That “central bankers alone cannot solve the world’s economic problems” was the most extraordinary concession to come out of the mouth of Federal Reserve Chairman Ben Bernanke during last Friday’s speech at the Jackson Hole Economic Symposium.
Of course, he’s right, but, rather than acknowledging that fiscal policy is the most effective counter-stabilisation tool available to national governments, Bernanke still trumpets the idea that monetary policy is the only game in town. Despite huge efforts by the Fed to stimulate the private sector via “quantitative easing” and a veritable alphabet soup of lending programs over the past year and a half, consumers remain reluctant to spend, banks remain reluctant to lend, and businesses are hoarding corporate cash rather than reinvesting. The problem is that “unconventional monetary policy measures" have had no impact because all the central bank is doing is changing the term structure of assets on its balance sheet, rather than generating additional spending power in the economy. This is understandable, given the economic backdrop: in a time of over-indebted households and weak aggregate demand, workers are simply losing their jobs, remaining unemployed and loath to spend.
In short, we have what Keynes once described as the “paradox of thrift” in action. Any individual can increase his/her savings by reducing spending on consumption goods. So long as this decision does not affect one’s income—and there is no reason to assume that it would—she ends up with less consumption and more saving. My friend, Randy Wray, gives a good illustration of this phenomenon:
The example I always use involves Mary who usually eats a hamburger at Macdonald’s every day. She decides to forego one hamburger per week, to accumulate savings. Of course, so long as she sticks to her plan, she will add to her savings (and financial wealth) every week. The question is this: what if everyone did the same thing as Mary—would the reduction of the consumption of hamburgers raise aggregate (national) saving (and financial wealth)?
The answer is that it will not. Why not? Because Macdonald’s will not sell as many hamburgers, it will begin to lay-off workers and reduce its orders for bread, meat, catsup, pickles, and so on.
All those workers who lose their jobs will have lower incomes, and will have to reduce their own saving. You can use the notion of the multiplier to show that this process comes to a stop when the lower saving by all those who lost their jobs equals the higher saving of all those who cut their hamburger consumption. At the aggregate level, there is no accumulation of savings (financial wealth).
Of course that is a simple and even silly example. But the underlying explanation is that when we look at the individual’s increase of saving, we can safely ignore any macro effects because they are so small that they have only an infinitely small impact on the economy as a whole.
But if everyone tries to increase saving, we cannot ignore the effects of lower spending on the economy as a whole.
One of Chairman Bernanke’s persistent blind spots in his inability to recognize this basic “fallacy of composition." The President of the European Central Bank, Jean-Claude Trichet, suffers from the same cognitive defect as evidenced by his call to deal promptly with “fiscal imbalances” as “an important precondition for sustaining a durable recovery."
The non-government sector’s newfound love of thrift is precisely what everybody keeps urging in order to create the foundations of a sustainable economic recovery, but both Bernanke and Trichet fail to realize that if private households and businesses desire a surplus then the government sector has to target a deficit for growth to be maintained. This inability to understand basic sectoral balances leads to the fraudulent idea that the government is “running out of money." It is not. The only shortfall that exists today is political will and imagination. The US government refuses to fill a greater proportion of aggregate demand with public spending or additional tax cuts and so exacerbates the private sector’s uncertainty and its corresponding desire for a higher ex ante savings rate.
For decades, governments have been pressured to run tight fiscal positions which have entrenched persistently high unemployment rates so that the inflation genie would not break out of the bottle. But the evidence continues to mount that the policy of simply keeping interest rates down is a variable instrument with diffuse impacts that creates as many losers as winners. For every borrower who benefits, there is a pensioner, starved of income from the government’s financial assets. In the meantime, unemployment, by any honest measure, remains in double digits.
Ben Bernanke is right: central banks can’t do all of the heavy lifting here. Real recovery is going to require government initiative via fiscal policy, starting with job creation by government. And we will need direct job creation, with government paying the wages and benefits for up to 12 million new jobs. Announce a Job Guarantee program, a national payroll tax holiday, and a per capita revenue sharing program with the states. In regard to our housing crisis, we need massive loan modifications to make mortgages truly affordable for the length of the loan. We also need large scale employment programs that restore households’ capacity to pay; we need to deal with the over-supply of homes and to help people to stay in their houses; and we need swift and cheap bankruptcy procedures that provide a fresh start to the people who cannot afford to keep their houses. Given that the government effectively is the main instrument behind housing finance today, it is in a position to simplify the foreclosure process and stand ready to buy the homes of distressed mortgagors at the lesser of current market value or the value of the mortgage. It can allow the homeowner to lease the home at a fair market rental price, with an option to buy it back after two years at the then-prevailing market rate. This would not only help to deal with the excess supply of homes (and so put a floor under home prices), but also would help to restructure the finances of households while allowing them to remain in their homes.
Taken in sum, all of these measures will allow households to go about the business of actually repairing their balance sheets. Not only do they make economic sense, but they would be politically popular as well, because they are designed to serve the vast majority of Americans who don’t work on Wall Street. Expanding fiscal policy further will provide further support to private saving while continuing to expand aggregate demand and employment growth.
Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.