an abstraction and hence not fully understood or well applied. It is viewed as an abstraction because practitioners have made it more complex than it should be, rather than reducing and simplifying it.

Economics deals with the production, consumption, and distribution of goods and services and their management.

Macroeconomics is concerned with the behavior of the economy as a whole; it deals with booms, recessions, the growth of total output and good and services, growth of output, rates of inflation and unemployment, balance of payment and exchange rates.

Microeconomics is concerned with the behavior of consumers and firms, the determination of prices in particular markets, or the effects of monopoly on individual markets.

If macroeconomics and microeconomics were well understood policy makers would have foreseen the current economic crisis. They would have understood that higher crude oil prices would lead to an economic slowdown as predicted in “Middle East instability drives crude oil prices,” (Ellis, 2006), see http://www.jethroproject.com/Energy%20Prices-Rev4.pdf.

Politicians are now clamoring for additional fiscal stimulus. However, additional stimulus when crude oil prices are declining is the wrong policy prescription; it will lead to inflationary pressures, higher interest rates, and economic expansion and contractions. Declining crude oil prices is, in itself, an economic stimulus.

The appropriate policy is to prevent speculators from artificially bidding up crude oil prices and to temporarily support mortgage holders in foreclosure problems, following the Federal Deposit Insurance Corporation (FDIC) model implemented by Chairwomen Sheila Bair with IndyMac Bank troubled mortgages.

This does not mean that funds should not be allocated for long-term public works, such as rebuilding roads and bridges, modernizing schools, alternative energy research, and so on. These are needed endeavors and should be implemented as part of the government long-term strategy.

Additionally, the government should strive for greater accuracy and timeliness in monitoring aggregate demand. Aggregate demand is the total demand for goods and services produced in the economy; it is a key determinant of employment demand. And, reducing unemployment requires increasing aggregate demand.

Actual aggregate demand is the sum of consumption plus investment (C + I); consumption is approximately 60 percent of aggregate demand and investment about 20 percent.

Consumption is spending by consumers and investment is spending by firms. However, when consumers are not spending, because their incomes have been allocated to higher crude oil prices, the inventory of firms increases.

Inventory accumulation decreases the level of production and hence employment. When firms cannot sell products or services, they lay workers off. And, lower employment adversely affects consumption and output.

Consumption is a function of output. That is, an individual level of consumption is determined by the individual’s income; therefore, consumption increases (decreases) when income increases (decreases).

Thus, it is paramount for the government to execute proper macroeconomic policies. And, to understand that policies have consequences, whether they are applied at home or abroad.

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