Wednesday, December 03, 2008

How To Get Out of Quicksand

Understanding today's economy and how to fix it has consumed economists with far more expertise than I possess. Nevertheless, I’d like to take a stab at explaining the ideas Nobel Laureate Paul Krugman has recently trumpeted on his blog, Conscience of a Liberal (he's unapologetic about his worldview). My motivation in undertaking this exercise is simply to help me understand the nature of the current economic crisis and what can be done to remedy it, and perhaps, to help a few more people down the line understand these issues as well.

So, with that foreword, here's the first installment of the Readers' Manual on How To Get Out of (Economic) Quicksand:

Reviving the economy in a state of depression requires more than just a few doses of medicine to spark a happier spending mood among consumers. It requires an aggressive policy of fiscal expansion; even more aggressive, perhaps, then the current best estimate of what’s needed. (Chuck Schumer threw out a cost of $700 billion but pulled that number from pretty much out of nowhere). [For an Econ 101 primer: Fiscal policy relates to government spending and taxation and is within the domain of Congress and the President. Monetary policy, on the other hand, is controlled by the Federal Reserve and seeks to influence the direction of the economy by regulating the supply of money and interest rates. Lowering interest rates generally increases the supply of money and economic investment, and therefore is considered an economic stimulus.]

One of the main reasons that the government is going to need to adopt such a bold strategy is because we’re currently hovering on the brink of a liquidity trap. Japan suffered through ten years of such a trap during the “Lost Decade” of the 1990s and we don't want to go through the same thing. Without getting too complicated, a liquidity trap occurs when the following happens: 1) The Federal Reserve loses its ability to stimulate the economy through monetary policy because it can’t lower interest rates anymore to increase money supply; and 2) banks decide that they're unwilling to lend money to consumers and businesses, so the investment rate tanks. When the interest rate approaches zero, as it is now, people choose to keep their money at home under the mattress instead of injecting it into the economy. This tends to cause deflation (sustained losses in general price levels) and can lead to a vicious downward spiral of people delaying purchases as prices fall, which lowers overall consumption, which causes more deflation. When this happens, we're in a liquidity trap because monetary policy is no longer effective in regulating the supply of money.

With monetary policy rendered impotent, the only way to escape the throes of a liquidity trap is to adopt an aggressive fiscal policy.

If you've gotten all the way to this point in my posting, then the next logical question of course is why does the government have to engage in an expansionary fiscal policy? Why does the government have to spend more to stimulate the economy and take on huge deficits, instead of pursuing a contractionary fiscal policy (or at least a more moderate expansionary one) by cutting back on spending and taxes? The answer to this question invokes Keynesian economics, the New Deal and FDR and, in the interest of keeping this post to a reasonable length, will have to wait for the next installment of the Reader's Manual on How to Get Out of (Economic) Quicksand. Stay tuned.