Wednesday, December 19, 2007

Is 'Pump Priming' the Solution?

Is 'pump priming' the solution to the weakness in our economy? Does the U.S. economy need a a large policy-induced positive aggregate demand shock? Nouriel Roubini and Larry Summers both scream "Yes!"

As I discussed in a previous posting, Nouriel's view is that monetary policy easing now will not put off the necessary real adjustments needed "for the credit excesses, the asset bubbles, the reckless leverage, the lack of minimal appropriate supervision and regulation of financial markets of the last few years." He goes on to say a "sharp recession is unavoidable and necessary to cleanse the financial system and the economies from such excesses." Nouriel, however, is concerned that the looming recession of 2008 could turn into the next Great Depression if massive monetary easing is not attempted now. Consequently, he is calling for central banks of the world to aggressively cut interest rates.

In a similar vein, Larry Summers is calling (also see here) for dramatic action since he believes that "slow growth is a near certainty, that a recession is more than a 50% chance, and that there's a distinct possibility of a more serious recession that will lead to the worst economic performance since the late 1970s and early 1980s.
" Larry is therefore calling for a $50 -$75 billion tax cut and spending package by the federal government as well as more aggressive easing by the Federal Reserve.

Do these calls for more 'pump-priming' make sense? Ken Rogoff says no. He notes "[s]harper Fed interest rate cuts today might well mute the housing price collapse, at least in nominal terms. However, if the Fed should ease too far, too fast, it could get hit by a boomerang a couple of years down the road, in the form of sustained higher inflation." I would add that contrary to Nouriel's assertions it may also mean a postponment of the necessary economic adjustements needed in the housing and financial sector.

Maybe Nouriel and Larry are right and we should nip this one in the bud with a massive policy-induced positive aggregate demand shock. No need to go through the Great Depression again. On the other hand, I keep going back to Japan and its lost decade that started in the 1990s. There too was massive government intervention in a post-bubble bursted economy. Some argue this intervention allowed banks and other sectors of the economy from making the painful changes that were needed to bring back robust economic growth (although without the intervention the deflationary pressures may have been worse). Are we headed down that path? Will the massive government stimulus to the macroeconomy proposed by Nouriel and Larry put off the needed economic adjustments until a later, more painful time? Or are they correct?

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