March 22, 2009
What President Obama Should Know About RecessionsBy Earl A. Thompson
The tools are in place to get us out of the recession, and could already have been used to good effect.
Ideal and Actual Anti-Recession Policy
As macro-economies falter and the aggregate demand for labor falls, monetary authorities should automatically expand the money supply so as to quickly restore the original demand for labor and corresponding wage level. Failing to do so invites many workers to erroneously maintain their previous wage demands in the face of a falling aggregate demand for labor and thereby lose their jobs, creating inefficiently low aggregate employment levels.
In most cases, achieving the optimal, employment-maintaining, monetary policy is very simple. For most business cycles are caused by "aggregate-demand shocks," which lower the demand for labor by suddenly lowering the prices of the goods competitively produced by labor. Monetary authorities -- such as the Federal Open Market Committee (FOMC) of the U. S. Federal Reserve Bank -- need only respond to such negative price-shocks by quickly injecting more and more currency into the private economy through a daily sequence of significant open-market cash purchases of government bonds until daily commodity-price-indices rise back up to their original levels. In fact, ever since the Employment Act of 1946, it has been the FOMC's legal responsibility to adopt such anti-recessionary monetary policies.
However, actual monetary authorities, who tend to favor lower commodity prices, seldom adopt such simple and legally mandated monetary policies. For monetary authorities are predominantly bankers (5/12 of our FOMC members are bankers). Since most bank assets generate secure fixed-money-incomes, the real wealth of banks increases as prices fall during demand-side recessions. Bankers are therefore biased in favor of lower prices and thus are typically unwilling to offset recessionary shocks with suitable monetary expansions. In view of this monetary paralysis, anti-recessionary cuts in our Federal Income Tax rates have become a laggard, second-best-but-fairly-effective, way to prevent extended U. S. recessions. Such anti-recessionary tax-cuts have thus become a regular feature of our economy, especially after international oil prices began their sporadic, supply-side-recession-inducing, jumps in the early 1970's.
Since then, up to 2008, again despite our persistently recalcitrant FOMC, tax-cuts have been wisely timed by our legislatures to coincide with recessions and thereby have kept our economy reasonably healthy.
Examples of This Reasonably Healthy Policy Sequence, and the 2008-09 Exception
Thus, while the burst of the dot-com bubble in early 2000 should have led the FOMC to sufficiently jump the money supply, instead we suffered an immediate recession until the 2001 tax cut saved us from a lengthy recession. Similarly, the obvious drop in travel demand that immediately followed 9/11 led to a demand-side recession rather than a simple increase in the money supply, the downturn lasting until the 2003 tax cut yielded a healthy economic recovery by the end of 2004. Even more recently, the FOMC failed to respond to the spreading burst of our real estate bubble in late-2006-2007, which was accompanied by accelerating 2007 oil prices. These shocks would have produced a substantial 2007 recession were it not for the 2007-08 tax rebates, which thereby prevented a substantial 2007 recession. Although not quite an ideal response to the recessionary shocks, this was as good as modern anti-recessionary policy gets.
The further collapse of real-estate prices and further jump in oil prices in the first half of 2008 called for additional macroeconomic stimulation, preferably a monetary expansion. Correspondingly, the first half of 2008 featured rationally speculative increases of both stock and commodity prices. But the FOMC perversely reacted against these stimulus-expecting speculators with a Hoover-1929-style monetary contraction! As in 1929, the speculators were thereby "successfully" foiled and the financial system collapsed. And no ameliorative tax-cut was put forth by Congress to counter the predictably steep, ongoing, commodity price collapse in the latter half of 2008. We had to wait for February 2009 before Congress finally came up with some sort of a tax cut, one coming in the form of a Keynes-inspired "stimulus package."
Problems with the Stimulus Package
President Obama and Congressional Democrats should have acceded to the substantial-business-tax-cut requests of many Republican Senators. Informed economic theory, supported by a long series of econometric studies, tell us that: (1) greater government expenditures matter very little in helping recessionary economies recover while (2) overall (business-inclusive) tax-cuts matter a lot.
Regarding (1), greater government expenditures tend to "crowd out" private expenditures. Debt-financed governmental expenditures merely re-direct cash that was about to be spent on something in the private sector. While handing government agencies more spending cash, such deficit spending programs take the same cash away from private individuals, who would have otherwise spent the money.
Regarding (2), previous tax-cuts not only directly improved business' production incentives but also raised expected prices, as people did not have to turn over as much currency to the government when paying their near-future taxes. But the recent, Keynes-inspired, tax-cut is unique, both in failing to directly improve business production incentives and in reducing tax-withholding rates. Withholding reductions are perversely contractionary, because they increase the concentration of future aggregate demands for cash into peak tax-collection weeks, when cash is already scarce, thereby tending to lower expected future prices and exacerbating recessions.
As a result, Obama's unconventional stimulus package cannot be expected to generate anything like the per-dollar economic expansion produced by previous tax cuts.
Not only should Congress and the President have substantially reduced business income taxes in their recent stimulus package, but the tax-hikes that President Obama has now officially planned for future high-income recipients should be restricted to non-business incomes.
The feeble nature of the recent stimulus package -- even when complemented by the President's subsequent call for still-more governmental expenditures -- would not be such a big deal if the economy had not already been plunged by the exceptionally large recessionary shock into a low-level equilibrium, one that needs an exceptionally powerful policy jolt to quickly restore our previous, high-level, equilibrium and thereby avoid a genuine depression. Thus, by adopting a fallacy-filled, profit-ignoring, Keynesian ideology and failing to respect the opposing positions of independent economists and relatively pro-business Republicans, the current administration appears to have sealed our economy's fate. It's like an infant has fallen into the deep end of a swimming pool and the Congress has just leaped into the shallow end in order to save it.
How Roosevelt Succeeded, but then Failed
In contrast, when the debtor-supportive President Roosevelt took office in 1933, rather than pushing for a large increase in the number of governmental spending programs, he declared a "Bank Holiday" during which he bankrupted hundreds of insolvent banks and then -- to the further horror of the banking community -- substantially raised the official price of gold and thereby many, related, commodity prices along with the total money supply. This raised, finally, profits and employment and thereby firmly placed the economy on the road to recovery.
The economy had already substantially recovered through this monetary expansion by 1936, when substantial governmental spending programs (the WPA) began significantly expanding. Such programs were so ineffective that they failed to significantly counter the FOMC's largely coincident, monetary-restriction-induced, recession of 1937-38. In this latter respect, FDR's second term in office would also have economically succeeded if he had not trusted the FOMC Chairmanship to a banker, Marriner Eccles, who took his first opportunity to drop the price level by draining currency from the U.S. economy in 1937.
The FOMC to the Rescue...Finally.
The March 18th Meeting of the FOMC produced a genuine monetary shock analogous to the Roosevelt's 1933-34 monetary expansion. After nine months of starving our economy of cash, the Committee suddenly reversed its course and decided to purchase 1.05 trillion dollars worth of government debt over the next few months. Commodity prices have jumped and the dollar has finally fallen in the world's money market. We can, as the FOMC carries out this long-needed monetary expansion, expect an escape from the current low-level trap and return to the efficient, upper equilibrium in the near future. Stocks will correspondingly boom, real estate prices will finally bottom out, and we will see a rapid recovery from the current recession. Retail prices will, by the end of the sequence, rise, as they should have in the first place. And interest rates will dramatically recover.
But what took the FOMC so long?
How the FOMC escaped criticism
FOMC Chairman Ben Bernanke's unprecedented Summer 2008 decision to pay interest on bank deposits at the Federal Reserve Bank not only perversely exacerbated the then-accelerating decline in commodity prices by reducing bank incentives to spend cash on the private sector, but made it appear as if the Federal Reserve Bank were expanding the money supply! For the most intellectually popular measure of our money supply, the "Monetary Base," includes bank deposits at the Federal Reserve Bank. The corresponding jump in this respectable "money supply" made it appear that Bernanke was working to resist the recession while nothing of the sort was happening.
Meanwhile, the other popular money-supply measure, M1, which contains interest-bearing checking accounts at banks and therefore lacks the essential, "hot potato," feature of true money, artificially expanded because the public was switching relatively risky accounts at non-bank financial intermediaries into insured bank deposits. This similarly created an appearance to popular observers that our central bank was expanding the relevant money supply, which, again, it certainly was not.
The most relevant measure of the money supply is the U.S. currency outside of the banking system. The linked graph shows that this uniquely high-quality measure of the true money supply -- rather than expanding to combat the emerging recession -- actually ceased its normal growth during the first ten months of 2008. Thereafter, this relevant money supply quickly recovered to its 5-year trend level in the final 6 weeks of 2008. Commodity prices correspondingly started to reflate in December.
However, since late December, this relevant money supply flattened out despite the fact that the ongoing housing price crash and corresponding slew of foreclosures were increasingly screaming out for a huge above-trend jump in this money supply. (See this.) So our economy had been money-starved. Witness the perverse rise in the dollar's international value up until the FOMC's momentous March 18th Meeting. Why did this flattening occur? And what finally broke the logjam?
Amateur Economic Advice and the Final Breakthrough
Perhaps the most common objection to a simple monetary expansion has come from the large number of amateur and semi-professional economists, who argue that an increase in the money supply would be "inflationary." Of course it would be, but that is exactly what has been needed all along to restore the early 2008 demand for labor and employment levels. Average final-goods prices will correspondingly rise, but that's what was needed in the first place. For the initiating shocks again were the collapsing real estate bubble and the rise in oil-import prices. These shocks decreased the demand for homeowner-demanded consumer products and construction materials as well as energy-using industrial outputs. To prevent these 2008 macro-shocks from decreasing the aggregate demand for labor, the initiating shocks would have had to be accompanied by increases in the final-goods prices of other products. The appropriate policy response to this pair of shocks was an immediate, quite substantial, increase in the currency supply and corresponding price-level in early-mid 2008. Something in the order of 250 billion dollars would have done the trick. However, now that we find ourselves in a low-level equilibrium, we require a much larger monetary expansion to escape it. A trillion dollars will very probably suffice, although we will require a subsequent drop in the money supply to prevent overshooting.
While all this should be qualitatively obvious to any welfare-oriented student of business cycles, it was not obvious to the 2008 presidential candidates, who perhaps recognized the political unpopularity of a rise in average retail prices. This might explain the policy in 2008, and indeed the expansionary monetary policy following the Presidential Election.
However, it does not explain the paralytic monetary policy since the end of December. Who benefitted? The creditor-bankers, as usual, but why no offsetting clamor from debtors? The only obvious explanation is that the numerous advisors in our current government are predominantly mature academics and professional bureaucrats, people whose money incomes, like those of most politicians, are essentially fixed over the near future. The financial interests of such individuals -- our new ruling elites -- are similar to those of bankers and economic amateurs who inordinately oppose retail price increases. Such profit-ignoring individuals actually prefer low consumer-good prices to a healthy economy and full employment.
So why have our monetary authorities finally relented? The only explanation I can offer is that English monetary authorities have been aggressively expanding their money supply and depreciating the pound in response to the recession. The outcome, if allowed to continue, would have been a recovery for England and deepening U.S. recession. Our monetary authorities have thus been facing the prospect of an awful professional embarrassment. This prospect is probably what finally changed our FOMC.
Does the above, unnecessarily painful, sequence carry a lesson for our President?
Advice to the President
President Obama should immediately call, just as President Bush should have called, Chairman Bernanke into his office to request his immediate resignation on the grounds that he significantly failed to do his job. No FOMC should ever allow commodity prices to plummet over 75 percent for half-a-year (see this) without resisting it with a significantly above-trend jump in an appropriate money supply. As an alternative Federal Reserve Chairman, I'd propose Dr. Jeffrey Lacker, the only FOMC member voting at their February meeting for an immediate FOMC purchase of government bonds. A responsive summer 2008 monetary policy would have prevented the wave of financial failures and resulting lock-up of our financial system as well as our current recession and associated foreclosure, bankruptcy, and bail-out nightmares.
But that's just temporary. As for permanent monetary reform, there does conceptually exist an alternative, automatic, monetary system, one designed to forever prevent substantial fluctuations in the effective demand for labor and thereby permanently end the business cycle. At the same time, the system would eliminate secular inflation from our economy while giving our central government maximal emergency finance capability. (See this.) The system, which would work by effectively, through financial transactions with the government, allow people to freely convert their dollars into an intertemporally fixed amount of labor services. It is called a "labor standard." I suggested this system to a meeting of the FOMC over 20 years ago. The response was, to paraphrase, "What, you want to replace us all with an automatic system? Take your proposal elsewhere!" Since then, I have been patiently waiting for the FOMC to sufficiently embarrass itself to induce political leaders to take my proposal seriously. Perhaps the time has arrived.
Earl A Thompson is Professor of Economics, UCLA.