Is Government Spending Too Easy An Answer

Is Government Spending Too Easy an Answer? By N. GREGORY MANKIW Published: January 10, 2009 WHEN the Obama administration finally unveils its proposal to get the economy on the road to recovery, the centerpiece is likely to be a huge increase in government spending. But there are ample reasons to doubt whether this is what the economy needs. Skip to next paragraph Enlarge This Image

David G. Klein Arguably, the seeds of the spending proposal can be found in the classic textbook by Paul A. Samuelson, “Economics.” First published in 1948, the book and others like it dominated college courses in introductory economics for the next half-century. It is a fair bet that much of the Obama team started learning how the economy works through Mr. Samuelson’s eyes. Most notably, Lawrence H. Summers, the new head of the National Economic Council, is Mr. Samuelson’s nephew. Written in the shadow of the Great Depression and World War II, Mr. Samuelson’s text brought the insights of John Maynard Keynes to the masses. A main focus was how to avoid, or at least mitigate, the recurring slumps in economic activity. “When, and if, the next great depression comes along,” Mr. Samuelson wrote on the first page of the first edition, “any one of us may be completely unemployed — without income or prospects.” He added, “It is not too much to say that the widespread creation of

dictatorships and the resulting World War II stemmed in no small measure from the world’s failure to meet this basic economic problem adequately.” Economic downturns, Mr. Keynes and Mr. Samuelson taught us, occur when the aggregate demand for goods and services is insufficient. The solution, they said, was for the government to provide demand when the private sector would not. Recent calls for increased infrastructure spending fit well with this textbook theory. But there is much to economics beyond what is taught in Econ 101. In several ways, these Keynesian prescriptions make avoiding depressions seem too easy. When debating increased spending to stimulate the economy, here are a few of the hard questions Congress should consider: HOW MUCH BANG FOR EACH BUCK? Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect. In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment. Most is for what the government has ordered, which raises the next question. WILL THE EXTRA SPENDING BE ON THINGS WE NEED? If you hire your neighbor for $100 to dig a hole in your backyard and then fill it up, and he hires you to do the same in his yard, the government statisticians report that things are improving. The economy has created two jobs, and the G.D.P. rises by $200. But it is unlikely that, having wasted all that time digging and filling, either of you is better off.

People don’t usually spend their money buying things they don’t want or need, so for private transactions, this kind of inefficient spending is not much of a problem. But the same cannot always be said of the government. If the stimulus package takes the form of bridges to nowhere, a result could be economic expansion as measured by standard statistics but little increase in economic well-being. The way to avoid this problem is a rigorous cost-benefit analysis of each government project. Such analysis is hard to do quickly, however, especially when vast sums are at stake. But if it is not done quickly, the economic downturn may be over before the stimulus arrives. HOW WILL IT ALL END? Over the last century, the largest increase in the size of the government occurred during the Great Depression and World War II. Even after these crises were over, they left a legacy of higher spending and taxes. To this day, we have yet to come to grips with how to pay for all that the government created during that era — a problem that will become acute as more baby boomers retire and start collecting the benefits promised. Rahm Emanuel, the incoming White House chief of staff, has said, “You don’t ever want to let a crisis go to waste: it’s an opportunity to do important things that you would otherwise avoid.” What he has in mind is not entirely clear. One possibility is that he wants to use a temporary crisis as a pretense for engineering a permanent increase in the size and scope of the government. Believers in limited government have reason to be wary. MIGHT TAX CUTS BE MORE POTENT? Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand. The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley,

finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases. Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate. Christina Romer, incidentally, has been chosen as the chairwoman of the Council of Economic Advisers in the new administration. Perhaps this fact helps explain why, according to recent reports, tax cuts will be a larger piece of the Obama recovery plan than was previously expected. • All these questions should give Congress pause as it considers whether to increase spending to stimulate the economy. But don’t expect such qualms to stop the juggernaut. The prevailing orthodoxy among the nation’s elite holds that increased government spending is the right medicine for what ails the economy. Mr. Samuelson once said, “I don’t care who writes a nation’s laws or crafts its advanced treaties, if I can write its economics textbooks.” The coming stimulus bill, warts and all, will demonstrate brilliantly what he had in mind. N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President Bush.

Inflation Reality Check(The Korea Times)

Harvard Economist Kenneth Rogoff points out that inflation is a major problem in many of the world’s largest economies today: Inflation in Russia, Vietnam, Argentina, and Venezuela is solidly in double digits, to name just a few possibilities. Indeed, except for deflation-ridden Japan, central bankers could meet just about anywhere and see high and rising inflation. Chinese authorities are so worried by their country’s 7 percent inflation they are copying India and imposing price controls on food. Even the United States had inflation at 4 percent last year, though the Federal Reserve is somehow convinced that most people won’t notice. Usually, inflation can be combatted with restrictive monetary policy, or the selling of bonds on the open market, which reduces the money supply, raises interest rates and slows down consumption and investment, and thus the pressure on prices in the economy. Today, however, the US Fed is in the process of expanding money supply and lowering interest rates, in an attempt to avoid a recession at home. In a world of isolated economies, the US monetary policy would only affect the US economy; however, today the US economy finds itself intertwined in complex ways with other economies of the world. America’s inflation would be contained but for the fact that so many countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements. As a result, whenever the Fed cuts interest rates, it puts pressure on the whole “dollar bloc” to follow suit, lest their currencies appreciate as investors seek higher yields. Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ? perhaps as much as 60 percent ? of the global economy. The reason other countries must mimic US monetary policies has to do with exchange rates, which many countries try to peg to varying degrees to the value of the dollar. One of the determinants of exchange rates is relative interest rates between countries. If the US lowers interest rates, and a country like Argentina keep rates high, global investors looking for a return on their savings will take their money out of US savings accounts and deposit it in Argentinian savings accounts, where they can earn a greater interest rate. In order to save in Argentina, investors need to convert their dollars to Argentinian pesos, driving up demand for pesos and the dollar/peso exchange rate. A stronger peso could have negative impacts on demand for Argentina’s exports as they become more expensive to foreign consumers. In order to avoid appreciation of its currency and declining demand for its exports, Argentina is thus forced to lower its own interest rates as the Fed cuts those in the US. When you consider that much of the world adjusts its currency in relation to the dollar, you can see how an easy money policy in the US could lead to falling interest rates worldwide, triggering all sorts of new consumption and investment, driving price levels ever higher. There is hope for curing the inflation problem. Relief may come at a price for Americans, however: If the U.S. tips from mild recession into deep recession, the global deflationary implications will cancel out some of the inflationary pressures the world is facing. Global commodity prices will collapse, and prices for many goods and services will stop rising

so quickly as unemployment and excess capacity grow. Of course, a U.S. recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the U.S. recession remains mild and global growth remains solid. Once again the Fed’s challenge of balancing unemployment, inflation, growth and recession is made clear. The choice of several major world economies to affix their currencies’ values to that of the dollar makes the challenge ever more dire for Mr. Bernanke. Discussion Questions: 1. If a US interest rate cut is not matched by countries that tie their currency to the dollar, what would happen to the value of those countries’ currencies? 2. Why are lower world interest rates inflationary? 3. What will happen to the value of the Euro if the ECB does not start cutting interest rates soon? 4. Why might a US recession counter the inflationary pressure caused by rising food and energy prices and loose monetary policy in the US and other nations?

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About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards".

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Related posts: 1. Unemployment and inflation: understanding the Fed’s balancing act

2. From the Help Desk – more on loanable funds and the money market 3. Little used monetary policy tool called into battle! 4. Stagflation – a blast from the past could mean trouble for US economy 5. Enter the age of inflation…

19 responses so far 19 Responses to “Will the Fed’s easy money policy fuel global inflation?” 1. # Helenon 15 Mar 2008 at 1:23 am

If a US interest rate cut is not matched by countries that tie their currency to the dollar, the value of those countries’ currencies would rise. Similarly, the Euro would appreciate if the ECB does not start cutting interest rates soon. Lower world interest rates are inflationary because these lower rates offer higher incentives for people to borrow money from commercial banks, therefore increasing consumption and investment, raising AD and thus pushing up the general price level. The rise in AD is part of the intended effect of the lower interest rates as countries fear that the appreciation of their own currencies arising from a stable interest rate would reduce demand for exports, and thus reduce AD. The interconnections between countries thanks to globalization will trigger a domino effect of dropping interest rates and inflation after the US initiates the process. A US recession might counter the inflationary pressure as the drop in demand will drive down global commodity prices, and the prices of other goods and services will drop as well when unemployment and excess capacity emerge. 2. # Angel Liuon 15 Mar 2008 at 6:00 pm

If ECB does not cut its interest rate soon, demand for euro will increase, forcing interest rate to climb. As a result, investment decreases and net export decreases. The initial increase in the demand in euro is a byproduct of US’s monetary policy. It can be seen in the transition below: Fed buying bonds–>demand for bonds increase, interest rate decrease–> demand for dollar decrease and demand for euro increase–>Euro interest rate increase and net export decrease–> AD of Europe decrease 3. # Chan Min Parkon 15 Mar 2008 at 11:27 pm

If the US interest rate cut is not met by other countries that tie their currency to the dollar, the demand for their currency will rise and therefore the value of their currency will appreciate. This will cause lower exports since their products are becoming more expensive. Lowering world interest rates will drive up investment and consumption and therefore prive levels will rise. If the European Central Bank does not cut interest rates, demand for Euros will go up and the currency will appreciate. 4. # optional.xuon 15 Mar 2008 at 11:49 pm

If a US interest rate cut is not matched by countries that tie their currency to the dollar, what would happen to the value of those countries’ currencies? The countries currencies would appreciate in value.

Lower interest rates means more investment and consumption causing aggregate demand to increase causing an upward shift of price level. The currency will appreciate and demand for the Euro will go up. A US recession would mean that global demand would go down since unemployment would rise and excess capacity would also increase causing a decrease in commodity prices. This basically means it would slow the growth of prices on goods. 5. # Mollieon 16 Mar 2008 at 12:18 am

As the Fed pours more money into our economy, we watch as the Dow seems to slowly rise – or at least not fall so quickly. As was mentioned in the article, the supply of currency in the US is expanding (due to the Fed’s latest move) and interest rates falling. This move seems a bit backwards to me; if inflation “can be combatted with restrictive monetary policy,” why are we adding more money? To help in the short run, so we don’t plunge further into the abyss? By now, I’m sure all of our Econ teachers have pounded into our heads the principle that if something is good for an economy in the short run, it’s bad for the long run, and vice versa. So my question is, is the government really worried about keeping us afloat or about looking like they’re doing something so that they won’t get criticized further down the road? Last I checked, if you screw up now, you have to fix it later. So doesn’t it make more sense to just work a bit more slowly and fix things for the long run? In stead of fixing things for now and then refixing them later? And then again later? And so on. You get my point. Don’t forget about those interest rates – with interest rates falling, fewer nations will want to buy US bonds, which means we’ll be less popular, and ultimately, with less money. A ‘weak’ dollar isn’t all bad; it hurts some, but helps others. Same with a strong dollar [but that's a different article]. Other countries are more interested in our exports since they can buy more American with, say, the Euro. More bang for their buck, right? And a larger amount of exports than imports will only further help our economy. Why not at least try to lessen our trade deficit? 6. # judychenon 16 Mar 2008 at 9:22 pm

If a US interest rate cut is not matched by countries that tie their currency to the dollar, the value of those countries’ currencies will be even higher. Lower world interest rates inflationary because people can then borrow money from commercial banks easier, so consuption and investment become higher, which drives up the prices. If the ECB does not start cutting interest rates soon, the amount of euro demanded would be higher. 7. # emilyyehon 16 Mar 2008 at 10:35 pm

Wow the devaluing USD is really affecting global economics, and I think that although the interest rate may affect the value of the dollar in various nations, and hence probably negatively impacting these nations in causing inflation, the biggest reason the weakening USD is affecting global inflation is because oil prices are so dependent on the USD. With a weaker USD, and lower purchasing power by the oil suppliers, the rise in energy costs makes perfect sense, although for most of us, that means we should perhaps abandon our constant use of drivers and spend time exploring Shanghai’s local public transport!

8. # Kristie Chungon 17 Mar 2008 at 6:25 pm

1.) If the U.S. interest rate cut is not matched by other countries that tie their currency to the dollar, the value of those other countries’ currencies will appreciate. 2.) Lower interest rates would mean increase investment and consumer spending. In turn, this would shift the AD curve to the right thereby increasing the price level. 3.) If the ECB does not start cutting its interest rates soon, the demand for the Euro will increase. 4.) The recession in the U.S. would decrease the global demand, and the global commodity prices would decrease as well. Also, unemployment will rise. 9. # Kristie Chungon 17 Mar 2008 at 6:33 pm

1.) If the U.S. interest rate cut is not matched by other countries that tie their currency to the dollar, the value of those other countries’ currencies will appreciate. 2.) Lower interest rates would mean increase investment and consumer spending. In turn, this would shift the AD curve to the right thereby increasing the price level. 3.) If the ECB does not start cutting its interest rates soon, the demand for the Euro will increase. 4.) The recession in the U.S. would decrease the global demand, and the global commodity prices would decrease as well. Also, unemployment will increase. 10. # KatherineYangon 17 Mar 2008 at 7:07 pm

1. If the US were to cut its interest rates, then other countries will have to match the cut or their currencies will appreciate. 2. Lower interest rates mean an increase in investment and consumer spending which means a rightward shift of the AD curve and an increase in price levels. 3. The value of the Euro will increase, demand for the Euro will increase 4. A US recession could mean a decrese in global demand and therefore prices which will lead to an increase in unemployment. 11. # howard linon 17 Mar 2008 at 8:38 pm

If a US interest rate cut is not matched by countries that tie their currency to the dollar, then the value of the currencies will increase, meaning it would now cost more for foreign goods in america, and im sure the countries wouldn’t want that to happen. If consumption goes up, this means that AD will shift out, thereby bring the price level up, unemplyment down and real GDP up. 12. # MichaelChowon 17 Mar 2008 at 10:11 pm

The US interest rate cut will have to be matched by other countries if a tie in their currency to the dollar is hoped to be achieved. Just like as mentioned in several posts before mine. Recession occurring in the U.S will only cause a decrease in demand therefore increasing the unemployment rate. 13. # Jessica Ngon 17 Mar 2008 at 10:52 pm

If a US interest rate cut is not matched by countries that tie their currency to the dollar, those countries’ currencies would appreciate in value. Lower interest rates stimulates more investment in the world, causing AD to causing aggregate shift out, increasing the PL. If the ECB does not start cutting interest rates, the currency will appreciate the demand

for Euros will go up. With the U.S. entering a recession, this pushes demand for goods and services down, unemployment would rise and excess capacity would also increase. 14. # Jack Loon 17 Mar 2008 at 11:13 pm

Rising US interest rates will cause the price level of US goods to be higher relatively in foreign countries. This will result in less demand for American goods around the world. This effect shifts AD back in and decreases GDP and will in turn increase the unemployment rate. 15. # Michael Dailyon 18 Mar 2008 at 5:41 pm

If a US interest rate cut is not matched by countries that tie their currency to the dollar, then those countries’ currency will rise in value. Lower world interest rates are considered inflationary because with the increased spending that comes with them and increases GDP, prices are increased. The value of the Euro if the ECB does not start cutting interest rates soon will end up increasing as it is demanded by more people. And a US recession might counter the inflationary pressure caused by rising food and energy prices and loose monetary policy in the US and other nations because it will weaken the global economy’s demand for goods and services and increase unemployment. 16. # Howard Jingon 18 Mar 2008 at 7:46 pm

What would happen if instead of countries pegging their currency to the dollar, they switch to the Euro? Would the US dollar stop having so much of an effect on foreign currencies? 17. # kevinmaon 18 Mar 2008 at 8:56 pm

If the US interest rate cut is not matched by countires that tie their currency to the dollar, the value of those coutries’ currencies will appreciate. The value would go up. There would be an increase in price level because of the outward shift of AD. There is an outward shift because lower interest rates equal to more investment and consumption. The demand for euros will increase because the value of it would appreciate if the ECB does not start cutting interest rates. There will be an increase in unemployment when US is in recession because the demand for their goods and services globally will decrease. 18. # Drew Venkatramanon 18 Mar 2008 at 9:30 pm

Meanwhile i read that the interest rate will be lowered, which in turn means that the AD will be increased and PL will go up. THis said, i think this could possibly lead to a global inflation due to the anture that many governements are backed byt he dollar and 45% of all of the U.S. currency is held outside the united states, many people will be very angry with this rise in inflation. Also many governments and organizations have bought bonds from America which will now be worth less, therefore they will also be hurt. 19. # Hansen Guon 18 Mar 2008 at 11:28 pm

As everyone has already mentioned, not matching the US interest cut will lead to appreciation of other currencies. The interesting question here is that of how US recession counters inflationary pressures. This relates a lot to the other article posted about how the economies are somewhat balancing. Although this combats inflation, a US recession, as stated still lowers demand. To other nations who export to the US, this is not a good sign.