Crisis Diary as it unfolds ….

The Keynesian Moment for Greg Mankiw

The debate over US stimulus is heating up. While Obama’s much praised economic team in busy putting together the nitty-gritties of the stimulus package, the biggoes of academia are busy romancing around the depression economics.

Recently Greg Mankiw, a noted Harvard economist, stepped into the shoes of John Maynard Keynes in his NY Times column here to speculate what he would have done had he been around today. He analyzed the four components of GDP (C+G+I+X) and went on to comment how it is becoming increasingly difficult to influence any one of C, I and X in a meaningful way. This, according to him and many other prominent economists, leaves us with one option – Government Spending aka stimulus aka Keynesian Economics.

GOVERNMENT PURCHASES That leaves the government as the demander of last resort. Calls for increased infrastructure spending fit well with Keynesian theory. In principle, every dollar spent by the government could cause national income to increase by more than a dollar if it leads to a more vibrant economy and stimulates spending by consumers and companies. By all reports, that is precisely the plan that the incoming Obama administration has in mind.

But then he goes on argue why the huge stimulus package as some other economists are recommending is not such a good idea – primarily due to already burgeoning national debt.

The fly in the ointment — or perhaps it is more an elephant — is the long-term fiscal picture. Increased government spending may be a good short-run fix, but it would add to the budget deficit. The baby boomers are now starting to retire and claim Social Security andMedicare benefits. Any increase in the national debt will make fulfilling those unfunded promises harder in coming years.

Keynesian economists often dismiss these long-run concerns when the economy has short-run problems. “In the long run we are all dead,” Keynes famously quipped.

The longer-term problem we now face, however, may be more serious than any that Keynes ever envisioned. Passing a larger national debt to the next generation may look attractive to those without children. (Keynes himself was childless.) But the rest of us cannot feel much comfort knowing that, in the long run, when we are dead, our children and grandchildren will be dealing with our fiscal legacy.

He also then suggests the possible solution to the problem could be innovative monetary policy by Fed.

So what is to be done? Many economists still hope the Federal Reserve will save the day.

In normal times, the Fed can bolster aggregate demand by reducing interest rates. Lower interest rates encourage households and companies to borrow and spend. They also bolster equity values and, by encouraging international capital to look elsewhere, reduce the value of the dollar in foreign-exchange markets. Spending on consumption, investment and net exports all increase.

But these are not normal times. The Fed has already cut the federal funds rate to 1 percent, close to its lower bound of zero. Some fear that our central bank is almost out of ammunition.

Fortunately, the Fed has a few secret weapons. It can set a target for longer-term interest rates. It can commit itself to keeping interest rates low for a sustained period. Most important, it can try to manage expectations and assure markets that it will do whatever it takes to avoid prolonged deflation. The Fed’s decision last week to start buying mortgage debt shows its willingness to act creatively.

It is hard to say how successful monetary and fiscal policy will be in avoiding a deep downturn. But as events unfold, you can be sure that policymakers in the Fed and Treasury will be looking at them through a Keynesian lens.

From Greg’s conclusion, it appears that he is still hopeful about Fed and its monetary policy to carry us thru this crisis even though Fed has proved completely ineffective so far whether it is in unlocking the credits markets, in stimulating demand, in stimulating investments or in targeting the inflation. When conventional Fed policy fails, the only option left (pun intended) is G for Governmental expenditure aka stimulus package, no?

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December 4, 2008 - Posted by | Opinions | , , ,

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