On the Obama Stimulus Plan

I suspect that we have entered a depression. There is no widely agreed definition of the word, but I would define it as a steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and a sense of crisis.

Suppose some shock to the economy, such as the bursting of the housing and credit bubbles, causes people to reduce their demand for goods and services. Before the shock, demand and supply were both X; now demand is X - Y. How do producers respond? If all prices, including the price of labor (i.e., wages), are completely flexible, producers (and suppliers of inputs to them, including suppliers of labor--i.e., workers) will reduce their prices, and this will induce consumers to increase their buying. Consumers will have less income because those who are employed will have lower wages, but since prices are lower they will buy enough to prevent a substantial reduction in output.

Unfortunately, not all prices are flexible; wages especially are not. This is not primarily because of union or other employment contracts. Few private-sector employers in the United States are unionized and as a result few workers (other than federal judges!) have a guaranteed wage. The reasons that employers generally prefer to lay off workers than to reduce wages when demand drops are first that by picking the least productive workers to lay off an employer can increase the productivity of its work force; second that workers may respond to a reduction in their wages by working less hard, and, conversely, may work harder if they think that by doing so they are reducing the likelihood of their being laid off; and third that when all workers in a plant or office have their wages cut, all are unhappy, whereas with lay offs the unhappy workers are off the premises and so do not incite unhappiness among the ones who remain.

When, to bring output down from X to X - Y in my example, producers and other sellers begin laying off workers, demand is likely to sink even further because the workers who have been laid off suffer a loss of income and the ones who are not laid off fear that they may be next and so try to save more of their income rather than spending it. As demand falls, sellers will lay off more workers, putting still more pressure on demand, but in addition they will reduce prices still further in an effort to avoid losing all their customers. As prices spiral downward, consumers may start hoarding their money in the expectation that prices will keep falling. In addition, they will be reluctant to borrow (and borrowing increases economic activity by giving people more money to spend) because with prices falling they will be paying back their loans in more expensive dollars, that is, dollars that have greater purchasing power. When the same number of dollars buys more goods, we have deflation--money is worth more--as distinct from inflation, where money is worth less because more money is chasing the same number of goods and services.

One way to try to prevent a deflationary spiral is for the Federal Reserve Board to increase the supply of money, so that dollars don't buy more goods than they used to. The Fed does this by buying federal securities from banks; the cash the banks receive from the sale is available to them to lend, and what they lend ends up in people's bank accounts and so increases the number of dollars available to be spent. Fearing deflation, the Fed has done this--without success. The banks, because they are close to being insolvent, are fearful of making risky loans, and loans in a recession or depression are risky. So they have put more and more of their money into federal securities, thus bidding down the interest rate virtually to zero. Zero-interest short-term federal securities are the equivalent of cash. If banks want to hold cash or its equivalent rather than lend it, the Fed's buying cash-equivalent securities for cash does nothing to increase the money supply. So the Board is now buying other debt, and from other financial firms as well as banks--debt that has a positive interest rate, so that if the Board buys the debt for cash, the seller is likely to lend out the cash so that it does not lose the interest income that it was receiving on the debt it sold to the Fed. But as yet this program has not had much success either.

This is the background to the stimulus program proposed by soon-to-be President Obama. To return to my example, if monetary policy is not going to equate demand to supply--is not going to close the gap between a demand of X - Y and a supply of X--then maybe government spending can do the trick. The government can buy Y worth of goods and services, thus replacing private with public demand, or it can reduce taxes by Y, so that people have more money to spend, or it can do some of both, as in fact Obama proposes to do. At this writing, roughly 40 percent of his proposed multi-hundred-billion deficit-spending package (that is, spending financed by borrowing rather than by taxing) is earmarked for tax reductions. The rest is split between public-works programs, such as road construction, and transfer payments in such forms as additional unemployment benefits, mort-gage relief, and health insurance for people who don't have any.

There are three basic questions to ask about the program. The first is whether it is necessary, the second whether it has the right structure, and the third whether it is the right size. I will discuss just the first two questions.

Ben Bernanke, the chairman of the Federal Reserve Board and the leading economic student of the Great Depression of the 1930s, is a conservative economist. Conservatives don't like huge deficit-spending programs, or at least the public-works and transfer-payment components of them, which increase government involvement in and control over the economy. Bernanke supports the program, after having failed to avert a depression by means of monetary policy alone. Almost the entire economics profession converted--virtually overnight--from being Milton Friedman monetarists (Friedman believed that only bad monetary policy could turn a recession into a depression) to being John Maynard Keynes deficit spenders. I'll assume they're right, and move on to the question of structure.

I do not think the tax cuts are a good idea. Most of the increase in after-tax income is likely to be saved, rather than spent on buying goods and services. One of the reasons why the recession has turned into a depression is that Americans have meager savings, most of them in overpriced houses and overpriced stocks, and so they are sensibly reallocating income from consumption to saving. And there is much evidence that even in normal times, people spend less out of temporary income spurts than they do when they receive what they think will be a permanent increase in in-come. There is no such thing as a permanent tax cut, because the Congress that enacts a tax cut cannot bind subsequent Congresses (there is a new one every two years) not to rescind it.

I also think the transfer payments are a bad idea. The goal of a Keynesian deficit-spending program is to restore demand to X, not to increase it. If instead of demand rising as a consequence of the program from X - Y to X, it rises from X - Y to X + Z, there will be inflation because demand will exceed supply. Programs to transfer wealth are very difficult to abolish, because interest groups form about them. The problem is somewhat less serious with public-works programs, especially road-building and other infrastructure projects, and especially those infrastructure projects that were planned or begun by states or municipalities and interrupted or deferred because of the fall in tax revenues resulting from the depression. The federal government can finance these projects until the depression is over, and then the states can continue them with its own tax money.

There is a legitimate concern that many of the projects undertaken by the federal government will yield costs in excess of benefits. But the concern is exaggerated, because it ignores the benefits that such projects confer on fighting the depression as distinct from simply improving the nation's transportation system or reducing carbon emissions or buying military equipment to replace what has been lost in the Iraqi and Afghan wars. To the extent that the projects by increasing demand reduce unemployment, and reduce fear of unemployment by those who are not laid off (yet), they not only increase people's spendable income (unemployment benefits are lower than the wages they replace) but by reducing job insecurity reduce the fraction of wages that people save rather than spend. The saving rate has soared in recent months and is one of the major factors in reducing consumption and pushing us to the edge of a deflation.

In addition, public-works spending has a multiplier effect. The government's expenditure on buying goods and services (a road, a bridge, or whatever) increases output directly, but it also does so indirectly because the company that builds the project with government funds pays its employees and suppliers, and they in turn spend part of the money they receive, further stimulating output.

Properly structured, a Keynesian program can help to check a downward economic spiral. With monetary policy apparently inadequate to avert a downward spiral big enough to trigger deflation, there may be no good alternative to such a program.