Wednesday, January 14, 2009

Tyler Cowen asks an important question

How long is the liquidity trap going to last?

The proposed fiscal stimulus is a big, irreversible investment, which may or may not be needed, and of course it takes some time to get rolling. The traditional economist's recommendation is to apply a very high hurdle rate to such commitments. One alternative is to wait and see if the liquidity trap ends in the near future.

I am not an optimist about the real side of the economy, but I would be surprised if we still were in a liquidity trap one year from now.

Here's the jist of it:

When the economy slides into a recession, the government needs to do something to get it back on track. This can be done through two different ways, monetary and fiscal policy. Monetary policy is basically playing around with the money supply, usually by having the Federal Reserve lowering and raising interest rates.

The problem is that we are in a "liquidity trap," meaning adding additional money to the economy isn't going to create any extra growth in the economy. Monetary policy doesn't work, which is why the Federal Reserve can dump hundreds of billion dollars onto banks without seeing another dime in lending.

So, in such a situation, we can use fiscal stimulus...IE, cutting taxes by a hell of a lot or increasing government spending by a hell of a lot. The problem being that fiscal stimulus carries with it all sorts of issues, like waste, crowding out private investment, etc. Plus, increasing spending tends to lead to permanently higher levels of spending. Once you give the Department of Transportation $2 billion extra because of a recession, it is hard to rein that spending back in.
Plus, there are timing problems. Even if we implement lots more spending now, we won't see gains until late 2009 at the VERY earliest. 2010-2011 is more likely.

So, if the liquidity trap ends within a year, then fiscal stimulus looks like a bad idea, particularly fiscal stimulus focused on spending (as opposed to stimulus focused on tax cuts)

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