Tuesday, September 7, 2010

We Need More Money

I enjoyed reading Prof. Ramirez's previous post and think the analysis is spot on. I slightly disagree, however, with his policy prescription. I believe he is absolutely correct in that "instead of trickle down bailouts the Obama Administration needs to pursue bottom up bailouts." I also agree that a massive stimulus would help the economy. But, learning the lessons of the previous stimulus we know that there are certain practical limitations on how quickly the government can spend money. For this reason, many economists believe that monetary policy is the best way to stimulate a recovery.

Probably the bast way to explain why this is is to start with why recessions happen in the first place. It's not because people make bad business decisions or because people desire to work less, but because of poor policy decisions made by those who handle monetary policy, the Federal Reserve. Paul Krugman explains in a piece he wrote in 1998 (for explanation why structural reasons are an unlikely cause of this recession I'd suggest reading the whole piece):

"A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?"
What Krugman is saying here is that we have lots of people who want jobs and lots of work for them to do, but people value money more than they value what is produced. There is excess labor and capacity, but not enough demand. Why does this matter? In an excellent post, which contains some colorful language , Karl Smith explains:
This is not a big deal like the GOP doesn’t appreciate public goods. Or, Democrats don’t understand incentives. Or some other such second order debate that could reasonably concern us in different times.

This is a failure of our basic institutions of production. The job of the market is to bring together willing buyers with willing sellers in order to produce value. This is not happening and as a result literally trillions of dollars in value are not being produced.

Let me say that again because I think it fails to sink in – literally trillions of dollars in value are not being produced. Not misallocated. Not spent on programs you don’t approve of or distributed in tax cuts you don’t like. Trillions of dollars in value are not produced at all. Gone from the world entirely. Never to be had, by anyone, anywhere, at any time. Pure unadulterated loss.

Time and time again I see people speak about recessions as if they are a bad harvest – an unfortunate event wherein we have to figure out how to go with less. Some say we should all sacrifice – some say the sacrifice should be based on X or Y. Some say each family should take their lumps as they come.

However, they are all getting the basic idea wrong. This is not a bad harvest. The problem isn’t that there is less to go around. The problem is that we are creating less, building less, making less.

We have people who would be working but are instead watching Judge Judy. We have machines that could be spinning but are literally rusting for lack of use. This is a coordination disaster.

So what is the right policy to solve this problem? Certainly stimulus helps, it puts people to work and creates demand in the economy because these jobs put money in their pocket, something the economy craves. A better approach, however, is to favor inflation (or rather a NGDP target). Without explaining the intricacies of inflation, this would make the debts that people currently have worth less and make them easier to pay off, reducing the incentive to save and the demand for money. This policy would also not only provide debtor relief, but does not require the consent of Congress who is clearly clueless as to how this recession happened and the policies that are necessary to fix it. In the end, it doesn't matter how the economy gets the excess demand that it requires, whether through stimulus or an inflation target, but that our institutions are strong enough to solve the policy errors that got us into this mess. On that count I'm quite worried.


  1. "Without explaining the intricacies of inflation, this would make the debts that people currently have worth less and make them easier to pay off, reducing the incentive to save and the demand for money."

    I like this approach, if it will make debts easier to pay off and does not require any hand of Congress I am all for it.

    As we can see from recently elected GOP officials, many have no idea where to start on cutting the deficit...and it is highly likely that nothing will get done during the coming term of Congress...better they stay out of it and dig a deeper whole through gridlock.

  2. I agree with the previous comment. The thought of fixing the economy via monetary policy is appealing.
    The only trouble with increasing the Fed Fund Rate-to stimulate inflation-is that some of the homes that are on adjustable rate mortgages will be lost.
    Either way whether we chose a stimulus or we chose to fix the economy by monetary policy soothing must be done.