Two Keys to Economic Recovery - 1/25/09
While the partisan rancor over Obama's stimulus plan rages on, the most important keys to economic recovery remain unchanged. The first key, an aggressive slashing of interest rates languishes in the graveyard of month old news while the second key, aggressive liquidation of toxic assets, has been addressed, but not fully resolved by the TARP.
Partisan wrangling over government spending comes as no surprise to economists. One college macroeconomics textbook even includes this passage that urges consideration of political practicalities when pursuing economic stabilization:
"In practice, most students of stabilization policy have come to believe that the unwieldy and often partisan nature of our political system make active use of fiscal policy for stabilization purposes difficult, if not impossible. Monetary policy, they claim, is the only realistic game in town, and therefore must bear the entire burden of stabilization policy"
- Macroeconomics: Principles and Policy 10th Edition.
The most important development in the last six months is and still remains the aggressive slashing of the interest rate window down to 0.0 - 0.25. It will take time to feel the effects of these drastic rate cuts. Rather than toss our eggs into the monetary basket and hope it works, government stimulus exists as a support option should monetary policy prove to be ineffective. The question becomes: do we need fiscal stimulus AND monetary stimulus at the same time? Is it possible to over-stimulate?
Preliminary numbers from the Congressional Budget Office identified that "only $26 billion out of $358 billion in infrastructure and other appropriated spending would be delivered into the economy by the Sept. 30 end of the budget year." This suggests that larger, more rigid components of the stimulus will be delayed until further evidence of their necessity emerges.
As Barack Obama's Director of the Office of Management and Budget, Peter Orszag states, "there is an important economic argument that you don't want to jump-start the economy and then create a huge air pocket at the end." Baumol and Blinder's book illustrates Orszag's case:
"The argument of stabilization policy runs something like this: Policy makers recognize that the recession is a serious problem at point B, and they take appropriate actions. These actions have their major effects around point C and therefore limit both the depth and the length of the recession"
"But suppose the lags are really less predictable than those just described. Suppose, for example, that actions do not come until point C and that stimulative policies do not have their major effects until after point D. Then policy will be of little help during the recession and will actually do harm by overstimulating the economy during the ensuing boom"
A second key to economic recovery is an aggressive policy to cleanse the banking system of toxic assets. It appears the expected Treasury Secretary, Timothy Geithner, is thinking along these lines.
"The good bank/bad bank-type solution has been present as the solution to most financial crises around the world," Geithner remarked, "[pricing toxic paper] is enormously complicated to get right... We want to be very careful, not just that we are using the taxpayer's money most effectively ... but also that we do these in ways where the taxpayer and the government understands the risks we're taking."
In Age of Turbulence, Alan Greenspan points to unique cultural forces in Japan that made a policy of aggressive asset liquidation a hard sell in the 1990s, "throwing delinquent debtors into bankruptcy and liquidating their bank collateral was to be avoided, as was firing people. The Japanese hewed to a code of civility that made inducing a loss of face virtually unthinkable."
This failure to act decisively and drain the banking system of bad assets leads Greenspan to conclude, "the Japanese had purposely accepted hugely expensive economic stagnation to avoid a massive loss of face for many companies and individuals. I cannot imagine U.S. economic policy following such a track."
The Obama stimulus is a call option, a pledge, and a hedge if monetary policy combined with a cleansing of the banking system fails to have the desired effect on the economy. While arguing over how to spend one trillion dollars of government money makes for better tv and fills more blog space, it's a mistake to overlook the drastic fed action as inconsequential and ineffective after one month. If the economy shows improvement in the next year, the expected fiscal spending becomes unnecessary.
"There seems to be some perverse human characteristic that likes to make easy things difficult." -Warren Buffett