doubted his own theory on the sensible ground that people were not so rational and long-termist

TO BE NOTED: From the FT:

"Insight: Public sector replaces private as engine of borrowing

By John Plender

Published: April 14 2009 16:28 | Last updated: April 14 2009 16:28

With so many countries running big current account surpluses during the credit bubble, the resulting excess savings ensured that bond market vigilantes – investors who go on strike in government bond markets – were well and truly anaesthetised. Government budget deficits, however great, could always be financed without difficulty while markets were awash with petro-funds and surplus Asian and continental European savings.

Not so today. In both the US and the UK, recent bond market auctions have met with poor receptions. Last week’s fiscal stimulus package in Japan caused government bond yields to rise initially. The inevitability of huge increases in bond issuance to address the economic and financial crisis has prompted alarmist talk about dwindling investor demand, collapsing bond prices and a return of inflation.

Meantime, Ricardian equivalence, one of the fine old chestnuts of economic theory, has been making a comeback. This is the notion that where governments finance expenditure by borrowing rather than taxing, rational folk will save more to offset the impact of taxation further down the line. In other words, fear of government deficits turns them into squirrels, thereby offsetting the stimulus that the fiscal largesse is supposed to achieve. So what, in the face of these potentially conflicting arguments, is in store for the bond markets?

There is no disputing the reality of a huge potential supply of bonds, but the demand side of the equation is more complicated.

To start with, Ricardian squirrels can firmly be discounted. David Ricardo, the 19th century economist, doubted his own theory on the sensible ground that people were not so rational and long-termist.

The recent experience of rising budget deficits in Japan likewise casts doubt on the theory, since household savings rates there have declined.

That said, what is now happening in the Anglophone economies is that over-indebted households are rebuilding their balance sheets. The private sector’s desired savings rate is increasing, while debt is being paid down. In effect, the public sector has replaced the household sector as the engine of borrowing.

At the same time, the protracted decline in commercial bank holdings of government paper is set to reverse. In the period following the second world war, banks on both sides of the Atlantic held as much as 30 to 40 per cent of their assets in government paper. By 2007, when the credit crunch began, that had fallen to next to nothing, leaving the banks unusually vulnerable to liquidity problems.

Revisions to the Basle capital regime in response to the financial crisis will put greater emphasis on liquidity. The percentage is thus set to rise again.

On top of that we now have central banks engaging in quantitative easing, whereby they purchase assets – chiefly government debt – in exchange for money.

These demand side influences are together very powerful. That is not to say that investors will have no concerns about inflation. When governments are obliged, in the attempt to stave off deflation, to expand budgets and increase public sector debt rapidly, the risk is obvious. The key to addressing concerns about inflation – and also default – is for governments to articulate credible medium-term strategies to exit from fiscal and monetary largesse.

In the meantime, a world that is suffering from deficient demand and large output gaps is not the kind of place where inflation poses an immediate threat. Yet the scale of potential debt issuance is such that there is bound to be periodic indigestion in the market, with pressure appearing at different points on the yield spectrum.

The likelihood is that we are back to the kind of courtship rituals seen in the UK in the 1970s, with investors becoming increasingly coy in the face of a relentless barrage of IOUs. Government debt managers will have to re-acquire marketing skills, which at that time included offering partly-paid gilts and other devices, to add speculative spice to the surfeit of bonds on offer. Stand by for the focus of financial engineering to shift from private to public sector paper.

John Plender is an FT columnist and chairman of Quintain"

If the government takes our money (through taxes), and spends it on our behalf, does that increase aggregate demand?

From Nick Rowe:

"Ricardian Equivalence and government spending

If the government takes our money (through taxes), and spends it on our behalf, does that increase aggregate demand?

If the government borrows our money, making us pay back the loan (through future taxes), and spends it on our behalf, does that increase aggregate demand?

The answer is: it depends. It depends on what the government spends the money on. It depends on whether we are able to borrow ourselves. It depends on whether we, or new immigrants, or people not yet born, will pay the future taxes. H/T Kevin Quinn.

I'm going to assume that the central bank wants aggregate demand to increase (because output is below the natural rate), and so does not raise the rate of interest, or allow the exchange rate to appreciate, to offset any effects of fiscal policy.

Let's start with three simple cases.

1. Suppose the government takes our money in taxes, and gives it back to us as transfer payments. It takes $100 from my right pocket and puts $100 in my left pocket. No effect on Aggregate Demand. Unless it taxes the people who would have saved an extra dollar and transfers it to people who will spend an extra dollar.

2. Suppose the government takes our money, spends it on goods we would have bought anyway, and gives them back to us. No effect on AD. The government is just doing our shopping for us. It's like transfers in kind, instead of in cash. If the tax was $100, we cut our own consumption spending by $100, and save the same as before.

3. Suppose the government takes our money, spends it on goods which are totally useless to us (or spends it on useful goods but then throws them away). We are poorer, and so save less, and our consumption falls, but by less than the $100 tax increase. AD increases, output may increase too, but we are not better off. The best that can happen is we get the "balanced budget multiplier" of one, so a $100 increase in taxes and government spending causes output to increase by $100, but useful output to stay the same.

The more realistic cases are where the government spends our money on goods which are useful to us, but are not goods we would have bought ourselves. Unfortunately, these are less simple. It all depends on how it affects savings, and this depends on how the government spending affects our permanent income, current income, and whether the government buys goods that are substitutes or complements for current consumption and future consumption.

4. Suppose the government takes our money, and spends it on goods that will not directly affect our incomes, will give us utility, but will not affect the marginal utility of present or future consumption. Think art galleries, museums, or making the country look nice. The new art gallery does not affect our trade-off between present and future consumption or our savings decision. The result is exactly the same as in example (3), where the new goods were useless, except now they aren't useless. We get the balanced budget multiplier, and we really are happier because of the new art gallery, even though our consumption expenditure stays the same.

5. Suppose the government takes our money, and spends it on goods which are a complement to current consumption. Think of a firework display, which is free, but you need to buy a new lawnchair. (Sorry, I can't think of a more sensible example). This affects the trade-off between current and future consumption. People will save a smaller portion of their disposable income today, to buy a lawnchair. We get "crowding-in" of consumption. The multiplier is bigger than the standard balanced budget multiplier.

6. Suppose the government takes our money, and spends it on goods which are a complement to future consumption. Think of a scenic highway, which won't be completed until next year, and you may need to buy a car to enjoy it. People will now save a larger portion of their current disposable income, so they can buy a car next year. The multiplier is now smaller than the balanced budget multiplier. If the effect is strong enough, it can even be negative.

Now suppose the government spends on new investments, which don't directly make us happier, but do make us richer. Think infrastructure, education, R&D. With this sort of investment spending, it's simpler to think of them being financed by borrowing, not taxes.

7. Suppose the government borrows money, and spends it on a new investment project that will give the same rate of return as government bonds. If the return on the investment goes directly to the government, rather than increasing household income (think government toll road), then future taxes will not need to rise to repay the borrowing. It is exactly the same as an increase in private investment. We get the same large multiplier (1/[1-c] in the simple model). If the return on the investment goes to households instead (think education), then any rise in future taxes to repay the borrowing is exactly offset by the increased future income from the investment. So we get the same large multiplier effect. All this assumes, of course, that the government did not do an investment project that would have been done by the private sector anyway, and does not cause a rise in the rate of interest or shortage of inputs that would otherwise crowd out private investment or consumption.

8. And if the government borrows to invest in a project which has a greater (smaller) rate of return than on government bonds, the multiplier will be even larger (smaller) than 1/(1-c).

Now to compare spending financed by taxes to spending financed by borrowing. The Ricardian Equivalence Proposition says they are equivalent. The easiest way to do this is to consider:

9. Suppose the government borrows $100 per person and gives a transfer of $100 per person. According to REP, this is equivalent to (1) above, and so should have no effect on AD. The reasoning is that people will save all the transfer, so they can pay the higher future taxes, and will not want to change their trade-off between current and future consumption, since their lifetime wealth or permanent income is unchanged. There are many reasons that REP might be false. The most important are:

A. Some people are borrowing-constrained. They wanted to borrow more and consume more, but couldn't. Now the government has borrowed the money for them, they increase consumption.

B. Some future taxes will be paid by future immigrants, or by those not yet born. So the current generation is wealthier, and will increase consumption. (But some may not increase consumption, because they will want to leave higher bequests to their children to offset their higher taxes.)

C. Some people may not figure out the effect of borrowing on future taxes, so will increase consumption. (But others may panic at the increased debt, and may cut consumption).

D. Taxes may affect incentives, and may discourage future earning, or current investment, and so may reduce current consumption and investment.

Conclusion: if we can think of government investment projects that are productive, and give the government future income or give us future income, and which earn a good rate of return, this sort of government spending is not only good microeconomics, it can be good macroeconomics as well, if what you want is to increase aggregate demand."

And me:

"Conclusion: if we can think of government investment projects that are productive, and give the government future income or give us future income, and which earn a good rate of return, this sort of government spending is not only good microeconomics, it can be good macroeconomics as well, if what you want is to increase aggregate demand."

This is true of any investment. The problem is that, even in the private world, there's no guarantee that money invested will be productive.

By the way, since government spends a large amount of our money, we must believe, or at least some of us, that some government spending is warranted.

In other words, neither the productivity argument or argument about whether government can do anything better is very useful here. Rather, in Debt-Deflation, we are trying any number of ways to get out of it. One way is to stop a savings spree that is part of debt-deflation. The question is can government spending stop a savings spree?

I say that it can, because it helps create a perception of investment and employment, as opposed to continual job losses and little or no new investment.My argument would be based on what people say about how they might react to a stimulus. That interests me more than theories, which assume behavior not in evidence. There are so many countefactuals being bandied about, it's hard to see them as anything but a list of possible cases, none of which might occur.

Posted by: Don the libertarian Democrat | January 28, 2009 at 03:45 PM

Now Nick:

Hi Don:
" neither the productivity argument or argument about whether government can do anything better is very useful here. Rather, in Debt-Deflation, we are trying any number of ways to get out of it."

Surprisingly, it IS useful here. In normal times, we evaluate a government spending project in terms of whether it makes better or worse use of resources than alternative uses of resources (either government or private). And we choose the project if it has benefits exceeding the (opportunity) costs. But in bad times like these, all we care about is whether it will stimulate total demand - cause spending rather than saving. But surprisingly, it turns out that projects which meet one form of the first criterion - they create money income in the future - also give the biggest "bang for the buck" in stimulating spending now. This is because there is no "drag" from higher anticipated future taxes on current consumption. I may do another post on this, since I can expand on the reasons.

On your last paragraph: economists would phrase this as "yes, expectations matter". In this case, the more successful people expect the policy to be (in increasing income and preventing deflation) the more successful it will be. Usually, people can just learn from experience what the effects of various things will be, even if they don't understand why. But when new stuff happens, people can't rely on experience, so expectations aren't as well anchored.

Posted by: Nick Rowe | January 28, 2009 at 08:54 PM

Now me:

Hey Nick,

"they create money income in the future"

How can you guarantee that? Many projects have enormous overruns ( The Big Dig, The Bay Bridge) . As well, depending upon what we're talking about, the demand can change. For example, gas prices can lessen traffic and tolls. I'm assuming that what you're saying is that some projects can lead to such an increase in revenue.

My view is that infrastructure spending sends the signal that we are confident enough to invest in our future, thereby calming fears of the future.

Here's another problem: Everyday we make choices about what to do, spend, wear, etc. There are too many variables in human action to know how much people will save for a presumed tax. The theory of human action that allows such prediction doesn't exist for me. Perhaps, since you love philosophy, you can tell me what your philosophy of action is.

Posted by: Don the libertarian Democrat | January 28, 2009 at 10:18 PM

why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool

From Econospeak:

"Ricardian Equivalence Does Not Imply That Obama’s Fiscal Stimulus Will Be Ineffective

Kevin Quinn noted that the Wikipedia discussion of Ricardian Equivalence had the following error:

Ricardian equivalence states that a deficit-financed increase in government spending will not lead to an increase in aggregate demand. If consumers are 'Ricardian' they will save more now to compensate for the higher taxes they expect to face in the future, as the government has to pay back its debts. The increased government spending is exactly offset by decreased consumption on the part of the public, so aggregate demand does not change.

As noted here, John Cochrane made the same error. I would hope the Myron S. Scholes Professor of Finance at the University of Chicago Booth School of Business does not rely upon Wikipedia for his economic research. Alas, in an otherwise excellent post on fiscal policy, Menzie Chinn sort of falls into this trap as well:

Case 5 (government debts will have to be paid off in its entirety the future): When budget constraints hold with certainty intertemporally, and there is no way to default even partially on government debt (say via unexpected inflation), then increases in government debt due to tax cuts (for instance) induce no change in current consumption because households fully internalize the present value of the future tax liability

Menzie is right about transitional changes in tax policy not being able to change consumption in this Barro-Ricardo model, which is why GOP calls for using tax cuts to stimulate demand are likely not going to be the most effective policy tool. But what about transitional changes in government purchases? It is interesting that Wikipedia noted Ricardo’s 1820 Essay on the Funding System:

Ricardo studied whether it makes a difference to finance a war with the £20 million in current taxes or to issue government bonds with infinite maturity and annual interest payment of £1 million in all following years financed by future taxes. At the assumed interest rate of 5%, Ricardo concluded that "In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever ... are precisely of the same value".

Let’s modernize this example. Suppose we decide to have an additional $100 billion in public investment in 2009. In Ricardo’s example, permanent taxes will increase by $5 billion per year which would have a very modest offsetting reduction in consumption. So if government purchases rise by $100 billion and consumption falls by $5 billion, then isn’t the direct impact on aggregate demand closer to $95 billion for the year rather than zero?

Update: Republicans will oppose more government spending as they prefer tax cuts:

Hours before a meeting with President Barack Obama, House Republican leaders sought to rally opposition Tuesday to a White House-backed economic stimulus measure with an $825 billion price tag. Several officials said that Reps. John Boehner of Ohio, the GOP leader, and Eric Cantor of Virginia, his second-in-command, delivered the appeal at a closed-door meeting of the Republican rank and file. Both men said the legislation contains too much wasteful spending that will not help the economy recover from its worst nosedive since the Great Depression, the officials added ... Senate Republican Leader Mitch McConnell, R-Ky., said in a televised interview that Obama was having problems with Democrats, whom he said favor spending over tax cuts as a remedy for the economic crisis.

If Ricardian Equivalence holds, the GOP is opposing fiscal stimulus that will impact aggregate demand preferring tax cuts that will not increase aggregate demand. Go figure!

Posted by ProGrowthLiberal at 10:56 AM "

Now me:

January 28, 2009 1:09 PM

Don said...

"households fully internalize the present value of the future tax liability"

I'm puzzled by this statement. Does it purport at all to be about human behavior? Any incentive will work more or less well depending upon a whole number of factors that go into actual human beings making decisions at any given time. Even the historical context makes a difference. I don't think that there's much doubt that massive government spending could influence people's behavior. The question is how much it would take and what might the negative consequences be? These economic equations all look like correlative reasoning or counterfactuals, which are then taken to be like equations that detail the actions of non-teleological objects. Why can't we say say that we're going to spend some and cut some taxes hoping that something might work?

Don the libertarian Democrat

January 28, 2009 2:55 PM

"Economic policy is based on a collection of half-truths."

This has been Buiter's view all along:

"Can the US economy afford a Keynesian stimulus?
January 5, 2009

Economic policy is based on a collection of half-truths. The nature of these half-truths changes occasionally. Economics as a scholarly discipline consists in the periodic rediscovery and refinement of old half-truths. Little progress has been made in the past century or so towards understanding how economic policy, rules, legislation and regulation influence economic fluctuations, financial stability, growth, poverty or inequality. We know that a few extreme approaches that have been tried yield lousy results - central planning, self-regulating financial markets - but we don’t know much that is constructive beyond that.( I AGREE )

The main uses of economics as a scholarly discipline are therefore negative or destructive - pointing out that certain things don’t make sense and won’t deliver the promised results. This blog post falls into that category.

Much bad policy advice derives from a misunderstanding of the short-run and long-run impacts of events and policies. Too often for comfort I hear variations on the following statements: “the long run is just a sequence of short runs, so if we make sure things always make sense in the short run, the long run will take care of itself.” This fallacy, which I shall, unfairly, label the Keynesian fallacy, compounds three errors.

The first error is( 1 ) the leap from the correct assertion that a long interval of time is the sum of successive short intervals of time to the incorrect impact that the long-run impact of a policy or event is in any sense the sum of its short-run impacts. The second error is( 2 ) the failure to recognise that our models (formal or implicit) of how the economy works are inevitably incomplete( TRUE ). Parts of the transmission mechanism - positive or negative feedbacks and other causal links between actions today, future outcomes and anticipations today of future outcomes and future actions - that can safely be ignored when we consider the impact of a policy over a year or two can come back to haunt us with a vengeance over a three-year or longer horizon. The third error is that, ( 3 ) when economic agents, households, firms, portfolio managers and asset market prices are even in part forward-looking, the long run is now. More precisely, the long-run consequences of current policies can, through private sector expectations ( YES )and through forward-looking asset prices influence consumption behaviour, employment and investment decisions and asset prices today( TRUE ).

Matching the Keynesian fallacy is the view that just because a certain set of policies is not sustainable, in the sense that it cannot be maintained indefinitely, such policies should not be implemented even temporarily. I will call this the sustainability fallacy. It rests on the simple error that identifies a sustainable policy rule or programme, with a specific constant policy action. A sustainable, sensible or even optimal contingent policy programme, or contingent sequence of policy actions, will in general involve specific actions that will be undone, reversed or even neutralised by later contingent policy actions in the opposite direction. These specific actions may be eminently sensible, even from a long-run perspective, provided they are not maintained indefinitely and are, and are expected to be, reversed in due course, according to the rule, when the state of the economy has evolved or when a new unexpected contingency arises.

US fiscal policy: the Keynesian fallacy on steroids

How does this apply to the macroeconomic stabilisation policy and the financial stability support policies being pursued in the US today?

First, the fiscal policy actions pursued thus far by the Bush administration, but even more so the policy proposals leaked by Obama’s proto-administration are afflicted by the Keynesian fallacy on steroids. They appear to exist outside time, with neither the long-run consequences of the actions like to be implemented over the next couple of years, nor the history that brought the US to its current predicament, the initial conditions, being given any serious attention.

A nation in fundamental disequilibrium: the disappearance of American ‘alpha’

Even before the crisis erupted, around the middle of 2007, the US economy was in fundamental disequilibrium. The external primary deficit (the external current account deficit plus US net foreign investment income) was running at around five or six percent of GDP. The US was also a net external debtor( SPENDER COUNTRY ), Its net external investment position (at fair value, or the statisticians best guess at it) was somewhere between minus 20 percent and minus 30 percent of annual GDP. The US economy managed to finance this debt and deficit position quite comfortably because it gave foreigners an atrocious rate of return on their investment in the US - a rate of return much lower, when expressed in a common currency, than the rate of return earned by US-resident investors abroad.

Some of this lousy ex-post average return on foreign investment in the US was no doubt unexpected and one-off. If risk premia on foreign investment in the US and on US investment abroad were the same, the appearance of excess returns to US investment abroad relative to foreign investment in the US may simply have been an example of the ‘peso problem’ - a ‘small-sample bias’ in expected returns. Assume expected returns are equal using the true distribution of returns. The true distribution may, however, have fat or long tails, with extreme negative values that occur infrequently (e.g. the collapse of a currency peg). The term ‘peso problem’ came from observations on realised returns on US dollar-denominated securities and Mexican peso-denominated securities during the 1970s. The forward premium on the Mexican peso relative to the US dollar was positive through 22 years of a pegged exchange rate, until August 1976, of eight Mexican pesos to the US dollar. On September 1, 1976, the peso devalued by 45 percent vis-à-vis the US dollar.

The term peso problem was, according to Paul Krugman, invented by a bunch of MIT graduate students of the late Rudi Dornbusch. William S. Krasker published the first paper using the expression (”The ‘peso problem’ in testing the efficiency of forward exchange markets”, Journal of Monetary Economics, Volume 6, Issue 2, April 1980, pages 269-276), long before fat tails, black swans and related regurgitations of the same phenomenon became current. The attribution of the expression ‘peso problem’ to Milton Friedman is almost certainly incorrect.

When the disaster scenario (a collapse of the currency peg) materialises, the roof caves in for peso investments. Before the collapse, statisticians, unlike market participants, don’t know the true distribution but base their calculation of the expected return on a sample during which the extreme event has not (yet) materialised. The result is that statisticians overestimate the expected return on the peso (there has been no depreciation of the peso during my sample, therefore the future expected depreciation rate is zero) and attribute the positive (risk-adjusted) rate of return differential on the peso to ‘alpha’. It is, of course, ‘false alpha, as the September 1, 1976 collapse of the peso (repeated a number of times since then) made clear.

Some of the excess returns on US investment abroad relative to foreign investment in the US, may have been anticipated, and may have reflected a low or even a negative risk-premium on US investment. In that case, if risk-adjusted rates of return to foreign investment in the US and on US investment abroad are the same, we would expect that the so far unrealised risk will in due course materialise and blow a large hole in the US external asset position( YIKES ). Even with a very long enough sample, ex-post realised average rates of return on investing in the US will still be lower than ex-post realised rates of return on investment abroad, but the (ex-post) positive correlation between the return on foreign investment and consumption growth could be stronger for foreign investment in the US than for US investment abroad.

Some of the excess returns on US investment abroad relative to foreign investment in the US may have reflected true alpha, that is, true US alpha - excess risk-adjusted returns on investment in the US, permitting the US to offer lower financial pecuniary risk-adjusted rates of return, because, somehow, the US offered foreign investors unique liquidity, security and safety( YES ). Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run( YES. THAT'S HOW IMPORTANT GUARANTEES ARE. ). This is the ‘dark matter’ explanation proposed by Hausmann and Sturzenegger for the ‘alpha’ earned by the US on its (negative) net foreign investment position ....

Now, from H and S:

"In short, the US is a net provider of knowledge, liquidity and insurance( GOVERMENT GUARANTEES. YOU KNOW HOW IMPORTANT THAT THIS IS IN MY OPINION. ). As the world became more global financially, the increasing asset value of these services underlies the spectacular increase in dark matter over the last two decades."

Back to Buiter:

" If such was the case (a doubtful proposition at best, in my view), that time is definitely gone. The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally ( TRUE ). Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed. Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways( TRUE ). Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations. The problem is not confined to commercial banks, investment banks and universal banks. It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others. ( TRUE )

The legal framework for the regulation of financial markets and institutions is a complete shambles. Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture.( FRAUD, ETC. )

There is no chance that a nation as reputationally scarred and maimed as the US is today, could extract any true ‘alpha’ from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations. I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear. ( HERE I DISAGREE. THE SAVER COUNTRIES ARE TEMPTED, FOR SOCIAL STABILITY REASONS, TO TRY AND KEEP THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS GOING. )

There will, before long (my best guess is between 2 and 5 years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard( IT CAN LEAD TO SOCIAL DISLOCATIONS ). The US dollar and US Treasury Bills and Bonds are still viewed as a safe haven by many( TRUE ). But learning takes place. The notion that the US Federal government will be able to generate the primary surpluses required to service its debt without selling much of it to the Fed on a permanent basis, or that the nation as a whole will be able to generate the primary surpluses to service the negative net foreign investment position without the benefit of ‘dark matter’ or ‘American alpha’ is not credible. ( PROBABLY TRUE )

So two things will have to happen, on average and for the indefinite future, going forward. First, there will have to be some combination of higher taxes as a share of GDP or lower non-interest public spending as a share of GDP( I AGREE ). Second, there will have to be a large increase in national saving relative to domestic capital formation. ( GRADUALLY, YES )

The need for a massive resource transfer towards the public sector

As regards the required massive transfer of resources from the public to the private sector in the US, it has long been recognised by those who look at long-term prospects for taxes and public spending in the US, that a combined permanent increase in the tax share/reduction in the share of public spending in GDP of around ten percentage points would be required to fund existing Medicare and Medicaid commitments (and to a lesser extent Social Security commitments). In the past decade the US has legislated for its citizens (though Medicare, Medicaid and Social Security retirement) a West-European-style welfare state( TRUE ). Obama’s proposals for universal health care will complete this process. The US has done so with a general government public expenditure share in GDP that is about 10 percentage points below the West-European average (in the mid-thirties for the US, in the mid-forties in for Western Europe. Evolving demographics and entitlement will drive US welfare state expenditure towards the West-European levels, in the absence of political decisions in the US to limit coverage and entitlements( TRUE ).

This resource shift from the private to the public sector would only manifest itself gradually however, and no doubt, there will be changes in (whittling down of) these commitments before their full impact is felt. ( I AGREE )

The US Federal government has taken on massive additional contingent liabilities through its bail out/underwriting( GUARANTEES ) of the US financial system (and possibly other bits of the US economic system that are too politically( TRUE ) connected to fail). Together will the foreseeable increase in actual Federal government liabilities because of vastly increased future Federal deficits, this implies the need for a future private to public sector resource transfer that is most unlikely to be politically feasible without recourse to inflation( A BAD CHOICE ). The only alternative is default on the Federal debt( I SAY THAT SAVER COUNTRIES MIGHT GO FOR THIS. ). There is little doubt, in my view, that the Federal authorities will choose the inflation and currency depreciation route over the default route.

If I can figure this out, so can anyone in the US or abroad who follows recent economic developments. The dawning of the realisation( INFLATION ) will lead to the dumping of the assets.( BECAUSE THEY WILL BE WORTH LESS IF HELD. AN INFLATION RUN. )

Even if the US Federal government decides to go the inflation route for ‘paying off’ public debt is would be too politically difficult to service through tax increases or spending cuts, it is unlikely that some, not insignificant, resource transfer from the private to the public sector will have to take place. And there we have the short run-long run conundrum. If the economy were at full employment and a high rate of capacity utilisation today, it would still require a permanent resource transfer from the private sector to the public sector, that is, higher taxes or lower public spending. But for cyclical purposes( OUR CURRENT RECESSION ), lower taxes and higher public spending are indicated - provided the authorities have the credibility to commit themselves to future tax increases and/or spending cuts that would not just take care of the existing obligation, but also of the additional debt that would be incurred as a result of the Keynesian stimulus.( I'M FOR THIS SOLUTION. )

The latest gurgling about the magnitude of the Obama fiscal stimulus are certainly impressive: $775 bn or so (around five percent of GDP) over two years. This on top of a Federal deficit that even absent these stimuli could easily top $750 bn. I now anticipate a Federal deficit of between $1.5 trillion and $2.0 trillion for 2009 and something slightly lower for $ 2010. With both the Fed and the Treasury exposed to trillions of private assets and institutions of doubtful quality and solvency, the stock of US Federal debt could easily increase by many more trillions of US dollars during the next couple of years.

Those familiar with the post World War I and post-World War II public debt levels will not be impressed with even a doubling of the public (Federal) debt held by the public as share of GDP, from its current level of around 40 percent of annual GDP (gross public debt, including debt held by other government agencies, like the Social Security Trust Fund, stands at around 70 percent of GDP). Chart 1 is taken from Wikepedia. Following World War II public debt stood at more than 100 percent of annual GDP.

Chart 1

usdebt.png

A simple (coarse?) indicator of ‘tax tolerance’ - willingness to pay taxes or to make others pay taxes( YES ) - is the highest marginal rate of personal income tax. For the US this is shown in Table 2 below. It is taken from the website of TruthAndPolitics.org.

Chart 2

That, however, was then. The debt was incurred to finance a temporary bulge in public spending motivated by a shared cause: defeating Japan and the Nazis. The current debt is the result of the irresponsibility, profligacy and incompetence of some( FRAUD, ETC. ). Achieving a political consensus to raise taxes or cut spending to restore US government solvency is going to test even the talents of that Great Communicator, Barack Obama.

If you add to the Keynesian fiscal stimulus package Obama’s ambitions for increasing infrastructure investment to stimulate growth, to fund (not quite) universal healthcare and to stimulate alternative energy production and use, the incompatibility of US public spending ambitions and the political capacity to raise the necessary revenues is glaring. So the government would borrow. From whom? Not from the domestic private sector. They are saving rather little and are being discourage from saving what little they are saving by the fiscal stimulus package. So the US government will borrow abroad to finance its infrastructure, health ambitions and green agenda? Some day perhaps. But not during Obama’s presidency.

So will the Keynesian demand stimulus work? For a while ( a couple of years, say) it may. When the consequences for the public debt of both the Keynesian stimulus and the realisation of the losses from the assets and commitments the Fed and the Treasury have taken onto their balance sheets become apparent, the demand stimulus will fade and may be reserved as precautionary( A PROACTIVITY RUN ) behaviour takes over in the private sector. My recommendation is to go easy on the fiscal stimulus( I AGREE ). The US government is ill-placed financially and fiscally, to engage in short-term fiscal heroics. All they can really do is pray for a stronger-than-expected revival of global demand, without any major stimulus from the US.

The need for a massive resource transfer towards the rest of the world

Beggars can’t be choosers. The US has been able to get away with decades of private sector improvidence because of two unique and time-limited factors. The first is a sequence of capital gains on household assets (stocks and real estate) that provided a lovely substitute( TRUE ) for saving to provide for retirement, old age and a rainy day. The second was the excess returns earned by the US on its net foreign investment (its ability to borrow at an unbelievably low rate of interest/rate of return, because of the unique position of the US as the ultimate source of liquidity and security( GUARANTEES ).

Both rational drivers of a low US saving rate are gone. The US housing market and global stock markets have imploded. It will take years, even decades, to restore household financial wealth-income ratios to levels that don’t guarantee retirement in poverty for much of the US population. The rest of the world will also no longer lend to the US at a negative nominal (and real) interest rate, as it has done for years.( AGAIN, I'M NOT SO SURE. )

So the US has to shift aggregate demand from domestic demand to external demand. And it has to shift production from non-tradables to tradables - exportable and import-competing goods and services. By how much? At full employment, probably at least six and more likely by around eight percent of GDP.

As regards shifting production towards tradables, this will not be easy( NO IT WON'T ). And policy is pushing in the wrong direction. The Bushbama administrations have decided to bail out the US car industry( FOR SOCIAL REASONS ). That industry does not produce cars the rest of the world wants. If and when the global economy recovers and oil prices rise to $150 per barrel again, US consumers also won’t want the cars produced by Detroit. Sure they can change. They could have changed in 1973, in 1980 and at any time since then. If they could change, they probably would have by now.

Other US industries are more competitive internationally. But shifting resources towards tradables and away from non-tradables will require re-training and re-education as well as a significant depreciation of the US dollar’s real exchange rate - which amounts to a significant cut in real wages( FOREIGN GOODS WILL BECOME MORE EXPENSIVE ). Chart 3, which shows the US broad real effective exchange rate index, provided by the Fed, shows the behaviour of one measure of the real exchange rate since 1973.

Chart 3

In the past year, the effective real exchange rate of the US dollar has in fact strengthened rather than weakened, thus impeding the necessary external adjustment. With the short risk-free nominal interest rate effectively at the zero floor, conventional expansionary monetary policy cannot be used any longer to weaken the exchange rate. The effect of quantitative easing and qualitative easing on the exchange rate are ambiguous. If they succeed in stimulating spending by credit-constrained businesses and households, it could well strengthen the currency and weaken the trade balance.

In the decades since I first lived in the US, the quality of secondary education and of vocational training appears to have worsened. Despite the excellence of some institutions, including the wide range and variety of community colleges that give a second chance to so many Americans, the educational system of the US increasingly resembles that of the UK: islands of excellence in a sea of mediocrity. This means that, to become competitive, if you cannot compete on quality and innovation, you will have to compete on price. A larger real exchange rate depreciation and cut in real consumer wages will be required to achieve a given shift of resources to the external sector.

With all the talk about investing in the future, improving infrastructure and creating a dynamic competitive economy, I don’t think the Obama administration will want to achieve the necessary shift of resources towards the rest of the world by reducing domestic investment. In fact, in the one area where domestic investment could and should be reduced (residential construction), there is bipartisan support for boosting investment in residential housing( REALLY ? ). That leaves an increase in national saving as the only way to achieve the required primary external surplus. The government is, however, planning to boost its spending and cut taxes. No increase in public saving therefore can be anticipated for many years( A FEW YEARS ) to come.

The private sector in the US is, at last, saving. We have gone from a declining growth rate of private consumption to a declining level of private consumption. But what do the policy authorities do? Rising household saving equals falling household consumption equals declining effective demand equals longer and deeper recession. Can’t have that. Here is a tax cut. If you can no longer borrow from your bank, we may guarantee your mortgage so you can borrow after all( NOT A GOOD IDEA ). Everything that is desirable from a short-run Keynesian aggregate demand perspective (assuming these measures are indeed effective) is a step in the wrong direction from the perspective of restoring external equilibrium and raising the US national saving rate. ( THAT'S TRUE )

One obvious response to this opposition between what is desirable now and what is necessary in the longer run is to say: let’s do now what is desirable now and let’s take care of what is necessary tomorrow. That might be viable if the US private sector and the US policy makers had the necessary credibility to head south when the destination is north, because they can commit themselves to a timely reversal. If the authorities go ahead with the short-run Keynesian stimulus without having convinced the global capital markets and domestic producers and consumers that there will be a timely reversal, the policies will not work. ( TRUE )

This failure of expansionary fiscal policy is not for Ricardian reasons (Mr. Jean-Claude Trichet gets this wrong all the time - the Ricardian model has as one of its key assumptions that the government always satisfies its intertemporal budget constraint, that is, the government when it cuts taxes or raises spending today, is believed to raise taxes or cut spending by the same amount, in present discounted value, in the future; the second key assumption is that postponing taxes, while keeping their present discounted value constant, does not stimulate consumer demand. There either is no redistribution (from the young to the old, from those currently alive to the unborn and from those who are constrained by permanent income to those constrained by current income) or this redistribution does not have aggregate spending effects. Instead the failure of expansionary fiscal policy is because of the fear, uncertainty and higher risk premia ( TRUE )caused by the higher risk of sovereign default caused by expansionary policy.

If the government is believed to be fiscally continent (future taxes will be raised and/or future public spending will be cut by enough to safeguard the solvency of the state) but turns out not be so after all, the Keynesian fiscal policy will be effective in the short run (as long as the public believes in the fiscal virtue of the government) but will become highly contractionary once the truth dawns. ( TRUE )

Conclusion

Given the bad fiscal position of the US Federal government and given the vulnerability of the external position of the US and its growing reliance on foreign funding, the scope for expansionary fiscal policy in the US is much more limited than president-elect Obama’s advisers appear to realise. Underneath the effective demand problem is a deep structural rot, especially in household sector and financial sector balance sheets. Keynesian cyclical policy options that would be open to more structurally sound economies should therefore not be tried on anything like the same scale by the US authorities. "

I believe that the stimulus should not be more than:

Infrastructure: $100 Billion

Social Safety Net: Whatever is needed

Tax cuts: Sales Tax Cut and Targeted Investment Cuts: $300 Billion

Hopefully: $750 Billion

However, under my definition of stimulus, the figure is $400 Billion.

We should also make sure to keep repeating that we will in the future:

1 ) Raise taxes

2) Cut spending

3) Encourage saving

Finally, about the Saver Countries, I simply believe that it is going to be very hard for them to change.

"people are not going to rush to borrow to buy such big-ticket, long-lasting items anytime soon."

Sudden Debt with an interesting post about where we've been and where we might be going:

"Two of the largest sectors of the US economy are housing and automobiles. Both are reeling (see charts below).

Looking at the charts, we observe that both industries had been on a more or less continuous uptrend since 1990-92 - until they jumped off the cliff in 2007. What happened? It's quite simple, really: houses and autos are the #1 and #2 most significant purchases people make in their lifetimes, usually financing both ( TRUE ). That's where easy-easier-easiest credit came in: in just a few years household debt as a percentage of GDP jumped from 67% to nearly 100% (see chart below).
In other words, between 2000 and 2007 we over-borrowed and over-spent on houses and cars, satisfying future demand for many years to come. No matter how low the Fed takes its rates (a record low 0.0% - 0.25% as of yesterday), people are not going to rush to borrow to buy such big-ticket, long-lasting items anytime soon. They do not need them, because they've already bought them. It follows that household lending - the driving force behind finance in recent years - is also going to be down on its heels for many years ( TRUE ).

Conclusion: don't go bottom-fishing in these sectors just yet ( YOU CAN BUY INDIVIDUAL STOCKS IF YOU CAN DO THE RESEARCH ). Instead, investors will be better off looking for The Next Big Thing. What's that? My bet is on alternative energy and everything that revolves around it, such as smart electricity grids. A wholesale shift from "black" to "green" will necessarily require massive investment and will, also necessarily, lead to a shift from consumption to saving, in order to finance it( IT'S A VERY WIDE AREA, BUT THE GENERAL POINT SEEMS RIGHT ). This will pose significant challenges to the retail and traditional services sectors, too.

I fully expect a long period of massive Creative Destruction to unfold, i.e. OPPORTUNITY. ( I AGREE WITH THIS, AS DOES JIM GRANT )Any and all ideas from readers are welcome.."

One added point. I've said that houses are an investment, so that, theoretically, the money that had been used for buying houses would now be spent on other things. As well, it is important to remember that for the people who remain in their houses after buying in recent years, the house is still an investment which generally pays off better than renting. As for autos, that money should also go towards other purchases. I'm not savvy enough to know where that money is going to go. This is a version of Ricardian Equivalence.

"Allowing central banks to transfer cash directly to households would be the purest form of Milton Friedman’s “helicopter drop”.

By now, you know my position on printing money. I'm for it, damn it, and don't get in my way. Here's Eric Lonergan in the FT:

"The most direct and efficient solution to the economic and financial problems is for central banks to transfer cash directly to the household sector.

Final demand and profits would recover, asset prices would rise and as a result banks would have strengthening balance sheets. Fiscal positions would similarly improve with rising revenue.

These are the effects that policymakers are trying to achieve in an indirect and inefficient manner: we are using governments to do the spending, and we are trying to fix the financial system piecemeal, when the problem is demand, profits and prospective default risk.

Allowing central banks to transfer cash directly to households would be the purest form of Milton Friedman’s “helicopter drop”."

I'm starting to feel very proud of myself for having read that Buiter paper. Let's put Wagner on and get the helicopters flying, like those lovely monkeys in "The Wizard Of Oz". I'm not joking. I've always loved those monkeys. I love the smell of cash dropping from the sky in the morning. It smells like...like...Recovery.

"What is lacking is a legal and institutional framework to do this. "

To hell with that. We don't have time to worry about legalities and institutions. Sadly, that's exactly opposite to what I believe, but let's go on. Maybe he knows a way around this problem, not involving torture.

"The helicopter model is right, but we don’t have any helicopters. Open market operations are ineffective at the zero bound because the financial system just holds more cash, as we have seen in Japan. We need to print the money and give it directly to consumers."

Why don't you just rent some helicopters from the traffic reporters? Ah yes, I do love the printing idea. Agreed.

"Central banks, and not the fiscal authorities, are best placed to make these cash transfers. The government should determine a rule for the transfer. It is the government’s remit to decide if transfers should be equal, or skewed to lower income groups."

As long as you're giving free money out, you might want to skew it towards the poor. Just a thought.

"This rule should be decided in advance."

How else could they decide who to give it to? Unless you're taking this helicopter thought experiment seriously.

" But the quantity and timing of the transfers should be the authority of the central bank, subject to their discretion and to be used with the intention of meeting their inflation and growth objectives. The central bank would then raise interest rates and shrink its balance sheet when the economy recovers.

The reasons for granting this authority to the central bank are clear: it requires use of the monetary base. Granting government such powers would be vulnerable to political manipulation and misuse. These are the same reasons for giving central banks independent authority over interest rates.

Under the existing legal and institutional framework, the closest equivalent policy to this helicopter drop is for the government to make transfers financed by the central bank. Indeed, I suspect this is indirectly what America will do next year."

It will if I have any influence on my fellow citizens with this blog.

"Tax rebates (i.e. cash transfers) will likely be a part of Larry Summers and Tim Geithner’s fiscal stimulus and US Federal Reserve chairman Ben Bernanke has already talked - to considerable effect - about buying government debt as a next step for the Fed.

This is an entirely reasonable approach, given current institutional constraints. But a pure helicopter drop has obvious and compelling advantages. It protects central bank independence, and gives central banks a means for stimulating demand quickly and efficiently when interest rates reach zero. What will we do if the fiscal stimulus fails to trigger a recovery?"

I'm a helicopter and tax cut and stimulus man. What do you say to that?

"Possibly of importance is the issue of Ricardian equivalence (the theory that suggests that unfunded tax cuts will have no effect on spending because the public know they will be taxed in future to pay for current government largesse).

Ricardian equivalence is a useful concept not because individuals are hyper-rational, but because the opposite is true: framing matters. If cash transfers are financed by government borrowing from the central bank there will be calls for prospective fiscal policy to be tightened. If the central bank prints money this pressure will not exist, and a framework for responsible use of this tool already exists - medium-term price stability."

Leave Casey Mulligan out of this. But I agree, just print the money.

"We need a legal and administrative framework to allow central banks print money and transfer it to households. This would be efficient, effective and would eliminate the deflation risk for good."

Good luck my friend, and thanks for the post.

"For now, of course, Macro Man has to scratch his head at some of the pricing out there. "

MacroMan sees good news out there:

"Macro Man remains dubious that this is the appropriate conclusion. His view is that the actions of both the Fed and the Treasury, however ineptly communicated (here's lookin' at you, Hank!) simply represent the principle of Ricardian equivalence at work."

I guess he means that there will be no increase in demand.

"The past few decades, but particularly the past few years, have seem enormous rise in private sector leverage....both through traditional lending and derivatives contracts. The past couple of years have seen the total face amount of outstanding derivatives contracts increase at a run rate of $150 trillion dollars per year, according to the BIS.

And guess what? The value of that stuff has gone down. Financial institutions and private sector actors have learned the hard way that assets may come and go, but debt lasts forever. UBS estimates that banks need to raise an additional $1 trillion in capital to offset the amount of forthcoming losses and writedowns."

It seems he believes that banks, are, in essence, saving. I don't read that chart in quite the same way. I see a lot of derivatives yet to be worked out.

"At the end of 2007, Citigroup had more than $2 trillion of assets on their balance sheet. That number will be a lot lower by the time all is said and done. Not that US banks have a monopoly on absurd leverage, of course; at the end of last year Deutsche Bank had over €2 trillion of assets- that's 80% of German GDP. Again, trends in that figure are only going one way moving forwards."

The banks are saving.

"So in Macro Man's view, any dollars "created" by the Fed to expand its balance sheet (and let's not forget, they have yet to really crack out the printing presses by not sterilizing their asset purchases) will merely partially offset dollars lost through de-leveraging and the implosion of the shadow banking system, rather than finding their way into new the purchase of fresh turds."

There's no increase in demand.

"The impact of these programs will, in Macro Man's view, only submarine the dollar once the crisis is resolved and domestic demand begins growing organically again. That seems likely to be several years away, for there is another kind of Ricardian equivalence at work- the ballooning of the US budget deficit should be offset by a sustained rise in the US private sector savings rate.
I don't see how it's different, except that it's individuals saving money, as opposed to banks paying down debt.

"For now, of course, Macro Man has to scratch his head at some of the pricing out there. US sovereign CDS have ballooned out.....
...and are now trading merely a dozen bps below BNP! Are you kidding me? The US government (a flawed beast, to be sure, but the owner of a printing press for the current world reserve currency) a similar credit to a French bank? Puh-leeeez....."

Well, here's where MacroMan's thesis goes a bit sideways, because the CDSs on US Government Bonds, which I've already talked about today, are saying that the risk of default is worse. From MacroMan's point of view, they should have stayed the same, and, quite frankly, be getting better.

"His methodology has served him well this year, and he has little intention of becoming another footnote when the history of today's Ricardian equivalence is written."

Good luck to MacroMan and Casey Mulligan.

“Congress has allocated hundreds of billions of dollars to reset mortgages"

Floyd Norris considers the plight of a luxury home builder in the NY Times:

"Today, Toll reported its fourth-quarter revenues. They are down again, with cancellations ticking up. A bit belatedly, Mr. Toll realizes his fleeing customers were right: There really is an economic problem.

He has a solution:

“We urge Congress to stimulate demand by reducing mortgage rates and fees and by providing incentives such as a buyer tax credit for the purchase of all types of homes. We believe these initiatives would offer the greatest benefit for the taxpayer’s dollar.”

The way he sees it, stabilizing home prices is the only way to keep all the other efforts from failing.

“Congress has allocated hundreds of billions of dollars to reset mortgages, help people who are in foreclosure, and protect those who have been the victims of rapacious lending practices. We believe all of these goals are very worthy. However, we believe that, if home prices are not stabilized, these efforts will be for naught, more mortgages will go under, and the taxpayers’ money will have been wasted.”

Others might say that tax breaks and unreasonably low interest rates helped to get us into this mess. Making new buyers overpay runs the risk of a repeat of what happened after the Japanese bubble burst, when artificially high prices simply prolonged the pain."

Do I hear a second for a Nobel Prize in Economics for Mr. Toll?

"Mr. Toll was asked in the call if any members of Congress were on board to back his plea to subsidize home prices. He said there had been talks, but he had no endorsements.

As to why the government should be subsidizing home builders when there is an oversupply of houses, he said the country needed the construction jobs."

Here's my comment:

He has a solution:

“We urge Congress to stimulate demand by reducing mortgage rates and fees and by providing incentives such as a buyer tax credit for the purchase of all types of homes. We believe these initiatives would offer the greatest benefit for the taxpayer’s dollar.”

Technically, I believe that he’s asking the Congress to pay to lower and stabilize prices. The demand is there. They’re just asking for better terms for themselves. Lowering the price even more by themselves or easing terms should accomplish the same object. It’s called supply and demand. Oh, and let’s add Ricardian Equivalence just for fun. To the extent that the government chips in, it forces the private sector out. I knew I had a use for that concept.

— Don the libertarian Democrat

"In light of the most recent data another fiscal boost is needed, and it had better be big."

Clive Crook also supports a stimulus:

"How big a boost? One leading policy economist -- also a noted scholar of the Depression and a level-headed man not given to exaggeration -- is Barry Eichengreen of the University of California (Berkeley). He has called for a further stimulus of 5 percent of national income: in other words, another $700 billion. "This means that the [budget] deficit may be closer to $2 trillion than $1 trillion next year," he points out. A $700 billion stimulus is at the high end of the numbers currently being suggested. Among economists, packages of $300 billion to $500 billion are more the norm, and proposals circulating on Capitol Hill are at the lower end of that range. A year ago, even these smaller sums would have been regarded as staggering.

I agree with Eichengreen. The economy is no longer on the edge of the precipice but tipping over into free fall. A second stimulus package of $500 billion or more -- to include spending on infrastructure and unemployment assistance as well as tax cuts -- is necessary. If you are going to do this, there is no point in half-measures. The government has to fill the space that terrified consumers are now vacating, and it is a very big space."

I agree. Here's my comment:

"If European governments and other countries introduce big fiscal plans of their own (as they should, in their own interests), the chances of a flight from the dollar would come down. Second, the package should ideally include commitments -- including postdated tax increases and reform of the budget process -- that would reassure investors that Washington will bring the deficit back under control once the crisis is over."

But this:

http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2008/10/the-benefit-of-inequality.html?cid=137119795#comments

"Stumbling and Mumbling on a stimulus plan:

"This raises an obvious question. If government borrowing today merely means lower state spending or higher taxes tomorrow, why should it boost aggregate economic activity at all? Won’t it just cause tax-payers to save in anticipation of higher future taxes, or public sector workers to save in anticipation of redundancy?
This is, of course, the challenge of the Ricardian equivalence hypothesis. This says that fiscal policy is impotent, because people should save in anticipation of higher future taxes, which is what borrowing is."

Will people save in preparation of tax increases? Or losing a job?

"the UK is one of the few countries in which Ricardian equivalence is wrong. So perhaps fiscal policy might work.
How can this be?
It‘s not necessarily because people are short-sighted. It‘s because they are liquidity-constrained - they can’t save or borrow enough.
Put yourself in the shoes of a poorly-paid person. You might anticipate higher taxes in five years’ time. But what can you do about it? You’re struggling to pay rent and leccy bills today. You just can’t save as a precaution against future problems - you’ve enough on your plate making ends meet now."

Well, if people are poor enough, No. They can't. They need to live.

"But what if we had a more progressive tax system, with taxes only levied upon those of us who can afford to save? We might well trim spending on fripperies to save more. We would then be in the world of Ricardian equivalence, in which public borrowing was offset by private saving."

So, people who can save will.

Conclusion:

"My point is simple. What allows Darling’s fiscal policy to work is the fact that taxes fall upon people who can‘t save. If the poor were better off - and so able to save - or if taxes were more progressive, fiscal policy would be less powerful.
Personally, I’d prefer a world of greater equality and less powerful fiscal policy. But not everyone shares my preference."

I agree, but I'm not sure I accept the reasoning. For one thing, oddly, if the rich will save in anticipation of future taxes, why not tax them now, and obviate that problem. Another possibility would be to raise taxes until they don't want to save. One could also tax their savings. I'm not advocating any of these things, but there do seem possibilities to counter this effect where it exists."

And this:

"You might be interested in this about the Japanese stimulus plan from the FT:

http://www.ft.com/cms/s/0/00df00ae-a63c-11dd-9d26-000077b07658.html

"Although the handouts would increase household disposable income, given that there could be a consumption tax rise in three years, the plan was structured in a way that would encourage people to save, Mr Morita said."

Now, are we more like Britain or Japan? Easy, where saving is concerned. But you've already mentioned the tax cuts earlier this year, and the fact that a lot of it was saved. Now this, from the WSJ:

http://blogs.wsj.com/economics/2008/10/31/good-news-for-stability-bad-news-for-growth/

"Part of the reason that consumer cut back on spending in September is that Americans were putting more of their money into savings. That may not be good news for GDP growth in the short-term, but it’s a positive sign for the long-term stability of the economy.

In September, personal saving — disposable personal income less spending — was $140.3 billion, compared with $82.5 billion in August. That raised the savings rate to 1.3% from 0.8% in the previous month. The savings rate spiked from May to July on the back of the government’s stimulus payments, but averaged below 1% for a number of years. It was just 0.2% in April before the stimulus payments went out, and has been nearly flat for years, not rising more than 1.5% in any month since 2004. The rate was in double digits in the 1970s and early 80s, but began a steady decline to the historic lows reached in recent years."

So, I'm with you on the stimulus, and we should eventually work on the deficit and debt, but, for God's sake, don't announce that now.

As the WSJ reports:

http://blogs.wsj.com/economics/2008/10/31/ecb-to-governments-spend-more/

"In a currency bloc governed by strict rules about how much debt national governments are supposed to hold, it doesn’t happen often that a central banker encourages governments to up spending. But radical times call for radical measures."

Let's be radical now, and conservative later.

Posted by Don the libertarian Democrat | October 31, 2008 3:48 PM