Thursday, August 16, 2012

The stimulus debate is getting really painful

Just when it appeared that the sheer weight of evidence indicating that the ARRA stimulus spending measures worked in promoting economic growth and reducing unemployment was enough to settle the debate, a group of distinguished economists have once again reminded us that we may be living in the dark age of macroeconomics.

The whole debate is now becoming ever more painful and a real torture. Clearly, ideological predilections have taken over the instincts and reasoning powers of even the most distinguished of economics professors. Even when faced with overwhelming evidence, they dig in and refuse to acknowledge the facts. Their theories become articles of faith.

Consider this. The economy is facing a liquidity trap, with interest rates locked in at near zero and expected to remain so for an extended time. Inflation remains very low and expectations too appear firmly anchored. Household balance sheets are some way off from regaining normalcy and therefore consumption is muted. This in turn keeps private investments away. In any case, banks, hobbled with several problems, still remain wary of normal lending, especially to the second-tier of corporates and small and medium enterprises. Fears of government borrowing "crowding-out" private investments is therefore largely illusionary. The disasters in Europe and weakening economic environment in many emerging economies, including China, makes the prospect of export-led growth remote. Hobbled with falling revenues, state and local governments continue to lay off workers and cut down on their ongoing programs.

In the circumstances, federal government is the only agent with the ability to power the economic growth engine. In other words, fiscal and monetary policy should take over. But monetary policy, even with quantitative easing and other accommodatory policies, has limited traction. However, the ultra-low interest rates makes borrowing cheap and fiscal policy potentially useful. And the poor state of America's infrastructure provides ample opportunities, indeed necessities, for public spending.

This logical case for another round of stimulus is supported by standard macroeconomic theory. The IS-LM model, which demonstrates the interaction between the goods and services and the money markets, leaves us with no doubts about the way forward. At close to the zero-bound, since cash and bonds become interchangeable, at the margins, money is just being held as a store of value, and changes in the money supply (say, by way of increased government borrowings) have no effect. Government spending results in economic expansion.

In the absence of fiscal policy action, the economy risks being trapped in a deflationary, low growth, high unemployment equilibrium for an extended period. If there is any doubt, one only need to look at post-nineties Japan.  

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