Rebuilding aggregate demand the key to stimulus

Feb.2, 2009 2:43 pm

Strange days . There are more than 10 inches of snow in London. I just got off the phone speaking to my in-laws and friends there and they are both amazed and excited to see so much snow and cold weather. Monetarists and fiscal conservatives are equally amazed to see Keynesian stimulus packages sprouting around the world like fields of tulips in the spring.

Unfortunately their amazement has not stopped them from blasting these absolutely essential plans with a range of misleading criticism. They claim that they will not work, that they will not create jobs, that will case inflation by creating money, they will cause interest rates to rise,they will foster pork barrel and boondoggle projects, they will simply result in tax rebate recipients paying off consumer debt and bank loans and so on. None of these critiques is correct in all respects.
Some like the claim that no jobs will be created is quite false and easy to refute. Others like the claim that tax cuts might lead to some recipients using the money to pay off debt are partially right but ignore the next stage consequences of debts to banking institutions being repaid in terms of a growing loan base and increased banking capacity to make new loans.

Of course, that requires a banking system that is willing and able to make loans and a return of entrepreneurial animal spirits searching for profitable returns on loans.

Allow me to deal with these criticisms in detail. Let us continue with the analysis of what happens if new money is injected into the system through deficit spending allocated as tax cuts. Always remember the key to Keynesian approaches is the issue of sustaining aggregate demand that is the sum of purchasing power available to the population and their willingness to use it. This portion of aggregate demand we call consumption. For the moment let us put aside the issue of sustainable consumption versus wasteful indulgence in materialism and squandering of energy. We can return to this key 21st century issue at the end.

Total aggregate demand consists of consumption(C) plus investment(I) by the private sector plus government expenditures G)((also of a consumption and an investment nature) .Since government normally finances its expenditures by taxation (T) it is sensible to deduct taxation from Government G to get G-T a measure of the deficit or surplus if T exceeds G. So the larger that G-T is the larger will be, other things equal ,aggregate demand. Unless the fact that G-T is large and growing causes private I to be smaller(economists call this the crowding out effect) there can be no doubt that over time higher aggregate demand both sustains existing jobs and causes new jobs to be created as suppliers respond to the greater aggregate demand by hiring more workers.

But since the whole point of a recession , slump or depression is the shrinking of private investment because of depressed animal spirits among entrepreneurs and corporations there cannot be any crowding out or not at least until prosperity has been restored and animal spirits reignited. So long as the central bank does its work of keeping interest rates very low crowding out will not occur.This is precisely what the Fed is doing when it buys up Treasury bills. What the deficit financed stimulus does is transfer idle savings that are not being invested in job creating investments from this passive position to an active one where the stimulus uses them for real investments in infrastructure.If the deficit is used to finance tax cuts to the extent that the tax cut increases purchasing power, particularly if directed at the moderate income majority, this should result in a restoration of consumer spending which helps the money circulate in the economy. If it is used to pay off debt then banking and personal balance sheets are improved and provided the banking system is unblocked( a major item of importance which cannot be neglected in the present circumstances ) then new loans can be made and animal spirits reawakened.

In fact, instead of crowding out, crowding in is what happens. That is , government investment and expenditures induces private investment that would not otherwise occur. There is no risk of inflation since the general environment is either deflationary or disinflationary. Later as vector forces begin to raise prices rather than output as the economy once again approaches low unemployment stimulus can be withdrawn so that the growth rate and lower unemployment is compatible with low to moderately low inflation.

But none of this happens overnight. Just as it took time for the economy to unravel and the implosion to occur it takes some time for the recovery to begin. Already in the US the recession is about 12 months old. We can expect it to continue for some months still. But then once the stimulus begins to have an impact and particularly if other leading economies enact similar packages the combined impact of these will begin to restore both stability and positive growth to the economy. As the economy grows again and so long as interest rates are kept low we should experience a falling debt to GDP ratio, the return of some opimism and the exciting prospects of rebuilding a shattered global economy. As we do that we will need to focus on balanced ecological growth, spiritual renewal and an enormous expansion of service activities like the culture industries, education, the helping professions, the care of the young and the elderly almost all of which can be accomplished in an ecological fashion as well as high tech innovation and the production of material goods.