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Stimulus or Austerity?

Presentation for THE PRESIDENTIAL ELECTION OF 2012

Hiram College, November 16-17, 2012

Uğur AkerProf. of EconomicsHiram College

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Source: http://www.dallasfed.org/research/swe/2005/swe0502.pdf

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How To Deal With Recessions

• Do nothing.

• Use monetary policy.

• Use fiscal policy.

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Do Nothing• Inflation will go down.

If ε > 1, consumption spending will rise increasing the demand for goods and services, and hence for resources.

Diminished uncertainty due to lower inflation coupled by higher consumer spending will spur business expansion (investments).

Exports will become more competitive and add to demand for resources.

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Do Nothing

Length of time to get back to “full employment” may be “too long.”

Pervasive bankruptcies may devastate communities.

If government services are dependent on public revenues, the pain on the population will be exacerbated.

Borrowing by firms and individuals during a recession becomes very difficult, closing another door to weather the blow.

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Monetary Policy

The need for a “lender of last resort” to insulate banks from runs and inevitable bankruptcies thatfreeze the whole financial system, caused the establishment of the Fed, US Central Bank.

Central Banks increase or decrease the amount of money in the system and as a result, lower or raise the short term interest rate.

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Monetary Policy

During recessions Central Banks increase the amount of money in the system and lower the short term interest rate.

In mild recessions this approach seems acceptable to spur consumption and investment spending.

During expansions that trigger inflation, raising interest rates is the policy response of the Central Banks.

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Fiscal Policy

Keynesian answer to the Great Depression was to counter the drop in consumption and business investment spending by having government to increase spending and decrease taxes.

The ensuing deficit and the increase in national debt was supposed to be reversed during boom times.

In fact, the concern was that as the economy grew and tax rates remained constant, tax collections would exceed spending and there would be a “fiscal drag.”

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Fiscal PolicyKeynes wanted an accommodative monetary policy to accompany a fiscal stimulus. By keeping the interest rates constant, the fiscal stimulus would not crowd-out private sector spending.

Governments found this approach very appealing politically and utilized it son and off since WWII.

The different price experience in the 20th century compared to the 19th century can be ascribed to the activist government practices.

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Fiscal PolicyThe last half century also saw a objections to the activist policies.

• Implementation lag was too long, with Congress piling up self-serving projects into law.• Spending lag meant the recession was already over when spending took place.• Late unnecessary stimulus fueled inflation.• People lowered their consumption spending to save for future taxes.• Deficits raise the interest rate and displace private sector with more government control of resources..

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How Recessions Occur?The preferred approach to business cycle research is using Dynamic Stochastic General Equilibrium models.

DSGE models use random demand or supply shocks to alter the economy from its full employment path.

Demand shocks are drops in spending by consumers, businesses, government, and foreigners on our exports.

Supply shocks are any increase in the economy-wide costs of production.

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How Recessions Occur?

A complementary approach concentrates on the response of the Federal Reserve. To counter the rising inflation of the booming economy, the Fed increases interest rates and slows down the economy. The higher interest rates reduce the spending on the output and recession occurs.

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1981-82 RecessionsIn spite of the stimulative effects of Reagan tax cuts and military spending increases, the overnight interest rates were pushed up to close to 20% by the Fed and the economy plunged into two back-to-back recessions.

GDP growth in the United States in the early-1980s. The short recession at the start of the decade, followed by a brief period of growth and the deeper recession in 81–82, have led to this period being characterized as a W-shaped recession. Percent Change From Preceding Period in Real Gross Domestic Product (annualized; seasonally adjusted); Average GDP growth 1947–2009Source: Bureau of Economic Analysis

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Recessions from Financial Meltdown

Over-leveraged, heavily indebted economies face risk of default. The indebtedness can be either to domestic or external lenders. The debt can be sovereign or private.

When default risk rises, banks holding the debt as assets become vulnerable and bankruptcies are imminent.

Bank bailouts and injections of money to counter the freezing of credit may soften the blow.

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Recessions from Financial Meltdown

Central bank money injection lowers the interest rate and should spur borrowers to take loans and engage in spending. At the same time, the banks are flush with reserves and should be willing to part with their excess reserves.

If neither the borrowers nor the banks are fulfilling their normal functions and the injection of money already lowered the interest rate to zero (liquidity trap), the only tool the government has left is fiscal policy (stimulus).

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http://seekingalpha.com/article/195986-unemployment-chart-deconstruction-of-the-day

Source: Reinhart, C. and K. Rogoff, This Time It’s Different

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How Far the Stimulus?If inflation is not increasing, then the expected burdens of the stimulus are not in the horizon.

Inflation will increase the nominal interest rate and will allow the Central Bank to utilize its monetary policy further.

Inflation will also signal pressure on resources, or expansion of the economy.

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Impact of StimulusIn the past, studies covering the period after WWII, did not necessarily provide uncontestable results. A sizable group claimed to come up with multipliers less than one. That means for one dollar spent by the government the income of the economy increased by less than one because other sources of spending dropped.

For instance, in February 2009, in a short note entitled “Voodoo Multipliers,” Robert Barro claimed that stimulus will have a multiplier of 0.7-0.8.

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Impact of StimulusAbout the same time, Mark Zandi published his multipliers. He claimed that unemployment insurance, food stamps, and infrastructure spending all had multipliers of greater than 1.5.

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Mark Zandi’s Multipliers

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Impact of Stimulus

Alesina and Ardagna show instances where the multiplier is negative: reducing government spending actually increases output. The transmission mechanism is through the fall in interest rates due to a reduction in risk. Tax increases do not give the same results.

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Impact of StimulusAuerbach and Gorodnichenko find fiscal tools to be more effective in recessions than in expansions. According to their calculations, reducing taxes during recessions do not budge the total output; increasing military spending does.

Christiano, Eichenbaum, and Rebelo find multipliers to be around one when the federal funds interest rate is positive but they are about three when liquidity trap is existent.

In October 2012, IMF declared that fiscal multipliers were two to three times higher than thought just a couple of years ago. That meant the negative impact of austerity on the economy was larger than previously thought.

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What About the National Debt?A common objection to the deficits and piling of the debt is the extra burden the future generations will carry to pay down the debt. This cost to the future generation has to be weighed against the sacrifices of the present generation.

If the unemployment rate is 50% higher than normal, is it worth the future generations to pay extra taxes to have their parents and grandparents employed with all the psychological, economic, and social benefits?

And if the real interest rate is zero or negative, why doesn’t the government borrow to spend on high return projects? The children will benefit mightily.

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Bibliography

Alesina, A. and S. Ardagna, The Design of Fiscal Adjustments, NBER Working Paper #18423, September 2012.

Auerbach, A. and Y. Gorodnichenko, Measuring the Output Responses to Fiscal Policy, NBER Working Paper #16311, August 2010.

Christiano, L., Eichenbaum, M., and S. Rebelo, When is the Government Spending Multiplier Large? NBER Working Paper #15394, October 2009.

http://www.economy.com/mark-zandi/documents/Economic_Stimulus_House_Plan_012109.pdf

Rose, F., “The Art of Immersion: Why Do We Tell Stories?” Wired, 03.08.11

Shermer, M., “Patternicity: Finding Meaningful Patterns in Meaningless Noise,” Scientific American, November 25, 2008

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Bibliography

Voltaire, Candide, 1759

Keynes, J.M., The General Theory of Employment, Interest, and Money, 1936

http://www.dallasfed.org/research/swe/2005/swe0502.pdf

http://oregonstate.edu/cla/polisci/faculty-research/sahr/sumprice.pdf(Robert Sahr)

Del Negro, M. and F. Schorfheide, “DSGE Model-Based Forecasting,” Federal Reserve Bank of New York Staff Reports, No. 554, March 2012

http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm

Reinhart, C. M. and K. S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009.

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BibliographyBarro, R., “Voodoo Multipliers,” Economists’ Voice, www.bepress.com/ev, February, 2009