A lot of bucks, but how much bang?, by Richard Clarida, Vox EU: “We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand” – John Maynard Keynes, “The Great Slump of 1930”, published December 1930.
I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts to discuss the state of global markets, geopolitics, and the many and varied ways that Russia factors into these complex domains. The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me, from the two-and-half-hour session that included probing questions from a number of the audience members assembled for the event.
That theme suggests the title I’ve chosen for this column; there are, at last, a ‘lot of bucks’ now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much ‘bang’ we can expect from these bucks.
In the US, President Obama has just signed a nearly 800 billion dollar stimulus package and the Fed has cut the Federal Funds rate to zero. Monetary policy in the rest of the G7, while lagging behind the US, will follow the US lead and soon come close to zero. (In the case of the ECB, the policy rate may end up at 1%, but the effective interbank rate has been trading well below the official policy rate in recent weeks so a policy rate of 1% could translate into an effective interbank rate of nearly zero). Likewise for fiscal deficits – they are rising globally and headed higher, propelled by a combination of discretionary actions and automatic stabilisers.
To date, however, these traditional policies have been insufficient for the scale and scope of the task. Recall that the Obama stimulus package is actually the second such US effort in the last 12 months. The 2008 edition was deemed to be a failure because a big chunk of the rebate checks were saved or used to pay down debt and not spent. The Obama package includes tax cuts and credits that will provide a boost to disposable income, but how much of these will be spent rather than saved or used to pay down debt? The package also includes a substantial increase in infrastructure spending, as well as transfers to the states, but the infrastructure spending is back-loaded to 2010 and later, and the transfers to states will most likely just enable states to maintain public employment, not expand it appreciably.
Bucks without bang
What is the source of this concern that the US fiscal package will not deliver a lot of ‘bang’ for the ‘bucks’ committed? Because of the severe damage to the system of credit intermediation through banks and securitisation, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Recall the Econ 101 idea of the Keynesian multiplier – the impact traditional macro policies are ‘multiplied’ by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It important to remember why and how policy multipliers actually come about. Policy multipliers are greater than 1 to the extent the direct impact of the policy on GDP is multiplied as households and companies increase their spending from the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand from the initial round of stimulus.
Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001, the economy was in recession, but households took advantage of zero-rate financing promotions – as well as ready access to home equity withdrawal from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts and income earned from government spending on goods and services will not be leveraged by the financial system to nearly such an extent, resulting in (much) smaller multipliers.
There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates. Just in 2008 alone, I estimate that the net worth of US households fell by some 10 trillion dollars, with much of this concentrated in older demographic groups who, in our defined contribution world, must now be focused on building back up their wealth to finance retirement, which is not that far away. This means more saving, less consumption, and smaller multipliers.
Outside of the G7, many of the major countries (certainly including Russia) are commodity exporters. The global recession has triggered a collapse in commodity prices, turning 2007’s fiscal surpluses into deficits and turning property and capital spending booms into busts in a matter of months. For example, as I am writing this, a headline has just popped up confirming that Dubai has received a “10 billion dollar bailout” from the UAE central bank to help provide financing for the rollover of debt backed by thousands of unfinished and unsold houses and apartment projects. Immense reserve stockpiles, which only months ago were criticised by some as excessive and without any purpose other than to manipulate national currencies so as to prevent appreciation are now, in Russia and some prominent other countries, being drawn down rapidly in a futile attempt to slow speculative depreciation of their currencies.
In Russia’s case, Deputy Prime Minister Shuvalov spoke at the conference and made very clear that 2009 will be a year of hard choices for the Russian government. Most importantly, Shuvalov made clear that Russia is unwilling to spend more than the 200 billion (a third) of the reserves they have already spent in what has turned out to be a futile attempt to support the Ruble. This will mean that companies and some banks will be allowed to fail, and that fiscal outlays will be scaled back and not funded at previous levels through a further draw down of reserves. So in Russia’s case, and I suspect some others, a lot of ‘bucks’ remain in reserve coffers, but they will be mostly saved, not spent to finance a major discretionary expansion in fiscal policy.
Will the Fed pull it off?
So where does this leave us? A LOT is riding on the efforts of the Fed and other central banks to stabilise the financial system and restore the flow of credit.
Officials recognising these challenges are now seriously considering “non-traditional” policies that combine monetary and fiscal elements. Cutting rates to (near) zero has not been a mistake, but it has been ineffective – really the most striking example of ‘pushing on a string’ I have witnessed in my lifetime. The reason, again, is the impaired credit intermediation system. The private securitisation channel, which at its peak was intermediating nearly 50% of household credit in the US, has been destroyed. Banks are hunkering down in the bunker, hoarding capital as a cushion against massive losses yet to be recognised on the trillions of dollars of ‘legacy’ assets that they have been unable or unwilling to sell at the deep discount required to attract private investors. For this reason, the Fed and Bank of England – with many other central banks likely to follow suit in some form or fashion – are filling the vacuum by directly lending to the private sector. The Fed aims to purchase 600 billion dollars worth of mortgage-backed and agency securities this year and, via the soon to be launched Term Asset-Backed Securities Loan Facility (TALF), to finance without recourse up to one trillion dollars worth of private purchases of credit cards, auto loans, and student loans. Since last fall, the Fed has also been supporting the commercial paper market via the Commercial Paper Funding Facility (CPFF).
Altogether, between the MBS, CPFF, and TALF programs, the Fed is committing nearly 2 trillion dollars of financing to the private sector. While these sums may be necessary to prevent an outright economic collapse that extends and deepens into 2011 and beyond, it is not clear to me that they are sufficient to turn the economy around so that it returns to robust growth. Moreover, based on the Fed’s just released economic forecast and Chairman Bernanke’s recent testimony to the Senate Banking committee, the Fed is also not convinced that these policies are sufficient to turn the economy around. On 24 February, knowing that an 800 billion stimulus had passed, that the Fed has committed nearly 2 trillion dollars of lending to the private sector, and that the Treasury’s Public Private Investment Fund will aim to support up to one trillion dollars of private purchases of bank legacy assets, Chairman Ben Bernanke said,
If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability – and only if that is the case, in my view – there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,
As I said in my remarks at the conference, I think of myself as an optimist, and that outlook on life has served me well. However, the last nine months have severely tested that mindset, at least as it pertains to my professional endeavours. But old habits are hard to break, so I am casting aside the contrary evidence and putting my ‘bucks’ on the Fed. But it is a close call.
Next, Brad DeLong:
Why we need not fear that a bigger stimulus will be counterproductive, by Brad DeLong, Vox EU: My favourite line from Jaws is uttered police chief Martin Brody (Roy Scheider) when he finally sees the shark: “You are going to need a bigger boat.”
We are at last seeing the shape of this downturn – and we are going to need a bigger fiscal stimulus than the deficit-spending package President Barack Obama pushed through the US Congress in February. We might get lucky; maybe the next four months will be months of unreserved good luck; maybe four months from now we will think that what we have collectively done to stabilise the North American and world economies is appropriate. That is not very likely; mixed news would mean that four months from now we are going to want to do another round of government spending boosts and tax cuts to try to keep the unemployment rate from rising too much higher and capacity utilisation from falling too much lower. (And the legislative calendar means that we should start thinking about laying the groundwork for such a second round of stimulus right now; in order to be in the budget reconciliation bill that will pass the congress in August, provision for fiscal stimulus must be in the budget resolution that will pass the congress in April.) Moreover, if the next four months are months of worse-than-expected bad news – well, let’s not go there right now.
Getting another round of spending boosts and tax cuts will, however, be problematic. Partisan opposition is mounting. That there is partisan opposition is very strange. We know John McCain’s chief economic advisers – people like Douglas Holtz-Eakin, who made an excellent reputation for himself as head of the Congressional Budget Office, like well-respected forecaster Mark Zandi, like AEI’s Kevin “Dow 36000” Hassett. We know how they think. We know that had John McCain won last November’s presidential election a very similar stimulus plan (but with fewer spending increases and more tax cuts) would just have moved through congress with solid Republican support. So the current 98% Republican opposition (except by governors who have to, you know, govern) leaves us scratching our heads.
So as we get ready to try to go and buy a bigger fiscal stimulus boat to deal with this Jaws recession, whose bite pushed the unemployment rate up to 8.1% in February, it is important to be clear why we ought to be doing this. And the first point that needs to be made is that the strange right-wing talking point that a government fiscal boost would not spur the economy because… because… well, it’s not sure why… is badly mistaken at best and disingenuous at worst.
Four legitimate fears
But there are legitimate reasons to fear that deficit-spending fiscal boost programs would not work well enough and would have high enough longer-term costs to be not worth doing. I classify these legitimate fears into four groups.
- Bottleneck-driven inflation. The fear is that although more deficit spending will increase total spending, and although businesses seeing increased demand for their products will indeed try to hire more workers to boost production, they will succeed only by offering their new workers higher wages – wages higher enough that they then have to boost their prices – and by snatching scarce commodities out of the supply chain by paying more and then having to boost their prices more as well. Thus rising inflation will make the increase in real demand an order of magnitude less than the increase in nominal demand. And if the inflation produces general expectations that prices will continue to rise – well, then we are back where we were in the 1970s, with everybody focusing on changes in the overall price level rather than whether their business plan made sense given individual goods and services prices. An inflationary economy is one in which the price system does not do a very good job of telling people and businesses where to focus their energy. It is likely, over the decades, to be a slow-growth economy. Breaking an inflationary spiral would require another recession on the order of 1979-1982. It is better not to go there, and a fiscal stimulus plan that takes us there is not worth doing.
- Capital flight-driven inflation. The fear is that the stimulus package will cause foreign holders of domestic bonds to believe that inflation is on the way and trigger a mass sell-off of US Treasuries and other dollar-denominated assets that will push the value of the dollar down. And as the value of the dollar falls, the dollar prices of imported goods and services rise – and we are off to the inflation races once again.
- Crowding-out of investment spending. The fear is that additional government borrowing may – not will, not must, but may, for this is a fear not a certainty – push up interest rates, make financing expansion even more expensive for businesses, and so discourage private investment. The boost to spending would thus come at a high cost-benefit ratio as much additional borrowing leaves us with only a little additional demand. Moreover, it would leave us with a low productivity-growth recovery that has too little productivity-boosting private investment and too much government spending in the mix.
- Reaching the limits of debt capacity. The fear is that the long-term costs of additional fiscal boosts via deficit spending will be very large because those from whom the US government will have to borrow the money to finance spending will only loan it on lousy terms – high and unfavourable real interest rates that impose substantial amortisation burdens and associated deadweight losses from taxation on America’s taxpayers.
All of these are legitimate fears when a government undertakes a deficit-spending plan. We can all recall historical episodes when they turned out to be not just fears but realities. We remember bottleneck-driven and wage-push inflation from the late 1960s and from the oil shock-ridden 1970s – those episodes were the first fear coming home to roost. Nobody today is happy with American fiscal policy in the late 1960s or American demand management policy in the 1970s.
The second fear became a reality in France in the early 1980s. Capital flight and anticipated-depreciation-driven inflation were the immediate result of Francois Mitterand’s attempt to institute Keynesianism in one country and drive for full employment when he became president of France in 1981.
The third fear was perhaps not a reality but it certainly was greatly feared in the winter of 1992 and 1993, back when I carried spears for Lloyd Bentsen and his subordinates Roger Altman and Lawrence Summers in the Clinton Treasury. They argued that the Clinton-era economy could not afford the crowding-out of private investment that even the steady-course deficits then projected for the mid-1990s were threatening to produce through high and rising interest rates.
And the fourth fear is an even older legitimate fear yet. It goes back to Adam Smith and his Wealth of Nations, which contains pages warning that deficit spending on the imperial adventures of George III and his ministers would produce an unsustainable debt burden that would crack the British economy like an egg – as had been the consequences of debt-financed wars in Holland, France, Spain, and the Italian city-states over the previous three centuries.
Why we need not fear
These four fears are all legitimate fears, but I believe that we, here, now do not need to fear them.
In each of the cases in which these fears are legitimate, we can see in advance that the stimulus program is going wrong. Stimulus packages produce increases in nominal but not real demand when exchange rates fall and prices rise; we can watch the exchange rates fall and the prices rise, and we can watch as financial markets anticipate these events beforehand. Stimulus packages crowd-out private investment when the government’s borrowing causes medium-term interest rates on corporate borrowings to rise. Stimulus packages impose a heavy financing burden on the government when they cause long-term interest rates on government securities to rise.
In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead.
Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds.
If any of these start to materialise, expect me and a number of other stimulus advocates to start backpedalling rapidly. But so far, so good.
Originally published at the Economist’s View and reproduced here with the author’s permission.