The RGEMonitor Weekly Newsletter of November 26 – it is distributed by e-mail to subscribers every Wednesday – contains an excellent analysis of the US economic and financial situation. I decided to separate two paragraphs in order to make some comments about the effectiveness of fiscal policy as far as attacking recession is concerned.
“Fiscal policy will play a pivotal role in 2009 as the Fed Funds rate approaches zero. Significant fiscal stimulus will be needed during these 4-5 quarters to prevent significant growth contraction and deflation. Since any boost from tax cuts to households and businesses will be temporary, raising government spending via grants to deficit states and infrastructure spending would be more effective. While spending on infrastructure and green technology as endorsed by Obama can provide some stimulus during this prolonged growth slowdown, the extent of job creation would largely depend on the reallocation of the unemployed labor between sectors. Democrats are also pushing for unemployment benefits and food stamps which are well-targeted and have the largest bang-for-the-buck. While Obama has prioritized a large fiscal package as soon as he comes into office in Jan 2009, delays in Congress approval and actual implementation will make the stimulus less timely. Meanwhile a $500-700 bn stimulus along with other Treasury bailouts will push the fiscal deficit in the $900bn to $1 trillion range in the next two years, especially as the recent revenue boom in corporate income and capital gains and dividend taxes are fading significantly.” … “The backdrop to the renewed flurry of government interventions remains the completely frozen credit environment that is now gripping the non-financial corporate sector, both high-yield and investment grade. The spreads in the cash bond markets went on to exceed their CDS counterparts and reached new record highs on November 21 as the specter of bankruptcy looms ever larger for automakers and manufacturers around the world. Debt-ridden LBO companies are struggling to refinance or repay their debt while private equity companies face investor flight.”
I believe we must go back to Milton Friedman and discuss the effectiveness of fiscal policy and monetary policy in the present situation where interest rates are near zero and there is already a credit crunch in the private sector of the economy. Surprisingly, given the existence of a zero interest rate bound, analysts are discarding the use of monetary policy in order to take the US economy away from the present dramatic recession-deflation story. On the other hand, as it can be seen in the analysis above, fiscal policy seems to be the “solution” now. In other words, everybody is expecting that Government spending will take the economy away from a recession path.
There is a major missing point here – a word that became very popular in the seventies when we were all monetarists: “crowding-out”. Since we are all Keynesians now, we tend to forget that Government spending has to be financed by taxation, bonds or money issue. Naturally, it is accepted that spending plus taxes has a minimal positive impact on the economy, but surprisingly people tend to neglect the “crowding-out” effect of Government spending financed by bonds.
Particularly in the present situation, it seems to us that credit markets will feel the crowding-out impact of the issue of U.S. Government bonds and bills designed to finance the expected huge Government deficits that will occur as a consequence of all the economic packages announced to save and help banks and corporations in the US economy.
Therefore, by making this point, we intend to emphasize that only a combination of fiscal and monetary policy – in other words, Government spending plus the expansion of the monetary base through money issue – can attack the problem adequately.
It is interesting that monetary aggregates in the past 20 years or so – in contrast to the period 1968-1988 – are entirely neglected by analysts. In spite of the fact that Bernanke is a “student” of Friedman’s interpretation of the Great Depression, it seems that the lessons of Friedman were not entirely absorbed. Independently of zero interest rates, the US economy needs money supply growth – with or without Government spending.
It is possible that – just like in the 30’s – the fear of inflation (or even hyperinflation) and the memories of cases like Germany in the 20’s and Brazil in the 80’s are in the back of the mind of Bernanke and other US Central Bankers like Geithner (the future Secretary of Treasury). Otherwise, it is difficult to understand why the bets are now focused on fiscal policy only, in spite of the dangerous evidence that fiscal policy might be totally ineffective if spending is financed by Government bonds.
The public and the banks – all over the world – will continue to buy US Government bonds (a somewhat paradoxical situation for lack of alternatives in the flight to quality) and this will certainly produce what in the seventies Friedman (and Friedmanites such as the St. Louis Federal Reserve Bank at that time) called “the crowding-out of the private sector”, in order to demonstrate why fiscal policy does not work properly unless it is backed by monetary expansion.