Economics 1420 Spring 2009 Memo 1

To: Larry Summers From: Tarun Singh Re: Meetings with Critics of the President’s Stabilization Policy Issue: The issue at hand at this series of meetings is the effectiveness of President Obama’s proposed recovery plan. Critics of the plan are anticipated to argue that the President’s stimulus plan is ineffective because: 1. Monetary policy can reign in the business cycle better than fiscal policy. 2. Any stimulus proposal involving large amounts of government spending unacceptably augments the national debt. Their Reasoning: 1. Monetary policy can reign in the business cycle better than fiscal policy •

In the paper “What Ends Recessions” Christina and David Romer’s findings show that monetary policy has played a crucial role in ending recessions whereas fiscal policy has not contributed as much.

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Fiscal policy was used in the 1960’s and 1970’s which only lead to high rates of inflation and unemployment.

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Monetary policy is more flexible, it can be adjusted and re-adjusted in increments without Congressional approval and there are fewer lags compare with fiscal policy. There is also no pork barrel spending with monetary policy

Our Response: •

It’s true that monetary policy can be effective at reigning in the business cycle, but it is important to realize that monetary policy can only do so much.

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The current Fed Funds rate is between 0 and .25%, the most the Fed could lower the rates is to the lower bound of 0%. Since lowering the rates to their current levels hasn’t restored liquidity in markets, it is hard to conceive that lowering rates by another 10-25 basis points will free up a significant amount of more liquidity.

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The current recession wasn’t caused by the Fed increasing interest rates, so it can’t be treated like other recessions. Instead it was caused by the drop in home values and resetting of ARMs on subprime mortgages. Homeowners could no longer afford higher payments and the drop in home prices increased the Loan to Value of many mortgages to as much as 130%, causing delinquency and foreclosure (Figure 1). Furthermore, since banks had miscalculated the risk on securitized loans which were levered at ratios of 30:1, many banks are unaware of how much underlying risk they hold. Thus, increasing monetary supply has been ineffective in restoring liquidity as banks are still unaware of how much risk is held in their portfolios.

Figure 1:

Their Reasoning: 2. Any stimulus proposal involving large amounts of government spending unacceptably augments the national debt. •

According to the Federal Reserve the national debt is already above $10 trillion, and running another large deficit as proposed by this stimulus plan will only create problems in the long run. o When we run deficits we have to have them financed by foreigners since our savings rates are so low – ¾ of U.S. net investment is now from foreign capital inflows

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A large portion of this foreign capital is from foreign governments, whose inflows are not dependable as we cannot predict their actions.

o According to Ball and Mankiw, budget deficits reduce national savings which means either national investment or net exports also decrease. 

Lower national investment means lower returns on capital stock.

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Lower net exports creates a flow of assets abroad.

Our Response: •

It is important to realize that the stimulus package proposed by the President is a onetime increase in the national debt and the President does not intend to run such large deficits each year, but is doing so in order to respond to the current financial crisis.

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There is an advantage to running a large deficit – it will stimulate the economy through the Keynesian multiplier. o

For every dollar increase in government spending we expect an increase in 1.5 dollars of output. Since monetary policy is proving to be ineffective in responding to the current financial crisis, adding to the national debt on a onetime basis in order to prevent a prolonged recession is worth the costs.

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It is still possible to grow our way out of the national debt. As long as the rate of GDP growth is higher than the interest rate, the ratio of debt to GDP falls over time. Thus, the economy can grow its way out of the debt.

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Although a large portion of our debt is financed by foreign governments, it is unlikely that foreign governments will stop financing our debt amidst this recession. The recession has been a global one, and since November the dollar has appreciated in value as other countries have added more funds to the US economy. The US Treasury is still seen as the

safest investment and therefore the concerns of other countries not being willing to finance our debt due to this onetime expenditure is unlikely. •

Though there are definitely legitimate concerns with running long term deficits, the large stimulus provided by the President is absolutely essential in revitalizing the economy.

Summary: The current global financial crisis presents unique challenges that haven’t been present in previous recessions. Although the administration recognizes that monetary policy is an effective means at dealing with the stabilization of most business cycles, it has proven ineffective in restoring liquidity in the market. There is little room for the Federal Reserve to maneuver further with interest rates as low as they are currently and any further change is unlikely to solve the liquidity crisis. Thus, President Obama has put forth a stimulus which incorporates a onetime increase government spending in order to revitalize the economy. We believe this measure is essential in order to avoid a prolonged recession and to revitalize the economy.