Why the Government Must Increase Spending

Managing the Federal Budget is not like managing a household budget.

Managing a state, municipal or county budget is more like managing a household budget, but none of these entities has either the responsibility or the capability of controlling the national economy.

The bottom line: given our current state of the economy, reducing federal expenditures will reduce jobs and bring the present weak recovery to a screeching halt.

Why is this so?

The federal government has two principal means of managing the economy:
a. Monetary policy, which is the responsibility of the Federal Reserve System (the Fed) and;
b. Fiscal policy, which is the purview of the elected political leadership.

It is the Fed that controls the level of economic activity by managing the money supply, mostly through indirect controls of short term interest rates and open market operations. If they are concerned about inflation, they work to contract the money supply by increasing interest rates. If the economy is weak, they attempt to stimulate economic activity by decreasing short-term interest rates, which have the greatest influence on commercial activity.

It has been the case for some time that short term interest rates have been essentially zero. That means the Fed is out of ammunition. When the short-term interest rate is zero, it cannot be lowered. Further increases in the money supply will be ineffective in stimulating economic activity.

A possible way to stimulate economic activity is to increase exports. That would likely require a substantial depreciation in the value of the dollar against major trading currencies. The Fed's only tool to affect the exchange rate would be to lower the interest rate. With a zero interest rate, that won't work, either. The other factor inhibiting exports is that our major trading partners are in the same boat as we are.

That leaves monetary policy. In other words, federal expenditures. We have no choice, unless the object is to further wreck the American economy. The only thing that has kept the economy from falling into a death spiral leading to another Great Depression is the safety net put in place in the aftermath of that catastrophe.

Unemployment insurance, for example, is not just of benefit to the recently unemployed - it makes sure laid off workers can continue to purchase the necessities of life. It is a subsidy to WalMart, Food Lion, Sears, and countless property owners who continue to be paid rent.

Food stamps, Medicaid, Medicare and other "entitlements" fall in the same category.

We would have more options for dealing with the situation had we not quadrupled our national debt under Reagan and Bush I and further increased it under Bush II.

We can't put that toothpaste back in the tube, but we need to foresee the consequences of doing what the Congress seems hell-bent on doing.

There is a name for the situation we are in. Economists call it a "liquidity trap."

Liquidity traps are rare. The first one we encountered was during the Great Depression. Recently, in the 1990's, Japan experienced a liquidity trap.

Gauti Eggertsson, an economist with the New York Federal Reserve Bank, has written a recent research paper reviewing the modern understanding of a liquidity trap. The paper (here) is highly technical. It even uses calculus formulas to make several points.

Don't be put off by the calculus. It is still worth reading.