The ridiculous controversy over whether we are technically in recession is finally over. Everyday Americans know we have been in recession for a long time. So how do we get out if it? Let's go back to basic macroeconomics as introduced to college sophomores in Econ 101.
There are two basic approaches to managing our macro-economy - monetary policy and fiscal policy. Monetary policy is carried out by the Federal Reserve System. It involves increasing or decreasing the ability of banks to make loans, and the interest rate on those loans. Advocates of this approach are referred to as "monetarists."
Fiscal policy refers to government spending and taxation for the purpose of affecting employment and economic activity. Fiscal policy is the responsibility of the president and Congress. Advocates of this approach are referred to as "Keynesians" after the renowned economist, John Maynard Keynes, who championed this approach.
Each of these approaches has its advantages and limitations. Mainstream economists recognize the need for each approach, the relative effectiveness of which varies with economic conditions. Monetary policy generally is more effective during periods such as the prosperous '90s in controlling inflation by limiting banks' ability to lend. Fiscal policy tends to be more effective during economic downturns such as we are presently experiencing. Let's take a look at the reasons for this.
Beginning economics students are introduced to the concept of gross domestic product (GDP), which is the estimated market value of all goods and services produced within a nation's borders in a year. GDP is composed of four components, C+I+G+X, where C represents personal consumption; I represents investment, including the important housing component; G represents government expenditures for goods and services; and X represents net exports.
The largest component of GDP is consumption expenditures (C), representing more than 70 percent of GDP. Although a smaller component, investment (I) is crucial because it affects future production, and includes the important housing sector.
Now, back to the questions, "How do monetary and fiscal policy affect GDP, and how can they be used to get us out of recession?" Monetary policy affects short-term interest rates and availability of money and credit. A lower interest rate, all else equal, encourages investment, and is expansionary. Higher interest rates make borrowing more costly, thereby restricting investment, and are contractionary for the economy as a whole.
As long as the economy is humming along and the federal budget is in balance, as during the mid and late '90s, the economy could be "managed," more or less, simply by tinkering with short-term interest rates. Interest rates were seen (incorrectly in the view of some of us) as the major determinant of investment. In any case, during periods of full employment, lenders were willing to lend, and investors were willing to borrow.
However, for reasons too numerous to enumerate, the economy has taken a nosedive. In an attempt to counteract recession, through aggressive monetary policy, short-term interest rates have been lowered, and could be reduced to zero, and the economy has not responded. Here's why.
Short-term interests are not the major determinant of investment - certainly not during periods of recession. Businesspersons must have confidence they can realize a return on their investment, and this confidence is lacking during recession when business is slow and consumers are not spending. And even if lenders have the funds, they may not choose to lend during recession.
Let's amplify by returning to the components of GDP, C+I+G+X. During recession, even with lower interest rates, I (investment) is low due to lack of confidence of borrowers and lenders. If unemployment is high and incomes are low, C (consumption) is low. With the world economy in recession, X (exports) is low. In a stagnant economy, government expenditures at the state and local level will be stagnant - or certainly not rising.
Therefore, if we are to increase GDP, this leaves the federal government as "spender of last resort" to increase the G component of GDP. This lands us squarely in the realm of fiscal policy. The lesson: During periods of recession, it takes an expansionary fiscal policy to create the demand for goods and services to crank up GDP and get us back to full employment. That is the reason for the current emphasis on fiscal stimulus by government and academic economists.
Using other words to make the same point, during economic prosperity, monetary policy, via high interest rates and restricting credit, can surely put the brakes on investment, thereby dampening economic activity. But during recession, monetary policy, via reducing interest rates and making credit available, does not ensure economic expansion, as lenders may not choose to lend and potential borrowers may not choose to take the risk. It therefore takes fiscal policy to drive the economy to full employment.
Even economists who lean toward the monetarist school are calling for an expansionary fiscal policy, as are many bankers and business people who would not ordinarily lean in that direction. But these are not ordinary times. And, as reasoned in my Nov. 25 column, some stimulus programs are more effective than others. The fiscal stimulus should meet definite criteria - create ongoing demand for goods and services, especially labor; create a multiplier effect; and increase our productivity.
Just as it took massive federal expenditures during WWII to pull us out of the Great Depression of the '30s, so it will take massive federal expenditures to get us out of our current recession that, barring corrective measures, could get us into even deeper trouble.
While there are several related policy measures needed, it is reassuring that President-elect Obama and his economic advisors are pushing for an effective fiscal stimulus program. It cannot come too soon.
- John Waelti can be reached at jjwaelti@charter.net.
There are two basic approaches to managing our macro-economy - monetary policy and fiscal policy. Monetary policy is carried out by the Federal Reserve System. It involves increasing or decreasing the ability of banks to make loans, and the interest rate on those loans. Advocates of this approach are referred to as "monetarists."
Fiscal policy refers to government spending and taxation for the purpose of affecting employment and economic activity. Fiscal policy is the responsibility of the president and Congress. Advocates of this approach are referred to as "Keynesians" after the renowned economist, John Maynard Keynes, who championed this approach.
Each of these approaches has its advantages and limitations. Mainstream economists recognize the need for each approach, the relative effectiveness of which varies with economic conditions. Monetary policy generally is more effective during periods such as the prosperous '90s in controlling inflation by limiting banks' ability to lend. Fiscal policy tends to be more effective during economic downturns such as we are presently experiencing. Let's take a look at the reasons for this.
Beginning economics students are introduced to the concept of gross domestic product (GDP), which is the estimated market value of all goods and services produced within a nation's borders in a year. GDP is composed of four components, C+I+G+X, where C represents personal consumption; I represents investment, including the important housing component; G represents government expenditures for goods and services; and X represents net exports.
The largest component of GDP is consumption expenditures (C), representing more than 70 percent of GDP. Although a smaller component, investment (I) is crucial because it affects future production, and includes the important housing sector.
Now, back to the questions, "How do monetary and fiscal policy affect GDP, and how can they be used to get us out of recession?" Monetary policy affects short-term interest rates and availability of money and credit. A lower interest rate, all else equal, encourages investment, and is expansionary. Higher interest rates make borrowing more costly, thereby restricting investment, and are contractionary for the economy as a whole.
As long as the economy is humming along and the federal budget is in balance, as during the mid and late '90s, the economy could be "managed," more or less, simply by tinkering with short-term interest rates. Interest rates were seen (incorrectly in the view of some of us) as the major determinant of investment. In any case, during periods of full employment, lenders were willing to lend, and investors were willing to borrow.
However, for reasons too numerous to enumerate, the economy has taken a nosedive. In an attempt to counteract recession, through aggressive monetary policy, short-term interest rates have been lowered, and could be reduced to zero, and the economy has not responded. Here's why.
Short-term interests are not the major determinant of investment - certainly not during periods of recession. Businesspersons must have confidence they can realize a return on their investment, and this confidence is lacking during recession when business is slow and consumers are not spending. And even if lenders have the funds, they may not choose to lend during recession.
Let's amplify by returning to the components of GDP, C+I+G+X. During recession, even with lower interest rates, I (investment) is low due to lack of confidence of borrowers and lenders. If unemployment is high and incomes are low, C (consumption) is low. With the world economy in recession, X (exports) is low. In a stagnant economy, government expenditures at the state and local level will be stagnant - or certainly not rising.
Therefore, if we are to increase GDP, this leaves the federal government as "spender of last resort" to increase the G component of GDP. This lands us squarely in the realm of fiscal policy. The lesson: During periods of recession, it takes an expansionary fiscal policy to create the demand for goods and services to crank up GDP and get us back to full employment. That is the reason for the current emphasis on fiscal stimulus by government and academic economists.
Using other words to make the same point, during economic prosperity, monetary policy, via high interest rates and restricting credit, can surely put the brakes on investment, thereby dampening economic activity. But during recession, monetary policy, via reducing interest rates and making credit available, does not ensure economic expansion, as lenders may not choose to lend and potential borrowers may not choose to take the risk. It therefore takes fiscal policy to drive the economy to full employment.
Even economists who lean toward the monetarist school are calling for an expansionary fiscal policy, as are many bankers and business people who would not ordinarily lean in that direction. But these are not ordinary times. And, as reasoned in my Nov. 25 column, some stimulus programs are more effective than others. The fiscal stimulus should meet definite criteria - create ongoing demand for goods and services, especially labor; create a multiplier effect; and increase our productivity.
Just as it took massive federal expenditures during WWII to pull us out of the Great Depression of the '30s, so it will take massive federal expenditures to get us out of our current recession that, barring corrective measures, could get us into even deeper trouble.
While there are several related policy measures needed, it is reassuring that President-elect Obama and his economic advisors are pushing for an effective fiscal stimulus program. It cannot come too soon.
- John Waelti can be reached at jjwaelti@charter.net.
