We are glad to be in such august company as Willem Buiter’s, professor at the London School of Economics who has also held a number of positions with various monetary authorities.
Early this week, former Treasure Secretary Larry Summers, in the Financial Times, argued that the US needed a fiscal stimulus to ward off a recession. We took issue with the view that recessions are always and ever to be avoided. While they clearly do damage to businesses and households, the treatment can often be more damaging than the disease. In this case, we view the culprit as America’s unsustainably low savings rate. Any increase in savings (which can take the form of debt reduction) means lower consumption, which will lead to a slowdown.
Buiter makes a detailed case along broadly similar lines, and also examines Summer’s and Robert Rubin’s stimulus proposals in detail.
From the Financial Times:
Larry Summer wants a tax cut for the US of between $50 billion and $ 75 billion. 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 percent age 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 $50 to $75 billion proposed by Larry would be 0.36 percent to 0.54 percent of GDP. Rubin’s proposal amounts to all of 0.67 percent 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?