Thursday, January 1, 2009

In the Short Run Keynes is Right

President-elect Obama's big stimulus package is getting bulkier and more complex by the day. No longer confident that the Congress would be able to move quickly to deliver legislation for the newly sworn in president to sign, Senate Majority Leader Harry Reid has tampered expectations by rejecting a "false deadline" for such a delivery.

As is always the case in Washington, we are scheduled for a clash of ideologies even as we seek a solution to our current economic woes. The Republicans want deliberation (or delay) and fiscal restraint and the Democrats want, well, big government. Cognizant of this, Senate Minority Leader Mitch McConnell has already registered his wariness of "very big systemic changes" proposed in the stimulus package. Republican leaders have taken to calling the proposed $800 billion stimulus package a "trillion dollar" package even though about 40% of it will pay for tax cuts all sides agree on.

But Democrats are likely to prevail in this battle not only because of their store of electoral goodwill locked into congressional majorites, but also because economic history is presently on their side. Traditional monetary policy becomes increasingly ineffective as interest rates fall (because rates cannot fall below zero). The fact is that the banks are still not lending enough. Just in the last three months, cash holdings in banks have tripled to over 1 trillion dollars, according to the Federal Reserve. Other drivers of growth are also unavailable to us this time round. Inventory rebuilding was a powerful engine of growth in 1976, as was residential construction 1992, while consumer spending helped in 2002 (recall President Bush's invitation for Americans to go out and shop after Sep 11). The private sector in 2009 is moribund.

This is why Fed officials and economists have come out in support of a fiscal stimulus package. “If ever, in my professional career, there was a time for active, discretionary fiscal stimulus, it is now,” said Janet Yellen, San Francisco Fed president. According to Allen Sinai, chief global economist at Decision Economics in New York, “When we do recover, the engine will be government spending, not home building or the consumer.” John Maynard Keynes, not Milton Friedman, is the dead economist du jour.

Since the September 2008 Wall Street crash, the S.& P. has moved more than 5 percent in either direction on 18 days. There were only 17 such days in the previous 53 years, according to calculations by Howard Silverblatt, an index analyst at S.& P. If the invisible hand of the market cannot calm its own nerves, then government must.

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