Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul.
Today’s Economist
Perspectives from expert contributors.
With the debt limit debate temporarily set aside, the Obama administration is talking about finding some way to create jobs and stimulate growth. But the truth is that there really isn’t much it can do and it knows it. There may be some small-bore things it can do without Congressional action that may help a little, but the operative word is “little.” The only policy that will really help is an increase in aggregate demand.
Aggregate demand simply means spending — spending by households, businesses and governments for consumption goods and services or investments in structures, machinery and equipment. At the moment, businesses don’t need to invest because their biggest problem is a lack of consumer demand, as a July 21 study by the Federal Reserve Bank of New York documented.
The federal government could increase aggregate spending by directly employing workers or undertaking public works projects. But there is no possibility of that given the political gridlock in Congress and President’s Obama’s desire to appear moderate and fiscally responsible going into next year’s election.
That really leaves just consumers as a potential avenue for increasing spending. But that will be difficult as long as unemployment remains high, thus reducing aggregate income, and households are still saving heavily to rebuild wealth, which was decimated by the collapse in housing prices. Saving is, in a sense, negative spending.
Changes in wealth affect spending because people will spend a percentage of their increased wealth. And they are more likely to raise their spending when the wealth increase is perceived to be permanent rather than transitory.
Historically, people have viewed increases in home equity as more permanent than increases in stock market wealth because they know the latter is more volatile. A recent Federal Reserve Board working paper estimated that the long-run increase in spending from an increase in housing wealth may be as high as 9.1 percent per year.
As home prices increased, many people came to believe they had no real reason to save since they could always tap their home equity — which banks were more than happy to help them do — in the event that they needed funds. Thus the personal saving rate fell from 3.5 percent in the early 2000s to just 1.4 percent in 2005 at the peak of the housing bubble.
Home prices roughly doubled between 2000 and 2006, according to the Case-Shiller index, and many homeowners talked themselves into believing they would continue rising indefinitely. Thus they increased their spending and reduced their saving based not only on actual price increases, but also on expectations of future increases.
A prescient 2007 Congressional Budget Office study explained how this would affect spending and growth in the economy. It said that if people were expecting a 10 percent rise in home prices and instead they fell 10 percent, the impact on spending would be equivalent to a 20 percent fall in prices. The budget office estimated that this might reduce growth of gross domestic product by 2.2 percent per year. Since actual home prices have fallen by about a third, this suggests that G.D.P. may be $500 billion less this year than it would be if home prices had simply remained flat since 2006.
One way that the rise and fall of spending can be visualized is by looking at the velocity of money. This is the speed at which money turns over in the economy. When velocity rises, more G.D.P. is produced per dollar of the money supply. When velocity falls, the economic impact is exactly the same as if the money supply shrank by the same percentage.
The chart below comes from the Federal Reserve Bank of St. Louis and shows velocity as the ratio of the money supply (M2) to nominal G.D.P. It rose from 1.85 in 2003 to 1.96 in 2006. It has since fallen to a current level of 1.66. Thus one can say that each $1 increase in the money supply produced almost $2 of G.D.P. in 2006 and only $1.66 today.
Source: Federal Reserve Bank of St. LouisVelocity of M2 money supply, expressed as the ratio of quarterly nominal G.D.P. to the quarterly average of M2 money stock. (Shaded areas indicate United States recessions.)
This suggests that the Federal Reserve could have offset the decline in spending and velocity resulting from the fall in home prices with a sufficient increase in the money supply. And it tried. Since 2006, money supply has increased by about $2 trillion. But velocity fell faster than the money supply increased as households reduced spending and increased saving — the saving rate is now over 5 percent — and banks and businesses hoarded cash.
Nonfinancial businesses are now sitting on close to $2 trillion in liquid assets that could be invested immediately if there was an increase in sales, and banks have $1.5 trillion of excess reserves that could be lent as well.
Fiscal policy could raise velocity and growth by getting money moving throughout the economy. But since that is not feasible, the Fed is the only game in town. Joseph Gagnon, a former Fed economist, says that it should immediately increase the money supply by $2 trillion and promise to keep increasing it until the economy has turned around.
But the Fed is already under pressure to tighten monetary policy from its regional bank presidents, three of whom dissented from last week’s Fed decision to keep policy steady. They fear that inflation is right around the corner. But as the Harvard economist Kenneth Rogoff has argued, a short burst of inflation would do more to fix the economy’s problems than any other thing. One reason is that inflation raises spending by encouraging consumers and businesses to buy things they need immediately because prices will be higher in the future.
The right policy can be debated, but the important thing is for policy makers to stop obsessing about debt and focus instead on raising aggregate demand. As Bill Gross of the investment firm Pimco put it recently: “While our debt crisis is real and promises to grow to Frankenstein proportions in future years, debt is not the disease — it is a symptom. Lack of aggregate demand or, to put it simply, insufficient consumption and investment is the disease.”
Article source: http://feeds.nytimes.com/click.phdo?i=8ce4e978e5f4b1bbd8dd791816e5dc76
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