How to Think About Stimulus

Scott Sumner and Tyler Cowan, among many others argue that creative monetary policy is a better instrument than fiscal stimulus. They argue that policies such as paying interest on excess reserves or setting a nominal GDP target would be better remedies than fiscal stimulus. Paul Krugman and Brad DeLong argue for fiscal stimulus. Is there a way to think about the differences without resort to ideology?

It seems to me that there are two ways people think about the current crisis. One is that we suffer from a huge precautionary demand for savings. Everybody is risk averse, they all want liquidity, and nobody will spend. John Cochrane has articulated this view quite clearly here. If this is the diagnosis then paying interest on excess reserves or other creative forms of monetary policy (quantitative easing) may be sensible. This could unlock the monetary system and revive spending.

The advantage of the monetary policy approach is that it is easy to turn off. So if you believe that the recession is due to this huge risk aversion this is a big advantage. If attitudes return to normal there will be a lot of liquidity out there, but we won't have spending programs in the pipeline that are hard to turn off.

The alternative view, I think, is that the end of the bubble has led to a large destruction of wealth (or realization that it was not there). Between the collapse in housing prices and the stock market a huge share of wealth has been destroyed (more than 45% if we go by the stock market alone). So households must increase savings -- from the former level of zero -- to something like 8% of GDP (we are not there yet, but we will be). So if saving rises something else is needed to make up the gap. It is not net exports -- the currency is not depreciating, so we are not more competitive, and the rest of the world is in a bigger slump than we are. So it is either a huge increase in investment or government spending. It is hard to believe that investment is going to rise significantly when our export markets are deteriorating and when incomes are declining. So it must be the government that has to fill the gap.

Now the anti-stimulus view would be that if we unlock the monetary system banks will lend and firms will invest. The gap can be made up by investment spending rather than government spending. Perhaps that is the case. It is a logical argument. Personally, however, I do not see it. It is not the cost of capital that is hurting investment now but sour prospects.

In any event, it seems that there is a rational argument for both approaches. What is crucial is to figure out which explanation of the causes of the slump is correct.

Fiscal Stimulus, Again

Jim Hamilton's recent post on the stimulus hits the nail right on the head. The point is not that fiscal stimulus cannot work, as some argue. If you could change some textbook G in a continuous fashion like a TV dial it could work in a time of massive unemployment. But that is not the world we live in, so real programs must fill in the spending. But Hamilton's key point is that we need to think of the type of crisis we are in. If the cause of the recession is the piercing of a housing bubble and a credit crisis it is not clear that public works is the answer. We need to get the financial system working properly again.

I also agree with Jim that helping States with budget shortfalls to prevent further layoffs is a good idea.

Recession May be Bad

Officials at the Treasury and the Federal Reserve are expecting a serious recession, according to this article in the Financial Times. One quote captures the feeling, that from former Fed Vice Chair, Alan Blinder:

“It looks to me like the economy has fallen off a cliff...The game is now about making sure this recession is less deep and less long than the 1982 recession.”

One difficulty in forecasting how deep this will be is the fact that the crisis is international. Another, is to understand how US households will respond to the cut in their wealth. Will savings rise in reaction? We have depended for a decade on households consumption based on the growth in asset prices. Now that households cannot rely on this, what will happen to consumption?

Keynesian Recession Coming

It looks like we are in for a real Keynesian recession. The liquidity crisis seems to have led to a stop to bank lending, so we are approaching a liquidity trap. Demand is now falling, witness the drop in retail sales announced today which shook the markets, and this is a sign that the recession is already underway. If monetary policy is ineffective due to bank's unwillingness to lend, we are in the almost classic "Keynesian type" recession of old textbooks.

The relevance of Keynes to our current experience was highlighted by Robert Skidelsky in this column. He is perhaps correct when he writes that

To understand how markets can generate their own hurricanes we need to return to John Maynard Keynes.

But I think he overstates his case considerably when he argues that " mainstream theory has no explanation of why things have gone so horribly wrong." In particular, he expresses the view that is prevalent now that economists focus on efficient markets blinded them to

Greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics -- the forces that drive boom-bust cycles -- only exist off the balance sheet of their models.

This is factually incorrect. We have models of bubbles and herd behavior. But more important it ignores the point that much of the problems we have now are the result of ignoring market efficiency. When investors believed they could earn extra return for no extra risk they were not basing their behavior on efficiency. The carry trade is an example of profiting from the absence of efficiency. The problems we now face are that markets caught up. The excess returns they were earning were just a compensation for the losses that are now incurred. If savers and investors had assumed that they could not earn extra return for no extra risk they would have been in index funds not CDO's. They would not have been fooled by ratings from ratings agencies.