Feldstein: How to Avert a Recession

Marty Feldstein says it's time to use both monetary and fiscal policy to deal with the weakness in the economy:

How to Avert Recession, by Martin Feldstein, Commentary, WSJ: The American economy is now very weak and could get substantially weaker. Current economic conditions call for lowering interest rates and for enacting a tax cut now that is conditioned on economic developments in 2008. More generally, fiscal policy should be considered in the future whenever there is a risk that an excessively easy monetary policy could cause an asset-price bubble. ...

Almost every economic indicator -- including credit conditions, housing and consumer sentiment -- has deteriorated significantly since the Federal Reserve's October meeting. In my judgment, the probability of a recession in 2008 has now reached 50%. If it occurs, it could be deeper and longer than the recessions of the recent past.

Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral... Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the ... Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.

Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. ...

But rate cuts can still help. Lower interest rates will still reduce monthly interest payments for the one-third of homeowners who have adjustable rate mortgages, thus freeing up cash to spend on other things. When banks make new loans, they will do so at lower interest rates, encouraging more business and household borrowing.

Yet more than lower interest rates is needed. Fed Chairman Ben Bernanke signaled a desire for additional policies to reinforce monetary easing when he called for a dramatic temporary rise in the maximum size of eligible Fannie Mae and Freddie Mac mortgages -- to $1 million from the current $417,000. While this would help to stimulate the market for high-priced homes, it would cause these government-sponsored lenders to assume an even greater share of the U.S. housing market when there is a strong fundamental case for reducing their role. And why should American taxpayers provide an implicit guarantee to mortgages of up to $1 million when the average sale price of a home is now less than $250,000?

In a similar attempt to go beyond Fed easing, the head of the FDIC recently proposed that the government impose an across-the-board limit on the mortgage interest increases that are now scheduled to occur. With more than $350 billion of mortgages scheduled to adjust up in 2008, such an imposed limit could no doubt avoid many personal defaults. But arbitrarily changing the terms of mortgages ... would also destroy the credibility of American private debt. Who would invest in U.S. bonds or mortgages if the government could arbitrarily reduce the contracted interest payments?

What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.

Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process. ....

The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand. Now is surely a time for such a two-part strategy of expansion.

If we go the temporary fiscal policy stimulus route, which can occur through either an increase in government spending or a decrease in taxes, there is a reason to prefer increased spending. A tax cut creates an incentive for households to increase consumption, but there is no guarantee that they will, e.g. they could just retire debt instead. This is just the familiar split of a change in taxes and hence disposable income into a change in consumption and a change in saving, and most of the time consumption and hence aggregate demand will increase when taxes are cut, but we can't be sure in advance how a tax cut will be used. In addition, when the tax cut is temporary, as this one would be, the impact on consumption is generally lower than with a permanent change in taxes.

With government spending, however, the impact on aggregate demand is assured. A change in government spending impacts aggregate demand directly on a dollar for dollar basis so there is no uncertainty at all about whether or how much aggregate demand will increase with a change in fiscal policy. And, with all of our infrastructure needs, it's not as though we can't find places where government spending could increase output and employment and also improve our public capital (there are many other ways spending could help as well, infrastructure enhancement is not our only need).

So, I agree that we may need to try fiscal policy, but I don't see why temporary tax cuts should be preferred to temporary increases in spending. In fact, here's Greg Mankiw on this point. This is from his textbook Macroeconomics (5th ed., pg. 454) and it explains why temporary changes in taxes are not very useful for stimulating the economy:

 The permanent-income hypothesis can help us to interpret how the economy responds to changes in fiscal policy. According to the IS-LM model..., tax cuts stimulate consumption and raise aggregate demand, and tax increases depress consumption and reduce aggregate demand. The permanent-income hypothesis, however, predicts that consumption responds only to changes in permanent income. Therefore, transitory changes in taxes will have only a negligible effect on consumption and aggregate demand. If a change in taxes is to have a large effect on aggregate demand, it must be permanent. ... The lesson to be learned ... is that a full analysis of tax policy must ... take into account the distinction between permanent and transitory income. If consumers expect a tax change to be temporary, it will have a smaller impact on consumption and aggregate demand.

[Update: William Polley continues the discussion. Update: Free Exchange also comments.]

Comments

[Dickeylee]

What? The WSJ calling for tax cuts? Who'da thunk it? God please, please, PLEASE don't tie another Bush tax cut to another Bush war.

[yamada]

Government expenditure increases aggregate demand. On the other hand, the down price of real estate decreases both consumption and investment of aggregate demand. The point is, each of which is more effective in the long term. I wish the former excceds the latter in the U.S. Or else U.S. trail the case of Japan, the country with huge government debt.

[Brooks]

Important point made by Mark Thoma. My understanding is that immediate stimulus per immediate dollar lost to the Treasury is maximized by spending rather than tax cuts (because part of the latter is saved [including retiring debt] rather than spent), and second would be tax cuts to lower-income (or lower wealth) households who generally spend a higher portion of after-tax income (while these households may also be under more pressure to retire or service debt, I assume they would still use a greater proportion for immediate consumption vs. higher income/wealth households -- can anyone confirm if that's correct?).

The advantage, on the other hand, that I can see for tax cuts over spending is in efficiency per dollar spent on consumption, assuming that the private sector allocates resources more efficiently in terms of maximizing utility. Nevertheless, if the goal is immediate fiscal stimulus (increased consumption), I spending seems like the way to go.

[James]

"A tax cut creates an incentive for households to increase consumption, but there is no guarantee that they will, e.g. they could just retire debt instead."

Retire debt? God forbid.

At some point we will have to begin the structural reforms necessary to repairing the damage caused by twenty years of reckless monetary policy. We may try to keep pushing it into the future until it becomes a deadly blow for 'someone else' but with the dollar at historic lows it appears that the bell is tolling, for us.

[Deepish Thinker]

You have accurately highlighted one problem with temporary fiscal stimulus, that temporary tax cuts aren't reliably stimulating, but neglected another - temporary spending increases aren't temporary.

No matter the original intent, increases in government spending almost invariably become permanent. Spending increases are not really a solution, but a means of trading the short term economic problem of recession for the intractable long term problem of chronic deficits.

[save_the_rustbelt]

The center of the country is already in or near a recession, the rest will tip soon.

When you have a hangover do you have a shot of booze to try to moderate it, or just suffer the pain?

No good choices now.

[Don]

Given the numbers on employment and productivity out today for November, (increased payrolls of 198,000 and 6.3% increase in productivity) it's not clear to me that the economy is slipping into a recession, or even that one is likely.

I say take a wait and see approach. Leave the fed funds rate where it is for awhile, and let the housing market find a bottom. The last thing you want is to over-stimulate w/ more easy money.

And as for the housing market--declines in home prices represent to me a return, somewhat, to reality, before the great run-up beginning after 9-11's infusion of liquidity that continued through 2006. Home prices falling 5%, or even 20% or so from the lofty recent levels doesn't even get us back to the prices that long-term average growth rate of 3-5% over inflation would have got us. There is still a long way to fall to return to what historical trends (before the great expansion) say a house should be worth in late 2007.

Let the infusion of cash work its way through for awhile before doing anything more monetarily or fiscally. If 4.5% really is a "neutral" rate, it should allow housing to find a bottom and eventually return to growth.

[robertdfeinman]

Like others I fail to see the difference between more consumer "spending" and retiring debt. In one case they are spending on a toaster and in the other they are spending on a bank loan. The money still goes into circulation.

In the case of retiring debt the bank gets to use the capital for new loans so someone else can buy the toaster. This is the same issue that I can never understand when the idea of a "consumption" tax is raised.

Directing consumer spending towards material goods seems more like a way to favor certain sectors over others. So retail gets a boost. Why is this good? Wouldn't lessening retail spending also help our foreign trade deficit?

I don't see the Fed as a neutral agency, they are predisposed to help the financial sector.

[bailey]

Let's give three cheers for free market capitalism!
Hip Hip Hurray!
Hip Hip Hurray!
Hip Hip Hurray!
Enough said?

[eclectic artist]

I agree with and support Don above.

A recession is not just a slowdown in growth. As a consulting economist for Prudential, Robert F. DeLucia, observes, a recession is an actual contraction in economic output across the broad spectrum of economic sectors. There need to be declines in most of these: industrial production, employment, fixed investment, corporate profits, and credit. And it must be self-reinforcing, thus requiring a fix from outside. In a recession, a slowdown in demand would have to lead to cutbacks in production, which then trigger declines in payroll and a turnoff of business investment. Only that self-reinforcing vicious circle justifies radical steps like increasing government spending without increasing government revenues at times of record government budget deficits.

Housing prices should be allowed to come down from their historic highs. If the 4.5 percent federal reserve interest rate is really a neutral rate, that would allow mortgage lending to proceed as it normally does, and allow housing prices to accurately communicate to builders and sellers the value of homes to buyers. As economists like Timothy Taylor and Diane Coyle teach us, prices function to communicate demand to suppliers.

[Kaleberg]

Remember, their is a left wing version of the Laffer curve, which I will call the Reffal curve. If the government increases taxes, it can afford to spend more, and that spending turns into jobs which put money in people's pockets, and that encourages investment to get said money out of said pockets. All told, the increased economic growth puts more money in everybody's pockets, including the government's. Unlike the Laffer curve, the Reffal curve has been observed to work in the high tax years of the 1940s, 1950s, 1960s and 1990s.

Another freaky liberal trick to remember is that the increased spending should go to those as low on the food chain as can be managed. Giving the money to Bill Gates won't affect the economy. Giving the same money to ten million walking around randoms will siphon it through the economy much more effectively as each layer of the chain - shop keeper, distributor, manufacturer, and so on - takes a cut of it. Sure, no one likes giving money to the kind of person who is going to blow it on food, clothing or medical care, but there is no point in giving it to someone, however morally superior, who is just going to save it.

[bakho]

Spending does indeed go down. Especially spending that is not sustainable goes down. We saw a contraction of defense spending (as percent GDP) with the "peace dividend" starting with GHW Bush and continuing throughout the Clinton years, GW Bush has doubled defense spending since 2001 but that will not continue because it is not sustainable and competes with more important domestic needs. Infrastructure spending declined during the 1990s as well. Overall spending as a percent of GDP dropped from over 22% in 1992 to 18.4% by 2000.

[bakho]

During recessions, states often cut back on projects by delay or elimination because most states (unlike the Federal Government) cannot deficit spend. States contribute to the downward spiral when they cut employment. It makes a lot of sense for the Federal Government to help the states during recessions. This is indeed a temporary increase in Federal spending that can be in effect until the recession ends and state revenue recovers.

What is wrong with spending on programs that hire people to do things that need to be done when there is excess unemployment?

[nodakdude]

You don't know how big the multiplier effect is with spending increases either. How much will the people who benefit directly from the spending go out and spend on new domestic goods and services? How much will they just use to retire debt? It depends. I think your general point is correct, which is that the multiplier for spending probably has a lower floor than the multiplier for tax cuts.

Robert--strictly speaking, spending and saving both put money into circulation, but they have very different effects. Among other things, spending pushes interest rates up while saving pushes them down.

[Farrar Richardson]

RDF -
I would have thought better of you

"Like others I fail to see the difference between more consumer "spending" and retiring debt. In one case they are spending on a toaster and in the other they are spending on a bank loan. The money still goes into circulation."

Paying off loans decreases the money supply. Are capital rations so tight that a bank can't make a new toaster loan unless an old one is repaid?

Better to enable more consumers and investors, and thus more borrowers. As the old saying goes, you can't push on a string.

[Brooks]

Question (real, not rhetorical) for anyone:

If the Fed is concerned about a weak dollar and/or inflation (perhaps due to oil prices) even in a slowdown, to what extent would the Fed respond to fiscal stimulus by increasing interest rates, leaving us putting one foot on the gas pedal and the other on the brake?

[calmo]

bakho asksWhat is wrong with spending on programs that hire people to do things that need to be done when there is excess unemployment? [Nothing] Such a sensible question, removed of all that political over-burden, yes? The question is not phrased:What is politically reckless with spending on programs that hire un-connected people --possibly adversaries, to do things that may not benefit the Party when the unemployment is not excessive? [Everything]

[robertdfeinman]

Farrar Richardson:
"Are capital rations so tight that a bank can't make a new toaster loan unless an old one is repaid?"

Well it would seem so, otherwise how does the fed policy cause a change in economic activity? If you assume that banks have money lying around that they can't lend out (above reserve requirements) then paying down your debt to them won't have any affect as you imply. Is this a realistic case? It would seem that might be the situation right now where banks aren't willing to lend because they don't know how reliable their reserves are and/or they don't know the credit worthiness of new borrowers. This situation is apparently so unusual that it has caused an international panic.

There must also be something similar if spending vs paying down debt is going to directly influence interest rates. We would have to be in a situation where money is tight.

I think I would need some realistic examples to be convinced that allocating one's funds one way or the other has the effect that you state. It sounds like another one of those axioms that every economist just "knows".

[James Killus]

Hmm, it looks an awful lost like someone is taking a model known as the "permanent-income hypothesis" and treating it as if it were a factual truth. Really? Has this been demonstrated? Because it looks to me a lot like people who are strapped for cash because of various living expenses (food, shelter, health care, servicing the car so it can get you to work for another few months), don't let the fact that it's "temporary" income get in the way of spending it.

What I will note is that, in an economy/society where the long term trend is to destroy mass demand (i.e. middle and lower class incomes) in favor of the accumulation of wealth for the establishment of an oligarchic class, real investment will be curtailed because there is no future in providing more goods and services to the majority of citizens, and investment becomes "investment," which is to say methods of transfering money from the lower income pockets to the higher income off-shore accounts.

Put another way (one that is so extremely charitable as to set my teeth on edge), we are in the reverse situation that created the stagflation of the late 1970s, where capital investment was perceived as being overtaxed. Now, capital investment is undertaxed, but productive investment is underutilized because there is no growing market for the added goods and services. Such a model just incidentally, would predict record corporate profits and a dearth of capital spending, which seems to me to be at least as defensible as the "permanent-income hypothesis." It also suggests that ordinary Keynesean fine-tuning is merely a bandaid and structural reform is in order.

[Winslow R.]

RDF reexamine your framework for lending. Capital ratio's are not restricting lending right now. Take a look at bank residual vs. loans outstanding. They are at 2 times the levels they were in 1974.

Loans outstanding
http://www.federalreserve.gov/releases/h8/data/m/b1001a.txt

Bank residual
http://www.federalreserve.gov/releases/h8/data/m/b1091a.txt

RDF wrote: "Well it would seem so, otherwise how does the fed policy cause a change in economic activity?

**The Fed changes the price of liquidty not the quantity. The quantity is always infinite.

If you assume that banks have money lying around that they can't lend out (above reserve requirements)

**Reserve requirements play little role now...don't listen to Delong. Even he is slowly changing his stance.

[Maynard]

This is just what I said here: http://gecon.blogspot.com/. My vote is for fiscal stimulus in the form of support to state budgets. States spend money on lots of useful things (schools, roads) and tend to cut back on spending during recessions. It would be pretty easy to enact an increase in aid to state governments triggered by a string of bad economic news.

[robertdfeinman]

Winslow R.:
Sorry, I'm still confused. What does "**The Fed changes the price of liquidty not the quantity. The quantity is always infinite."

How can the quantity of money be infinite? And what is illiquid money? If it can't be spent then it's not money.

It would seem that the Fed is not as effective as they would like us to believe. Otherwise we wouldn't see stories about what the Fed should do next and why the last thing it did wasn't enough. I know there are people who devote their careers to understanding the Fed, and I'm certainly not one of them, but to my mind they have only a hammer and thus everything looks like a nail to them.

Nothing they can do will put more oil into circulation. Nothing they can do will cut down the pressures caused by explosive population growth. Nothing they can do will force the US to redirect spending from blowing things up into building things up. All they can do is make it easier or harder for the financial sector to make money.

Raise the cost of borrowing or increase the reserves and banks have a harder time. Not only are their motives not "pure" in my opinion, but the lack of any overall economic planning in the US means that various sectors are at war with one another. I'm not saying that the Japanese model is ideal, or even works better, but there is something to be said for having a national industrial policy. As a result of it since 1945 Japan went from a near feudal state to one which developed into a world leader in electronics and other high tech areas.

Recent pushes by the government have yielded such benefits as a state of the art communications network. I don't know why they haven't been able to keep up in the past decade. Perhaps there is just a limit to how much a small nation, with no natural resources, can accomplish. Whatever it is there isn't the same obsession over what their central bank is up to as there is in the US.

[Michael Kaufman]

Because of the current credit crunch, the Fed is lowering interest rates to fight the oncoming recession. Is this the best course of action for the Fed to take, since it might not stimulate the economy as much as intended? Is going through a recession now better than going through one later? Lowering interest rates is good for homeowners who have adjustable rate morgages, but what effect is the lower interest rates going to have on asset prices? I think asset prices will increase because the interest rate is so low and the growth rate is higher.

[Emily Opferman]

Michael Kaufman-

Yes,interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. We can increase government spending or decrease taxes to stimulate the economy. This can boost the confidence of households and businesses and banks can offer loans at a lower interst rate.

[Winslow R.]

RDF wrote: "How can the quantity of money be infinite?"

The Fed sets the price and prints the quantity demanded up to a capital ratio to which, from what I can tell, the overall bank system is not even close. The quantity is currently determined by borrower demand.

Any quantity limits are self imposed as the Fed can print as much money as they desire within the political boundaries set by the government.

Point: Banks do not need people to pay back loans in order to make new loans! They won't run out of money!

And what is illiquid money?

The sources for GM and Ford money are also 'infinite' though this type of money tends to be 'illiquid'. This lack of liquidity leads to discounting. Banks had this problem back in the old days. GM and Ford can use company 'money' to purchase things, usually other companies.

If you look up split tallies it helps to understand how money is created and extinguished. It helps to see that there are multiple issuers of tallies (Fed, Treasury, BofA, Citigroup etc.) and there are large systems set up to exchange these tallies at par/discounted value.

http://en.wikipedia.org/wiki/Tally_stick

[wimpie]

Winslow, r u implying the US is becoming a BANANA REPUBLIC?

Come mister tally man tally me bananas
(daylight come and me wanna go home)
come mister tally man tally me bananas
(daylight come and me wanna go home)
lift six foot seven foot eight foot bunch!
(daylight come and me wanna go home)

[bob mcmanus]

Winslow, wimple:Have open on my desktop to dip into as possible:the "Handbook of Alternative Monetary Economics" E Elgar, 2006. Have made thru Ch 1 on the history of money, so this discussion of "tallies" was fun. According to these heterodox dudes, coinage as value-in-itself is trivial & uninteresting. Always been fiat.

Money = debt/credit, to put it most simply.

Winslow's assertion the quantity of credit (money) is always infinite is interesting

[Winslow R.]

Banana republics issue too many single tallies. To avoid inflation they could 'simply' tax any excess tallies out of existence.

If you think about the split vs. single tallies it can help to understand the difference between Fed and Bank created dollars.

Fed dollars are an asset with no current liability (their liability is future gov taxes - which may never be collected) so are single tallies. Also called vertical money.

Bank dollars are created with a current asset and liability (when you get a $10 loan from the bank you also get a $10 deposit). These are split tallies. Also called horizontal money.

[bob mcmanus]

Searching for "vertical money tallies" I came up with this:

Keynes Approach to Money pdf, L Randall Wray, Levy Economics Institute 2006

Which helps me understand this:

"On such assumptions I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation" ...GT, Ch 16

I don't know if I am contributing anything. Maybe I need to return to auditing Thoma's online course.

[Winslow R.]

"I don't know if I am contributing anything. Maybe I need to return to auditing Thoma's online course."

Not an unsual thought around here.

[calmo]

The essential character of thought...and so irrefutable for those who have ever owned a parrot: make it unusual...not the regular '2 over easy on brown, please'
...no, step up and out
...before the parrot takes over.

[Winslow R.]

I was explaining the difference between the single tally and the split tally to my son during carpool (captive audience) and decided to share.

Single tallies are issued by governments and are taxed out of existence (or buried in walls in Bagdad) and have no time component to them.

Split tallies are issued by banks (those without the power to tax) and have a time component to them by which they can expire (40 years - last time I checked for uncollected mortgage debt)

If you read Krugman's famous babysitting coop story

www.pkarchive.org/theory/BabySittingCantAvoidRecessions.html

you'll find it is a story of coupons or single tallies. The coop failed because the people that ran the coop lacked sufficient knowledge of monetary systems. They needed to create:
1) the power to tax excess coupons out of existence (Fed Money)
and/or
2) expand into split tallies that could be issued by couples with a time value attached to them. (Bank Money)

They could have done both as our current system does both. In the case of the coop, it is very apparent who benefits from issuing tallies. In our real economy it is not so evident.

In a real economy you have a king (president) that controls single tallies and a banker (bank presidents) that oversee split tallies. In between these two entities stands the Fed chairman, Ben Bernanke with the power to regulate the price of single tallies. These single tallies are made available to the various bank presidents with which to settle their debts with each other in the interbank market.

The split tallies these bankers make never leave the bank. If a customer demands a withdrawal in cash they are given single tallies. If a customer transfers their deposits from one bank to another, the account is settled with Fed issued single tallies in the interbank market. Thus the need for bank capital and the ability to liquify that capital at the Fed, lender of last resort.