The Need for Aggressive Fiscal Intervention
Before we move on to looking at the global economic crisis from a medium term perspective, i.e., before we take a look at the phenomenon of the house price bubble and associated speculation that created the grounds for the current credit crisis, it might not be amiss to focus on what can be done in the short-run to deal with the real consequences of the economic crisis: the deep and prolonged recession that the US economy will undoubtedly be pushed into. Real GDP figures released by the US Bureau of Economic Analysis (BEA) on October 30 indicated that the US economy was in the midst of a slowdown even before the financial storm hit the world economy in the middle of September. Real GDP in the US contracted at an annual rate of 0.3 percent for the third quarter (i.e., for the months of July, August and September), led by a sharp fall in consumer spending; businesses cut 240,000 jobs in October alone, the highest figure in 14 years. The financial storm, comprising a severe credit crisis and even a possible banking crisis, worsened the slowdown further. In such a scenario, fixing the financial mess, dealing with the credit freeze, averting a possible run on the commercial banking system and restoring confidence in the financial system will not be enough to prevent a plunge into a deep, prolonged and painful recession; addressing the credit crisis is necessary but not sufficient to deal with the grave crisis in the real sector. A direct and aggressive boost to aggregate demand is the only way to prevent the current recession from becoming a depression. Why is that so?
In any capitalist economy, such as the US economy, the level of aggregate economic activity and employment is determined, in the short run, by the level of aggregate demand, and fluctuations in employment and output are accordingly determined by fluctuations of aggregate demand. Aggregate demand is defined as the sum total of all expenditures on goods and services produced in the economy. Macroeconomists divide total expenditure that make up aggregate demand into four categories: consumption expenditure, investment expenditure, government expenditure and net export expenditure. Consumption expenditure is the total spending by households on durable and non-durable goods, and also services; investment expenditure is the total spending by firms on plant, equipment, machinery and inventories, and the residential investment expenditures by households; government expenditure includes the total spending by local, state and federal government agencies on goods and services (excluding transfer payments); and net export expenditure is the net amount that foreigners spend on buying goods and services produced in the domestic economy.
BEA figures released for the third quarter show that every component of aggregate demand emanating from the private sector of the US (or foreign) economy either declined or slowed down when compared to the second quarter. In real terms, consumption expenditure decreased by 3.1 percent, the steepest decline since 1980 when the US economy was in the grip of a severe recession; during the previous recession in 2001, consumption expenditures had not even declined. Investment expenditures, other than those devoted to maintaining inventories, have also declined. Real nonresidential fixed investment expenditures decreased 1.0 percent in the third quarter, in contrast to an increase of 2.5 percent in the second. Expenditures on nonresidential structures increased by 7.9 percent, compared with a much higher increase of 18.5 percent in the last quarter; expenditures on equipment and software decreased 5.5 percent. Real residential fixed investment decreased 19.1 percent, compared with a decrease of 13.3 percent in the second quarter. Demand emanating from the external sector has a similar story to tell: even though exports registered a positive growth, the growth had slowed down considerably falling from 12.3 to 5.9 percent.
This is hardly surprising. With credit drying up, home equity vanishing and layoffs increasing, working-class households cannot be expected to increase their expenditures on the purchase of goods and services; a continued decline in the stock markets, coupled with increasing volatility will make matters worse. A recent survey in the US showed that consumer confidence was at it’s lowest value in 40 years, and so it is almost certain that consumption expenditure will not rise in the foreseeable future. Neither will export expenditures rise to shore up aggregate demand because most of the economies in the world are either already into a recession or are rapidly slowing down. Nor can firms be expected to increase their expenditures on plant and machinery and equipment. And the problem here is more than a credit freeze: even if the credit markets were to ease due to government intervention, which it is adamantly refusing to do, firms might not be willing to expand their operations because they face sagging demand. Capitalist firms produce to make profits; if they expect markets to be down and demand to fall, they will cut back and not increase their expenditures even if the cost of financing goes down.
That leaves us with government expenditure as the only source for increasing aggregate demand. In the midst of possibly the worst economic crisis since the Great Depression, the US government needs to aggressively step up it’s expenditure on goods and services; since private expenditures, either of firms or of households, cannot be expected to increase in the short-term, aggressive fiscal intervention seems to be the only way the US government can prevent the economy from sliding into a decade long L-shaped recession that was Japan’s fate in the 1990s. Moreover, such expenditures are warranted even from a long-term perspective of economic growth. Rebuilding the crumbling public infrastructure like roads and bridges, improving and widening the ambit of the public transport systems in US cities, jump-starting the movement towards green technologies, making health care available to all working-class Americans, increasing the unemployment benefit substantially, investing in the educational infrastructure makes both short-term and long-term sense. It will help boost aggregate demand in the short run and prevent a slide into a prolonged recession, and in the long run it will build the physical and human capital to help take the US economy into a higher growth trajectory.
Two alternatives to boost the economy, which are often brought up in this context, also seem to have lost their efficacy: tax breaks and monetary policy. Tax breaks have already been tried out and does not seem to have worked; reeling under mountains of debt, the tax break (or refund) cheque is often used by households not for making new purchases but for reducing the outstanding debt. The second alternative, monetary policy action, is also rapidly reaching the point where it will become totally ineffective. For it is almost certain now that the US economy is already stuck in what John Maynard Keynes long ago called a liquidity trap, a situation where the Central Bank can no longer boost aggregate demand by reducing interest rates. The Fed has already reduced the target federal funds rate to 1 percent and reducing it further to 0 percent, the lowest it can go, will possibly not help. Even if confidence in the financial system is restored and nominal interest rates lowered, this might not increase borrowing by firms because of their bleak forecast of falling demand for the goods they produce. Monetary policy has reached it’s limits; the only option to ward off a severe recession and decrease the pain on the working class seems to be aggressive fiscal intervention in terms of direct expenditure on goods and services by the US government.
(To be continued.)