I found this wonderful and awesome article n think we would all benefit from this, it is written in a precise, concise, direct n simple way that anyone would comprehend......

From the blog din merican: the malaysian deejay blogger.

by Sakmongkol AK47

Next year (2010), our economy is expected to shrink by 4-5%. Simply put, that will mean reduction in our national income. The government will have less income to tax from. This will mean cutting back on certain expenditures, less development, less capacity building, less of everything. Jobs will be lost as plants and factories scale down. Our exports will decrease. A shrinking economy will create reversed multiplier effects.

Banks will not want to lend money or they will make it more stringent to lend money. The psychology associated with sub-prime loans will be so pervasive that bankers will be paralyzed with fear. They will lend to people whom they are comfortable with. They will lend to the same old boy network. That productivity has shrunk or will shrink means that the labour market is not responsive to changing market environment.

What can the government do? There is universal agreement among policy makers that this condition is brought about by insufficient aggregate demand. The slack in aggregate demand is caused by several factors. Tight liquidity, people are not confident to spend, investors are not wiling to expand, labour isn’t as productive and competitive. How then to bolster the aggregate demand?

Use either fiscal or monetary policies. Spend and tax. Ease liquidity or reduce interest rates. That’s monetary measures. Which to use?

All over the world, the economic recession is pointing towards the failure of the market system. And since the economy depends on demand from Households(C), Investors (I), Government Spending (G), and Net Exports(X-M) – it remains for the authorities to manage these variables. Further, it is generally accepted that now, the only variable manageable by the authorities and seen to be the most potentially effective, is (G) that is, government expenditure. The government must step in to correct the market and restore confidence.

Let’ see what this government has done. First it introduced the RM7 billion package. This was followed by the RM60 billion. That’s a total of RM67 billion to be spent over a period. What have the packages achieved? The answer who knows?

The man who announced the stimulus packages then was the finance minister. He is still the finance minister and now Prime Minister. He must have gotten advice from the Malaysian Keynesians. Like Keynes in the 1930’s, the basic idea was simple: to keep the economy fully employed, governments have to run deficits when the economy is slowing because the private sector will not invest enough to increase production and reverse the recession. Keynesian economists want governments during times of economic crisis to pick up the slack by increasing government spending and/or cutting taxes.

Note the two important key elements here: – run deficits and finding answers as to why the non-government sector reluctant to invest, increase production so as to reverse the recession? We will have to come back to this issue later.

In order to justify specific expenditures, economist will offer empirical tests. The best expenditures economists argue are those that give greatest multiplier effects. This is the idea that an initial amount of spending leads to increased consumption spending and so results in an increase in national income greater than the initial amount of spending. Suppose an investor invests RM 1 million to build a factory. The money spent becomes wages to builders and revenue to suppliers, etc. The builders will have higher disposable income and provided they spend, consumption rises as well, and hence aggregate demand will also rise. Those who supply goods and services to the builders and consumers, in turn receive additional disposable income will further raise consumption and demand.

The rationale is this. In order for the government to have money to spend, it taxes the economy. Nobody likes to be taxed. But suppose, more income can be generated from the taxed amount, then the decision to tax can be defended. But the government must know that more can be generated if the money is rationally and prudently applied to economic actors capable of generating surplus revenues. So now, the government must find: – (a) those who when receiving doses of money, know how to apply it and make more money and (b) apply the money to economic activities that are capable of creating more money.

In other words, spend more that you tax. If you have been taxing RM100, spend 150. That RM50 is the fiscal stimulus. That RM50 is also deficit spending. How do you finance the deficit? The deficit spending must be financed from government reserves (if any) or net borrowing from private or foreign investors. If the money is borrowed, it must eventually be paid back with interest, such that the long term effect on the economy depends on the trade off between the immediate increase to the GDP and the long term cost of servicing the resulting government debt.

So it is not easy after all to manage the economy responsibly. People will start question, what happened to our reserves? The government answers, we have plenty. That is good news, but now we want to know, whether the reserves will be applied wisely so that more income can be generated. It is reasonable to impute, the people say, that if the government can fritter away the billions of money it receives from PETRONAS, our reserves can also be wasted away.

We can dovetail the issues thus: – find ways to induce the public to spend more. This will depend on whether the households have more disposable income. They can have more disposable income if taxes on them are reduced. For example, the government can reduce payroll taxes (EPF contributions and other compulsory payments) so that disposable incomes increase. Investors spend if cost of capital is reduced and more importantly, if the ease by which to borrow is enhanced. Millions of SMEs want to borrow easily and quickly. But if loans to SME’s are cornered by a few people, then the idea to finance as many SMEs and entrepreneurs to re-start the economy falls flat. There are vicious rumors circulating that loans for SMEs are cornered by some well connected people only.

Government could provide the needed Keynesian spending by decreasing taxes, increasing government spending, and increasing individuals’ incomes. As incomes increased, they would spend more. As they spent more, the multiplier effect would take over and expand the effect on the initial spending.

Whose disposable income should be increased? Who do you give the money to? Milton Friedman, who is associated with the permanent income hypotheses, says that the marginal propensity to consume is more pronounced in poorer people. That is, if poorer people receive more money they will spend while richer people spend less if they received additional income. The policy implication then is to raise the income of the relatively less well off than the richer people. Give them more money.

Just suppose that the economic institutionalists are right- that our economy is also slowed down because of misfeasance and malfeasance by bankers and industrialists, or incompetence by government officials. This school of economists believes that much of the problems in our economy are caused by the institutions that exists – bureaucratic controls and regulations, bankers and financial intermediaries doing dirty work( the sub-prime loans in America were caused by bankers colluding with unqualified borrowers).

Suppose these institutional elements are, in fact, a substantial contributor to our depressed aggregate demand, they actually produced artificial blockages to liquidity. What can the monetary authority do? Then the public would certainly welcome what Milton Friedman suggested that a monetary authority do to escape a liquidity trap; we bypass financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter.

Maybe the government needs to look at mechanisms where it can give money directly to people?