Wednesday, December 24, 2008

Are we all Keynesians now?

As the financial crisis has developed, economic indicators weaken consistently. A recession has been declared by the NBER, surprisingly since December of 2007. But it is even more important to look at the the trend in every major indicator: it is downward. There are indeed some signs of deflation at the US, which combined with relatively high unemployment and the grim attitude toward risk in the financial sector resemble some features of the Great Depression.

Since the cure for slow growth in those nasty years is closely related to high levels of public spending, is natural to start looking in these policies for a cure to the current crisis.
It is remarkable how all policy makers and some scholars had change their attitude toward temporal public deficits, ending an "era" of fiscal discipline as the key for sustainable economic growth. Moreover, spending money is the best way to get the financial system into tough regulation, since it forces bailed out firms to follow the guidelines that the government dictates. But how exactly will this increase in public spending change the outlook of the economy? How will expectations and the attitude toward risk be affected? It seems complicated to link throwing-money-at-like solutions to a feasible stable growth path.

A higher level of public spending, as old-school keynesians ask, does not necessarily stimulates the level of employment of the economy, as professor Mankiw's post says, there is hard evidence proving that lowering the tax burden would constitute a more powerful way to make the economy grow. Furthermore, Lawrence Summers published recently an article with more details of the Obama administration spending targets. Those aim at schooling, alternative energies and infraestructure. Even though it is not detailed in how it will be financed, it is clear that no limits on debt are bounding.

So even though government's balance sheet is almost unchanged in either policy -tax cuts and debt growth- the odds that a tax cut policy work seem more effective that
throwing-money-at a problem. It allows every economic agent to make the best decisions in allocating resources. There still one problem, how can government create incentives for people to spend their "new" income?

Clearly, tax rebates should not be allocated to the unemployed, since this would create a negative incentive for them to work. This is a question to be answered soon: which tax structure poses a premium in looking for a job? Furthermore, would this tax structure lead to an increase in consumption of the employed? There is a recent paper recommended by Mankiw from the IMF on this. This is a loose end that the incoming administration will have to address to provide sustainability and reinforce credibility in the stimulus plan.

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