Download what president obama should know about recessions

WHAT PRESIDENT OBAMA SHOULD KNOW ABOUT RECESSIONS
Earl A. Thompson*
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, employmentmaintaining, 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 shortly after we lost our energy .
independence 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-20062007, which was accompanied by accelerating 2007 oil prices. These shocks would have
produced a substantial 2007 recession were it not for the 2007-8 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.
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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 otherwise have also 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 nonbusiness incomes.
Where We are Now
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. It’s like an infant has fallen into the deep end of a swimming pool
and we’ve just leaped into the shallow end in order to save it. Consequently, without a
suddenly significant FOMC open market purchase of government bonds, we are in for a
massive depression as the strikingly low current commodity prices that have
characterized our currently low-level macro-equilibrium for the past three months (see
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http://www.bloomberg.com/markets/commodities/cfutures.html) further spread to
manufacturing and retail sectors this year. Thus, by adopting a fallacy-filled, profitignoring, 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, and that of our well-intentioned President as well.
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.
How the FOMC has escaped criticism
Most worrisome is current FOMC Chairman Ben Bernanke’s unprecedented
Summer 2008 decision to pay interest on bank deposits at the Federal Reserve Bank. This
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.
So Bernanke and the FOMC have unfortunately been able to escape the usual
liberal political pressures imposed on a grossly insensitive monetary authority.
The most relevant measure of the money supply is the U.S. currency outside of
the banking system (see
http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=WCURCIR&s[1
][range]=5yrs.) 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 two months of 2008.
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Commodity prices correspondingly started to reflate in these two post-election months.
However, since late December, this relevant money supply flattened out despite the fact
that the ongoing housing price crash and corresponding slew of foreclosures have been
increasingly screaming out for a huge above-trend jump in this money supply
http://www.americanthinker.com/blog/2008/09/no_bailout_necessary.html. So our
economy is money-starved. Witness the perverse rise in the dollar’s international value.
Amateur Economic Advice
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 energyusing industrial outputs. To prevent these demand-decreases 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.
While all this should be obvious to any welfare-oriented student of business
cycles, perhaps 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 finally expansionary monetary policy in November and
December. 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 are inordinately concerned with
retail price increases. Such profit-ignoring individuals actually prefer low consumer-good
prices to a healthy economy and full employment. Only an informed President can save
ordinary people (debtors) and our profit-driven economy from such one-sided elites.
Advice to the President
President Obama could immediately call, just as President Bush could have
called, Bernanke into his office to request his immediate resignation on the grounds that
he has significantly failed to do his job. No FOMC should ever allow commodity prices
to plummet over 75% for half-a-year 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 last meeting for an
immediate cash injection, a simple FOMC purchase of government bonds.) But this
would require the President to become informed about recessions and rise above the slug
of Keynesian ideologues, politicians, and bureaucrats that have now got him surrounded.
*Professor of Economics, UCLA
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