Tuesday, December 02, 2008

Why We Are In A Recession And Why Fiscal Policy (increasing government spending) Might Not Help

Normally I don't like to just put in links to other blogs since you can read that stuff by clicking on my links to those blogs. But since the economy is in the news so much and since alot of that is on what caused the crisis and what needs to be done, these two links are important in giving a different perspective.

The first one is What Really Happened? by Larry White of the University of Missouri. He blames the FED keeping interest rates too low for too long and there being too many "sub prime" loans, that is, loans with lower standards for incomes of the borrowers and downpayments. The government encouraged these home loans. Adjustable rate mortgages play a role, too.

Then there is Fiscal Policy Puzzles where Harvard professor Greg Mankiw disucsses the fact that fiscal policy might not work the way we want it to. That is, increasing government spending might not help very much (although he says " I am not sure what model I should use to explain" this). He also says "At the very least, these puzzles should give us reason to pause when using the Keynesian framework for policy analysis. There is still a lot about macroeconomics that remains deeply puzzling."

Another post by Mankiw is The Bils-Klenow Stimulus Plan. This suggests that cutting payroll taxes (social security taxes) is the best stimulus.


Halo30k said...

One of the issues I don't see in the debate on policy response is that the major problem is all on aggregate demand side, demand has fallen and I don't think we are going to address that by pushing $300-600b to a few industries through fiscal stimulus when 100 industries are going into a fall in AD.

The issue at the heart I think is corporate earnings, which are falling and with demand falling we are in a thrift paradox on the corporate, consumer & public side.

As corporate earnings keep falling, corporate investment falls, employment falls, demand falls etc..

I think we could shock the economy with a 10% of GDP tax cut for 2009.

This will shock corporate earnings side if we had a 2009 only massive tax cut.

Corporate rates taken down to 0 for 09 (corp taxes are only going be $300-400b) in 09 anyways.

R&D tax credit that is huge $400b at $100b a quarter available only for R&D/CapX,/Plant Equip etc..

Cap gains to 0% for 09 only

Payroll tax cut to 0% for all of 09

All of these will stimulate corporate earnings in 09 by 10-30% Equity prices will raise 20-50%, debt prices will come down from 8-18% to 5-10% and drive demand in CapX which will have solid multiplier effects. With large value to the balance sheet.

On the individual side
a 2009 payroll tax cut to 0%

a 2009 indiv. tax cut of 20%

both of these will drive large savings, debt payments, bank deposits & better credit ratios, asset prices will rise 401k's, home buying will begin and the consumer balance sheet will be cleaned up

Add the $600b to state & local governments for cleaning up their balance sheets and allow them to cut state taxes

All of these would drive huge aggregate demand shock across the whole macroeconomy and would replace 10% of GDP

I also think we could encourage the G20 to adopt the same policy with 2009 0% of GDP tax cut $4 trillion. This coupled with a US $2Trillion tax cut would jolt global AD.

Cyril Morong said...

Thanks for dropping by. I don't think I know enough to evaluate all of your proposals. But some economists have argued for tax cuts to be the stimulus. Although usually they want permanent cuts.