January 10, 2008
Why the US may well need a recession
This post is a slightly expanded version of a comment of mine on Larry Summers’ op-ed article in the FT on January 6, 2008 "Why America Must Have a Fiscal Stimulus".
Larry Summers wants a tax cut for the US of between $50 billion and $ 75billion. Robert Rubin, the former US Treasury Secretary, wants a fiscal stimulus worth $100 billion. Who bids more? And on top of this, the chairman of the Federal Reserve Board has declared (using either the royal ‘we’ or speaking for the FOMC): “We stand ready to take substantive additional action as needed to support growth and to provide additional insurance against downside risks.”
I consider further policies to stimulate demand in the US economy undesirable. The US needs a fall in domestic absorption (the sum of private consumption, private investment and government spending on goods and services, or ‘exhaustive’ public spending) to support a lasting depreciation of the US real exchange rate. Such an increase in the relative price of traded to non-traded goods is in turn required to reduce the US trade deficit to sustainable levels, say by a permanent three percentage points of GDP.
This reduction in domestic consumption ought to come through a reduction in private consumption. Public spending on goods and services in the US is already low by international standards. Underfunded public services and substandard infrastructure also support the view that exhaustive public spending should not be cut. US private investment rates are not particularly high, either by historical or by international standards. There is also the need to invest on a large scale in energy security, energy efficiency and other green ventures. That leaves private consumption. US private saving rates are far too low, so lower private consumption is the obvious way to support a reduction in the trade surplus.
Larry responds to any sign that private consumption may be doing at last what it ought to have done a long time ago, that is, decline, by suggesting monetary and or fiscal measures to reverse this decline. This is perverse. The fall in private consumption should be welcomed, not fought.
Would the proposed tax cut actually boost private consumption materially? First, the amounts proposed are tiny. US GDP is around $14 trillion. The $50bn-$75 billion proposed by Larry would be 0.36 per cent to 0.54 percent of GDP. Rubin’s proposal amounts to all of 0.67 per cent of GDP. By no means all of these tax cuts would end up with liquidity-constrained households. Of the part that does, the combined marginal tax and benefit-withdrawal leakage and the marginal import leakage (plus any marginal saving leakage the liquidity-constrained consumers may possess) make for a smallish Keynesian multiplier.
And that assumes away both the ‘inside lags’ or policy formulation, adoption and implementation lags, and the ‘outside lags’ between the implementation of the tax cut and its effects on spending, production and employment. These lags are long, variable and uncertain. They are the reason discretionary fiscal policy to fine-tune the business cycle has been abandoned in most of the thinking world. If Larry’s or Rubin’s proposal were to blunder ahead, it would in all likelihood end up delivering a modest boost to demand and output sometime well into the next upswing of economic activity in the US, around the middle of 2009.
Monetary policy also works with long, variable and uncertain lags, although actions to smooth disorderly financial markets and to ease the credit crunch through expanded open market operations, easier collateral requirements and more relaxed access terms to the discount window, may have their impact a lot faster than the interest rate cuts that Bernanke more than hinted at.
The same arguments against measures to boost domestic demand I made against fiscal policy also apply to monetary policy, although monetary policy is more likely to be effective. It is, however, not the mandate of the Fed to boost demand to levels that imply an unsustainable external imbalance. The Fed’s poor recent record on inflation and the combined further threats to price stability posed by high oil prices and elevated inflation expectations would seem to mandate an end to rate cuts for the time being.
A significant slowdown in the US, perhaps even a recession, is necessary to restore a sustainable desirable level of the national saving rate. There can be further beneficial longer-run effects from a recession, because recessions are quite efficient mechanisms for purging, through defaults, insolvences and financial and real restructuring, the distortions, inefficiencies and misallocation of resources that were created by the financial excesses in the US economy during these past five years. When it has to happen, why wait?
“When it has to happen, why wait?”
Err… because this is an election year?
PS: your comment doesn’t appear on the Economists Forum.
Posted by: Carlomagno | January 10th, 2008 at 10:47 pm | Report this commentFunnily enough, there are rather few fiscal give-aways during election years.
As regards the posting not (yet) appearing on the Economists’ Forum even though I posted it there before I posted the slightly expanded version on my own blog, the reason is that I control the posting on my own blog. What I put on the Economists’ Forum first gets vetted. As I posted well past normal working hours, there is a delay in the appearance of my post on the EF.
Posted by: Willem H. Buiter | January 11th, 2008 at 12:29 am | Report this commentWhy not give up on posting in both places? The Forum’s closed-club approach is grating.
Posted by: RCS | January 11th, 2008 at 5:50 pm | Report this commentInteresting, although doesn’t that depend how you define “fiscal give-away”? I wouldn’t be surprised if a lot more pork goes into US laws in election years. Granted that’s not the same as tax cuts.
On another point, your call for a recession to clean out the stables is OK if all we get is a “normal” recession. Don’t you see a risk that the credit crunch could spin out of control and that we end up with something a lot worse (by which I mean anything from Japan in the 1990s to the US in the 1930s)?
Posted by: Carlomagno | January 11th, 2008 at 5:53 pm | Report this commentAnother sustainabilty benefit from a decline in US consumption is the reduced impact on the strained natural environment. Any reduction in the US’ excessive consumption is to be welcomed, but not just as a means to adjust economic imbalances. Remember that, by providing us with our food, raw materials, energy etc., the natural environment is the foundation of the economy, not the other way around.
Posted by: Paul Settles | January 12th, 2008 at 4:15 pm | Report this commentThe fact that the Fed can increase or decrease money supply makes the economic system naturally corrupt and uncompetitive. Furthermore, their efforts to “regulate” interest rates will result in an economic disaster (see current mortgage crisis). Isn’t that what Marx, Jevons, Smith and Menger were so hung up on - Capitalism’s inevitable outcome of a lower rate of interest on a greater expense (i.e. see Interest rates x GDP). The monopolistic economy is growing in size, but not value, as it depletes its finite natural resources.
Perpetual land rent increases (including energy rents) are the natural root of inflation (based on land’s scarcity) and it is there we must strategize to ward off inflation, or in this case, catch up to it. As prices for land production and distribution have skyrocketted around the world, our labor time has porportionately increased as well. However, the problem is that we are running out of valuable land (Ricardo Rent Theory) to feed the labor. As a result, the economy will be forced to rebalance or cycle back to equilibrium between land and labor.
The scary thing this time around is the bigger they are, the harder they fall (i.e. Global Economy). We must competitively stabilize our land prices for production and distribution and progressively grow our net equity through a most competitive Renewable Energy Revolution. Otherwise, economic science will once again dictate an inevitable economic cycle.
Posted by: Doug Wolkon - Author of The New Game | January 14th, 2008 at 11:25 pm | Report this commentThe US has had an unsustainable CA deficit and Consumption/Savings pattern (partly driven by unrealistic residential real estate prices), and these certainly need to adjust.
The Fed and Govt have blunt tools of monetary and fiscal policy at their disposal. We should recall that these tools, in theory, do nothing in real terms, in the long run. Rate cuts might temporarily boost growth (or reduce a recession’s bite), but expanding the money supply will just shift real losses into inflation. Similarly a fiscal spending spree will add to the debt burden and slow long-term growth. So WB’s question is exactly the right one: do we need inter-temporal smoothing of this kind?
The reason it matters is because debt is largely fixed in nominal terms, and also because the frictional costs of adjustment can be high, especially if they occur all at once. Like an obese man, the US needs to slim, but a starvation diet can cause damage and prevent a healthy outcome. Some more rate cuts and much-needed infrastructure and educational investment will smooth the downturn (but not prevent it), and that’s a good thing.
That does not mean that massive rate cuts or crazy bail-outs are called for. Inflation, moral hazard, corruption are real costs, and the cure can be worse than the disease!
Posted by: David Nowakowski | January 15th, 2008 at 6:27 pm | Report this commentI find this talk of a fiscal stimulus both utterly ridiculous and politically predictable. There is no doubt that much of the talk from Washington is due to the fact that this is an election year. Who wants to be against the working folks, right?
What I find ridiculous is what Marc Faber has repeatedly called the Fed’s “asymmetrical monetary policy”, a policy which attempts to circumvent the natural business cycle by preventing any sort of recession. Ever. This is utter folly and is only exacerbating the problems, much as it has done for many year now.
At some point, the market will clean out the excesses. The only question is whether that will occur now or some time in the future. And the longer we attempt to delay it, the worse it will be.
What is truly amazing is that someone who claims to be the economic historian that Bernanke does would seemingly have such little idea of this. The most ludicrous example came in Bernanke’s Congressional testimony of a few days ago. In it, he claimed that the U.S. was not in a recession, that growth would merely be “slower” and that the 2nd half of 2008 would be stronger. Given these “facts”, why did he then urge an immediate stimulus package? If we’re not in recession and the 2nd half forecast looks strong, what are we saving, Ben?
I’m so tired of the federal government, I’m going to vomit.
Posted by: Peter Davis | January 20th, 2008 at 4:58 pm | Report this commenti would suspect that if this rate cut helped the writer of this article sustain employment he’d be all about it. Understand, this is a crisis of confidence. We can’t separate ourselves from other’s bad financial deeds we can only work to lessen the blow. This rate cut will help to bottom out the market and help deter reductions in capital expenditures. Many of us rely on the expenditures to sell goods and services to corp america, you shake their confidence and this puzzle just unravels faster. give us another 1/2 point and we’ll be out of this by end of year.
Posted by: donald | January 22nd, 2008 at 8:05 pm | Report this commentinflation is a joke, it’s not the real enemy. uncertainty is.