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Sunday, February 15, 2009

WILL TAX CUTS BE USEFUL FISCAL STIMULI TO COUNTER THE EXISTING RECESSION?

Today's Buggy Topic Was . . .

... posted four days ago by prof bug at Economist's View  --- a very good economics blog run by Professor Mark Thoma of the University of Oregon, himself a well-known specialist in macro-economics . . . with a New Keynesian theoretical approach.  Don't worry about the meaning of this approach.  Prof bug explains it in the post.   The topic is accurately reflected in the subject-title above . . . though with a twist: it looks at the impact of tax cuts not directly on the demand-side of the economy --- such as how much of the tax cuts would lead households to spend their higher take-home income on new consumption and how much would instead be saved and reduce the impact effects of stimulating GDP growth --- but rather on the supply-side. 

And as you'll see, looking at tax cuts on household income --- labor income if you want --- turns out to have very paradoxical effects in a recessionary environment marked by a zero-bound nominal interest-rate . . . exactly the policy of reducing short-term interest rates that the Federal Reserve has purposefully brought about.

Some Background Here

The thread at Economist's View started with a link to a summary of a new study by Gauti Eggertsson . . . an economist with the Federal Reserve Bank of New York.   Does the name sound familiar to buggy visitors?  Possibly.  Back in the fall, prof bug analyzed an unusual study by Eggertsson that came out earlier in 2008 --- a sustained effort, with a lot of formal mathematical modeling, to justify what has always been the most controversial and criticized part of the early New Deal of FDR between 1933 and 1937:  in a word, its efforts to deal with the depression that FDR inherited not just by some deficit spending ---- FDR, remember, was generally a fiscal conservative, and his Budget Director and his Secretary of the Treasury were even more so (not to mention the head of the independent Federal Reserve --- nor in taking the $US off the gold standard and depreciating the dollar's value in exchange rate markets. 

No, not just these helpful policies, but rather in three other counters to the Depression:  1) to reorganize basic industry into cartels; 2) to destroy a lot of agricultural output; and 3) to push heavily for more unionization of the US work force and, additionally, urge unions to press management to raise their wages.

 Eggertsson's Counter to These Criticisms

Until Eggertsson's paper last year, these three additional programs were criticized as irrational and counter-productive.  What Eggertsson tried to do was show that this wasn't the case . . . at any rate, amid not just a serious plunge in GDP since 1929 by a third (compared to a slight overall GDP growth rate in the US last year despite the decline in the 4th quarter) --- or amid a dire environment of 20-25% unemployment --- but also  ongoing declines in the price-level of the US economy.  Such declines are know, of course, as deflation.  In such a case --- we haven't have deflation here since 1937 (except for a few months briefly in the mid-1950s) --- three things happen:

  1. Households tend to reduce their spending, holding back until the prices of non-essential goods fall further.  That generates widespread expectations of future deflation, and in turn that further restrains consumption.
  2. Business firms, faced with declining sales and profits, resort to further price cuts.  That accelerates the price decline and further reduces sales and profits.
  3. On top of all this, the real interest rate --- as opposed to the nominal interest rate in dollar terms in which, say, business firms entered into earlier contracts or workers bought houses with mortgages or cars with loans --- tends to rise with the fall in the price level.   This shifts the burden away from creditors (who lose some of their loans' value with inflation is occurring over time) and toward debtors . . . not just the vast majority of average American workers and households, but also business firms that depend on bank loans for short-term and long-term investment purposes. 

Amid such a deflationary environment, so Eggertsson argued in that stimulating 2008 article, the interlocked programs of cartelization, the policy to reduce supply of agricultural output, and the push to get workers higher wages ---- however counter-intuitive --- actually made sense.  They were all an effort to do two things: first, to reverse deflation, and second and even more important, to reverse deflationary expectations and prod households to start buying non-essential goods as a way to boost aggregate demand and grow the economy.  And, of course, if the price level started rising again, then the real interest rate would fall and stimulate both new business investment and consumer purchases on loan-credit. 

Enter Eggertsson's Latest Paper on the Current Recession and the Impact of Tax-Cuts

It's a complex argument, which unfolds a mathematical model that looks initially at what happens to the aggregate supply-side of the US economy, and then shows how --- amid incipient deflation right now, and especially under the influence of a zero-bound limit to nominal interest-rates --- such tax cuts would likely lower the price-level and create or aggravate deflationary expectations . . . with all the pernicious effects that would follow: households reducing consumption while waiting for further price falls; the real interest rate rising; and business firms, faced with declining sales, reducing their prices even further while holding back from new investment.

Enough Background

The long buggy analysis will likely deal with all the questions you might have about Eggertsson's formal math model and the theoretical argument and policy-oriented conclusions that follow.  So click here for prof bug's length initial post at Economist's View.  

Why initial? 

Well, two days alter, prof bug found that Professor Nick Rowe, a talented Canadian economist, had started a thread at his web site that partly summarized Eggertsson's complicated argument while taking issue with its conclusions ---- at any rate, as far as the impact of a sales-tax went.  Prof bug set out a lengthy reply.  And tried to show that Professor Rowe --- whose work he respects --- hadn't fully grasped the complexities of Eggertsson's argument and tried to show why.  But that is the subject matter for the next prof bug post here.