Long-Term Stimulus-This latest Krugman steaming
Long-Term Stimulus-This latest Krugman steaming pile parallels closely what I was covering in my macroeconomics class on Thursday. I was talking about the Permanent Income Hypothesis and how tax rate cuts are more simulative than lump-sum credits and why long-term tax cuts are more simulative than temporary ones.
Although other news has been drowned out by the barking of the dogs of war, something ominous is happening on the economic front. It's not dramatic, but month by month the numbers keep coming in worse than expected. Let's put politics completely aside for once, and review where we are and what should be done.You have overinvestment in a few industries, not as a whole. He's going to have to blame this on a lack of investment to put aggregate supply out of the loop so as to trot out a Keynesian solution.The key point is that this isn't your father's recession — it's your grandfather's recession. That is, it isn't your standard postwar recession, engineered by the Federal Reserve to fight inflation, and easily reversed when the Fed loosens the reins. It's a classic overinvestment slump, of a kind that was normal before World War II. And such slumps have always been hard to fight simply by cutting interest rates.
Now there's no question that the Fed's rapid rate reductions last year helped avert a much bigger slump. But a hard look at monetary policy suggests that the Fed hasn't done enough — and possibly can't do enough. Although the Fed funds rate, the usual measure of monetary policy, is at its lowest level in generations, the real Fed funds rate — the interest rate minus the inflation rate, which is what matters for investment decisions — is actually about the same as it was at the bottom of the last recession, in the early 1990's, because inflation is considerably lower.Sometime monetary policy can do the job, but this time, it might not be a short-term interest rate problem. Much of the market slump is a crisis in long-time confidence in the stock market, partly due to your old employer, Enron. The bloom is off the telecom and Internet rose, and the market doesn't yet have another market-driving industry to pull it out of the Enron/WorldCom slump. A long-term blow to confidence needs a long-term solution.And the drop in the Fed funds rate engineered by Alan Greenspan & Company, though faster than that in the last recession, has so far been considerably smaller; last time it fell by 6.75 points, this time it fell by only 4.75. Even if the Fed funds rate falls all the way to zero, that will be a smaller interest rate reduction than the last time around. If you think the excesses of the 1990's were larger than those of the 1980's, that the economy needs more stimulus to pull itself out, then it seems likely that the Fed hasn't done enough, and quite possible that even going all the way to zero still won't be enough.
The answer is that we should have a sensible plan for fiscal stimulus — one that encourages spending now, to bridge the gap until business investment revives. Some of the elements of such a plan are obvious, and were described by Jeff Madrick in yesterday's Times. First, extend unemployment benefits, which are considerably less generous now than in the last recession; this will do double duty, helping some of the neediest while putting money into the hands of people who are likely to spend it.The spending increases do nothing to add to aggregate supply and if they are temporary, they will not change people's long-term habits much. Extending unemployment benefits will actually lower aggregate supply, as people are actually encouraged not to work, thus lowering the labor force.
Second, provide aid to the states, which are in increasingly desperate fiscal straits. This will also do double duty, preventing harsh cuts in public services, with medical care for the poor the most likely target, at the same time that it boosts demand.This will mean marginal state programs, which includes providing children's medical care programs, will get funding; the important programs will be kept.
If these elements don't add up to a large enough sum — I agree with Mr. Madrick that $100 billion over the next year is a good target — why not have another rebate, this time going to everyone who pays payroll taxes?Temporary lump sum payments don't do much to aggregate demand, since people will tend to spend based on their long-term expected income rather than their short term income; that Permanent Income Hypothesis would suggest that long-term tax cuts will give people an expectation of a long-term income boost and will make them more willing to spend.
And how will we pay for all of this? You know the answer to that: Cancel tax cuts scheduled for the future. The economy needs stimulus now; it doesn't need tax cuts for the very affluent five years from now.No, that will take away the incentive of taxpayers to spend if you're going to raid their future paychecks. Also, that will take away the incentive to invest and work hard, thus shrinking aggregate supply as well. If the economy has oodles of excess capacity, Krugman might be right in giving a Keynesian demand-booster. However, we're also looking at a crisis of confidence in investment, and increasing taxes won't help aggregate supply.
This isn't rocket science. It's straightforward textbook economics, applied to our actual situation. It's also, I'm well aware, politically out of the question. But I think we're entitled to ask why.The problem is that it is straightforward textbook economics if the textbook is Keynesian. If you look at the long-term and include both supply and demand into the mix, that straightforward solution is simplistic.
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