Saturday, February 11, 2012

I do not understand US policy

The current situation in the US can be summarized in the following way: the economy is growing again, although not yet as fast as steady state, and unemployment is still high. Most sectors are doing kind of OK except for the construction sector, which operates roughly at half capacity. Budgets deficits are very high, but not at record level once you factor in cyclical effects. Inflation is moderate and on target around 2%, including its expectations. Everyone is sitting on a lot of cash and nominal interest rates are minimal. The crisis has been going on since 1997, 4.5 years.

What is the Federal Reserve doing? Keep in mind that it cannot address structural issues in the economy and cannot only boost the economy in the short term, if at all. Bernanke and co. are keeping interest rates rock bottom until at least 2014. That would be seven years of emergency measures. If you want to instill some confidence in the economy, you do not go about telling everyone the economy needs to stay in the emergency room three more years.

And by the way, if inflation is targeted at 2% and nominal interest rates are at zero for the foreseeable future, that means real interest rates are negative. Take any model and throw in negative real interest rates. The result are pretty ugly, especially if this is more than temporary. Yet this is what the Fed seems to be advocating.

And why would you need such low interest rates? A Taylor rule would call for low interest rates if inflation (or inflation expectations) are too high (correction: too low). They are not. Or if output is below potential. That may well be the case, but I do not think it is to the extend that the Fed believes it is. The rhetoric coming from the Board indicates that the potential output is simply a continuation of the trend line from before the crisis. I do not think it is adequate. The construction sector is gone, and is going to be gone for a while because of an oversupply of residences and structures. Most households suffered a significant wealth shock that is not going to recuperate soon, and consumption has shifted down. Long time unemployed are simply not employable because of sectoral reallocation. Potential GDP has suffered a permanent shock, and while it will get back to the usual trend growth, it will not get back of the previous path.

For the Fed, this means that it is currently chasing a target it will never be able to reach. Its estimate of potential GDP is much too excessive. And the difference is due to structural issues the Fed does not have the means to address.

Which brings us to fiscal policy. Temporary tax cuts of various sorts are good to address temporary weaknesses in consumption. They work best when targeted towards people with high propensities to consume. These are the poor, and more generally the liquidity constrained. These are not the rich, and certainly not everyone. And if the loss in consumption is permanent, then this cannot be address with such temporary measures. You just have to accept it and live with it. Thus: taxes need to go back up, especially for the rich, also because they got an unnecessary free ride in the past years.

And then there is the sectoral problem. Construction is in the dumps. If you want to do something about it, you target public spending towards construction. Not general tax cuts, not across the board stimulus. And the US could actually need some serious infrastructure replacement and improvements. Actually, it is the perfect time to catch up on lost time here: costs are low, interest rates are low.

Now there is of course the stimulus package. But it has had no impact because it was not sufficiently targeted towards infrastructure, It went to state governments, which just used this manna to avoid getting into debt. It went into all sort of pet projects, very few of which had anything to do with construction. And if there was some construction, it went into initiatives that have such long horizons that they are not going to help anytime soon.

So what needs to be done? Washington needs to acknowledge that the targeted path is too ambitious. Bring interest rates back up, This will entice people and businesses to do something with all the cash they are sitting on. The US Treasury needs to focus on infrastructure spending and restructure tax rates. And do not tell me we first have to wait until the presidential election is over.

8 comments:

Mark Thoma said...

You might want to rethink this claim:

"A Taylor rule would call for low interest rates if inflation (or inflation expectations) are too high"

I believe that's backwards.

Also, if the S=I lines intersect at a negative i-rate, as it appears they do right now, all that raising interest rates will do is increase the gap between S and I. Raising interest rates *lowers* the incentive to invest since it represents the opportunity cost of investment -- you seem to imply it will increase it, but where's the evidence that an increase in interest rates increases investment? You can find pos. correlations in the data since better economies tend to have higher interest rates and higher investment, but that relationship is not causal.

So raising interest rates reduces investment, and gives people an incentive to save even more. How can that cure a problem of too little investment relative the current volume of saving?

Raising interest rates right now is not the answer.

Michael said...

"If you want to instill some confidence in the economy, you do not go about telling everyone the economy needs to stay in the emergency room three more years."

I hardly think having the Fed just outright lie to everybody would fool many people.

And I'm with Mark on the rest of the post.

Economic Logician said...

Thanks Mark, I corrected the statement about inflation and the Taylor rule. In any case, inflation is on target, thus the outcome of the statement remains valid.

As for investment: we are in a situation where there is a surplus of liquidity because there is no interesting return in investment. Higher interest rates make investing interesting. I know, this may sound backwards.

Also, the low interest rates keeps income low for retirees, and those have a high propensity to consume.

Anonymous said...

I am with you completely on the stimulus money. With the staggering amounts that were mentioned, one should have noticed something. Yet, except for a temporary boom in the road asphalting industry, I saw nothing.

Kansan said...

There are positive signs in the economy, and the Fed can amplify them by indicating that emergency measures are not needed anymore (or as much). There is something to self-fulfilling expectations.

And besides, what if the potential output trend has indeed shifted and the Fed continues ignoring it. Are we going to stay with another decade of abnormally low interest rates? That cannot be healthy.

Anonymous said...

US economic policy does not make sense because we are past the midway point to the next presidential election. Not that it makes more sense at other times.

Anonymous said...

Ten year inflation expectations - which are basically what matters for the Taylor Rule - are 1.39 percent: http://www.clevelandfed.org/research/Data/inflation_expectations/ . GDP is well below trend. Why on Earth would you not want to have loose monetary policy now?

And "Bring interest rates back up, This will entice people and businesses to do something with all the cash they are sitting on"? This is nuts: we have people sitting on cash. Raising the interest rate on T-bills makes it more likely they will sit on the cash, not less likely. As far as infrastructure, I agree, though. It's crazy that the US has not built new transit/airports/power grids/etc. That said, net fiscal stimulus (not counting tax decreases), accounting for declines in state spending, is about zero over the recession...so it's not surprising you haven't seen any changes!

NormanB said...

Go balls out on energy development including the pipeline. But 'progressive' politics guised under 'saving the earth' keep us from acting like grown-ups. We've been talking about energy independence for 60 years and now its within our grasp but Obama won't pull the trigger. Who would have ever thunk?