Thursday, May 21, 2009

And yes, “financial” crowding out also takes place when financial markets are fully utilised. But they are not

TO BE NOTED: From the FT:

"Will stimulus spending stifle recovery?

May 21, 2009 4:53pm

By James W Dean and Richard G Lipsey

The enormous stimulus packages hastily put together by governments in most large economies encounter two sorts of criticisms from many conservative economists. Both criticisms are wrong.

The first is that spending will either be hurried and wasteful, or that it won’t come on stream until employment has recovered, and will therefore be inflationary.

The second is that deficit-financed government spending merely replaces spending by consumers and firms dollar for dollar; so-called 100 per cent ‘crowding out’. Critics often fail to point out that these two arguments cannot both be true. If government spending merely replaces private spending dollar for dollar, it does not affect total demand. As a result, it cannot be inflationary.

If “crowding out” is significantly less than 100 per cent, new spending will employ labour and capital that is now idle, and the earnings of workers and investors will re-ignite both consumer and investment spending. To be sure, stimulus programmes should target projects with productive potential. Economies from the US to China are in dire need of new physical and social infrastructure. But even “unproductive” projects are better than none at all if the alternative is to leave labour and capital unemployed.

And if stimulus spending for infrastructure comes into effect after the end of recession, when real resources and financial markets are re-employed, there are adequate monetary tools to contain such pressures. In other words, long-term plans for infrastructure planning can stand on their own merit.

So the key question is whether government spending that comes into action during recession is likely to crowd out new private spending, dollar for dollar. The answer depends on the extent to which real and financial resources are currently under-utilised.

“Real” crowding out occurs when labour and capital are already fully employed so that further spending exceeds capacity and leads to inflation. The logic of the harm done by inflation is well understood. But the logic of “financial” crowding out is less intuitive and more complex.

Simply put, financial crowding out results from rising interest rates when government deficits put pressure on bond markets. This kind of crowding out is most plausible in the US, which began the recession with the biggest deficit in world history. However, relative to national income, it is not nearly as large as that which Britain ran after the Napoleonic wars. And currently, the biggest as a percentage of national income is Japan’s: almost 200 per cent of its gross domestic product. It doesn’t seem to be crowding out private spending as the Japanese long-term interest rate is still only 1.5 per cent.

Nevertheless, skeptics argue that dramatic doubling of US deficits this year and beyond could leave little room for private sector borrowing. If the US deficit stifles rather than stimulates recovery of its private sector, prolonged worldwide recession is inevitable.

The US deficit will be financed in several ways. Much will be paid for simply by “printing money”. The jargon for this is “quantitative easing“, which means, inter alia, that central banks buy new issues of government bonds and pay for them with newly created money. This puts zero upward pressure on interest rates. But it does increase the money supply - thus far, in the US, by some 70 per cent since last year. If this money is not re-absorbed by the Fed when full employment is restored, we will witness inflation and consequent “real” crowding out.

The second way that the US will finance its deficit is by selling bonds to foreign buyers, particularly to large central banks such as those of China and Japan. Though their appetite for dollar-denominated liquid assets may have diminished, it is still enormous. There remains no financial asset as liquid and safe as US Treasury bonds, and for this reason the US dollar has not and will not collapse against the euro or the yen. By the same token, foreign financing of the deficit has not and will not put significant upward pressure on interest rates and thus will not lead to “financial crowding out”.

A third source of financing for the deficits is sales of government bonds to commercial banks. If private borrowers were beating down banks’ doors for loans, and if banks were willing to make loans, then the Fed’s bond sales to banks would indeed crowd out consumer and investment borrowing. But both the demand for and supply of credit have collapsed: indeed, that is the core cause of the meltdown. So the part of the deficit that is financed by bond sales to banks will not crowd out private borrowing.

A fourth way to finance deficits is to sell government bonds directly to firms or households. Under different circumstances this too could crowd out investment or consumer spending, since firms and households might simply increase their savings and reduce their spending by enough to offset the amount of new government spending that is financed by the bond sales. But such a dollar for dollar portfolio shift is highly unlikely. Why would firms, already sitting on high cash reserves and undistributed profits because they are afraid to invest, increase their savings even more because they are offered safe government bonds? An analogous argument applies to consumers.

In short, arguments that deficit-financed stimuli will be crowded out are far-fetched in the extreme, even when the deficit is as large as that of the US. Yes, “real” crowding out happens when labour and capital are fully employed. But the essence of our present problem is that the enormous productive capacity of our economies is dangerously underutilised, not the reverse.

And yes, “financial” crowding out also takes place when financial markets are fully utilised. But they are not: the core cause of our present problem is that credit markets are seriously underutilised, and financial markets have melted down. Financing large fiscal deficits by tapping those markets is much more likely to revive them than the reverse.

James W Dean and Richard G Lipsey are professors emeriti at Simon Fraser University"

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