Why Milton Friedman was wrong, and Keynes was right.
Fiscal or monetary, that is the question. Milton Friedman insisted that monetary stimulus alone could solve recessions and depressions. That is to say, the Fed fiddling with interest rates and bank reserve requirements could correct any macroeconomic bubble fallout and liquidity problems. Paul Krugman wrote a fine article laying this argument to rest, since in the current crisis, (and in Japan's of the 90's), interest rates are at zero, yet deflation and other dislocations still threaten. However he did not really delve into why a fiscal stimulus can do what free money to the banks can not. (A slate guy tried to, though).
Meanwhile, David Brooks decides that since he has no understanding of fiscal policy, the whole thing is very risky and shouldn't be attempted (in the hallowed tradition of doubt mongering on tobacco, climate change, etc.). And the Cato institute puts out the ever-helpful advice that what would fix the current economic problem is a large dose of tax cuts.
With all the years and brains devoted to economics since the great depression, one would have thought that more was learned. Indeed, more has been learned, but media megaphones are usually held by those who have other interests than the pursuit of disinterested economic theory. I am no economist, so once again, caveat emptor!
We find ourselves in an odd place. A massive credit bubble has collapsed, slicing values of assets, loan portfolios, loan collateral, and investments of many sorts to fractions of their former bid-up values. The musical chairs of greater-fool (and unregulated) investing has ended, with substantially fewer chairs than players. The prospects of many kinds of future cash/investment flows has suddenly declined, inducing a whiplash effect on the banks that deal in future-denominated assets (i.e. credit). All that free money on loan from the Fed is filling craters that used to be shiny assets but now turn out to be hockey pucks, or, though the magic of leverage, craters of debt.
So the Cato guy is right- funnelling free money to the banks (and even buying up their stock to provide capital) is not going to force them to lend- not in declining economic times when the next shoe to drop may be their own. The banks play a key role in the system, and monetary policy is essential to keep banks solvent, preventing total collapse, and for setting the stage for economic recovery. But it is not enough if lending is not yet attractive, either due to the wounds already inflicted by the collapse, or due to the lack of positive growth prospects.
Monetary policy alone is enough for many things, like slaying inflation, and mild recession balancing. But deflationary spirals appear to be beyond its reach. Banks and other major investors have fled to safety- specifically, to the safety of T-bills, and that is the key to the conundrum. Banks can clear a small profit from investing their zero-rate Fed money at T-bill rates, and any other investor interested in safety goes there as well. So the government ends up with vast amounts of low-interest money siphoned from the economy. What to do with it?
The obvious answer is to recycle it back into the economy, through a stimulus package like the ones being contemplated currently. The point of monetary policy, after all, is to maintain economic activity, especially jobs, so that the tender flame of money flowing around the economy does not sputter and go out. If the banks won't step up to the plate and the government is seeing a glut of cautious investment dollars coming its way, then it simply has to employ those dollars to give the flame a bit more fuel. Of course, if the government spends the money (as it would in a stimulus) instead of lending it (as the Fed does), then it is setting up future generations to pay back all those T-bill holders in the form of taxes.
That is where the theory of a stimulus gets interesting. The ability of future generations to repay all this money is going to depend on whether they end up better off (i.e. more productive) than we are today. If they are, then repayment will be a piece of cake. If not, they may be faced with currency devaluation or inflation as round-about ways of reneging it. The money thus should ideally take the form of investments that serve the common good in economically beneficial ways, especially in the long term. Usually, this kind of allocation is best left to private parties (forgetting for the moment the monumental short-sightedness demonstrated by our management culture in both the dot-com and finance bubbles), but now, of course, willy nilly, this decision is up to the government.
Let's consider a few different uses of the stimulus:
1. Tax breaks, as per the Cato guy. This has the virtue of leaving the decision of how to invest the money with private citizens. Unfortunately, among the rich, the money is quite likely to end up in T-bills or their equivalent once again ... not a productive use of the money at all, either short term or long term. At the lower end of the income spectrum, the extra money is likely to be spent rapidly, which is indeed good in the short term, since it would fuel the flame of economic activity in a generic way. But it would not constitute any kind of productive investment, especially if used towards the basic needs of food and gas that are likely targets. This kind of spending will maintain the economy, but productive investment must change the economy.
Incidentally, we do not know quite how stimulated the economy should be. If it was overheated and inflated two years ago, and if it is depressed and sagging today, where is the happy mean? That is a delicate question, indicating that the stimulus should be kept to a fraction (like 1/4) of the total wealth lost in this downturn. Economists probably have decent ideas about it, however. One sure-fire measure is the unemployment rate. Below is another measure, part of a Taylor rule presentation, courtesy of a treasure trove of economic data at the St. Louis Federal Reserve.
2. Foreclosure amelioration. Plummeting conditions in the real estate market underlie much of the current pain. Banks do not know how much their loans are worth, builders do not know when they will ever be able to get back to business, and wealth continues to evaporate. It would do a great deal of short-term good to prop up the mortgage industry with renegotiations and refinancing, as is being done now with voluntary programs with the banks and breathtakingly low interest rates. But this is dangerous as well, since we do not know what the natural level of the real estate market should be. If the government takes over loans that later slip further under water, what have we gained? Not much. And the unfairness of helping the most profligate mortgage holders while responsible holders get left paying the taxes to clean up the mess is also quite unattractive.
One idea is to develop incentives that encourage banks to resolve foreclosures by transforming them into market-rate rentals rather than evicting and selling at extremely steep losses. The flood of foreclosures is the worst kind of panic selling that hurts everyone- banks, householders, and the economy. The government could use HUD, or another agency along the lines of Fannie Mae to buy up titles to such properties and manage them, for eventual sale when the market improves.
3. Specific projects. Stimulus money would ideally to go into economically beneficial investments, like targeted education, power grid upgrades, green technology, research, broadband upgrades, and health system upgrades. The record of government direct investment is decidedly mixed. It brought us the internet and the highway system, but also the boondoggles of synfuels, hydrogen cars, the space shuttle, and nuclear power. Government tends not to do well in big projects, but can effectively broker small projects, as is done by the peer review system that has been such a stellar method of resource allocation at the NIH.
I'd like to see at least part of the stimulus go to small grants awarded rapidly on a peer reviewed basis on the broadest range of topics, from the arts to green technology to social policy development. Let a thousand flowers bloom, and perhaps a new internet will take root.
These investments will help shape the economy that will remain after the economic crisis is over. Short-term thinking is not useful, and over-allocation to any one sector (like research, for instance) would create unsustainable growth leading to retrenchment later on. Thus we will be shaping consciously what the future will look like, anticipating what the market will do once the current crisis, and the government participation it has called forth, leave the stage.
Incidentally, we might ask whether we even want economic growth!
- Later link- Krugman narrates the same story, summer 2009.
