Monday, November 24, 2014

The Usual Suspect

BERKELEY – Across the Euro-Atlantic world, recovery from the recession of 2008-2009 remains sluggish and halting, turning what was readily curable cyclical unemployment into structural unemployment. And what was a brief hiccup in the process of capital accumulation has turned into a prolonged investment shortfall, which means a lower capital stock and a lower level of real GDP not just today, while the recovery is incomplete, but possibly for decades.

One legacy of Western Europe’s experience in the 1980’s is a rule of thumb: each year that lower labor-force attachment and reduced capital stock as a result of declining investment depresses production $100 billion below normal implies that productive potential at full employment in future years will be $10 billion below what would otherwise have been forecast.

The fiscal implications of this are striking. Suppose that the United States or the Western European core economies boost their government purchases for next year by $100 billion. Suppose further that their central banks, while unwilling to extend themselves further in unconventional monetary policy, are also unwilling to stymie elected governments’ policies by offsetting their efforts to stimulate their economies. In that case, a simple constant-monetary-conditions multiplier indicates that we can expect roughly $150 billion of extra GDP. That boost, in turn, generates $50 billion of extra tax revenue, implying a net addition to the national debt of only $50 billion.

What is the real (inflation-adjusted) interest rate that the US or Western European core economies will have to pay on that extra $50 billion of debt? If it is 1%, boosting demand and production by $150 billion next year means that $500 million must be raised each year in the future to keep the debt from growing in real terms. If it is 3%, the required increase in annual tax revenues rises to $1.5 billion a year. If it is 5%, the government will need an additional $2.5 billion per year.

Assuming that continued subnormal output casts a 10% shadow on future potential output levels, that extra $150 billion of production means that in the future, when the economy has recovered, there will be an extra $15 billion of output – and an extra $5 billion of tax revenue. Governments will not have to raise taxes to finance extra debt taken on to fund fiscal boosts. Instead, the supply-side boost to potential output over the long run from expansionary fiscal policy would be highly likely not only to pay for the additional debt needed to finance the spending boost, but also to allow for additional future tax cuts while still balancing the budget.

Now this is, to say the least, a highly unusual situation. Normally, the multipliers applied to expansions in government purchases are much less than 1.5, because the central bank does not maintain constant monetary conditions as government spending expands, but rather acts to keep the economy on track to meet the monetary authority’s inflation target. A more usual multiplier is the monetary-policy offset multiplier of 0.5 or zero.

Moreover, in a normal situation, governments – even the US government and those in Western Europe – cannot run up the national debt and still pay a real interest rate of 1%, or even 3%. Normally, the math of increasing government purchases tells us that a small or dubious boost to output today brings a heavier financing burden in the future, which makes debt-financed fiscal expansion a bad idea.

But the situation today is not usual at all. Today the global economy is, as Ricardo Cabellero of MIT stresses, still desperately short of safe assets. Investors worldwide are willing to pay extraordinarily high prices for, and accept extraordinarily low interest rates on, core-economy debt, for they value as an extraordinary benefit having a safe asset that they can use as collateral.

Right now, investors’ preference for safety makes financing additional government debt abnormally cheap, while the long-run shadows cast by prolonged subnormal production and employment make the current sluggish recovery predictably costly. Given the need to mobilize idle resources in the short run in order to maintain productive potential in the long run, a larger national debt would be, as Alexander Hamilton, the first US treasury secretary, put it, a national blessing.

Read more from our "America's Precarious Recovery" Focal Point.

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    1. Portrait of Gregor Schubert

      CommentedGregor Schubert

      The thrust of the argument proposed here can be summarised as saying the following: Fiscal policy is very effective at bringing GDP back to trend in a situation where central banks are "unwilling to extend themselves further in unconventional monetary policy". While the rest of the article further details the exact implications of this situation, this is the crux of the argument, as otherwise, the central bank would "act to keep the economy on track to meet the monetary authority’s inflation target".

      Unfortunately, this is also where the argument is most lacking: It presents hardly any evidence that the special situation it relies on is currently in existence: Central banks seem as concerned as ever about their inflation target. In Europe, the ECB is notorious for raising its interest rates last spring even in the face of a severe financial crisis unfolding in the sputhern countries, because it was concerned about inflation. At the same time, statements by FOMC members and the public discourse in the US attribute great importance to recent upticks in headline inflation, often blaming the Fed for what is (incorrectly) viewed as a negative development. Why blame the Fed if inflation was out of its control?

      To summarize: there seems little evidence that central banks have stopped caring about, or are unable to influence, inflation. Thus, their response to fiscal policy attempts to raise output and inflation still matters, making fiscal attempts to raise inflation and output futile unless they are accommodated by complementary loosening of monetary policy. Consequently, in the face of a reluctant central bank the "more usual multiplier is the monetary-policy offset multiplier of 0.5 or zero". Thus the relevance of DeLong's argument in the current environment is questionable.

    2. CommentedProcyon Mukherjee

      The article strikes a chord on tweaking with multipliers while the world of investors would be watching with baited breath on the denouement as one would bet against the other; the jury is still out on the very definition of a safe asset. Every investor is also a consumer-spender, while every consumer is also an investor. The behavior as an investor cannot be completely out of sync with the behavior that we demonstrate as a consumer. This belies the rhetoric that the theory of ‘drawing from the future’ with multipliers of our choice envisions; how so ever efficient the markets are, or inefficient, whether as a herd or as an outlier, we the consumers-investors of the future must make a choice that is based on sustainable principles and we cannot draw from the future without an insurance that future generations can rely on. This insurance perhaps lies in our ability to make shared sacrifice and in investing in those assets that create sustainable long term value for the entire humanity; safe or unsafe is a myopic view.

      Procyon Mukherjee

    3. CommentedZsolt Hermann

      I hope we arrive to the point as soon as possible, when respected experts, political and financial leaders stop repeating their own mantras, and pull their heads out of their subjective, introverted boxes and start looking around.

      We are talking about highly qualified, educated, experienced people but since they are buried under their own subjective opinion they are simply incapable of seeing the true reality around us.

      Of course we are in unusual conditions as the article suggest, since we have run into such a dead end we have never been before. We are not in a crisis, but our whole human, political, economical system is collapsing as it has become unsustainable.

      The whole foundation of the expansive constant growth system is false. It is based on producing excessive amount of unnecessary goods, products that masses of people are brainwashed, tricked to consume through the marketing machinery, forcing people to take on credit way above their means making them slaves to the system on multiple count. On the other hand manufacturing is based on "near slave" labour, exploiting less developed countries as long as possible, also exploiting our natural resources and environment beyond tipping points.

      This is all objectively, well documented today.

      Beyond the false foundations we have also evolved into a closed, interdependent system, where all the above mentioned practices are now blowing up in our face as in such an integral system any negative effect I introduce into the system comes back at me with multiple force.

      So why are there still experts suggesting even more spending, stimulus or bailout, pretending further growth is still possible exhausting even our last assessts we could use for a recovery?

      Instead of stubbornly pushing on with the dead horse, we should stop, examine, analize our situation, the system we live in and then adapt to the new conditions and start building a new system that is suitable for the global world of the 21st century.

      We are badly in need of visionary people, who are capable of sharing the available factual, scientific information with the public, helping them to understand the need for change so people could enter a new system willingly, without any coercion, where these visionary leaders could create such a mutually responsible, equal, and considerate governing system that couldelevate all 7 billion people to a sustainable level.