A Unique Economic Situation

2010 July 4 by Frank Monaldo.

Economic analysis is complicated by the fact that controlled experiments are generally not possible. One cannot test different policy prescriptions on exact same economy and evaluate the different results. Arguments are made by analogy to previous circumstances. For this reason, it is difficult to conjure up a consensus among economists as to the best way to help the American economy recover from its current high unemployment and sluggishness.

There are two basic schools of thought: one that emphasizes monetary policy and one fiscal policy. Is the economy more or less responsive to controlling the money supply or federal taxation and spending, or some combination.

Milton Friedman won the Nobel prize in economics in 1976, for his explication of monetary policy and in part on his analysis of monetary policy during the Great Depression. Friedman argued that that collapse of the economy in the 1930s after its initial signs of trouble was caused the exact wrong policy followed by the central bank. The central back tightened rather than loosenes the money supply cause radical deflation and a lack of money available for investment.

The economist John Maynard Keynes is the champion of fiscal policy. Keynes has argued that federal deficits make up for demand in the private sector during recessions and provide a means for recovery. It should be noted deficits can be increased either by increased spending on reducing taxes

Since the banking crisis in 2008, the Federal Reserve has loosened the money supply about as much as it could. Perhap by this more than any other policy, the Federal Research helped avert a 1930s-like collapse in economic activity. At this point, however, the Federal Research has exhausted much of its ammunition. Interests rates are at historic lows. Monetary policy has helped, but all the Federal Reserve can do now is maintain a loose monetary policy until a strong recovery commenses.

In February 2009, after the immediate banking crisis had abated, the Obama Administration passed its stimulus package with nearly a trillion dollars of deficit spending. Results have been at best mixed. Growth remains anemic and unemployment and under employment remain much higher than the Obama Administration promised. Nobel-prize winning economist and NY Times columnist, Paul Krugman, recently argued that given the lack of economic response, we need to re-double fiscal stimulus. We note in passing that Krugman always argues from more governement spending and not reduced taxes. Either would increase the fiscal stimulus.

We submit the thesis here, that additional fiscal stimulus now would be ineffective because of collective physcology. Given the massive deficits we have already incurred, people will become more apprehensive about the future and hoard cash if the deficit increases much more. The problem was that the Obama stimulus was accompanied with health care changes and progressive agenda that promised not a one-time fiscal punch, but a fiscal trajectory that would incur even greater deficits or significant tax increases. In the face of this uncertainity, people are saving more. in anticipation of future bad times. Ironically, this fear is suppressing consumer demand. Business, also faced with uncertainty, sits greater than average cash reserves.

By creating what seemed to be a permanent and expontenially expanding deficit, rather than a short-term stimulus, the Obama Administration undermined the effectiveness of its signature economic policy. At this point, the best that can done is to reduce uncertainity by maintaining the current tax code and creating an economic plan that restrains federal spending. In any case, it will take a long time to dig out of the current situation, but if certainty returns, businesses will be more willing to invest their acccumulations of cash and consumers wil be more willing to spend some of their savings.

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