Fiscal and Monetary Policy

Global Unemployment

• Approximately 14 million Americans are jobless

• 21 percent of Spanish workers are unemployed

• O.E.C.D. on high unemployment “The room for macroeconomic policies to address these complex challenges is largely exhausted.”

OECD forecast for inflation

U.S. CPI

Core Inflation is Low

The Wage-Price Spiral: Not Happening

The overhang of private debt

Why some inflation might be good

• And a period of modestly higher inflation would help reduce that private debt overhang, which would help promote economic recovery, which would in turn raise revenues and help the fiscal situation.

Via Macroeconomic Advisers

A fiscal response

• 1. A fiscal response to a severe slump only requires unusual action while the situation remains grave.2. Fiscal policy is not wholly dependent on expectations changing for its effect

Adam Posen of the Bank of England

• The UK’s economic performance over the past year is no surprise. When you tighten fiscal policy significantly after a major financial crisis, both history and mainstream economics would tell you to expect what we have now : no growth in broad money or credit, persistently high interest spreads for small businesses and households, flat or contracting private consumption and retail sales, a dearth of construction and declining real wages – all only partially offset by some expansion in exports. In such a situation, you should expect little domestically generated inflation, and that is also just what the UK has.

• The recent consumer price inflation rates above 4 per cent result from this year’s value added tax increase and the recent energy price shock. Removing those factors, UK inflation has averaged 1.5 per cent over the past year – including any remaining effects of sterling’s past decline. Of course, higher taxes and energy prices shrink British real incomes, but the monetary policy committee was right not to respond to them, and should not do so now.

From Bloomberg (5/2011)

• U.K. business confidence declined in March to the lowest in two years, suggesting the economy may struggle to gather strength in the second quarter.

• A gauge of sentiment, which aims to predict economic developments four months in advance, fell to 1 from 3 in February, London-based Lloyds Banking Group Plc (LLOY) said in an e- mailed statement today. The share of companies that were less optimistic about economic prospects increased to 44 percent from 36 percent in the previous month.

A case for fiscal stimulus

Liquidity Trap

Bernanke’s Press Conference

OECD on US monetary policy:

“In the United States, where some long-term measures of inflation expectations have increased and the labour market has stabilised earlier than expected, the start of normalisation [by which they mean raising interest rates] should not be delayed beyond the last quarter of 2010. Policy interest rates should be well above half-way to neutral by end-2011, but the path of convergence to full normalisation would have to accelerate if long-term inflation expectations were to drift up further.”

Friedrich August von Hayek, T.E. Gregory, Arnold Plant, and Lionel Robbins on October 18, 1932.

• We are of the opinion that many of the troubles of the world at the present are due to imprudent borrowing and spending on the part of the public authorities. We do not desire to see a renewal of such practices. At best they mortgage the Budgets of the future, and they tend to drive up the rate of interest--a process which is surely particularly undesirable at this juncture, when the revival of the supply of capital to private industry is an admittedly urgent necessity. The depression has abundantly shown that the existence of public debt on a large scale imposes frictions and obstacles to readjustment very much greater than the frictions and obstacles imposed by the existence of private debt.

• Hence we cannot agree with the signatories of the letter that this is a time for new municipal swimming baths, etc., merely because "people feel they want" such amenities.

• If the Government wish to help revival, the right way for them to proceed is, not to revert to their old habits of lavish expenditure, but to abolish those restrictions on trade and the free movement of capital (including restrictions on new issues) which are at present impeding even the beginning of recovery.

1937 Prices

The Mistake of 1937

Budget balance, in millions of dollars, red line, right scale; long-term interest rates, blue line, left scale:

1937 and interest rates

• deficit came after the slump began, not before• bigger deficits never did push rates up.

Stimulus math• Obama stimulus plan probably cut less than 2 percentage points off the

average unemployment rate for two years• The starting point for this discussion is Okun’s Law, the relationship

between changes in real GDP and changes in the unemployment rate Okun’s Law coefficient : it says that you have to raise real GDP by 2 percent from what it would otherwise have been to reduce the unemployment rate 1 percentage point from what it would otherwise have been. Since GDP is roughly $15 trillion, this means that you have to raise GDP by $300 billion per year to reduce unemployment by 1 percentage point.

• Obama plan calls for $787 billion over two years, with $300 billion in tax cuts and the rest in spending. Call that $150 billion per year in tax cuts, and about $240 billion each year in spending.

• How much do tax cuts and spending raise GDP?

Bang for the Buck• Fiscal Bang for the Buck• One-year $ change in real GDP per $ reduction in federal tax revenue or increase in spending• Tax Cuts• Nonrefundable Lump-Sum Tax Rebate 1.02• Refundable Lump-Sum Tax Rebate 1.26• Temporary Tax Cuts• Payroll Tax Holiday 1.29• Across the Board Tax Cut 1.03• Accelerated Depreciation 0.27• Permanent Tax Cuts• Extend Alternative Minimum Tax Patch 0.48• Make Bush Income Tax Cuts Permanent 0.29• Make Dividend and Capital Gains Tax Cuts Permanent 0.37• Cut Corporate Tax Rate 0.30• Spending Increases• Extend Unemployment Insurance Benefits 1.64• Temporarily Increase Food Stamps 1.73• Issue General Aid to State Governments 1.36• Increase Infrastructure Spending 1.59Source: Moody's Economy.com

Multiplier• Mark Zandi of Economy.com indicate a multiplier of around 1.5

for spending, with widely varying estimates for tax cuts. Payroll tax cuts, which make up about half the Obama proposal, are pretty good, with a multiplier of 1.29; business tax cuts, which make up the rest, are much less effective.

• In particular, letting businesses get refunds on past taxes based on current losses, which is reportedly a key feature of the plan, is lump-sum transfer with no incentive effects.

• Assume that the overall multiplier on tax cuts is 1. Then the per-year effect of the plan on GDP is 150 x 1 + 240 x 1.5 = $510 billion. Since it takes $300 billion to reduce the unemployment rate by 1 percentage point, this is shaving 1.7 points off what unemployment would otherwise have been.

“Full employment”

• “Full employment” clearly means an unemployment rate near 5 — the CBO says 5.2

• Unemployment is currently about 9 percent, and heading much higher