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by Arnold Kling December 20, 2000
Times may not be good much longer. In January, I predicted that the next President would face a recession caused by a stock market crash. Also, I predicted that the President's economic advisers might not know what to do about it. Subsequent developments have been along the lines that I feared.
The father of macroeconomics is John Maynard Keynes. Since the 1960's, his reputation has declined steadily, particularly among conservative economists. I continue to believe that Keynes is relevant today. What follows is some elementary Keynesian economics that President-elect Bush is likely to need but unlikely to hear.
Keynes viewed the economy as a contest between the "hoarding" instinct and the entrepreneurial instinct. The "hoarding" instinct is to save and to look for conservative investments. The entrepreneurial instinct is to look for promising new business opportunities.
Entrepreneurial instincts, or "animal spirits," promote economic activity. The entrepreneur provides a productive outlet for the savings provided by hoarding.
When "animal spirits" decline, there is too much desired savings relative to the lower level of investment. As a result, economic activity contracts, and you have a recession.
The stock market is a major influence on business investment. Keynesian economist James Tobin argued that when the market value of capital is higher than replacement cost, investment will increase. He focused on the ratio of market value (in the stock price) to the replacement cost of capital. When this value, called Tobin's q, gets over 1.0, even by a small amount, investment is stimulated.
While a value of q of 1.2 would be stimulative, the dot-com mania caused "q" to soar close to 100. New dot-com stocks were valued at hundreds of millions of dollars, even though it cost only a few million dollars to create a new dot-com company. As a result, the number of new dot-com firms rose dramatically. Investment in the Internet mania was very high.
Keynes did not believe that financial markets behaved rationally. This was one of his most controversial positions.
Robert Shiller, a colleague of Tobin's at Yale, wrote a book called "Irrational Exuberance" that was published just before the stock market peak in March. In fact, the drop in the market that has occurred since the publication of the book has served only to take stock prices about to where they were when Shiller began to write the book. In other words, from Shiller's perspective, so far we have seen only some of the air let out of the bubble. There is still much more room for declines in share prices.
Suppose that the stock market continues to decline. This could lead to a major downturn.
Already, we are seeing signs of declining investment. One major venture capital fund returned $1 billion to investors, because the fund managers did not believe that they could invest the money profitably. Other venture capital funds are trying to prop up their earlier investments rather than finance new firms.
There is room for the Federal Reserve to reduce interest rates. However, when firms find that they have excess capacity on hand, a lower interest rate does not stimulate more investment. The main expansionary effect of lower interest rates will be to stimulate exports by reducing the value of the dollar. This is a sluggish and uncertain channel, and even if it works it implies higher inflation because the relative price of imports will increase.
If there is a deep recession, and monetary policy is not fully effective, then to counteract a downturn the government must use fiscal policy. Expansionary fiscal policy involves moving the government budget toward deficit, with a combination of increased spending and lower taxes.
Unfortunately, in the last several years, the public and politicians have come to believe "surpluses good, deficits bad." In fact, the surpluses have been the result of strong economic performance, not its cause. The proof of this is the fact that when President Clinton's fiscal policies were enacted early in his term, they were forecast to result in continued deficits. The surpluses were unexpected, because the strength of the economy was unexpected.
There is a slight case to be made in favor of budget surpluses. Other things equal, running a budget deficit will worsen the generational imbalance that is embedded in our demographics. That is, as a country we would like to save for the future, when the ratio of retired people to workers will rise sharply.
(See Farmers and Parasites. Incidentally, my thesis adviser, Robert Solow, took a similar view in a recent talk at an MIT Nobel Laureate forum. It's good to know that even though I have not seen him in over 20 years, our thinking still lines up.)
However, if you ask me to choose between a full-employment economy with a budget deficit and a recession economy with a surplus, I would not choose the surplus. The full-employment economy will help to give more work experience to younger people. That will make them more productive later in life. Ultimately, the best hope for dealing with the demographic crunch is higher productivity, not government savings.
One approach that would be congenial to Bush would be a large tax cut. Unfortunately, much of the tax cut that was part of his campaign was "back-loaded," with the larger cuts occurring farther into the future. If anything, we probably need a more front-loaded tax cut.
In addition, some of the tax cuts most popular with Republicans may not be very stimulative, because they are likely to be saved rather than spent. For example, eliminating the "death tax" is unlikely to unleash much spending. I cannot imagine that the marginal propensity to consume out of inheritances over $700,000 (smaller inheritances are tax-free today) is very high.
Another approach to running a deficit would be to increase Federal spending. However, the notion that the first Republican President-plus-Congress since 1952 would go on a spending spree is difficult to contemplate.
An alternative would be to give large grants to state governments--what used to be called general revenue sharing. For example, the Federal government might give each state $1,000 for every person living in that state. This would amount to a $280 billion program.
One impact of a recession is to reduce state revenues. Because they are obliged to balance their budgets, this leads them to reduce spending. The result is to reinforce the downturn. However, with revenue sharing, the states would have less need to cut back.
In conclusion, I believe that a large, temporary revenue-sharing program would be a good approach for fighting a recession. This form of fiscal stimulus would quickly find its way into the economy. Unfortunately, I suspect that there is little chance of any Keynes getting through to Bush.