Saturday Quiz – January 8, 2011

This Post Has 8 Comments

1. Not sure which world Q1 describes … here’s a real world scenario …

   In the early 2000s with the US budget running a surplus and the private sector in deficit and later partly due to a relaxation of fiscal policy and partly due to reversal of private expenditure relative to income – the budget back in deficit and the private sector still in deficit, what would work to control the house price boom – relaxing fiscal policy even further or tightening. ? The former leads to a further increase of demand for loans for house purchases and the latter risks throwing the nation into a deep recession.

   A fiscal expansion was indeed provided and did prevent a deep recession at the time.

   Why I am saying this ?… Japan is a scenario where zero rates didn’t lead to a boom in house prices. The case of the US was different. The asset bubble could not have been prevented by tightening fiscal policy because the private sector was in deficit.

   And then there is this assumption that interest sensitivity of loans for house purchases is low. Proof ? (Not Japan where at zero the private expenditure was less than income).

   The assumption that rates can be set at zero and everything can be left to fiscal policy is a dicey game. Couldn’t have been done in the case of the US in the 2000s. Tightening fiscal policy to contain the bubble would have left the private sector with more vulnerability. Relaxing continues the bubble.

2. Ramanan,

   I don’t see what your observation has to do with Q1.

   I believe Bill is arguing that the expansionary effects of government spending, whatever they may be, will be the level of deficit spending, not how that spending is financed.

   You seem to be arguing that aggregate demand has other components (e.g. foreign sector, household sector, firms, etc).

   Adjustments to the OIR — and really the whole package of capital requirements, financial sector supervision, guarantees to creditors, etc. — is an attempt by the government to cause the other sectors to increase or decrease their own contribution to demand. Even mortgage interest tax rates plays a role.

   As you point out, this may or may not succeed, depending on the interest elasticity of investment and depending on how the exchange rate adjusts to movements in the OIR, and the trade offs between higher foreign input costs for domestic production versus lower output costs for foreign purchase of domestically produced inputs, etc.

   All sorts of trade-offs are happening when the government attempt to adjust the non-government sectors’ contributions to demand.

   Nevertheless, deficit spending policy is an attempt by the government to increase or decrease its own contribution to aggregate demand, which always “works”. It’s much simpler.

   The sum total of demand management policies would be the combination of OIR policy (managing the non-government’s contributions to demand) and fiscal policy (managing the government’s own contribution to demand).

   And Q1 just says that the government’s contribution to demand is determined by deficit spending.

   P.S. — I would also take issue with the answer to Q1, because you need to subtract out interest payments, other capital transactions, transfer payments, as well as any purchases of foreign output. Only what is left constitutes government’s contribution to aggregate demand in the NIPA sense — i.e. purchase of domestically produced consumption and investment goods. Perhaps this is what Bill meant when he talked about “deficit spending”, but this is not how this term is traditionally defined. I.e. NIPA’s “G-TX” is a lot different than “Government deficit spending”. I don’t know if there is a word for “G- TX” — “net real deficit spending”?

   However the other government outlays — interest payments, purchases of foreign output, capital transactions, and transfer payments — may well affect the non-government sectors’ demands, by influencing the terms of trade, or altering interest rates, or shifting income among those with a different propensity to consume, etc. Again, here things get very hairy. But saying that the government is willing to spend $100 Billion on domestically produced goods clearly and directly affects aggregate demand.

3. RSJ,

   I know my comment doesn’t seem to have to do with Q1. But it does. The act of injection of demand comes from the deficit spending not financing, but the question is talking of stopping debt issuance and hence zero rates.

   The trick of paying interest on reserves was understood recently in the sense that absent knowing the trick, the scenario presented in Q1 implies “zero interest rate”.

   The lending rates on mortgages were quite low because of this. Now one may argue that it is dependent on other rates as well etc, but the rates on mortgages were low.

   Tightening borrowing through fiscal policy is wouldn’t have helped because the private sector was already in deficit. Its related to your comment in the other post.

   Don’t see a disagreement with you.

   My comment was posed as a question .. in early 2000s .. the government couldn’t have tightened fiscal policy … we live in an imperfect world … the sectoral imbalances were due to all the three sectors .. government, private and foreign … Greenspan’s policy just contributed to the private sector continuing its game.

   So all I am saying is that there is a jump here .. fiscal policy controls demand doesn’t mean it can control all demand.

4. @ramanan: first i don’t see any evidence that fiscal policy can’t affect the demand for houses. if a land value tax were imposed equal to rental value and we raised capital gains taxes substantially it would be much more difficult for banks to profitably bid up asset prices. fiscal policy in general could be expansionary in general and sustain full employment. i’m not declaring that there would be no difficulties, what i am saying is your scenario has nothing to do with the “real world”

5. NT,

   Didn’t say it doesn’t affect the demand for house prices.

   Yes that can be done – do not see it happening anywhere in the world.

   In what sense does my scenario have nothing to do with the “real world” ? I am talking of the scenario in the US in the early 2000s.

6. “My comment was posed as a question .. in early 2000s .. the government couldn’t have tightened fiscal policy … we live in an imperfect world … the sectoral imbalances were due to all the three sectors .. government, private and foreign … Greenspan’s policy just contributed to the private sector continuing its game.” you say that we couldn’t have tightened fiscal policy. i would respond that fiscal policy tightening may not have been a good idea but fiscal policy could certainly have been restructured. a redirection of the tax structure onto land value would have done lots to prevent rises in housing prices and fiscal policy could still have been used to preserve full employment. low mortgage rates does not necessarily imply high borrowing rates.

7. NT,

   Yes they can impose taxes but in the absence of it, the central bank has to step in.

   “low mortgage rates does not necessarily imply high borrowing rates.”

   True it depends on other factors as well. Such as the case now in the US or the UK and many nations where rates are low and borrowing not picking up.

   However, that isn’t a proof that this the case always. Right now, consumers do not want to deficit spend as a sector. If they want to, low interest rates won’t help.

8. my point is this Ramanan: the only reason the private sector ever willingly deficit spends is it sees an advantage from doing so. the expectation of capital appreciation is that incentive. land value taxes and other taxes/forms of regulation that cutoff expected capital appreciation or the benefits usually derived from realized capital appreciation would fatally discourage such bubble creating borrowing and make room for fiscal expansion. not only that, but such policies would bring the united states much closer to the “euthanasia of the rentier” and hence reduce production costs dramatically below other countries. this combined with a “doctrine-of-high-wages” policy like the kind advocated by American political economy in the 19th and early 20th centuries would lead to rises in per diem wage rates in order to generate a fall in per unit of output costs.