An analysis shows that the Federal Reserve’s large-scale asset purchases have been effective at reducing the economic costs of the zero lower bound on interest rates. Model simulations indicate that, by 2012, the past and projected expansion of the Fed’s securities holdings since late 2008 will lower the unemployment rate by 1½ percentage points relative to what it would have been absent the purchases. The asset purchases also have probably prevented the U.S. economy from falling into deflation.
Monetary expansion raises aggregate demand. That means more employment and more inflation. If the economy is already close to full employment, extra demand mostly means more inflation. But if the economy is far from full employment, then you mostly get more employment and more output.
Meanwhile Kevin Drum reads a new paper by David Glasner which shows that low inflation plus low interest rates lead to companies hoarding cash, thereby decreasing aggregate demand. Scott Sumner writes:
There is no way to overstate the importance of these these findings. The obvious explanation (and indeed the only explanation I can think of) is that low inflation was not a major problem before mid-2008, but has since become a big problem. Bernanke’s right and the hawks at the Fed are wrong.
….In my view the time-varying correlations between inflation expectations and stock prices are one of the most important pieces of evidence we have that [aggregate demand] became a problem after mid-2008. It will be interesting to see if those economists who are skeptical of demand-side explanations can come up with a plausible alternative explanation for this pattern.
Essentially it’s a perfect storm: low interest rates, low inflation, all on top of what appears to be a balance-sheet recession. Demand is weakened and can’t be spurred by cutting interest rates. Unemployment remains high and we can’t break out of the cycle so demand remains low. Large companies are sitting on cash rather than investing it in part because low inflation means cash is a worthwhile investment in and of itself. Why spend now when you don’t risk increased prices in the future? And consumers are in debt and/or out of work which certainly doesn’t help. We get a vicious cycle of low spending, low demand, and low employment.
Meanwhile, the supply-siders and deficit and inflation hawks are sending everyone barking up the wrong tree with austerity-now politics. While long-term concerns over fiscal collapse may be worth considering in the long-term, we’re much more likely to see fiscal ruin from a longer-than-necessary recession than we are from increased spending in the short-term. Economic growth and the subsequent increases in revenue are far better ways to stave off a budget crisis than cutting spending and further reducing demand. Unfortunately, more stimulus is politically impossible unless it’s in the form of even deeper tax cuts. But increased stimulus would not only pump more money into the economy and lead us closer to full employment, it would begin to drive inflation rates up a bit, leading to more capital investment in the private sector. So what’s to be done?
We could always start a war and increase military spending which would have a stimulative effect. Plus, more people would join the army which would lower unemployment.
I kid, of course, but it is funny that there’s such widespread agreement that military spending creates jobs and boosts the economy but that this logic never translates into any other kind of government spending. We see this reasoning come up any time someone raises the specter of defense spending cuts. Why is this? It doesn’t even make much sense on its own merits: a single troop in Afghanistan costs close to one million dollars a year. We could hire 25 teachers at $40,000/year salary for the cost of one troop in Afghanistan. Hell, we could hire ten really well-paid teachers and still get more for our money which would filter back into the domestic economy (not to mention the long-term investment in our childrens’ education). And it wouldn’t be digging holes and filling them back up sort of work, either. I think there’s plenty of work that needs to get done in this country – plenty of productive work. We wouldn’t have to break any windows just to fix them – there’s plenty of broken windows already that need to be fixed.
Am I missing anything?