14. Are We Ready for the Next Severe Recession?

Chapter 14

Are We Ready for the Next Severe Recession?

Prior to the Great Recession, I shared an optimistic assumption made by most economists who have advocated fiscal stimulus in past recessions. Most of us assumed that in the anxious climate generated by a severe recession, a majority in both houses of Congress and the president could be counted on to support fiscal stimulus that would be large enough to overcome the recession, even if it entailed a large temporary increase in federal deficits and debt. Given this assumption, there was no urgent reason for any of us to consider whether fiscal stimulus could be enacted without deficits and debt.

But in the Great Recession that began in 2008, we learned that our assumption was naive.

In early 2009, a majority in both houses of Congress and the president favored fiscal stimulus, but they were also worried about rising federal deficits and debt caused by the recession itself, and were therefore reluctant to propose a fiscal stimulus large enough to overcome the recession. The minority in Congress that opposed fiscal stimulus warned that it would cause a dangerous increase in federal deficits and debt. As a consequence, the fiscal

stimulus that was enacted and implemented was, according to my calculations in early 2009, only a half of what was needed, and according to my later calculations, a third of what was needed.

This sobering experience taught me that we are still not ready to combat a severe recession. So for the first time I asked whether it would be possible to implement a large fiscal stimulus without any increase in government deficits and debt. Once I asked the question, it wasn’t long before I saw that there was an astonishingly simple way to do it. I soon discovered that Keynesian economist Abba Lerner had seen clearly how to do it in the 1940s, and more recently, a few others have also.

The way to do it is simply have the Federal Reserve use new money to finance the fiscal stimulus. There is no need for the government to borrow to pay for fiscal stimulus. Federal Reserve paper money is not government debt because the government no longer promises to pay gold or anything else to any holder of paper money. This wouldn’t be inflationary as long as the stimulus is implemented only during the recession and is phased out as the economy approaches full employment and consumer and business confidence returns to normal. But how would this be implemented in our actual economy? Simply by having the Federal Reserve give a large transfer (not loan) to the Treasury equal to the fiscal stimulus so the Treasury does not have to borrow to pay for the fiscal stimulus enacted by Congress.

But as of today, to my knowledge, there are few economists, or economic policymakers, or members of Congress, or members of the Federal Reserve’s Open Market Committee who have even thought about whether it is possible to implement fiscal stimulus without government debt. Unless this changes, whenever the next severe recession hits, fiscal stimulus with debt will be proposed, triggering public and political opposition because of the large deficits and debt it will generate. As in 2009, the supporters of fiscal stimulus will either have to scale down their

fiscal stimulus to make its debt acceptable, thereby making it too small, or if they refuse to scale it down, their stimulus proposal will likely be politically defeated.

The stimulus-without-debt proposal, however, is not simply a tactic for getting a large fiscal stimulus enacted in a severe recession. It is certainly better for stimulus to be implemented without a large increase in government debt. Large government debt—that is, government debt that is a large percentage of GDP—may generate negative economic consequences and risks in the future. If interest rates rise in the future, large government debt will require large interest payment by the government to bondholders, which will force Congress to raise taxes or cut spending or borrow more, so in the future citizens will have to pay higher taxes or receive lower government benefits. More government borrowing and still larger government debt may at some point make financial investors anxious and cause them to sell corporate stocks, resulting in a fall in the stock market, which in turn would reduce wealth and confidence and may cause consumers and businesses to cut spending, precipitating a recession. The fall in the stock market and the recession may generate still more anxiety among financial investors and managers, thereby generating a financial crisis, worsening the recession. So it is certainly better to do a large stimulus without debt than with a large debt.

My stimulus-without-debt plan has five elements:

1. If the Federal Reserve judges that the GDP of the economy is significantly below the Fed’s estimate of potential GDP, the Fed decides whether to give a transfer (not a loan) to the Treasury, and if so, how much, on the condition that it be used only for fiscal stimulus; authority for the Fed to make this transfer might require an amendment to the Federal Reserve Act; the Fed could implement its transfer

by writing a check to the Treasury or by crediting the

Treasury’s checking account at the Fed. 2. Congress decides whether to enact fiscal stimulus, and if so, how much; its main component would be tax rebates to households, though other components should also be included in the fiscal stimulus package; the Treasury would mail tax rebate checks to households in amounts specified by Congress. 3. If the amount Congress enacts for fiscal stimulus is no greater than the Fed’s transfer, then the Treasury does not have to borrow to finance the fiscal stimulus; if the fiscal stimulus is greater than the Fed’s transfer, the Treasury has to borrow the difference. 4. The Fed decides how much to adjust its bond purchases or sales to try to keep employment high and inflation low; it is very likely that the Fed, having injected money into the economy through its transfer to the Treasury, would decide to inject less money into the economy through bond purchases or withdraw money from the economy through bond sales. 5. The Fed orders (from the Treasury’s Bureau of Engraving and Printing) an amount of new Federal Reserve notes equal to its transfer to the Treasury, and stores these notes in the Fed’s vault; this Fed vault cash would be an asset on the Fed’s balance sheet, and as a consequence of this new vault cash the Fed’s transfer to the Treasury would not reduce the Fed’s capital (net worth) on its balance sheet.

My proposal would preserve the separation of powers and checks and balances between Congress and the Federal Reserve. It would be up to Congress to decide whether to enact fiscal stimulus and to set its size and composition. It would be up to the Fed

to decide whether to give a transfer (not loan) to the Treasury and to set its size.

But why choose tax rebates (cash transfers) to households as the main element of the fiscal stimulus? There are at least eight reasons.

1. Most important, tax rebates work: a significant portion of tax rebates are spent within a year of being received.

This should not be surprising. Both surveys of recipients and econometric analysis of spending data following the payment of tax rebates indicate that households spend a significant portion of it: a quarter within three months and a half within a year. 2. Tax rebates clearly increase household spending on all goods and services rather just a subset of goods and services, so all businesses would recognize that rebates boost customer demand for their goods or services. 3. With tax rebates, there would be no shovel-ready problem; there is no limit to how much households can spend promptly on goods and services. 4. With tax rebates there would be no temporary or permanent increase in the size of government: rebates simply give spending power to millions of individual consumers whose spending stimulates the private sector. 5. Tax rebates to combat a recession are clearly temporary and require a new vote by Congress to be continued. 6. Every household would receive a rebate check in the mail from the US Treasury, so every voter would actually see a concrete personal benefit from this kind of fiscal stimulus. 7. The inclusion of every household would cause most voters to regard tax rebates as a fair way to implement fiscal stimulus.

8. Rebates have been enacted with bipartisan support three times—1975, 2001, and 2008. Thus, a tax rebate has many important advantages as an instrument for fiscal stimulus in a recession.

There is a good reason why tax rebates were able to pass with bipartisan support three times. Conservatives and liberals, Republicans and Democrats, have differing long-term agendas for government spending and taxation. For example, conservatives generally want permanent tax cuts, while liberals want permanent increases in social insurance and education programs. Neither side wants an antirecession stimulus that would advance the agenda of the other side if it became permanent. Tax rebates are obviously and inherently temporary. They do not favor the long-term agenda of either side. This is undoubtedly one reason that tax rebates were enacted three times with bipartisan support, whereas most other proposals, such as permanent tax cuts, or permanent increases in social insurance or education programs, have generated partisan support and opposition. The tax rebate does not favor one side’s long-term agenda over the other. It is neutral toward long-term agendas.

Should a fiscal stimulus package consist solely of tax rebates? No. I made the case for several fiscal stimulus supplements to tax rebates for inclusion in a fiscal stimulus package: a temporary increase in federal aid to state governments, temporary tax incentives for business investment, and infrastructure repairs and maintenance. But I also made the case against including any of the following in a fiscal stimulus package: a temporary cut in income tax withholding, a temporary cut in payroll taxes, a cut in income taxes, and an increase in spending on long-term programs.

I considered the main objections to my stimulus-withoutdebt plan and gave my responses. Would stimulus without debt

be inflationary? No, because stimulus would be phased out as the economy returns to full employment and consumer and business confidence returns to normal. Would stimulus without debt weaken the Fed’s balance sheet? No, because the Fed would print an amount of new paper money equal to the fiscal stimulus and keep the new paper money in its vault as an asset. Would stimulus without debt undermine Federal Reserve independence? No, because the Fed would decide whether to make a transfer to the Treasury, and how much the transfer should be. Can’t monetary stimulus overcome a severe recession? No, because in a severe recession, cutting interest rates to zero doesn’t induce much borrowing and spending because of consumer and business pessimism.

It would be straightforward to implement stimulus without debt in any country that, like the United States, has a central bank with the power to print the money it uses. But it would also be straightforward to implement stimulus without debt in the eurozone, where only the European Central Bank (ECB) can print euros. The ECB would transfer euros to each national treasury, using a formula that specifies how many euros should go to each particular treasury, in the same way that the Treasury of the US federal government implements revenue sharing by transferring dollars to the treasury of each state government, using a formula enacted by Congress that specifies how many dollars should go to each treasury.

Although stimulus without debt was conceived as a tool to combat recession—especially a severe recession like the Great Recession that began in 2008—it could also combat chronic insufficient aggregate demand. If a nation ever faces secular stagnation due to chronic insufficient aggregate demand for goods and services, applying stimulus without debt each year would keep demand at the level needed to maintain full employment without generating inflation. Each year the Fed would give a

transfer to the Treasury to finance fiscal stimulus (primarily tax rebates to households) enacted by Congress. As long as the magnitude of the stimulus is set so that it increases demand to, but not above, potential output, it won’t generate inflation. Thus, stimulus without debt is a solution to demand-induced secular stagnation.

In conclusion, we are not yet ready for the next severe recession (or demand-induced secular stagnation) for two reasons. First, most economists, policymakers, members of the Federal Reserve’s Open Market Committee, and members of Congress assume that a large fiscal stimulus must generate a large increase in government debt, and many would oppose any policy that generates such an increase in debt. A major purpose of this book is to try to communicate to them that it is indeed possible to implement a large fiscal stimulus without any increase in government debt, and to persuade them to seriously consider stimulus without debt in the next severe recession. Second, Congress must amend the Federal Reserve Act to empower the Federal Reserve’s Open Market Committee to authorize, if it chooses to do so, a large transfer (not loan) to the Treasury to finance a large fiscal stimulus during a recession (or demand-induced secular stagnation). Without such an amendment, the FOMC may be unwilling to make the transfer, and even if it does, its action would be challenged in court. Ideally, it would obviously be better for Congress to hold hearings on and debate such an amendment prior to the next severe recession. In practice, it may take the reality of a looming severe recession to get Congress to act.

So advocates of stimulus without debt must work hard to communicate that it is possible to implement large fiscal stimulus in a severe recession without any increase in debt and to persuade people—economists, policymakers, and the public— that stimulus without debt should implemented in the next severe recession. Prior to the next recession, advocates should try

to get Congress to hold hearings on and enact an amendment to the Federal Reserve Act that empowers the Federal Reserve’s Open Market Committee to authorize a large transfer (not loan) from the Fed to the Treasury to finance fiscal stimulus enacted by Congress in a recession. If this cannot be achieved prior to the next severe recession, advocates should be ready to offer the amendment to Congress as soon as a severe recession hits.

Stimulus without debt is not the only action that must be taken the next time a severe recession occurs. As in the Great Depression and the Great Recession, it will be necessary for the Federal Reserve and/or the Treasury to perform financial rescues of key firms and inject funds into financial firms to keep credit from freezing up. These essential interventions are not addressed in this book. There are many analysts, however, who believe that these interventions are all that is necessary—that once key firms are rescued and the flow of credit is restored, then nothing more needs to be done. This book strongly rejects that view. A severe recession always involves a plunge in aggregate demand for goods and services, and once that plunge occurs, it will not be reversed simply by rescuing key firms and restoring the flow of credit.

This book explains how a large fiscal stimulus can be implemented without any increase in government debt or inflation. It simply requires a large transfer (not loan) from the Federal Reserve to the Treasury to finance the fiscal stimulus enacted by Congress. If the argument of this book is widely accepted, and if Congress amends the Federal Reserve Act to empower the Fed, if it chooses, to make a large transfer to the Treasury for fiscal stimulus, then we really will be ready for the next severe recession.