It has been almost 4 years since the US fell into the Great Recession and we have yet to see a strong recovery. One of the after-effects of the Great Recession has been the increased attentiveness to monetary policy. Attentiveness to monetary policy existed before the Great Recession but not to the degree seen today; since the Federal Reserve took unconventional steps in 2008 to fight the recession, it now seems like every single word or action coming of the Federal Reserve (Fed) is a do or die moment for the markets and the economy.
Well, I got bad news for all those who think monetary policy is the “Holy Grail” to our problems – it’s not. Unfortunately, this reliance on the Fed has diverted attention away from the true matter we need to concentrate on: fiscal policy. Despite what all the supporters of monetary policy say, the Fed is out of bullets. They dropped interest rates to 0% (to make borrowing more affordable), conducted QE1 which calmed markets by providing liquidity (“Credit Easing”), tried QE2 & Operation Twist (which aimed to bring longer-interests rates down) and attempted better communication measures (“Rate Easing”) as they committed to keeping interest rates near zero “at least through late 2014”.
Despite these actions taken by the Fed, we still see high unemployment and weak GDP growth. While parts of the economy are showing strength, the two most important measures of the economy show anything but strength. anything but that. Why can’t we solve our problems if monetary policy worked in the past? Market Monetarists (strong supporters of super aggressive monetary policy) will say that the Fed (and every major Central Bank) has failed to do its job. However, this is just wrong.
The main reason we are in an economic malaise is because we are stuck in a “Balance Sheet Recession” (termed by Richard Koo). This is a rare but deadly type of economic illness in which the private sector (or parts of the private sector) is no longer concerned with maximizing profits, and instead is focused on minimizing debt – even at zero interest rates. The balance sheet recession happens when a nationwide asset bubble pops, and the private sector finds itself overleveraged and underwater as the asset price falls. In the US’s case, this nationwide asset bubble happened to be in the largest asset Americans owned , houses. The popping of the housing bubble left millions of households in debt. Those who could no longer afford to pay down the liability, (the debt) defaulted.
However, many Americans, despite being underwater (liability > asset) rationally chose not to file bankruptcy because they still generated enough cash flow to cover their debt payments. This is what threw the US in the balance-sheet recession; as households were focused on paying down debt, spending and investments fell. And when large populations of people do not spend money, aggregate demand falls, unemployment rises from weaker sales, and GDP contracts.
This is where monetary policy becomes impotent. Monetary policy works through two channels. The first channel is through credit. They can make borrowing cheaper or more expensive. The second channel is through expectations, mainly by altering views of inflation. There are two problems with these channels. People (especially the baby boom generation who experienced the housing collapse) don’t want to borrow as they are in the middle of the deleveraging cycle. The problem with expectations is assuming that actions taken by the Fed are communicated to everyone in the economy and that everyone will act upon it. This isn’t true as most small and medium businesses (which are a major part of the economy), don’t even know what the Fed is, let alone their policies.
Higher inflation is supposed to increase people’s spending and investing habits; however, as we know, that is not the issue here. People and/or companies who have healthy balance sheets are not hoarding/not spending money because they fear deflation, regulation, or any other issue; they are doing it because of one thing: low aggregate demand!
Fiscal policy on the other hand can provide direct stimulus, which not only can alter views (imagine knowing you would be getting a tax cut in 2013 instead of a possible tax increase), but can actually boost the economy right away. Through fiscal stimulus (government spending & tax cuts), the government can increase the total number of net financial assets the private sector holds to the point where it would boost aggregate demand. For example, a full payroll tax holiday will put up to a trillion dollars back in the economy (that is about 5-6% of GDP). A payroll tax holiday would put money back in the pockets of those who need the money. Debt will be paid down faster, and savings & spending will increase thus boosting sales. This will surely boost aggregate demand and would finally close the output gap. An infrastructure stimulus package would bring down unemployment almost immediately, would give a much-needed investment upgrade and would increase sales right away (which is the number one concern for businesses as confirmed by many economic surveys).
One of the main reasons we don’t see strong fiscal policy is because the people who “control the engine” refuse to step on the gas. Instead, they are actually about to hit the breaks and slow the car down even more despite already driving at 20 miles per hour below the legal speed limit! The problem with those in Congress (who controls the checks) is that they are economically ignorant and do not understand the basics and realities of the modern monetary system. This, along with the major focus on monetary policy, shifts the attention away from the main conversation we should be having on fiscal policy. We demand higher aggregate demand!
Jerry Khachoyan
Jerry Khachoyan is currently an intraday equity trader who blogs over at the Stocktwits Network. He is also a student at UCLA. His interests not only include trading and markets, but also macroeconomics.
13 Comments on “The Truth About Our Economy”
No, 1.5T is not enough if you want strong GDP growth and full Employment. Why is 1.5T viewed as “Big”? Just b/c its a big number? So is 10 Billion but that doesnt mean thats the proper amount deficit we should be running.
Anyway, what is a deficit? The public sector deficit is just the private sector net savings (savings-investments). Its a sectoral balance. If the Gov cuts its deficit, and the private sector is not to the point where they are holding enough net financial assets, then a recession will follow. This has been true every-time as this chart proves: https://twitter.com/#!/TheArmoTrader/status/183020364618670082/photo/1/large
The Net Savings of the priv sector drops, we fall into a recession, deficits grow larger, we implement austerity (Yes, I consider what the US is doing Austerity right now), and ‘tax revenues’ fall even further and spending jumps even higher (as automatic stabilizers kick in).
The reason Japan has been in a no-growth enviorment is b/c they FAILED to implement the policies I talked about, and in fact at times implemented policies that pushed them further back (this is ALL explained by Richard Koo in his book—dont have time to lay it out).
Yes, I will get an A+ on this by my professor Paul Krugman. I am brainwashed, lets face it.
I assume you mean that the fed is out of bullets which will actually improve the situation, and I agree. However, their having become such a large purchaser of treasury debt equates to a full arsenal aimed back at the USA. My friends, how can that end well?
I’m also astounded by people, including the current administration and many politicians of both parties, who think payroll taxes are just another part of the government slush fund. Yes, I know there is no actual “lockbox,” but to defund these programs which are already effectively insolvent, without even mentioning the necessarily enormous required changes to these programs which will be hastened by the so-called “holiday” you promote is irresponsible and destructive.
I get the argument that Keynesians and MMTers make. I was fortunate to only take two Macro classes in college, so I got just enough exposure to understand that argument. You should read America’s Great Depression by Rothbard and Human Action by Mises before you solidify your economic beliefs.
Nice to hear someone who understands the argument from a MMT perspective, don’t get that a lot.
Full arsenal aimed back at the USA? The Fed IS the US. The fed isn’t some private corporation or an amenity controlled by the Saudis or whatever conspiratorial theory out there. The Fed is 95% governmental. The only private part is the fact that financial institutions nominate the regional bank presidents….
As for the payroll tax issue, what is important to understand is that taxes, despite what is taught in macro econ 101, do NOT fund the government. Taxes serve as a way to create demand for the money, shape behavior, and
control aggregate demand. There is no “fund” with money sitting in it that might some day run out. The US can never EVER run out of money, so to call the program “insolvent” is erroneous.
My holiday idea would actually be the opposite of what you deemed “iirresponsible and destructive.”
Irresponsible? Is it not irresponsible to leave millions unemployed when it is fully within our abilities to create those jobs by just boosting aggregate demand?
Destructive? Is it not destructive to have our standard of living reduced? Is it not destructive when all these millions of people stay out of work for extended periods of time (thus rotting away their productive skills)?
Basically my point here is that you have it backwards…. By cutting the payroll tax, you’d be helping millions, not hurting them. Do not let politicians/biased hacks trick you into believing the debt hysteria that they love to promote.
Nice article Jerry but your solution to spend more is reckless and American politicians have tried it for many years but it is not working. There is a reason why ratings agencies are going to jump on the American Bond Rating and downgrade it as soon as this European issue is ‘over’ (or pushed aside).
The USA is getting downgraded because of its reckless spending.
In USA today:
Why the U.S. was downgraded:*
U.S. Tax revenue: $2,170,000,000,000*
Fed budget: $3,820,000,000,000*
New debt: $1,650,000,000,000*
National debt: $14,271,000,000,000*
Recent budget cuts: $38,500,000,000
Let’s now remove 8 zeros and pretend it’s a household budget:
Annual family income: $21,700*
Money the family spent: $38,200*
New debt on the credit card: $16,500*
Outstanding balance on the credit card: $142,710*
Total budget cuts: $385
Don’t tell me you honestly think that this ‘family’ needs to start spending a lot more and put their foot on the pedal to get themselves out of trouble?
No argument that the fed is a quasi-governmental organization. Apparently you assume that because it’s governmental, it can’t make mistakes. My point is the exact opposite; that its actions will prove terribly destructive.
If you allow for unrestrained money creation, then yes, technically, the US will never run out of money. Of course, this ignores the issue of currency debasement and potential for hyperinflation. Or is the whole supply – demand relationship just another falsehood from econ 101?
But really, you say it all when you claim that taxes do not fund the government. There may be better examples of disconnections from reality, but your statement puts you in contention for the title.
No argument that the fed is a quasi-governmental organization. Apparently you assume that because it’s governmental, it can’t make mistakes. My point is the exact opposite; that its actions will prove terribly destructive.
If you allow for unrestrained money creation, then yes, technically, the US will never run out of money. Of course, this ignores the issue of currency debasement and potential for hyperinflation. Or is the whole supply – demand relationship just another falsehood from econ 101?
But really, you say it all when you claim that taxes do not fund the government. There may be better examples of disconnections from reality, but your statement puts you in contention for the title.
well said: “Unfortunately, this reliance on the Fed has diverted attention away from the true matter we need to concentrate on: fiscal policy.”
I never said anywhere the Fed or gov cannot make mistakes.
They can, have and will. But your worry over hyperinflation is on a false premise. Hyperinflation has always occurred during/after exogenous events/situations. I suggest you read this just to save time here: http://pragcap.com/hyperinflation-its-more-than-just-a-monetary-phenomenon
And for what its worth, the Fed isn’t the one doing the printing. The Treasury technically is when it issues bonds, which are equivalent to cash (not counting yield). When the US spends, it prints (net financial assets). And since the US can never run out of money, there is no (non-political) default risk.
Taxes do not fund government. If you believe this you are stuck in believing one of the biggest myths out there on the economy and how the Sovereign issuer operates.
Think of it like this.
Taxes delete dollars from the system. Spending creates it. Almost like a scorekeeper at a basketball/football game. He can take away and give points (but think of points as dollars).
Now, this doesnt mean we can just give unlimited “points” to each team. The main and ONLY (operational) issue when it comes to a sovereign currency issuer is inflation, which puts us back to point #1. Can the US deficit spend enough to cause high inflation (like in the 70s) and even hyperinflation (albeit unlikely, but still possible). Yes. Is it likely? No.
And remember, inflation is NOT only a monetary phenomenon. supply disruptions can cause inflation too.
Thanks man.
Sam, thanks for the comment.
Your analogy comparing the US Fed Govt to a household is an erroneous one based on a myth about the economy.
The US, as a currency issuer, can never run out of money. They can spend as much as they want. (Now, that doesnt mean they should or that it would be without consequences, but thats a different debate….See my comment below to Edward).
Check out this photo that Romney put out but was edited by someone who understands the realities of the modern monetary system: https://twitter.com/deficitowl/status/192703978549673984/photo/1/large
Make sure to read the bottom print.
Also, another thing that is important to understand is that the economy is all double-accounting and is multi-sectoral. Your spending is my income (and vice-versa). The governments deficit is the private sectors surplus. If the govt aims to reduce its deficit, then the private sector surplus will fall,(and thus push us into a recession, has happened every time —> https://twitter.com/deficitowl/status/136537624713248769/photo/1/large )
There is also the external sector (exports/imports), but to keep it simple wont go into that.
The downgrades are silly/nonsense. As if the failures of these rating agencies in 08 wasnt bad enough, they downgraded the US and gues what happened to yields! They dropped hard! They were just trading at all-time lows a few weeks ago. Ask Japan if ratings matter. Their 10 year has traded below 2% since 2001 I believe. This despite having 250% Debt/GDP and being downgraded below Botswana!
The linchpins that Keynes and MMT miss is the role that savings and production play in the economy. In fact neither one focuses on savings at all and capital investments are given only a little weight. The focus should always be on what will make America more productive and efficient. Government spending will always be less efficient because there is no market discipline.
A sound economy starts with production then saving then investment. Spending and demand don’t drive long term production. Cuba has zero (or close to it)unemployment. Cuba is a single issuer of its currency, yet the people are very poor. Increasing demand by issuing more currency or deficit spending wouldn’t make the people better off over the long term. The only way to more prosperity is through more innovation and productive capacity.
Japan is used as the exemplar of avoiding a depression through massive deficits and money printing without hyperinflation. But their stock market is down 75% over the last 23 years and no country in history has gotten out of a whole that big and become prosperous again,. You should read the book “This Time is Different”. Countries that have over 90% debt/GDP historically stagnate at best and have default or technical default at worst if they maintain large deficits. Japan has had very little growth despite massive fiscal and monetary intervention. Essentially all they are doing is consuming the savings of the country through inefficient government spending. Not all spending is creating equally.The way the system is supposed to work is savers coordinate with borrowers to create an interest rate. When you have lots of people saving money that isn’t bad, it is sending a valuable signal to the market. Increased savings means banks have more money which means a lower interest rate. That gives businesses an incentive to borrow for long term projects and conveniently they know that they will have customers because dollars saved are dollars they are going to be consumed in the future. GDP doesn’t even have to drop as long as businesses are borrowing money and investing in capital goods.Low aggregate demand isn’t a problem now. High debt overhang and the consumer needing to rebuild his balance sheet are the problems. People should be incentived to save right now. That means higher interest rates. Government spending should be dramatically slashed right not increased “to create demand.” All government spending insures is that we will be some amount poorer in the future. Canada and Sweden are good examples of countries that slashed spending in the 90’s and are now more more prosperous than otherwise would be.