Stimulus – good for zero now, another recession later
With the worse than expected employment situation numbers released yesterday (July 2) some of the talking heads are calling for a second round of stimulus spending to kick start the economy. Others such as economist Steve Moore were calling for the suspension for some defined period of time of the personal and corporate income tax. It should go without saying that I tend to favor Steve Moore’s approach over “Porkulus Round 2″.
Understanding the problem will help in defining the solution. The US economy had been in a credit crunch since 2007 – the TED spread (difference between 3 month LIBOR and the 3 month Treasury bill) went above it’s typical upper range of about 50 basis points in mid 2007 and remained there until recently (and, as for you “green shoots” fans – it came down due to lack of demand – the 3 month LIBOR is at a ridiculously low level of 50-60 basis points, rather than an increase in the supply of credit, as evidenced by the 3 month Treasury remaining in the 15 basis point area). The situation came to a head with the Lehman bankruptcy; at this point consumers and investors all took their money and put it in their pockets. The net effects:
1. The velocity of money (the rate at which money changes hands to pay for the goods and services comprising the GDP) slowed. To use the macroeconomics jargon this steepened and moved the liquidity-money (LM) curve left – less money to purchase goods and services, and interest rates more sensitive to the supply of liquidity (if you want money, it’s going to cost you – in this environment it was referred to as the risk premium).
2. The consumers’ marginal propensity to consume (the portion of discretionary income – income after taxes and transfers – spent as opposed to saved) dropped. While there is long-term upside to this – a higher savings rate provides capital for business investment for an expanding workforce, improvements in technology, and dealing with depreciation (as long as it isn’t crowded out by high government deficits – are you listening Barry O.?) – the immediate term was a reduction in demand for goods and services.
These two factors resulted in the post-Lehman market clearing demand point being at a lower output level (read that “recession”) and sharply reduced interest rates (the three month Treasury briefly went to a negative rate). The (essentially) zero interest rate produced a liquidity trap – the FOMC had no room to buy treasuries to lower rates, and any additional liquidity the Federal Reserve might have provided would sit on the sidelines. The result was leftward/downward shift of aggregate supply brought the supply/demand market clearing point to a lower output at a lower pricing point – deflation.
So how does Steve Moore’s suggestion help?
1. The consumer gets more discretionary income. Even if the split between consumption and savings remains at the post-Lehman levels (and I for one hope it does) this improves demand and shifts the aggregate demand curve back up/right.
2. The dollar strengthens. Assuming no change in monetary policy, the resulting increase in consumer spending will cause the equilibrium demand point to not only be at a higher output quantity but also at a higher interest rate as a natural result of economic growth – money goes for goods and services as opposed to interest bearing instruments, so those instruments pay higher rates to become more attractive. The concept of interest rate parity indicates that as the aggregate interest rate associated with one currency rises vs. others the net inflows into the higher interest rate economy will raise demand for that currency and thus make it stronger.
3. The cost of producing goods and services drops across the economy. Since all suppliers get this cost reduction competition will cause them to pass along the savings vs. pocketing it. This moves the supply curve right and down; this and the demand curve shift result in a market clearing point that is at a higher output and lower prices than those that would be seen with a demand shift alone – growth with non-inflationary pricing power (didn’t some former actor from California successfully do this about 25 years ago?).
These effects would be as instantaneous from the time the tax holiday became effective – help when the help is needed.
It is true that government spending will need to be reduced during the tax holiday to keep deficits from crowding out investment, and that this reduced spending will somewhat reduce aggregate demand; however the combination of positive effects on higher demand from increased discretionary income, more cost-effective supply side, and a stronger dollar will outweigh the negative effects of reduced government spending. (And, I’d be remiss as a conservative if I didn’t state that the government spends too much as it is – the question of whether to spend should start with “does the Constitution specify this as a role of government?”)
My only argument with the tax holiday is that it would sunset and this would reverse some (or all) of the positive effects. I would propose a permanent reduction in the overall marginal tax rate on individuals and businesses. Yes, the effects would come in more gradually than the large step change associated with the tax holiday, but they would be permanent (at least until the liberals can repeal it…).
But did Barry O. do that? Nope – all we got were hope, change, and a mess of government spending programs. The effects:
1. Immediate (as in when the help is needed) effect on demand in the real economy = bupkis. There is no stated intention to have an effect on aggregate supply; as for immediate aggregate demand, government programs have a lead time – bidding contracts, hiring workers, obtaining materials (yeah, right – shovel ready…). And, since bureaucratic inertia is at play, it’s a looooong lead time. But in the meantime…
2. The money to pay for all these programs has to be raised to get the ball rolling; so far it’s been by issuing a whole pile of bonds. If the Federal Reserve doesn’t step in to put these on their balance sheet we get higher interest rates without growth; since they have done so to keep rates down in the recessionary environment we get…
3. The Federal Reserve printing money to pay for these government programs which have done nothing in the immediate term when the boost is needed.
We’ve seen the printing presses crank up to pay for government spending in the past. It’s how we paid for the Great Society and the Vietnam War. It’s the reason Nixon took us away from Bretton Woods. And it’s one of the factors that brought us the inflation of the 1970s. And this time it’s buying us NOTHING.
Someday a future Fed Chairman will need to massively tighten the Fed Funds rate, a la Paul Volcker, to clean up Barry, Harry and Nancy’s mess. We can trace the roots of that future recession to this.
We can only hope for a change in 2010 and 2012.