Sunday, June 21, 2009

Why fiscal and monetary expansion should not be prematurely closed?

In an Economist article, Christina Romer, the chairwoman of Barack Obama's Council of Economic Advisers, has cautions against cutting back on fiscal stimulus and tightening monetary policy on the grounds that "green shoots" have appeared on the economic landscape. She draws attention to the similar "recession-within-recession" situation that developed during the recovery from the Great Depression as the Treasury (by withdrawing the stimulus and raising social security taxes) and the Fed (by raising reserve requirements) switched over to contractionary policies in 1936 to address the growing deficits and ward off inflationary pressures.

She argues in favor of resisting the urge to cut back on stimulus spending till "the economy is again approaching full employment" and private demand increases by enough to fill the output gap. She also advocates granting the Fed additional tools like authorization to issue debt, so as to enhance its ability to withdraw excess cash from the financial system, and thereby help its balance-sheet contract once the economy has recovered. Much the same has been endorsed by Paul Samuelson here and here.

However, Allan Meltzer strikes a note of caution, by writing, "yes, stimulate now to reduce unemployment, but avoid creating a big inflation in a year or two", and finds issue with the focus of the stimulus program on tax cuts to boost consumption and prefers investments to increase productivity. While accepting the need to stimulate now to reduce unemployment, he feels that it is equally important to avoid creating a big inflation in a year or two. And accordingly, he advocates that the Fed and Treasury announce in advance how they propose to reduce the high money growth rate and the excessive deficits.

Brad De Long argues that the Obama stimulus is on the lower side by a substantial margin; the federal-level fiscal expansion is offset and neutralised by state-level fiscal contraction by lowering spending and cutting taxes; the massive expansion in the Fed balance sheet and the possibility of dollar sliding from its perch of pre-eminence, leaves the Fed vulnerable to the "mother of all bank runs", combating which would require giving the Fed the option to borrow in time-deposits (as opposed to demand-deposits) and the power to issue its own bonds; and that if it is the long-run budget you are worried about, ending the stimulus package, say, six months or a year earlier makes little difference to the (already very bleak)long-term budget outlook.

Barry Eichengreen cautions against reading too much into the hardening bond yields and rising commodity prices, and exiting from the stimulative policies, since, coincidentally enough, both these were the primary triggers for the relapse of 1936-37. The propensity of investors, battered by the shocks to the financial system, to keep their investments in short-term, liquid form is (and was) the primary cause of the hardening of yields. Further, as as evidence of green shoots began to accumulate, traders had bid up the prices of tin, rubber, wool and wheat, only for these speculative positions to quickly collapse and pull back commodity prices.

Mark Thoma provides a behavioural explanation for the reluctance to intervene until the economy is well into a deep recession and the inclination to draw back at the first signs of green shoots. He feels that the dangers of withdrawing the stimulus too soon (a severe depression) are far more devastating than that of continuing with the expansionary policies for a little longer (inflation and a slightly slower gorwoth for some time).

Carmen M Reinhart draws a "distinction between the appropriate time to begin withdrawing stimulus and the appropriate time to begin reassuring the public that a plan for such an exit has been developed". She calls for making public both "how the Federal Reserve will slim its balance sheet and how the administration will put the federal budget balance on a sustainable path". She draws attention to her studies with Ken Rogoff where they find that financial crises tend to last several years and significant additional real resources will have to be provided to fill the capital hole of firms at the centre of the global financial system.

Tyler Cowen points to the important fact that the current downturn isn't just a "business cycle", but it may herald a fundamental reset for many sectors of the economy, and an economic recovery won’t restore a lot of these sectors to what were once normal conditions. The full debate is available here.

Update 1
Economix has an analysis of the latest data on the CBO's projections of the budget deficit. See also David Leonhardt here.

Update 2
James Suroweicki argues against premature celeberation that the housing market crisis is over.

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