Tax Cuts, Household Balance Sheets, and the Duration of Recessions

Greg Mankiw:

It May Be Time for the Fed to Go Negative, by N. Gregory Mankiw, Commentary, NY Times: ...What is the best way for an economy to escape a recession? Until recently, most economists relied on monetary policy. ... The problem today ... is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools...

So why ... not lower the target interest rate to, say, negative 3 percent? ... The problem with negative interest rates ... is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive. ... At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. ... Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal..., such an incentive isn’t a flaw — it’s a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. ...

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt...

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In ... the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. ...

This reminds of the the gift card idea to make sure people spend their tax cuts. Under these proposals, instead of giving people tax cuts, which they are likely to save instead of spend, the government gives them cards worth a given amount, say $1,000, and has the cards expire after, say, three months (you could stagger the issue of the cards over a three month time period so that purchases don't bunch up at the beginning and the end). The connection to the above is, of course, that the expiring gift card is just like the "expiring" money drawn through the serial number lottery (except, of course, that in one case it was a "gift" from the government, while in the other it is your savings). In both cases you are inducing people to spend rather than save through the threat that their saving will become worthless in the future (hyper-inflation does this too).

The reason for gift cards is to prevent the tax cuts from being saved. Initially, I opposed tax cuts that would mostly be saved rather than spent because it wouldn't stimulate aggregate demand, and that's what the economy needed. But I've changed my mind about that, and I think tax cuts can be an important part of the solution in a recession like this one.

Here's why. This recession has wiped out a lot of balance sheets in the financial sector, and it has also done severe damage to the balance sheets of individuals, especially those with a large proportion of their savings in financial assets or real estate (equity in their homes). Those households are not going to spend until those savings for retirement and other purposes are replenished, so how soon the end of the recession comes depends, in part, on how fast those balance sheets are repaired. Tax cuts help to do this, some types better than others. The effect of these balance sheet repairing tax cuts may not be immediately obvious since they are going toward saving, but it helps the recession end earlier than otherwise. Big ticket items, in particular, are less likely to be purchased so long as balance sheets still have big, missing pieces.

So tax cuts should be part of a recovery package, and they can be used in two ways. Some tax cuts can be used to stimulate the economy immediately by helping families who are having trouble and cannot save even if they want to, they have no choice but to consume it all, and part can be targeted at speeding up the recovery by helping households make up for losses. We have to understand, though, that this component of the package will not stimulate aggregate demand immediately, the main effect is to bring an end to the recession sooner, and other measures - increase government spending or additional tax cuts targeted at people who will spend it all - must be increased to compensate.

Recessions can be characterized by their depth and their duration, and my initial opposition to tax cuts underplayed, I think, the role they can play in reducing the duration. I still think the best and most certain way to stimulate aggregate demand is through government spending, and that government spending can itself help to end a recession sooner, but there's a role for tax cuts too. Not in every recession, at least not to the same extent, it's not always the case that a recession wipes out household balance sheets like this one did. But when that happens, household balance sheets are one of the things that must be repaired before we can fully recover.