Over at Robert Reich’s blog, there is a discussion stating that now is the time for rising government spending in the US based on the “fact” that the government is the “spender of last resort” and that the economy has plenty of spare “capacity” (ht Mark Thoma at Economists View).
We have discussed fiscal policy before, and will discuss it again tomorrow. Now, I agree with chunks of this logic, but I feel that there is one gapping hole – the behaviour of prices!
In the above blog post the situation that is being described involves some fundamental level of output that can be supported by resources in the economy, but following a negative (demand) shock output falls and nothing happens to push it back up.
If prices could adjust, then the industries that are now experiencing an “excess supply” would see a reduction in price – something that would help to perk production back up to its equilibrium level. The case Robert is describing does not have this price mechanism – and as a result there is no way for the market to adjust to a change and the government must get involved.
When we frame it this way, the ultimate issue is the return of relative prices to where they should be. Once relative prices are set appropriately resources will be allocated in the best way possible – we will make the most efficient use of our limited capacity.
Now, if some prices refuse to fall there is a role for monetary policy to print a bunch of money and push other prices up – however, we have to be able to justify the fact that some nominal prices will not fall!
What about issues of confidence!
Confidence is an important measure as well – peoples expectations of the future influence their decisions now.
The best thing government can do here is give people a realistic appraisal of what is going to happen and let them make choices in their own interest – if consumers and businesses know what the environment is like then they can react accordingly.
In order to account for any feedback loops that occur through confidence (which can create “multiple equilibrium”), society can use monetary policy to change the actual payoff for saving in the future. By doing so, monetary policy can dull the economic cycle.
In the US things have moved past this. If there situation is a case of an insane decline in confidence, then the government could look to spend funds, drive up inflation, and effectively lower the real interest rate further.
However, in this case we have to be able to say that it is confidence doing this – that there hasn’t been a negative shock to the “capacity” of the economy.
Fundamentally, the cost of borrowing is rising for the US – implying that there has been a reduction in “capacity”. As a result, this has to be taken into account before “increasing spending to match capacity”.
A fiscal stimulus works when monetary policy has done its dash, prices are refusing to adjust, and the shocks to economic activity are not permanent. We need to ask whether all these conditions hold before demanding that the government increases deficit spending.