Anatomy of the Global Economy
The Stimulus Ostriches
J. Bradford DeLong
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BERKELEY – Of all the strange things that have happened this winter, perhaps the strangest has been the emergence of large-scale Republican Party opposition to the Obama administration's effort to keep American unemployment from jumping to 10% or higher. There is no doubt that had John McCain won the presidential election last November, a very similar deficit-spending stimulus package to the Obama plan – perhaps with more tax cuts and fewer spending increases –�would have moved through Congress with unanimous Republican support.
As N. Gregory Mankiw said of a stimulus package back in 2003, when he was President George W. Bush's chief economic advisor, this is not rocket science. Deficit spending in a recession, he said, “help[s] maintain the aggregate demand for goods and services. There is nothing novel about this. It is very conventional short-run stabilization policy: you can find it in all of the leading textbooks...”
I can understand (though I disagree with) opponents of the stimulus plan who believe that the situation is not that dire; that the government spending will be slow and wasteful (whereas properly targeted tax cuts would provide a more effective stimulus); and thus that it would have been better to defeat Obama’s stimulus bill and try again in a couple of months.
I can also understand (though I disagree with) opponents who believe that the short-run stimulus effect of the plan will be small, while America’s weak fiscal position implies a large long-run drag on the economy from the costs of servicing the resulting debt.
What I do not understand is opposition based on the claim that the stimulus package simply will not work: the government will spend its money, households will receive their tax rebates, and nothing will happen afterwards to boost employment and production. In fact, there is a surprisingly large current of thought that maintains that stimulus packages simply do not work, ever.
This opposition is not coming only from politicians who are calculating that opposition to whatever is proposed may yield electoral benefits; indeed, it does not even reflect any coherent right-wing or indeed left-wing political position. Root-and-branch stimulus opponents whose work has crossed my desk recently include efficient-markets fundamentalists like the University of Chicago’s Eugene Fama, Marxists like CUNY’s David Harvey, classical economists like Harvard’s Robert Barro, gold bugs like the Council on Foreign Relation's Benn Steil, and a host of others.
I simply do not understand their arguments that government spending cannot boost the economy. As far as I can tell, they are simply burying their heads in the sand.
At the start of 1996, the US unemployment rate was 5.6%. Then America’s businesses and investors discovered the Internet. Over the next four years, annual US spending on information technology equipment and software roared upward, from $281 billion to $446 billion, the US unemployment rate dropped from 5.6% to 4%, and the economy grew at a 4.3% real annual rate as the high-tech spending boom pulled extra workers out of unemployment and into jobs.
Back at the start of 2004, America’s banks discovered that they could borrow money cheaply from Asia and lend it out in higher-yielding domestic mortgages while using sophisticated financial engineering to wall off and strictly control their risks – or so they thought. Over the next two years, annual US spending on residential construction roared upward, from $624 billion to $798 billion, the US unemployment rate dropped from 5.7% to 4.6%, and the economy grew at a 3.1% real annual rate.
In both of these cases, large groups of people in America decided to increase their spending. You can argue that neither group should have boosted its spending to such a degree –�that both were subject to “irrational exuberance” – and that someone should have taken away the punchbowl earlier. But you cannot argue that these groups did not increase their spending, and that their increased spending did not pull large numbers of Americans – roughly two million in each case – into productive and valued employment.
The government’s money is as good as anybody else’s. If businesses’ enthusiasm for spending on high-tech gadgetry and new homeowners’ enthusiasm for spending on three-bedroom houses can boost employment and production, then what argument can Harvey, Fama, Barro, Steil, and company make that government spending will not? I simply do not see it.
J. Bradford DeLong, a former Assistant US Treasury Secretary in the Clinton administration, is Professor of Economics at the University of California at Berkeley.
Copyright: Project Syndicate, 2009.
www.project-syndicate.org
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tvselvakumaran 04:10 10 Mar 09
The liberals are facing increasing opposition to stimulus spending because of several fallacies in their argument. I have analyzed two of these fallacies here:
(1) Quoting Keynes to claim that if the stimulus package is not large enough, it could not deliver a recovery.
There is no provision in Keynesian theory that says one can spend several trillion dollars today in order to postpone a recession by a decade. As I explained in an earlier posting, the market mechanism, even in its most efficient functioning, tends only towards a random walk of price movements. Whereas in the functioning of the economy, most day-to-day decisions are made based on assumptions of continuity. Because of this fundamental discrepancy, the allocation of resources that the market mechanism makes in the short run, may not turn out to be optimal in the long run. Hence there is a role for an external agency, like the government or the central bank, to step in and take corrective measures whenever it is obvious that the functioning of the markets would not be optimal in the long run.
Now, the only tool that Keynesian theory provides for looking into the long-term future is time value of money. To wit, it was by employing this tool that Keynes envisioned "Economic Possibilities for our Grand Children" in 1931. The rationale Keynes provided in that essay for time value of money to stay above inflation, was that a 2% annual growth in productivity seems a safe assumption, in view of technological progress in recent centuries. At the macro-economic level, the procedure by which policy makers can ensure a positive inflation-corrected time value of money is to aim for a positive inflation-corrected growth rate in annual GDP. The most effective way to do this in a market-based capitalist economy is, of course, to let the markets do their work.
But, as explained in the first paragraph, Keynes identified that the market could be malfunctioning sometimes, at which times corrective measures from the state and the central bank are needed. The state's role could be to spend money in order to sustain consumer demand and to reduce unemployment to the extent possible. Thus Keynesian theory advocates a constant monitoring of the economy to ensure that the functioning of the economy is made close to optimal, with co-ordination between the markets, the central bank and the state. Keynesian theory does not prescribe a one-time huge spending to avoid all possible troubles in the next decade.
Now, in recent decades, a lot of research papers have been written exploring the possibilities of smoothening the fluctuations in the business cycle and even further, of avoiding a recession altogether. This line of investigation gains credence especially in light of East Asia's 25-year long boom before 1997, and the world economy's 63-year long growth without recession, from the end of the second world war to 2008. My own assessment is that due to changes in the circumstances, the assumptions made in these research papers would no longer hold in the current severe crisis situation -- the single major factor being that the American economy cannot be mathematically modeled any longer with the assumption that it is predominantly an isolated entity.
(2) The enigma of the credit crunch.
I had already explained in October 2008 (ref: Question 1 of my "FAQ on the Financial Crisis"), that this current crisis has more to do with the accumulated capital rather than the working capital of the American economy. In particular, I had stated that "the funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep busines investments, payrolls and consumer spending going on in the near-term". In contrast, starting from September 2008 or so, nearly all the liberal economists forecast a massive credit crunch that was unfold on Main Street. This led to a huge uproar demanding, that the Fed cut interest rates quickly, and that the economy be flooded with liquidity. The TARP legislation was hurriedly enacted to enable the government to spend 700 billion dollars at its dicretion. No consideration was given to the event that an economy going into a recession might not need as much credit. Did the liberal economists plan on avoiding the recession altogether, by scaring the government into implementing all of their policy recommendations? When the new government took office, the demand from the liberal economists took the form of a massive stimulus package. The spending so far, on account of this economic crisis, has exceeded four trillion dollars and no end is in sight.
Admittedly, I had missed one important point regarding the credit situation in October 2008. To explain this point, let us assume that a Wall Street Investment bank has invested in mortgage securities with a leverage of 24 to 1. This means that the bank's own capital makes up only 4% of the money invested in the mortgage securities. Now, the mortgages on homes are divided into tranches, with the risks of foreclosures reflected in progressively larger proportions as one went lower down the tranches. Assume that the mortgage on a typical home is divided equally into 20 tranches, and also that the bank has invested equally in all the 20 tranches. Note that this means that the bank's capital of 4% falls just short of covering the lowest of the tranches (the 20th).
Now, the stories heard in the media, if correct, imply that the 'toxic' mortgage securities are trading for 20 cents on the dollar. This already wipes out the bank's capital, if only the lowest tranch (the 20th) is toxic and all the other tranches are trading at full-maturity prices. If the situation is far worse than this, the banks could not have survived for so long, the mortgage crisis having come to light as early as January 2007. The bank's auditors and accounting rules would not allow for losses exceeding several times the capital. So, the banks must be in a situation where only the lowest tranches are trading at fire-sale prices, and the other tranches are valued in the market at close to full-maturity value.
The point I had missed in October 2008 is this: with the situation as described above, the Wall Street banks have an added incentive to simply keep holding their mortgage securities, freezing up their investments, so to speak. This is because their investments in mortgage securities were highly lucrative, in view of their huge leverage ratios. In fact, with the above 24 to 1 leverage ratio, just a difference of 0.8% between the interest rates obtained from the home-owners' mortgages, and the interest rate paid out to the banks' lenders, would ensure that the Wall Street banks recover profits of 20% on their capital. This means that their whole capital would get replenished in less than five years. So every month the banks could just let the profits flow in, and take losses on selling off the toxic assets just enough to offset the profits. If they could do this for a year or two, they could have already sold off a third of their toxic assets, and who knows, by then the economy could have recovered to get much better prices on their securities? Because of this added incentive for the investment banks to hoard their funds, there could be a scarcity of credit.
However, even though I had missed this point, I could still see that with the economy going into recession, the freezing up of funds among the investment banks was not the main concern, because of my belief that the crisis did not directly involve the working capital of the economy. Moreover, my solution for unfreezing the credit crunch was to hold a public auction of the mortgage securities directly for the home-owners. The home-owners could purchase the tranches from the security owners on Wall Street, and they could use the purchase towards reduction in their debt. No re-writing of the mortgage contract is necessary. No investment of $700 billion TARP funds is necessary. Neither nationalization nor Good bank/Bad bank is necessary. Moreover, all of these alternative methods do not address the moral hazard problem (The moral hazard is that the home-owners who paid their mortgage dues sincerely are being ignored, and the irresponsible home-owners are being bailed out). Only my solution addresses the moral hazard problem squarely. Lastly, the technology for implementing such a public auction among the home-owners already exists among software companies like eBay and PayPal. In conclusion, having spent much of their political capital chasing the ghost of credit crunch, the liberals are now finding that the economic crisis has gotten out of hand.
mshotar 10:59 27 Mar 09
what about the dire long term effect of these policies, should not you, at least, address them?
alexferro 04:53 08 Mar 09
With the US's savings rate taking a 600% jump in the past six months someone has to recirculate all that money, if the banks wont lend it out then the federal governmet has to. (From an annualized. 150 billion to 900 billion.
alex ferro