Government must make concerted effort to promote stability
During times of economic turbulence we need a concerted effort by the government to promote stability. The magnitude of the situation precludes most individual private efforts from meeting any success. There are two tools that the government has available: fiscal policy and monetary policy.
Monetary policy is the primary tool that the government wields. This involves selling or buying treasury securities by the Federal Reserve to shrink or expand the money supply. Banks and other financial institutions join the Federal Reserve in these open-market operations. When the Federal Reserve purchases securities from banks, it creates additional liquidity in the private banking system that allows banks to borrow more cheaply from each other. The interest rate that applies for inter-bank loans is the federal funds rate. This interest rate is the main target of Fed monetary policy; the Fed lowers the rate to boost the economy and raises it to rein in overexpansion. Currently the federal funds target rate, which is 1 percent, is low by historical standards. There is little downward room to maneuver, and we risk finding ourselves in a liquidity trap similar to what Japan faced in the 1990s.
The other tool is fiscal policy, which involves government spending. Government spending is a key component of demand and can be viewed as a form of consumption. This increased demand will stimulate production, which will increase employment and income for workers. The drawback of this tool is that it can lead to budget deficits.
Yet the extraordinary economic situation we are in calls for extraordinary behavior. Monetary policy has been used to its limit — it cannot do much more for us. Fiscal stimulus is required for two reasons: it will act where monetary policy cannot, and it will create demand in a market that is suffering from a lack of demand. The consequences of allowing another Great Depression are too dire to contemplate; budget deficits should not be of too much concern right now. The main drawback of budget deficits is that the extra government demand for loans crowds out private borrowers. The credit market is frozen as it is; we have provided liquidity in the form of a bailout plan but banks are still not lending. The benefits of such a large stimulus would outweigh the cost of the deficits.
It is useful to take a look at the Great Depression and the government's response. President Franklin Delano Roosevelt helped create the Works Progress Administration, which was a fiscal stimulus. Workers were employed and put to use constructing public infrastructure such as roads and dams. As useful as it was, it is important to remember that this did not save the economy — it was too small. A good indicator of government spending is the size of the budget deficit as a percent of potential GDP. Between 1933 and 1941, budget deficits were roughly 1-2 percent of potential GDP. The economy even suffered a downturn in 1938 when FDR unwisely attempted to balance the budget during the economic crisis. Declaration of war in 1941 provided massive fiscal stimulus, which had corresponding budget deficits of approximately 20 percent of potential GDP. This new stimulus was what gave our economy the necessary boost to rise out of the Depression. These events suggest that any fiscal stimulus provided by the government ought to be massive by historical standards if it is to achieve success.
The gap between actual GDP and potential GDP is known as the output gap. Potential GDP is the output that would result from an economy at full-employment. This is a misnomer, as there is still a natural rate of unemployment in a fully-employed economy. This natural rate of unemployment has been estimated at about 5 percent. Okun's law, named after the late economist Arthur Okun, states that every 1 percent of unemployment above the natural rate results in a 2 percent output gap. It would seem reasonable to propose fiscal stimuli on the order of the output gap to bring demand back to normal levels. Unemployment rates are between 7 and 8 percent. If the natural rate of unemployment is estimated to be 5 percent, then that translates into a 4-6 percent output gap. The potential GDP of the United States is approximately $15 trillion and 5 percent would be $750 billion.
It is better to err on the side of boldness rather than caution in our current circumstances. If the fiscal stimulus is too small, there is nothing that monetary policy can do to help. On the other hand, if the fiscal stimulus is too large, we can raise interest rates as a counter-measure. It is always better to have a backup plan.
There are plenty of areas that could use financial stimulus. Our deteriorating bridges, highways and rail systems require maintenance and upgrades if they are to be useful in the 21st century. We must also construct new mass-transit railways to cope with changing demographic and population dynamics. Despite the temporary drop in prices — due to a demand implosion — energy costs will rise as soon as demand picks up. We cannot be lulled into a false sense of security regarding our consumption habits.
We must use this crisis as an opportunity to invest in our future. New infrastructure coupled with investments in science and education will lay the foundations for future prosperity. Federal grants for scientific research in many areas, especially solar, wind, wave and nuclear energies, will be extremely important. This stimulus would provide new technologies and new sectors of employment. Our schools and hospitals, which provide critical resources to the public, are in desperate financial straits as states cut appropriations. Providing resources to infrastructure and education would invest in our physical capital as well as our human capital.
If we are to be serious about tackling our economic issues, we must take significant steps. A large fiscal stimulus is required and we cannot lowball this. The government must act immediately and it must act boldly in stimulating demand. This crisis is a challenge, but it is also an opportunity. The New Deal provided some short-term relief, but its greatest effect was a long-term safety net that supported a thriving middle class. We are now presented with a similar situation, and we cannot afford to miss the opportunity.
Alexander Draine is a Rutgers College senior majoring in economics. His column, "Draine on Society," runs on alternate Tuesdays.