Can a tax cut deepen the recession?

We've seen that demand-sided policies always have a trade-off between unemployment and inflation, yet supply-sided policies don't have that same trade-off. Gauti B. Eggertsson, an economist with the Federal Reserve Bank of New York, makes quite a convincing argument that supply-sided policies may not work when the interest rates are close to zero:

At zero short-term nominal interest rate, tax cuts reduce output. They do so because they increase deflationary pressures. Policies aimed at stimulating aggregate demand work better. These policies include (i) a temporary increase in government spending and (ii) a commitment to inflate. The multiplier of tax cuts goes from positive at positive interest rates to negative once the interest rate hits zero, while the multiplier of government spending not only stays positive but becomes many times larger at the zero bound.

There has been much discussion in recent weeks about a stimulus plan to revive the US economy. Many economists argue that a recovery plan should include aggressive tax cuts. In this paper I show that under the special circumstances which the US is experiencing today — interest rates that are close to zero and deflationary pressures — tax cuts are contractionary in a standard New Keynesian model. Why? Tax cuts cause deflationary pressures in the model and thereby increase the real interest rate. The Fed can’t accommodate this by cutting the Fed Funds rates, since they are already close to zero. Higher real interest rates are contractionary.

Wow... That's a lot of economics! Can you summarize Eggertsson's argument? What are supply-sided policies, and why does he say that supply-sided policies won't work right now? What's the deal with the multipliers? What happens when the real interest rate increases? Why would this be bad for the US economy right now?

Negative interest rates?

My economics hero, N. Greg Mankiw, proposes an ingenious solution to the recession:

Until recently, most economists relied on monetary policy [to escape a recession]. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them.

In many ways today, the Fed is in uncharted waters. So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent? At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress.

Unless, that is, we figure out a way to make holding money less attractive.

There is a way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.

Wow! What do you think? Evaluate Mankiw's proposal using sound economic theory on monetary policy, recessions, and inflation. [Remember that evaluate means to show pros and cons as you commit to a decision.]

Obama Gives Keynes His First Real-World Test

National Public Radio broadcast this report on January 29, 2009:

John Maynard Keynes is an unlikely hero for our time.

Keynes, a British economist who died more than 60 years ago, inspired President Barack Obama's plan to save the U.S. economy with a massive round of government spending. The British economist published his big theory, the one underpinning most of what Obama intends to do, in 1936.

Keynes corrected what he saw as a fundamental error in the economics that had come before. Classical economics teaches that if there's a downturn, the economy will eventually sort itself out. If people aren't buying enough, prices will drop to a point where people start spending. Keynes' radical insight was to look out the window in the 1930s and see that sometimes things don't right themselves. The economy goes into a downward spiral. The usual dynamic of supply and demand breaks down.

"A failure of effective demand is what he called it," says Alan Blinder, a Princeton economist who served as economic adviser to President Bill Clinton. Basically, people aren't spending enough money, either because they don't have any or because they got laid off or are afraid they're about to get laid off. If people aren't spending enough money, there's no way for the economy to automatically adjust. During the Great Depression, no one had figured out how to get people spending again. Then came Keynes.

"The Keynesian prescription is if all else fails, the government can spend the money," Blinder says. Normally, in a free-market economy, the public doesn't look to the government to prop up spending. "But Keynes' idea, which was revolutionary at the time, is if the private sector won't do it, then the public sector can do it as a fill-in stopgap," Blinder adds.

The Great Experiment

Many of the economists say they just don't know whether the Keynesian approach will work. Financial catastrophes don't happen often enough to prove theories like his. In fact, as economists like Blinder will tell you, this is the problem with economics.

Anti-Keynesians say this massive stimulus package is too risky an experiment on an unproven theory. It might not get America out of the recession, they say. It might cause vicious inflation and a bloated government, and leave a trillion more dollars in debt as a constraining burden on Americans' children and grandchildren.

The Obama administration is betting that won't happen. They're trusting this theory. They're trusting Keynes.

How might Neo-Classical and Keynesian economists look at this current crisis? Examine their differences. What are their respective strengths and weaknesses?

Responding to an Historic Economic Crisis: The Obama Program

Larry Summers, Director of President Obama's National Economic Council, made these remarks on March 13, 2009:

First, I'd like to describe how best to think about this crisis.

One of the most important lessons in any introductory economics course is that markets are self-stabilizing.

• When there is an excess supply of wheat, its price falls. Farmers grow less and others consume more. The market equilibrates.
• When the economy slows, interest rates fall. When interest rates fall, more people take advantage of credit, the economy speeds up, and the market equilibrates.

This is much of what Adam Smith had in mind when he talked about the "invisible hand."

However, it was a central insight of Keynes' General Theory that two or three times each century, the self-equilibrating properties of markets break down as stabilizing mechanisms are overwhelmed by vicious cycles. And the right economic metaphor becomes an avalanche rather than a thermostat. That is what we are experiencing right now.

What is the task of policy in such an environment?

The first component of the President's program is direct support for jobs and income to engage the multiplier process in favor of economic expansion. Increases in income lead to financial repair which supports further increases in income. Rising employment will lead to rising spending, which leads to further increases in income and employment.

The Recovery and Reinvestment Act is the largest peacetime economic expansion program in the country's history. It will inject nearly $800 billion into the economy, ¾ of it within the next 18 months. The Council of Economic Advisors' estimates suggest that the Recovery and Reinvestment Act will save or create 3.5 million jobs. It will at the same time do some of the work that the nation has needed done for a long time—doubling renewable energy capacity in the next 3 years, supporting middle class incomes, modernizing ten thousand schools, and making the largest investment in the spine of our national economy – the nation's infrastructure – since Dwight Eisenhower's investment 50 years ago.

It is surely too early to gauge the broader economic impact of the President's program. But it is modestly encouraging that since it began to take shape, consumer spending in the US, which was collapsing during the holiday season, appears, according to a number of indicators, to have stabilized.

What specific fiscal policy priorities seem to be at work here, and what are their pros and cons for AD or AS? You can view the line-item breakdown here. What specific things in this economic climate might hinder the multiplier effect of Obama's fiscal policy? Don't just write about general theory...

Robert Kennedy on GDP

In 1968, U.S. Senator Robert Kennedy gave an impassioned speech about using GDP as the measure of a nation's wealth:

We will never find a purpose for our nation nor for our personal satisfaction in the mere search for economic well-being, in endlessly amassing terrestrial goods. We cannot measure the national spirit on the basis of the Dow-Jones, nor can we measure the achievements of our country on the basis of the gross domestic product.

Our gross national product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for those who break them. It counts napalm and the cost of a nuclear warhead, and armored cars for police who fight riots in our streets. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children.

Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans.

What do you think, reading this 40 years later? Evaluate Robert Kennedy's ideas.

Are newspapers worth saving?

A recent article says "YES":

With many U.S. newspapers struggling to survive, a Democratic senator on Tuesday introduced a bill to help them by allowing newspaper companies to restructure as nonprofits with a variety of tax breaks... Cardin's Newspaper Revitalization Act would allow newspapers to operate as nonprofits for educational purposes under the U.S. tax code, giving them a similar status to public broadcasting companies.

Under this arrangement, newspapers would still be free to report on all issues, including political campaigns. But they would be prohibited from making political endorsements. Advertising and subscription revenue would be tax exempt, and contributions to support news coverage or operations could be tax deductible. Cardin's office said his bill was aimed at preserving local and community newspapers, not conglomerates which may also own radio and TV stations.

"We are losing our newspaper industry," Cardin said. "The economy has caused an immediate problem, but the business model for newspapers, based on circulation and advertising revenue, is broken, and that is a real tragedy for communities across the nation and for our democracy."

Newspaper subscriptions and advertising have shrunk dramatically in the past few years as Americans have turned more and more to the Internet or television for information. In recent months, the Seattle Post-Intelligencer, the Rocky Mountain News, the Baltimore Examiner and the San Francisco Chronicle have ceased daily publication or announced that they may have to stop publishing. In December the Tribune Company, which owns a number of newspapers including The Baltimore Sun, The Chicago Tribune and The Los Angeles Times filed for bankruptcy protection.

What do you think? Are newspapers going the way of horse-drawn carriages? Write about two in-depth connections to our intro unit on macroeconomics: GDP, the business cycle, unemployment, and/or inflation.

I, Pencil...

Another way to summarize all we've done in class so far is to look at all the economic interactions needed to produce a relatively simple good like a pencil.

A pencil, by almost any measure, is an exquisitely complex thing. Somewhere in a harvested forest was the stand of cedar trees that gave up their wood to provide the pencil's dowel. Somewhere in the Jamaican interior is the bauxite mine that provided the raw material for its little aluminum sleeve. Somewhere in the coal belt is the mine that provided the lump carbon for the graphite. Still elsewhere is the lab where the raw polymers were cooked up into rubbery erasers. And to those places that provided those things streamed still other things -- the smelting ovens for the metal plants, the autoclaves for the rubber labs, the blades for the sawmills, the backhoes for the carbon mines, the cotton to dress the lab workers, the bacon to feed the lumberjacks, the paymasters and truck drivers and box packers and shipping managers to keep all of the operations humming. A vast industrial machine rises up, switches on, and at its far end, spits out... a pencil, arguably one of the most complicated objects in the world. From Simplexity, by Jeffrey Kluger

Wow! Isn't that incredible? Think about all that in light of all we've learned in class. Choose another "simple" good and write about all the economic interactions that "magically" came together to get that good onto the shelves of Al Jazira market.