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Sunday, January 06, 2008

"There's Many a Slip Twixt the Cup and the Lip"

Larry Summers says fiscal policy needs to be part of the policy package that is implemented to try to avoid a recession. As I've noted several times recently, I agree. There are both theoretical and empirical reasons to expect monetary policy to lose its effectiveness as recessions deepen, and if you wait to see if monetary policy will work or not, it will be too late to use fiscal policy as a backup should monetary policy fail.

The title is a quote from Keynes where he talks about why monetary policy may not work in recessions. The problem is that there is a long chain of events that must occur for monetary policy to be effective - interests rates must fall when policy is eased (something that won't occur in a liquidity trap, for example), and once interest rates fall people have to be induced to go out and buy new houses and cars on the household side, and new factories and equipment on the business side (but in a recession people may be hesitant to make large purchases, and as Summers notes below credit, which is needed to buy these goods and services, may dry up in a recession, something that also makes it hard to use credit to replace lost income when GDP turns downward). For this reason fiscal policy, which operates directly on aggregate demand instead of merely creating incentives to purchase goods and services, can provide a more certain means of stimulating the economy than monetary policy (though the three principles Summers sets out below are important). Here's Larry Summers with more details:

Why America must have a fiscal stimulus, by Lawrence Summers, Commentary, Financial Times: The odds of a 2008 US recession have surely increased after a very poor employment report, growing evidence of weak holiday spending, further increases in oil prices, more dismal housing data and further writedowns in the financial sector. ... Markets now predict the Federal Reserve will provide further stimulus to the economy by cutting rates by an additional 125 basis points on top of the 100 basis points they have already been cut so that rates fall to the 3 per cent range.

There is now a compelling case for the president and Congress to create a programme of fiscal stimulus to the US economy that could be signed into law in the next several months. ...

The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) ...judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

Beyond policy mix considerations there is the desirability of maintaining stable demand by insuring against excessive declines in consumer spending... One reason why the economy has been more stable in recent years than historically is that consumer credit markets have allowed households that suffered income declines as the economy turned down to maintain spending by borrowing on credit cards or home equity. These mechanisms, like monetary policy, are less reliable with burdened borrowers and troubled financial institutions. Japan’s experience in the early 1990s when it failed to act decisively to respond to a downturn associated with collapsing financial bubbles ... should be highly cautionary regarding the importance of supporting consumption in the wake of financial problems.

Fiscal stimulus is appropriate as insurance because it is the fastest and most reliable way of encouraging short run economic growth... [But] ... Poorly provided fiscal stimulus can have worse side effects than the disease that is to be cured. This suggests close attention to three issues:

First, to be effective, fiscal stimulus must be timely. To be worth undertaking, it must be legislated by the middle of the year and be ... be implemented almost immediately.

Second, fiscal stimulus only works if it is spent so it must be targeted. Targeting should favour those with low incomes and those whose incomes have recently fallen...

Third, fiscal stimulus, to be maximally effective, must be clearly and credibly temporary – with no significant adverse impact on the deficit for more than a year or so... Otherwise it risks being counterproductive by raising the spectre of enlarged future deficits pushing up longer-term interest rates and undermining confidence and longer-term growth prospects.

Taken together these criteria suggest ... a programme of equal payments to all those paying either income or payroll taxes combined with increases in unemployment insurance benefits for the long-term unemployed and food stamp benefits. Such a programme could be implemented quickly, would largely benefit those most likely to be cut off from credit markets and with the most urgent need to spend. It could easily be made temporary. ...

    Posted by on Sunday, January 6, 2008 at 12:38 PM in Budget Deficit, Economics, Monetary Policy, Social Insurance, Taxes | Permalink  TrackBack (0)  Comments (34)

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