Friday, March 15, 2013

Zombie McCain took a bite out of Guam

Senator John McCain has recently annoyed practically the entire population of Guam, by cutting much-needed funding for water/wastewater system upgrades. His argument seems to be: until the military buildup plans are finalized, Guam will get little in federal funds that the Senate has the authority to approve. This is very misguided because that was a critical public investment that would yield dividends for decades to come. Which makes me identify this as not only a problem that John McCain has, but that a fair portion of Washington shares: short-sightedness.

Compare the problems of the future as an out of control eighteen-wheeler rapidly bearing down on the US bus. The drivers in Washington look in their side mirrors and think the truck is far, forgetting the counsel of the mirror, with letters reading: "Objects are closer than they appear."

There are three basic propositions to see why cutting back on public investments and austerity, in general, can be self-defeating. First, cutting back on government expenditures during a slump where monetary policy has little traction can decrease aggregate demand. Second, prolonging a slump by cutting expenditures can generate less potential output. Third, cutting back on public investments, in particular, can result in lower potential output.

I think it's pretty obvious that, despite experimentation with quantitative easing, it does not seem to cause a very speedy recovery. The main mechanism for monetary policy to work is through cutting the real interest rate. The two channels are by slashing the nominal interest rate, which is rather easy and the other is increasing inflation expectations, which seems difficult. Generally speaking, monetary policy in this circumstance is pushing on a string (or is it? ... ). The government spending more money is more certain because if it is being spent, it has been spent at least once, whereas money creation does not necessarily result in spending money!

As many economists have pointed out, including Krugman, Summers and DeLong, less spending can lead to less investing for the simple reason that if you aren't using your productive capacity an don't expect to soon, there isn't much reason to build up any extra. That means workers losing skills and plants not being built.

Consider public sector and private sector investment together, just for simplicity. Suppose output is characterized by a Cobb-Douglas production function, where the coefficient for capital output is 0.2. This means that if investment is cut back so that there is 1% less capital than there would have been, output is going to be 0.2% lower. Just as important, by this same equation, the labor-output ratio is 0.8. Thus, if the employable labor force declines 1% because of skills deterioration or giving up on finding work (for instance), then output will be 0.8% lower than otherwise. It is important to point out that these possibilities would not be easily reversible.

It may well be advisable to engage in Keynesian stimulus, particularly one that is focuses on building up productive capacity for the future. One can imagine large infrastructure rebuilding and upgrading, increased education spending and other investments in the future being good for us now and in the future, so I do not see what should stand in the way. I have suspicions there may be other ways to stimulate the economy through different monetary policy, but it doesn't seem to be coming. Ready, set, spend.

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