Where We’re Going

A few days ago, PGL noted this:

Dalton then advocates measures to increase savings – which means reduce consumption and aggregate demand. Maybe this would be a good approach for long-term growth when investment demand is booming and the Federal Reserve is contemplating higher interest rates to cool aggregate demand in a full employment economy. But when investment demand is falling, reducing consumption demand only makes the insufficiency of aggregate demand worse.

And of course, PGL is right.

But One Salient Oversight argues that with real interest already so low, and the government already running such a big deficit, expansionary monetary (pumping even more money into the economy) and fiscal (tax cuts) policy won’t work, and its time to focus on the long run:

The problem now, however, is what is the US going to do in order to solve their current problem? Since careless expansionary fiscal and monetary policy caused the current crisis, should we assume that expansionary fiscal and monetary policy can solve it?

Bush and the Fed (now under Bernanke) certainly think so. Bush is trying to push through a “rescue package” bill in congress that would attempt to provide much needed fiscal stimulus to the different markets in America that need it most (mainly, I believe, the housing market). Meanwhile, Bernanke at the Fed has been lowering rates as though it were going out of style. In fact, the rate cuts have been so substantial that the market is getting spooked by them.

I do not think, though, that these will work. US Federal government debt is already so high that interest repayments on government debt now exceed 3% of GDP. A continual and growing deficit has already begun to eat up federal spending to such a degree that the interest charges alone rival defence spending and health care costs. A fiscal stimulus package of the sort that Bush is proposing will simply result in higher deficits. Whatever growth such a package could encourage would be sucked up by the downturn that high deficits would have later.

Similarly, Bernanke’s cutting of interest rates is problematic. I have argued elsewhere on this blog that the declining US currency, now dredging the bottom of historical lows, will have an inflationary effect upon the economy. Oil, now at $100 per barrel, is spreading inflation too. The question is, though, whether the inflationary effects of a declining currency and high oil prices will be balanced out by the deflationary effects of an economic downturn. I doubt it, for the simple reason that other countries who have suffered currency devaluations and/or high oil prices always ended up in the mire of stagflation – high inflation mixed in with economic stagnation. Bernanke’s cutting of rates, during a period in which inflation is already eating into the value of people’s wages and savings, is a dangerous move.

So, if the solution is not through expansionary policies, then it can only come through contractionary ones – Austerity. Put simply, this involves an increase in saving money – and by money I mean cash in bank accounts, not money invested in shares or property that can lose value. Moreover, such saving needs to be protected from the ravages of inflation.

For an Austerity program to run in America, both the government and the Federal Reserve need to do the exact opposite of what they are currently doing. Instead of spending money and creating deficits, the government needs to run a fiscal surplus and pay back debt owed. This would involve raising taxes or cutting spending (mainly on health care or military costs) or a combination of both, in such a way that tax revenue exceeds expenditure, thus allowing earlier retirement of government debt (which is essentially paying off the principal earlier).

Instead of creating money and stirring inflation through lower interest rates, the Federal Reserve needs to increase rates to encourage household savings and control inflation (higher interest rates will make saving money more attractive to households and businesses, while at the same time killing off inflation, thus making money more valuable to keep rather than spend).

Of course, such actions are clearly contractionary. In other words, the austerity program I am proposing will, in effect, make the recession worse. Such an austerity program would cause a significant economic downturn that will result in high unemployment. Is it worth it?

Yes. It is. At some point in the future, an austerity program will be tried. It may occur next year, it may occur next decade. The issue is that the sooner such a program can be implemented, the easier it will be to recover from its shocks. Leave it too long, however, and the shocks will take longer to recover from, and the more potential damage such inaction will cause.

The shock of running an austerity program will be deep but, as Keynsian economists would point out, a recovery will eventually arrive. Not only that, but increased tax revenues from this recovery will make it easier for governments to pay off debt (assuming they remain fiscally restrained) thus making it easier for future governments to avoid the mess the current generation is in.

My view… recessions generally end by themselves, usually after about nine months or so. And yes, I don’t think monetary policy will help at this time – the Fed has been carrying the economy since GW took office. Any vaccine, given often and long enough to a patient, loses its effectiveness. And we’ve reached this point. Tax cuts aren’t going to help – they aren’t going to increase spending, and if they do, they won’t increase spending here.

So what I think is this… let the recession run its course. No “help” from the Fed. (In fact, if the Fed wants to help in a small way, paradoxically they should raise interest rates. Maybe the folks on fixed incomes, the ones who haven’t been spending money in the last seven years, might actually spend a bit of money if they had it. Those who spent because money was cheap are being foreclosed on left and right, and a cut in interest rates won’t help them or their resetting ARM now that their home is worth 20% less than they paid for it.) And no tax cuts… let the gubmint bank that money. Because if this is that rare event that is worse than a run of the mill recession, someone will need to spend a lot of money to get us out of it, and the private sector is too much in hock to do it.