Why Extra Spending Can Help

Readers Question: why are measures to increase spending in a recession generally considered a good response and why extra spending is less inflationary in this situation.

There are quite a few reasons. But, a general principle is the importance of confidence (Keynes referred to ‘animal spirits’). In a recession, people become pessimistic and therefore very reluctant to spend and invest. If unchecked this negative confidence can cause a negative momentum effect in the economy.

One specific example is the paradox of thrift. Keynes noted that in the Great depression, individuals felt their best response was to save more. But, cumulatively, this  was harmful for the economy.

In a recession, people tend to increase their savings significantly. But, this sharp rise in savings causes a sharp drop in consumer spending. Therefore, the government need to moderate this rise in savings. A higher savings rate may be desirable in the long term. But, if the saving rate rises too quickly too much, it can cause a sharp drop in GDP. More on Paradox of Thrift.

Saving Rates UK - Source: H.M Treasury

This graph shows how sharply UK saving rates have increased since the start of the current difficulties. This rise in savings means a corresponding fall in spending.

This rise in spending doesn’t cause inflation because in a recession there is spare capacity.

See also:

• Rise in Government borrowing to offset fall in private sector borrowing
• An economic crisis averted? - How rapid intervention to prop up spending has perhaps averted a much sharper fall in spending.