A well chosen name wins an argument by assuming its conclusion. Label cash subsidies to foreign government as "foreign aid" and who can be so hard hearted as to oppose them. Call subsidies to the public schools "aid to education" and you neatly skip over the question of whether additional spending in the public school system results in more education. Label something "pollution" and is no longer necessary to offer evidence that it is bad, since everyone knows pollution is bad—even thermal pollution, otherwise described as warm water. Occasionally we even get dueling names. Both "right to life" and "pro-choice" are obviously good things; how could anyone be against either?
For a more recent example, consider Obama's economic policy. Everyone—including Obama, back when he was running for President—is against deficit spending. Relabel it "stimulus" and everyone is for it. The label neatly evades the question of whether having the government borrow money and spend it is actually a way of getting out of a recession—a claim for which evidence is distinctly thin. It is stimulus, so obviously it must stimulate.
The success of the relabelling with the general public is not surprising. What is somewhat surprising is the way in which much, although not all, of the economics profession has suddenly adopted as gospel the 1960's Keynesianism that most of the profession rejected several decades back. Everyone talks as though deficit spending was a way, indeed the way, of reducing unemployment, a central recommendation of that theory.
One explanation, of course, is that government spending is popular, taxes are unpopular, so a argument that converts deficits from a problem to a solution has a lot of natural supporters. But that is not the whole story.
Another part of it is that the credit crunch seems to bear at least a family resemblance to what Keynesians expected to see, indeed believed they had seen, as the cause of depressions. Interest rates are so low that holding money makes more sense than investing it, so demand drops, so everything spirals down—underemployment equilibrium due to the economy falling into the liquidity trap. The solution they proposed was fiscal policy. The government borrows the money that was accumulating under mattresses, spends it, gets things going again.
There is, however, one small problem with this account of the present situation. The Keynesian liquidity trap was supposed to be a result of running out of investment opportunities. All the productive things that could be done with capital had been done, so firms were only willing to offer a trivial reward to investors, so nobody bothered to invest.
That story has nothing to do with what actually happened. Firms are eager to borrow money and invest. The problem is not that we have exhausted investment opportunities but that lenders don't know what borrowers, or what intermediaries, to trust, due to a malfunction of the capital markets set off by the bursting of the housing bubble. One can argue about who to blame for that malfunction and what to do about it. But whoever is to blame, it is not a liquidity trap, hence it isn't any reason to resurrect the economic doctrines of fifty years ago.
The first round of "stimulus" proposals, whatever their faults, could at least be defended as a response to the actual problem. Lenders did not know who to trust but did trust the Federal Government. So let the government borrow the money from them, lend it to the firms that needed capital, and so keep those firms from being destroyed by a temporary freezing up of the capital markets. Skeptics might express doubt as to the competence of the government to allocate capital, but at least the policy could be seen as an attempt to get capital allocated.
The current proposal has no such defense. It simply consists of borrowing very large amounts of money and spending it. Insofar as it has any effect on the ability of firms to borrow, it makes it harder, since public borrowing is competing with private borrowing. A dollar I spend in government securities floated to fund the deficit is a dollar I don't invest in a private firm.
For a more recent example, consider Obama's economic policy. Everyone—including Obama, back when he was running for President—is against deficit spending. Relabel it "stimulus" and everyone is for it. The label neatly evades the question of whether having the government borrow money and spend it is actually a way of getting out of a recession—a claim for which evidence is distinctly thin. It is stimulus, so obviously it must stimulate.
The success of the relabelling with the general public is not surprising. What is somewhat surprising is the way in which much, although not all, of the economics profession has suddenly adopted as gospel the 1960's Keynesianism that most of the profession rejected several decades back. Everyone talks as though deficit spending was a way, indeed the way, of reducing unemployment, a central recommendation of that theory.
One explanation, of course, is that government spending is popular, taxes are unpopular, so a argument that converts deficits from a problem to a solution has a lot of natural supporters. But that is not the whole story.
Another part of it is that the credit crunch seems to bear at least a family resemblance to what Keynesians expected to see, indeed believed they had seen, as the cause of depressions. Interest rates are so low that holding money makes more sense than investing it, so demand drops, so everything spirals down—underemployment equilibrium due to the economy falling into the liquidity trap. The solution they proposed was fiscal policy. The government borrows the money that was accumulating under mattresses, spends it, gets things going again.
There is, however, one small problem with this account of the present situation. The Keynesian liquidity trap was supposed to be a result of running out of investment opportunities. All the productive things that could be done with capital had been done, so firms were only willing to offer a trivial reward to investors, so nobody bothered to invest.
That story has nothing to do with what actually happened. Firms are eager to borrow money and invest. The problem is not that we have exhausted investment opportunities but that lenders don't know what borrowers, or what intermediaries, to trust, due to a malfunction of the capital markets set off by the bursting of the housing bubble. One can argue about who to blame for that malfunction and what to do about it. But whoever is to blame, it is not a liquidity trap, hence it isn't any reason to resurrect the economic doctrines of fifty years ago.
The first round of "stimulus" proposals, whatever their faults, could at least be defended as a response to the actual problem. Lenders did not know who to trust but did trust the Federal Government. So let the government borrow the money from them, lend it to the firms that needed capital, and so keep those firms from being destroyed by a temporary freezing up of the capital markets. Skeptics might express doubt as to the competence of the government to allocate capital, but at least the policy could be seen as an attempt to get capital allocated.
The current proposal has no such defense. It simply consists of borrowing very large amounts of money and spending it. Insofar as it has any effect on the ability of firms to borrow, it makes it harder, since public borrowing is competing with private borrowing. A dollar I spend in government securities floated to fund the deficit is a dollar I don't invest in a private firm.
24 comments:
Great post David. Again, the issue is firm profitability as a means of pulling us out of a recession, not creating jobs with dubious social value.
As always, Professor Friedman, you're able to write about these topics clearly and succinctly.
Where I question your logic a bit is in your last paragraph. While I'd agree that public borrowing crowds out private borrowing in a normal economic environment, why should we expect that to be the case currently?
I ask this question especially in light of your statement that, "The problem is not that we have exhausted investment opportunities but that lenders don't know what borrowers, or what intermediaries, to trust, due to a malfunction of the capital markets set off by the bursting of the housing bubble."
If investment isn't currently occurring -- for whatever reason -- then it seems like the "crowding out" is a moot point.
An interesting point, but flawed in many ways. You start off by denouncing the hidden meaning of labels (deficit spending). But the later on say we are not in a liquidity trap, then proceed to use a 60 year old definition to back your point. In truth, those circumstances describe one of a number of ways in which a liquidity trap can occur.
Simply put, a liquidity trap is any situation in which conventional monetary policy loses it's potency. Since the interest rate has been effectively lowered to 0% and the credit market has still not loosened in the slightest, we are in a liquidity trap.
Since most 'modern' schools of economic thought have little answer to this problem, Keynesianism is back in vogue. Though I would contend that it never really went away.
"A dollar I spend in government securities floated to fund the deficit is a dollar I don't invest in a private firm."
A Dollar spent is better than a dollar saved if you're trying to avoid Debt-Deflation. There's no a priori way to determine who spends anything better. To say that, in general, A spends better or more effectively than B, says just that. In general. For me, it's really a question of ownership. I'd like most resources to be in private hands, that way, if they are spent foolishly, at least it's their foolishness. Also, in the real world, governments rely on people's acceptance or acquiescence of it. One has to try and determine what can keep the system stable during a crisis. However perfect your ideas might appear to you, no one is bound to follow them. Hence, we often compromise our theories for irenic and justificatory reasons.
That's what the stimulus is. It's a product of Political Economy, which involves other factors than economic efficiency, even in you're right about that.
"Insofar as it has any effect on the ability of firms to borrow, it makes it harder, since public borrowing is competing with private borrowing."
So competition makes it harder. So what? Doesn't all competition do that? Isn't that the point?
"It simply consists of borrowing very large amounts of money and spending it."
You speak of names. How about we change "spending" to "investing"?
Does that change anything?
"Another part of it is that the credit crunch seems to bear at least a family resemblance to what Keynesians expected to see, indeed believed they had seen, as the cause of depressions"
That's it. It's a narrative. A story that we can tell ourselves to feel better about getting out of this. In truth, it's a lot of trial and error, which is how things usually work out.
By the way, there's also been a lot of talk about Helicopter Money. People are reaching for any idea that seems to help.
"Firms are eager to borrow money and invest."
In fact, employers have been proactively shedding jobs since the end of November and reducing investment. There has been a massive change in investment.
"The problem is not that we have exhausted investment opportunities but that lenders don't know what borrowers, or what intermediaries, to trust,"
Here I completely agree. But government has a role in rebuilding that trust.Why? I don't know, but people expect the government to help build it, and that's a good reason to do so. Sadly, it will probably overshoot. Take a look at the new Trust Index. Bankers are pretty low on that.
If you want to help capitalism and the free market, a good way to begin is to make sure that people understand that we have a welfare state. That way, capitalism and the free market might not be blamed for this mess. Now there's a good example of the problem of names.
Don the libertarian Democrat
A very good post. I hope many people come to read it. It's silly that we're even considering a "stimulus" like this. There are only a handful of things that economics can say with a good deal of certainty, but one of them is that the public sector is less efficient at allocating resources than the private sector.
I disagree with "firms are eager to borrow money and invest". Right now everyone is cutting back because they see lower demand for their goods. Factories are closing, employees are being fired, and inventories are high.
The economy as a whole was in a bubble fueled by debt. The recent past growth was an illusion.
So we are in a profound deflationary recession, with far too much debt. There are two possible resolutions. Either the debt gets reduced to a manageable level through bankruptcy, or through inflation. Although distasteful, inflation is probably the better option. But who knows what the bankers (Fed) will decide.
> A dollar I spend in government securities floated to fund the deficit is a dollar I don't invest in a private firm.
The essence of liquidity trap is that you are not investing with that private firm anyways. That should be first-grade Econ.
"The problem is not that we have exhausted investment opportunities but that lenders don't know what borrowers, or what intermediaries, to trust..."
Yes, this has puzzled me since October. The problem was never a shortage of money, or a shortage of lenders, or a shortage of borrowers, but a shortage of trust. So the government gave/lent a few hundred billion to major banks, and the banks still aren't lending it out because they still don't trust any of their borrowers.
Wouldn't a more obvious (and possibly correct) solution be to improve reporting and transparency? It would be painful in the short run, as lots of allegedly-sound financial institutions had to admit the shakiness of some of their investments, but nobody trusts them now anyway; at least then we would know whom to trust how far.
All of which is completely separate from the issue of the current "stimulus" package. Spending money that you don't have does increase economic activity now, at the expense of our children; it was true for Reagan and GWB, and I don't see why it shouldn't be true for Obama.
The question is where you spend it. There's no point in government investing in things that the private sector will invest in of its own accord. So Obama has proposed investing in areas that promise broad, externalized economic returns (so no private company is likely to be interested in them unless government takes the lead): energy efficiency and renewable energy, transportation and information infrastructure, etc.
A number of posters argue, in one form or another, that even if the present situation isn't the liquidity trap described by Keynes it is a liquidity trap, since interest rates are so low that you might as well hold onto the money.
But the cause matters. And time matters. Macro is ultimately a theory of disequilibrium, something economists understand much less well than equilibrium. If the cause of the liquidity trap is that all investment opportunities have been exhausted, the situation is permanent. If the cause is a temporary break down in the functioning of capital markets, it isn't.
A "stimulus" package isn't something that happens in an hour or a week--it's an increase in expenditure over several years, financed by borrowing over several years. Unless something--most likely federal interference--makes capital markets continue to have serious problems, that borrowed money will indeed be money diverted from private investment.
Which gets me to the claim that "Spending money that you don't have does increase economic activity now ... ." That isn't in general true. Spending money that you borrow instead of money that you tax diverts savings from private investment to government expenditure--there is no general reason why that should lead to more economic activity.
Money that's invested is buying things too--concrete and construction workers' labor instead of whatever the government would spend the money on. It's only the assumption of something like the Keynesian liquidity trap, where companies have no interested in borrowing money and spending it, that leads to the opposite conclusion.
Incidentally, it's worth noting that even in the Keynesian liquidity trap situation, there is still a full employment situation once equilibrium is fully established, although a rather odd one. Falling prices mean that the value of individual cash balances are rising, which is income, some fraction of which will be spent. In equilibrium, with zero investment due to no profitable investment opportunities, individuals are spending their entire money income--the fraction saved is all in the form of an increase in the value of their cash balances.
It's a bizarre model, and I wouldn't push it too far--implicit is the assumption that they keep saving forever, and never expect to actually spend the savings. But I think that's a problem with the model, not with the equilibrium.
I should add that if you follow the link in my original post, you will be led to a discussion of these issues by people who know a good deal more about macro--not my field--than I do. And are sceptical about current policy.
Too much consumer debt is killing the economy. The struggle to pay off debt reduces demand for goods and services, which causes deflation and unemployment, which makes it even harder to pay off the debt.
The monetary solution is for the Fed to create inflation, which doesn't require working through banks. The Fed can simply buy treasury bonds.
So the "stimulus" works this way: (1) the government runs a deficit, and (2) the Fed buys treasury bonds. The problem is knowing when to stop. Because there is no immediate feedback this operation will necessarily be underdone or overdone. God help us!
> Unless something--most likely federal interference--makes capital markets continue to have serious problems, that borrowed money will indeed be money diverted from private investment.
Even that is not true - there are various degrees of risk tolerance and a large amounts of money will only ever be invested into the sovereign debt. However even if it was true, the companies do not plan for the next two weeks either. The stimulus is the government saying "there will be about a trillion dollars more on the table than you thought - guaranteed. You Mr.Economy want a piece of it? Go and expand!" Market is a nice mechanism - 90% of the time. It is not infallible.
As for the topic at had "Stimulus". What I keep hearing from the previous admin and the current is that they know their plans are flawed, even greatly flawed but it's all in the name of expediency. Or more accurately in the name of "confidence". The rhetoric is "we must act now". I think it's obvious that this approach is not only failing it's actually responsible for at least a portion of the loss in confidence across the board (consumer, banker, investors, foreign investors, etc.). The helicopter theory might work but it assumes that the money being printed is needed and not flushed down the toilet.
Great post! Thoughtful comments!
I would argue that's it's not only a matter of trust but of knowledge. Firms and individuals simply do not know how much their assets are worth or what their income will be. Until market positions are allowed to unwind naturally - leaving some with a lot less and some with a lot more, from what are in effect mainly zero sum bets - they just won't know whether they can afford to borrow or have the money to lend. The seemingly endless stream of government interventions (aka bailouts, stimulus packages, etc.) is blocking those natural market adjustments, adding to and prolonging the uncertainty; the markets won't be able to sort themselves out until governments across the world stop trying to steer or bully them, in large-scale silly-money ways that are, in detail, largely unpredictable.
Which gets me to the claim that "Spending money that you don't have does increase economic activity now ... ." That isn't in general true. Spending money that you borrow instead of money that you tax diverts savings from private investment to government expenditure--there is no general reason why that should lead to more economic activity.
True, but another name for "private investment" is "lending your money to somebody who will do something with nonzero risk and pay you back more," which isn't happening anyway. A government can reasonably say "it is in the public interest for this investment to happen, even if a lot of financial companies aren't sure it's in their own interest." They may be right or wrong in saying that, of course :-)
Money that's invested is buying things too--concrete and construction workers' labor instead of whatever the government would spend the money on. It's only the assumption of something like the Keynesian liquidity trap, where companies have no interested in borrowing money and spending it, that leads to the opposite conclusion.
Right, our current situation is the opposite: companies have no interest in lending money. In either case, investment isn't happening.
To re-quote David: "Spending money that you don't have does increase economic activity now ... ." That isn't in general true. Spending money that you borrow instead of money that you tax diverts savings from private investment to government expenditure--there is no general reason why that should lead to more economic activity.
Yes, but you said before that private investment is down due to financial market problems. So it seems to me that government expenditure would lead to more economic activity now.
Perhaps I should disagree with the professor who taught my undergraduate history of thought class.. but..
There is a lot of "animal spirits" in Keynes and not only secular stagnation. The "liquidity trap" in the general theory pretty explicitly describes a situation in which short term interest rates are very low, but the bond speculators are keeping the long term interest rates up. That the bearish bond speculators probably aren't the culprits now, but corporate bond rates are still quite high.
Also, the economy went into recession more than a year ago, and the credit crisis was last September.
Anyway, the reality is that fiscal stimulous might result in a decrease in money demand/increase in velocity because people will hold the newly issued T-bills rather than hold money. Presumably, in a year or two, the economy would have recovered anyway, and people would have held private securities instead of money. Well, then, the already issued government bonds will "crowd out" these private securites that don't get issued. Interest rates on the T-bills will rise above "near" zero. And there is the crowding out. Stimulus now, crowding out later.
If people won't hold the T-bill rather than money right now, and rather hold the T-bills instead of AAA commercial paper or something, then the "fiscal" stimulous will be financed by newly created money. It will be monetary stimulous too. After a couple of years, when the economy recovers, and the demand for money falls again, then the Fed will sell those bonds and the crowding out will occur.
So, the spending that is done will increase aggregate demand either through lower money demand/higher velocity or through an increase in the money supply.
And, it will cause crowding out later.
This is only sensible if you believe that quantitative easing won't work, so that monetary policy can't do anything because the T-bill rate and Federal Funds rate is near zero.
And you don't want to go with the deflationary solution.
So, fiscal stimulous. Of course, this stimulus bill is really about using the crisis to justify another big increase in the size of government. The welfare state got a good start in the thirties. Maybe by 2012 we can finally achieve Scandanavian bliss.
Bill Woolsey
I believe the Austrian School of Economics would explain what we are seeing now as the liquidation phase of half a century's worth of accumulated malinvestments caused by repeated attempts to stimulate the economy with Federal Reserve interest rates pushed below the natural rate of interest set by the population's time preferences (enjoy now, or enjoy even more later), combined with fractional reserve banking, every time we got an economic downturn.
Under the fractional reserve system that is in place, money supply is inflated by credit creation (requiring both a willing lender AND a willing borrower), and deflated by debt defaults (such as million dollar mortgages on what are now $400,000 houses). There has been so much credit (debt) created that the interest costs on it all can no longer be supported by the economy. New debt defaults continue to come every day, putting the solvency of the lenders even deeper into the hole than they already are, and overwhelms new credit creation, meaning deflation is here, like it or not.
As for attempting to inflate the currency, if the government starts to do so, China, Japan, and other purchasers of U.S. Treasury debt will rightly sense an attempt to cheat them on the purchasing power of the dollars they get paid back with, and cease buying Treasury debt. That would mean the U.S. government would no longer be able to borrow any money, and would no longer be able to get away with deficit spending. That means the government would be forced to drastically raise taxes, which the politicians know is politically very risky, or be forced to drastically cut spending. As long as the government is able to borrow money, they can avoid (1) raising taxes, (2) slashing spending, and (3) currency inflation. A government only resorts to #3 when NOTHING else works. Meanwhile, the vast majority of roughly $52 trillion in credit, accounting for roughly 97% of the sum of currency and credit, is primed to be wiped out. That vast amount of credit is what enabled people to buy a $10,000 home for $500,000, or buy a $2,000 car for $25,000. Without that vast ocean of credit, prices are going to have to fall to levels where buyers can afford to pay cash in full at time of sale for everything, including cars and houses.
From Alice in Wonderland:
"When I use a word," Humpty Dumpty said, in a rather scornful tone, "it means just what I choose it to mean - neither more nor less."
"The question is," said Alice, "whether you can make words mean so many different things."
"The question is," said Humpty Dumpty, "which is to be master - that's all."
Couldn't have said it better myself.
That would mean the U.S. government would no longer be able to borrow any money, and would no longer be able to get away with deficit spending.
I agree with the rest of your analysis, but for this particular problem the US government already has a solution: the Federal Reserve can buy the treasury bonds. I believe that the idea of capping the 10-year yield at 3% via fed intervention (effectively, buying up any bonds that other buyers are not willing to at that price) has already been floated.
But yeah... all that debt, masquerading as money, has been the real source of inflation. Which is why doubling M0 has had no effect.
I found the persistent labeling of the government merger programs with small businesses as "private/public" cooperations very disturbing to say the least. :(
And watching C-span lately is enough to make me break out in hives. After watching two GOP reps point out the flawed history of Keynesian thought, how FDR's treasury secretary abandoned the approach eight years after the implementation, and how no stimulus package has ever achieved it's promises, I was stunned when Jesse Jackson Jr. took the stand.
He began by insisting that this new administration was creating a "new paradigm" (just after the GOP reps asked if we all became socialists), and dismissed the critiques of Keynesian approach as "pre-civil" war arguments. The latter in part because he felt bringing early US slavery into the speech was relevant. <:[
1) It is a tragedy that more people have not heard of the Austrian Business cycle theory because it does account for everything that is going on quite well.
2) "If investment isn't currently occurring -- for whatever reason -- then it seems like the "crowding out" is a moot point."
-First of all, investment is still going on, it's just slow but can always fall further. Second, no matter what is going on, the money for the stimulus has to come from somewhere. If not from investment than from savings which is also necessary to stabilize banking.
3) "Market is a nice mechanism - 90% of the time. It is not infallible."
-This reminds me of an old joke:
A man and his friend where walking in the woods when a bear comes out, the first man drops his pack and gets ready to run. The second says: "You don't think you can out run the bear do you?"
The first: "I don't have to, I just need to out run you."
In other words, we don't need markets to be able to function perfect to justify being committed to them, we just need them to function better than government.
-Zachary Anthony
very Nice post
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