To borrow a frequently uttered and painfully obvious observation from Everett, George Clooney’s character in the film “O Brother, Where Art Thou,” we’re in a tight spot. But so are economic policy makers.
On the one hand, the federal funds rate is now so low that further interest rate cuts designed to encourage lending and investment, like the Fed’s historic action today, may not have the desired effect. On the other hand, President-elect Obama and the Democratic party’s majority in the House of Representatives and Senate are talking about multiple, “shovel-ready” public works stimulus packages designed to spend our way out of the current recession. Will interest rate cuts and fiscal stimulus work?
Here’s the monetary rock. When nominal interest rates are close to zero, monetary officials like Ben Bernanke may find themselves facing what some economists have called a liquidity trap in which the opportunity costs of holding money in the form of cash or bonds are roughly equal. A consequence is that savers and investors may not foresee high returns in buying low-yielding bonds and so park money in short-term cash accounts. When monetary authorities inject more money into the economy it becomes “trapped” in banks unwilling to lend it out again. Monetarist economists like Milton Friedman asserted that monetary authorities might overcome a liquidity trap through gift, or helicopter money; the idea of flying over the economy and dropping money or giving it away to encourage consumption and investment. Not sure how that would “go over” politically.
And here’s the fiscal hard place. According to Amity Shlaes’ book The Forgotten Man: A New History of the Great Depression, years of federal stimulus packages and deficit financing did little to overcome the high unemployment levels of the 1930s. Likewise, the record of Japan’s fiscal efforts to end its so-called “lost decade” of deflation during the 1990s is not a clear-cut policy victory. [For a summary of these efforts, see today's WSJ editorial Barak Obama-san.] Keynesian critics claim that the American New Deal simply didn’t provide enough fiscal stimulus. This deficiency does not seem likely to be repeated in today’s climate of irrationally exuberant bail-out mania.
What policy or policy combinations will serve the common good in this tight spot?
