Calling All Economics Experts…

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.

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Salb
Salb
12 years ago

The socialist wing of the Democrat party is going to spend this nation into oblivion.
It’s now the DEMAOCRAT party:
http://www.freerepublic.com/focus/f-chat/2188391/posts

Bri in NC
Bri in NC
12 years ago

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.

Mario
Mario
12 years ago

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… Read more »

Mario
Mario
12 years ago

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
Mario
12 years ago

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… Read more »

kjr
kjr
12 years ago

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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