We're Going to Need a Bigger Stimulus

My favorite line from Jaws comes from police chief Martin Brody (Roy Scheider) upon at last seeing the shark: “You are going to need a bigger boat.” We are at last seeing the shape of this current economic downturn—and we are going to need a bigger stimulus. We might get lucky: maybe the next four months will be months of unreserved good luck, and four months from now we will think that what we have collectively done to stabilize the North American and world economies is appropriate. More likely not: mixed news would mean that four months from now we are going to want to do another round of government spending boosts and tax cuts to try to keep a lid on unemployment. And if the next four months are months of bad news—well, let’s not go there right now.

Getting another round of spending boosts and tax cuts will, however, be problematic. Partisan opposition is mounting. That there is partisan opposition is very strange. We know John McCain’s chief economic advisers—people like Douglas Holtz-Eakin who made an excellent reputation for himself as head of the Congressional Budget Office, like well-respected forecaster Mark Zandi, like AEI’s Kevin Dow 36000 Hassett. We know how they think. We know that had John McCain won last November’s presidential election a very similar stimulus plan—but with fewer spending increases and more tax cuts—would just have moved through Congress with 100% solid Republican support. So the current 98% Republican opposition (except by governors who have to, you know, govern) leaves us scratching our heads.

So as we get ready to try to go and buy a bigger fiscal stimulus boat to deal with this Jaws recession whose bite pushed the unemployment rate up to 8.1% in February, it is important to be clear why we ought to be doing this. Last time I wrote about how a government fiscal boost -- like any boost to spending when any group becomes more exuberant -- would spur the economy. The strange right-wing talking point that a government fiscal boost would not spur the economy because... because... well, it's not sure why... is badly mistaken at best and disingenuous at worst. But there are legitimate reasons to fear that a fiscal boost, while it would work, would not work well. And there are legitimate reasons to fear that undertaking a fiscal boost now will have significant costs later. These legitimate fears fall into four groups.

The first legitimate fear is the fear of bottleneck-driven inflation. The fiscal boost will increase spending, and businesses seeing increased demand for their products will try to hire more workers to boost production, but they will succeed only by offering their new workers higher wages—wages high enough that they then have to boost their prices—and by snatching scarce commodities out of the supply chain by paying more—and then having to boost their prices more as well. If inflation produces general expectations that prices will continue to rise, then we are back where we were in the 1970s with everybody focusing on changes in the overall price level rather than whether their business plan made sense given the individual goods and services prices that they saw. An inflationary economy is one in which the price system does not do a very good job of telling people and businesses where to focus their energy. It is likely, over the decades, to be a slow growth economy. Better not to go there.

The second legitimate fear is the fear of capital flight and exchange depreciation-driven inflation. If the stimulus package causes foreign holders of domestic bonds to believe that there some day will be inflation, they will sell their U.S. Treasuries and so push the value of the dollar down. As the value of the dollar falls, the dollar prices of imported goods and services rise, and we are off to the inflation races once again. The third legitimate fear is that government borrowing may—not will, not must, but may, for this is a fear not a certainty—push up interest rates, make financing expansion expensive for businesses, and so discourage private investment and leave us with a low productivity-growth recovery because we have too little private investment and too much government spending in the mix.

The fourth legitimate fear is the fear that the long-term costs of the stimulus plan will be very large because those from whom we have to borrow the money to finance the government’s spending today will only loan it to us on lousy terms that means we have to pay it back at high and unfavorable interest rates in all of these tomorrows.

All of these are legitimate fears when a government undertakes a deficit spending plan. We remember bottleneck-driven and wage-push inflation from the late 1960s and from the oil shock-ridden 1970s. Capital flight and exchange depreciation-driven inflation were the result of Francois Mitterand’s attempt to produce Keynesian full employment in one country in France in 1981. I carried spears for Lloyd Bentsen and his subordinates Roger Altman and Lawrence Summers in 1993 when they argued that the Clinton-era economy could not afford the crowding-out of private investment that even the steady-course deficits of the mid-1990s were threatening to produce through high and rising interest rates. And the fear that deficit spending will produce an unsustainable debt burden goes back to before Adam Smith warned the governments of George III about the costs of debt-financed wars.

In each of these cases, however, we can see in advance that the stimulus program is going wrong. We can see because the fact that the stimulus is going to go wrong becomes very visible in prices. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation we can see the bottlenecks bottleneck as whatever price or wage corresponding to the good or service that is the neck of the bottle spikes. If the stimulus is going to fail because of capital flight-driven inflation we can see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight-and then we can see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment we first see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden we see long-term Treasury bond interest rates spike instead.

Right now, however, we see none of these things. No signs of bottleneck driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds. If any of these start to materialize, expect me and a number of other stimulus advocates to start backpedaling. But so far, so good.

Comments

[Moon Kil Woong:]

Your points over the possible ramifications make the hopes of larger stimulus very very very risky. I would argue that it doesn't really simulate as it should, and I don't mean tax cuts. I mean that the funds should not be used just to supplement existing government bodies. Rather, it should be spent on infrastructure spending.

If I had my bones I would only stimulate when it is near or nearer the bottom of the cycle. One can not spend any amount of money to reverse a cycle without very bad ramifications like inflation. Keynes is right however that government stimulus can help an economy trying to shift into the next phase of a cycle.

Mar 08 06:15 AM

[Tradememe:]

"No signs of inflation. No signs of dollar depreciation. No signs of pushing up medium-term interest rates on corporate borrowing. No signs of pushing up long-term interest rates on government bonds."

It's great to be the world's currency. I wonder what the price is going to be for the purchase of all these T-bills. For everything has got a price.

Mar 08 06:36 AM

[Dave Wrixon:]

I think the dollar is very shaky. As much as foreign governments stand to lose through a depreciating dollar, they actually stand to gain more through increases in the purchasing power of their own currency. There is no real logic in them increasing their risk by doubling up. Indeed, Chinese acquisition of foreign assets suggests that they are actually dumping dollars. Being the World's Reserve Currency means more people are in a position to dump your currency. You have made out all the arguments why the dollar is so risky, so I don't even need to go there. At the moment the dollar has a Safe Haven premium which is not so much ridiculous as truly bizarre. There is only one way for the dollar and that is down.

A Stimulus to soften the initial shock of the recession, to avoid it being worse than necessary is justifiable, but don't confuse this with the option of trying to borrow and spend your way out of a crisis that has been caused by borrowing and spending too much in the first place. If it was that easy Mugabe would have figured it out by now!

Mar 08 07:00 AM

[steve graves:]

What about the stimulus failing simply for Krugmanesque reasoning, that its economic benefits are simply too meager to offset the massive contraction currently underway? A billion dollar patch on a trillion dollar hole.

Mar 08 11:12 AM

[Sober Realist:]

Yes Steve and ED K, I agree. A credit bubble that started forming 8 years ago and then imploded last year can't be fixed in 1 or 2 years by some so-called stimulus. We are still in free fall right now. It's like trying shovel out water from the Titanic with a tea cup.

Mar 08 01:55 PM

[Prudent Man...:]

Like Jaws, the government should have stayed out of the boat and kept it tied to the pier.

Mar 08 02:18 PM

[Prudent Man...:]

Solving a credit mania with more credit. Now that's a plan.

Mar 08 02:19 PM