Calling All Economics Experts…
Carroll Andrew Morse
Would anyone with an understanding of markets and finance -- I know we have a few people qualified on this subject in our reading audience -- like to take a stab at filling in the details about the relationship between deficits, monetary policy and interest rates that former White House (under Reagan) and Treasury Department (under Bush II) official Bruce Bartlett briefly explained in a recent posting to National Review Online…
I do not believe that budget deficits are inherently stimulative. However, when we are in a liquidity trap, as we were in the 1930s and I believe we are today, deficits are essential to make monetary policy effective. Monetary policy provides the real stimulus. But it doesn't work when interest rates are close to zero.
A longer version of Mr. Bartlett's economic prescriptions are available in his
Forbes Magazine column,
here.
I really don't think I am "Expert" on the topic, but no one else has chimed in, so...
Bartlett states he believed we are in a "liquidity trap", where the Fed is trying to increase the money supply (via extremely low interest rates), but there is no increase in money velocity nor resulting inflation. The banks refuse to lend money to people/investors due to the belief that they will not be paid back.
The cure for a "liquidity trap" is a money bomb -- Bypassing the banks and giving money directly to people who will spend it. Once the money velocity picks up, the economy (with the help of very low Fed rates) should recover. This is, obviously, politically difficult.
Personally, if the entire "liquidity trap" theory were true, I don't believe Japan wouldn't have had a "lost decade". Japan ran their national debt to 180% of GDP (the equivalent of our $11T debt being $25T) and it didn't pull them out of recession.
If the economy had perfectly flexible prices, recessions would be largely self-correcting; a drop in demand would decrease prices, making people effectively wealthier and reinvigorating demand. Since prices are sticky, the government uses monetary policy in a downturn to increase the money supply -- effectively mimicking ideal conditions by making people feel wealthier and spend more.
In a liquidity trap, monetary policy is tapped out and decreases in interest rates (the basic fiscal policy move in the US) no longer have any effect. Banks can't justify loaning money at current rates, so increases in the supply of money never make it out into the economy at large.
What Bartlett says is confusing because he is talking about using deficits (fiscal policy) to make monetary policy effective after it has ceased to be on its own. Typically, fiscal policy is a weak solution to downturns because people with long time horizons and rational expectations will hold onto extra money (from tax cuts without spending cuts, or simple government spending increases) because that money will have to be paid back in the future, and its current value is equal to the present value of future tax liabilities (Ricardian equivalence; although, in reality, people aren't all that rational or long-lived, so this doesn't really work as advertised. Nevertheless, it is something to worry about).
Now there are two cases where fiscal policy can have a stimulative effect. One, if people have a reasonable belief that the economy will pick up in the near future, temporary tax cuts or spending increases will smooth out consumption and hold off a recession. This isn't the case today.
Two, during a liquidity trap, when people's expectations of future inflation are so low that holding on to money in cash (whether by banks or individuals) is a reasonable form of saving. By a sufficiently large increase in spending, the Federal Reserve can signal a commitment to a long-term increase in inflation. If the spending is too low, it will not affect people's expectations, and have no long-term effect. If the spending is too high, however, there is a chance that the people will have the opposite reaction, and expect a future monetary contraction (in this case, tax increases) due to the debt burden.
Since we are almost certainly in, or close to, a liquidity trap, some form of stimulus is needed (although I greatly disapprove of the current plan's design). I don't know enough to know if it will have the desired impact. My sense is that the way the money was spent was so bad that it will both not be stimulative enough and that the level of debt will require tax increases in the next few years.
I should have pointed this out earlier. The reason why an effective stimulus doesn't fall prey to the same Ricardian equivalence problem where the present value of the future tax liability is the same as the money spent is because, if it works, the economy is at a higher level of growth.
For example, if I am the only wage earner and earn $1000 per year and the government required $200 in revenue, I would be taxed 20%. In an effective stimulus, I would have used that $1k to buy goods from someone else, so now we have two people, each with $1k income, so the tax rate can be just 10%* and raise the same amount of money. Effective stimulus is effectively cheaper than non-stimulative government spending.
*[Technically, you would have to assume that I would save part of my income to pay my taxes, so the second person's income would be less than $1k. The exact necessary tax rate would be about 10.56%]
Mario,
Good comment. When I read where you wrote...
Since we are almost certainly in, or close to, a liquidity trap, some form of stimulus is needed (although I greatly disapprove of the current plan's design). I don't know enough to know if it will have the desired impact.
...it brought this section of Bartlett's Forbes article to mind...
The critics were also totally opposed to deficit spending. As with Republicans today, they said that federal borrowing would simply draw funds out of productive uses in the private sector to be squandered on make-work government jobs, pork barrel projects of dubious value and welfare programs that would sap the dynamism of the American economy.
Apparently, it didn't occur to these critics that the existence of vast unemployment, closed factories, abandoned farms and extremely low interest rates meant that much of the private sector's resources were simply idle. Borrowing them by running deficits didn't reduce private output because there were no alternative uses available.
What I think Bartlett is saying, is that a stimulus needs to be targeted to unused capacity in the economy, i.e. a) if the economy was producing 1,000,000 widgets last year, but is only producing 900,000 this year (meaning the physical capacity for producing more widgets already exists, so production could be started quickly) and b) if there is an unmet demand for widgets among the population, and c) if there are idle members of the workforce who could be producing widgets if a widget-factory were to open up, then having the government spend some money to encourage the production of widgets is a good idea. Then as things get back to normal, i.e. where they were before a recession or depression started, the normal monetary policy effects you describe can start to work again.
Now, to try to tie this back to [my gaps in knowledge about] the monetary policy and interest rate stuff, do interest rates enter the problem in that, if they are too low, banks aren't willing to make the loans to business that would be willing to open up or expand widget businesses on their own? If so, what is it that keeps interest rates down, where there is unused capacity that, in theory, could be made profitable very quickly?
And if the key to crafting an effective stimulus is matching unmet demand, unused capacity, and unemployed members of the workforce, a number of questions about the current program are immediately raised...
- Does the whole theory still work where much of the "unused capacity" needing to be revived is in the finance industry? (God, I hate it when I start to sound like Kevin Phillips).
- How does spending on a program like food stamps match unused capacity to idle members of the workforce?
- Doesn't this mean that "green jobs" aren't really a good target for the stimulus, because there isn't a whole lot of unused capacity to ramp up?
Unused capacity is exactly the issue. When an economy is at full employment, stimulus is impossible, and will just crowd out private investment. Even when we aren't at full employment, stimulus spending will only be as successful as it is targeted at the places where capacity exists. This is why I don't like the current stimulus; I think too little is going to the specific people and businesses out of work (not that that is an easy problem to solve).
Your 'b' isn't quite right. If there were unmet demand, things wouldn't be so bad. Demand is falling for all items. The only real goal of stimulus is to get money in the hands of people, so that demand rises on its own. It isn't necessary that every project be worthwhile, although it is desirable. In your example, we want to find empty widget factories and unemployed people capable of making widgets, even if no one will ever want them. We'll shut the factory down once the economy can absorb the unemployment that would result.
Once you remove demand from the equation, I think you can see what keeps interest rates down -- there simply aren't enough businesses that want to expand, because there is no way to make a profit out of the increased production. Just like any other product, if no one wants to buy, the price plummets, except this particular industry benefits at the moment by not selling.
The demand problem is actually a little theoretical. Late last year, I would have argued that there was some pent up demand, and banks weren't loaning because they simply couldn't afford to. That kind of thing happens when a whole class of assets becomes worthless overnight. Since the TARP hasn't fixed the problem, though, there is probably a demand problem now, although I would argue that the inability to secure loans a few months ago caused today's lower demand (and that the Fed should have seen that coming).
Anyway, your questions:
1) I never would have thought of it that way. There are two aspects of the banking industry that are slumping, former finance workers who have lost their jobs, and the banks themselves as producers. The former are in a bad position, because many of those jobs probably won't come back, regardless of the state of the recovery. They will have to find new work, and the stimulus doesn't much help them (not that they should be the primary target).
The banks are receiving a type of stimulus of their own, through TARP and eventually nationalization. Fixing them is necessary to make the whole thing work, but they are such a basic part of the economy that we know they will have enough business to survive once demand rebounds. The only questions are which banks can make it that long, and how much will it cost the taxpayers to keep them afloat or deal with their demise. So the answer to your question is no, not really, but it's being dealt with.
2) Not well. People in this country don't really need more food, and don't much change their consumption of it regardless of incentives. It's basically a convoluted way to give money to poor people, which isn't a bad thing, but cash would be better still. If a family eats $100 a week in food, and receives $75 in food stamps, they will use cash for the rest (if they can). If you now give them $100, they will spend that $25 in cash on something else, so there is a little stimulus, although it is untargeted. If you instead give them $125, they will still only want $100 in food. The remainder will either be wasted on food they didn't want or need, or they will find a way to convert it to cash, usually losing some in the process. The entire food stamp program should be converted to cash, but it will never happen.
In any event, it won't actually do much good for the food industry, although it may actually harm restaurants. In the end it is mildly stimulative, but much, much less effective than the same amount in cash would be.
3) In my opinion, "green jobs" are rarely a good use of money. Most of these companies already rely on heavy government subsidies in good times. Maintaining those for the time being can be justified, given the state of the economy, but the only reason to give them more is ideology. Good companies can survive without subsidy or at least sell their business model to larger companies willing to wait for profitability. An exception might be something like the "smart grid" technology, that may very well need public investment to be put in place (although it makes for poor stimulus too).
No matter how you slice it the key to the stimulus plan being effective is going to be getting the money in the right hands. A coworker of mine had an idea that sounded pretty good. Distribute a stimulus payment to the public on a prepaid credit card. It would have an expiration date and would not be able to be used to pay debt, loans, etc. so it could be targeted to infuse the cash where we need it through consumer spending. I realize it would be more technical than this but at face value I thought the idea had some merit to potentially infuse capital into American business and industry which would make its way back out onto the street.
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Posted by: Salb at February 19, 2009 11:13 AMI really don't think I am "Expert" on the topic, but no one else has chimed in, so...
Bartlett states he believed we are in a "liquidity trap", where the Fed is trying to increase the money supply (via extremely low interest rates), but there is no increase in money velocity nor resulting inflation. The banks refuse to lend money to people/investors due to the belief that they will not be paid back.
The cure for a "liquidity trap" is a money bomb -- Bypassing the banks and giving money directly to people who will spend it. Once the money velocity picks up, the economy (with the help of very low Fed rates) should recover. This is, obviously, politically difficult.
Personally, if the entire "liquidity trap" theory were true, I don't believe Japan wouldn't have had a "lost decade". Japan ran their national debt to 180% of GDP (the equivalent of our $11T debt being $25T) and it didn't pull them out of recession.
Posted by: Bri in NC at February 19, 2009 7:50 PMIf the economy had perfectly flexible prices, recessions would be largely self-correcting; a drop in demand would decrease prices, making people effectively wealthier and reinvigorating demand. Since prices are sticky, the government uses monetary policy in a downturn to increase the money supply -- effectively mimicking ideal conditions by making people feel wealthier and spend more.
In a liquidity trap, monetary policy is tapped out and decreases in interest rates (the basic fiscal policy move in the US) no longer have any effect. Banks can't justify loaning money at current rates, so increases in the supply of money never make it out into the economy at large.
What Bartlett says is confusing because he is talking about using deficits (fiscal policy) to make monetary policy effective after it has ceased to be on its own. Typically, fiscal policy is a weak solution to downturns because people with long time horizons and rational expectations will hold onto extra money (from tax cuts without spending cuts, or simple government spending increases) because that money will have to be paid back in the future, and its current value is equal to the present value of future tax liabilities (Ricardian equivalence; although, in reality, people aren't all that rational or long-lived, so this doesn't really work as advertised. Nevertheless, it is something to worry about).
Now there are two cases where fiscal policy can have a stimulative effect. One, if people have a reasonable belief that the economy will pick up in the near future, temporary tax cuts or spending increases will smooth out consumption and hold off a recession. This isn't the case today.
Two, during a liquidity trap, when people's expectations of future inflation are so low that holding on to money in cash (whether by banks or individuals) is a reasonable form of saving. By a sufficiently large increase in spending, the Federal Reserve can signal a commitment to a long-term increase in inflation. If the spending is too low, it will not affect people's expectations, and have no long-term effect. If the spending is too high, however, there is a chance that the people will have the opposite reaction, and expect a future monetary contraction (in this case, tax increases) due to the debt burden.
Since we are almost certainly in, or close to, a liquidity trap, some form of stimulus is needed (although I greatly disapprove of the current plan's design). I don't know enough to know if it will have the desired impact. My sense is that the way the money was spent was so bad that it will both not be stimulative enough and that the level of debt will require tax increases in the next few years.
Posted by: Mario at February 20, 2009 5:01 AMI should have pointed this out earlier. The reason why an effective stimulus doesn't fall prey to the same Ricardian equivalence problem where the present value of the future tax liability is the same as the money spent is because, if it works, the economy is at a higher level of growth.
For example, if I am the only wage earner and earn $1000 per year and the government required $200 in revenue, I would be taxed 20%. In an effective stimulus, I would have used that $1k to buy goods from someone else, so now we have two people, each with $1k income, so the tax rate can be just 10%* and raise the same amount of money. Effective stimulus is effectively cheaper than non-stimulative government spending.
*[Technically, you would have to assume that I would save part of my income to pay my taxes, so the second person's income would be less than $1k. The exact necessary tax rate would be about 10.56%]
Posted by: Mario at February 20, 2009 6:03 AMMario,
Good comment. When I read where you wrote...
...it brought this section of Bartlett's Forbes article to mind... What I think Bartlett is saying, is that a stimulus needs to be targeted to unused capacity in the economy, i.e. a) if the economy was producing 1,000,000 widgets last year, but is only producing 900,000 this year (meaning the physical capacity for producing more widgets already exists, so production could be started quickly) and b) if there is an unmet demand for widgets among the population, and c) if there are idle members of the workforce who could be producing widgets if a widget-factory were to open up, then having the government spend some money to encourage the production of widgets is a good idea. Then as things get back to normal, i.e. where they were before a recession or depression started, the normal monetary policy effects you describe can start to work again.Now, to try to tie this back to [my gaps in knowledge about] the monetary policy and interest rate stuff, do interest rates enter the problem in that, if they are too low, banks aren't willing to make the loans to business that would be willing to open up or expand widget businesses on their own? If so, what is it that keeps interest rates down, where there is unused capacity that, in theory, could be made profitable very quickly?
And if the key to crafting an effective stimulus is matching unmet demand, unused capacity, and unemployed members of the workforce, a number of questions about the current program are immediately raised...
Posted by: Andrew at February 20, 2009 10:30 AM
Unused capacity is exactly the issue. When an economy is at full employment, stimulus is impossible, and will just crowd out private investment. Even when we aren't at full employment, stimulus spending will only be as successful as it is targeted at the places where capacity exists. This is why I don't like the current stimulus; I think too little is going to the specific people and businesses out of work (not that that is an easy problem to solve).
Your 'b' isn't quite right. If there were unmet demand, things wouldn't be so bad. Demand is falling for all items. The only real goal of stimulus is to get money in the hands of people, so that demand rises on its own. It isn't necessary that every project be worthwhile, although it is desirable. In your example, we want to find empty widget factories and unemployed people capable of making widgets, even if no one will ever want them. We'll shut the factory down once the economy can absorb the unemployment that would result.
Once you remove demand from the equation, I think you can see what keeps interest rates down -- there simply aren't enough businesses that want to expand, because there is no way to make a profit out of the increased production. Just like any other product, if no one wants to buy, the price plummets, except this particular industry benefits at the moment by not selling.
The demand problem is actually a little theoretical. Late last year, I would have argued that there was some pent up demand, and banks weren't loaning because they simply couldn't afford to. That kind of thing happens when a whole class of assets becomes worthless overnight. Since the TARP hasn't fixed the problem, though, there is probably a demand problem now, although I would argue that the inability to secure loans a few months ago caused today's lower demand (and that the Fed should have seen that coming).
Anyway, your questions:
1) I never would have thought of it that way. There are two aspects of the banking industry that are slumping, former finance workers who have lost their jobs, and the banks themselves as producers. The former are in a bad position, because many of those jobs probably won't come back, regardless of the state of the recovery. They will have to find new work, and the stimulus doesn't much help them (not that they should be the primary target).
The banks are receiving a type of stimulus of their own, through TARP and eventually nationalization. Fixing them is necessary to make the whole thing work, but they are such a basic part of the economy that we know they will have enough business to survive once demand rebounds. The only questions are which banks can make it that long, and how much will it cost the taxpayers to keep them afloat or deal with their demise. So the answer to your question is no, not really, but it's being dealt with.
2) Not well. People in this country don't really need more food, and don't much change their consumption of it regardless of incentives. It's basically a convoluted way to give money to poor people, which isn't a bad thing, but cash would be better still. If a family eats $100 a week in food, and receives $75 in food stamps, they will use cash for the rest (if they can). If you now give them $100, they will spend that $25 in cash on something else, so there is a little stimulus, although it is untargeted. If you instead give them $125, they will still only want $100 in food. The remainder will either be wasted on food they didn't want or need, or they will find a way to convert it to cash, usually losing some in the process. The entire food stamp program should be converted to cash, but it will never happen.
In any event, it won't actually do much good for the food industry, although it may actually harm restaurants. In the end it is mildly stimulative, but much, much less effective than the same amount in cash would be.
3) In my opinion, "green jobs" are rarely a good use of money. Most of these companies already rely on heavy government subsidies in good times. Maintaining those for the time being can be justified, given the state of the economy, but the only reason to give them more is ideology. Good companies can survive without subsidy or at least sell their business model to larger companies willing to wait for profitability. An exception might be something like the "smart grid" technology, that may very well need public investment to be put in place (although it makes for poor stimulus too).
Posted by: Mario at February 20, 2009 1:47 PMNo matter how you slice it the key to the stimulus plan being effective is going to be getting the money in the right hands. A coworker of mine had an idea that sounded pretty good. Distribute a stimulus payment to the public on a prepaid credit card. It would have an expiration date and would not be able to be used to pay debt, loans, etc. so it could be targeted to infuse the cash where we need it through consumer spending. I realize it would be more technical than this but at face value I thought the idea had some merit to potentially infuse capital into American business and industry which would make its way back out onto the street.
Posted by: kjr at February 21, 2009 8:53 PM