The US Federal Economic Stimulus Programs, Deficit Spending and Government Borrowing - A Zero Sum Game

The US Federal Economic Stimulus Programs,
 Deficit Spending and Government Borrowing - A
                 Zero Sum Game
Macro economic analysts and pundits are looking at US economic statistics and
wondering what went wrong with the various stimulus packages, in addition to the slow
conveyance of the stimulus funds. Why did the funds poured into the economy not have
the desired impacts of increased growth in US GDP and employment? Some initial
arguments have been put forward that the monies were channeled into the wrong
economic sectors where the overall external economic repercussions are very limited,
such as the state and local government sectors. Use of a simple tool such as the national
Input/Output model can easily show that the least economic impact of a dollar spent in
the economy will take place if that dollar is spent by state and local government. Out of
the 64 economic sectors in the standard US I/O model (USDOC/BEA1[1]) the state and
local government rank number 51 in the value of purchases from the overall economy
with purchases from only 21 sectors compared to, e.g., motor vehicles manufacturing
sector which ranks first in the value of purchases from 30 high value economic sectors.
(For more information please see the following article.)

The real problem of the anemic economic reaction does not really reside here. Federal
funds have been spent on projects that by all accounts, including a brief look at the
Keynesian Bible: The General Theory of Employment, Interest and Money (1936), should
fill the gap left by the disappearing private sector demand and the country would be on its
way to economic growth and prosperity. Yet two years into the recession there is only a
shimmering light at the end of the tunnel, which might, of course, be an oncoming train
in the shape of the actual double-dip recession and not the constant recurring newspaper
canard.

These stimulus packages are not, however, deficit spending vehicles in the neo-
Keynesian sense. Keynes, in his General Theory, discussed the possibility of covering
government budgetary deficits with "loan expenditures" (ch.10, vi.). His understanding of
the relationship between "deflation of effective demand below the level required for full
employment will diminish employment as well as prices". He was perfectly willing to use
"loan expenditures" to increase the demand, but was vague on the use of the central bank
to increase the quantity of money to counter deflationary threats to the economy. About
the central bank (the 3rd element) he says "But these again would be capable of being
subjected to further analysis and are not, so to speak, our ultimate atomic independent
elements." (ch. 18, i). This sounds more like a statement from US Congressional
committee: "We need to study the issue more deeply". Why Keynes stopped short of
recommending an increase in the money supply in recession times without "loan
expenditures" must be allotted a contemporary political "third rail".

Formally government expenditures may be larger than tax incomes, but if complementary
expansionary monetary policies without the "loan expenditures", are not pursued the
effect predicted by Keynes will not occur.

Taxation by the government removes purchasing power from the private sector. Thus, to
achieve the desired economic effect when private sector demand decreases is to decrease
taxation while increasing public spending. This is what should happen if the aim is to fill
in the demand gap. If the government issues and sells bonds in the US market, its initial
effect will be the same as a reduction in the money supply done by the Federal Reserve.
This action directly reduces the purchasing power in the private sector as free funds seek
safe harbors in government coffers. The initial negative effect of these withdrawals of
funds from the private sector depends on how fast the money moves back into the
economy. Given the experience since February 17, 2009 of the ARRA 2009 [2] fund
disbursement velocity one should not be too surprised of the very limited effect these
programs have had.

Thus, the withdrawal of funds from the private sector through the sale of Treasury Notes
is not only a problem of crowding out new real capital formation for production
capacities etc, but it also reduces the liquidity in the economy in the same way as a
Federal Reserve market operation. The mere fact that the US government provides this
safe harbor for private sector free funds, albeit currently at negative real interest rates,
makes the portfolio decisions in uncertain times very simple for normally risk taking
investors: park your excess funds at the Treasury and find your way to the golf course.
Implicit in a neo-Keynesian analysis is a simultaneous implementation of deficit
spending and increased money supply. This is done in order to increase consumption and
investments - public and private. A brief glance at how the Treasury and the Federal
Reserve behaved in the period from when the first signs of a downturn started to shine
through in the economic statistics until the full effect of the recession was upon the US
economy is shown in Table 1.

Table 1 -Estimated Ownership of U.S. Treasury Securities - (In Billions of US
                                                          dollars)
                                     Federal                                                                  Quarterly
                                    Reserve International                                        Domestic Changes in
Year and               Total                                            International
                                     & Intra          & Private                                    Private     Private
end quarter Public Debt                                                    Holdings
                                    US Govt Holdings                                             Holdings Domestic
                                    Holding                                                                   Holdings
2007 - Dec.             9,229.2 4,833.5                      4,395.7             2,352.9              2,042.8           -
2008 -
                        9,437.6 4,694.7                      4,742.9             2,507.5              2,235.4      192.6
Mar.
June                    9,492.0 4,685.8                      4,806.2             2,587.2              2,219.0      -16.4
Sept.                  10,024.7 4,692.7                      5,332.0             2,799.5              2,532.5      313.5
Dec.                   10,699.8 4,806.4                      5,893.4             3,076.3              2,817.1      284.6
2009 -
                       11,126.9 4,785.2                      6,341.7             3,264.7              3,077.0      259.9
Mar.
June                   11,545.3 5,026.8                      6,518.5             3,382.1              3,136.4       59.4
Sept.                  11,909.8 5,127.1                      6,782.7             3,575.3              3,207.4       71.0
Dec.                   12,311.4 5,276.9                      7,034.5             3,691.5              3,343.0      135.6
2010 -
                       12,773.1 5,259.8                      7,513.3             3,884.0              3,629.3      286.3
Mar.
Changes
Dec 07 -                3,543.9           426.3              3,117.6             1,531.1              1,586.5           -
Mar 10
Source: Office of Debt Management, Office of the Under Secretary for Domestic Finance, table titled as above.

Whereas the Federal Reserve just covered some $426 billion of the Treasury's funding
needs during this period, the private US sector provided close to $1.6 trillion, slightly
more than foreign investors - public and private. This means that the Treasury soaked up
a major part of available U.S. private funds, while the Federal Reserve was sitting on the
fence watching the US economy tank. Interest rate manipulation, the Federal Reserve's
normal monetary policy instrument, ceased to function as intended when the federal
funds rate fell into the 'liquidity trap" as it dropped from 3.94% in January 2008 to 0.11%
in January 2010. Only by February 19th of 2010 did the Federal Reserve move its
discount window rate from 0.50% to 0.75% where it still stood a the end of 2010, but left
the federal funds rate unchanged around 0.2%. The Bank's announcement November 3,
2010, the now famous QE2 announcement, i.e., the $600 billion monetary easing in $75
billion monthly tranches, might be to late and wasted in the expected inflationary fog.
Not entirely a leap out of the liquidity trap.

Looking at the development of the widely quoted measurements of US money supply M1
and M2 (see Federal Reserve Bank for detailed definitions) does not increase the level of
comfort with the Treasury and Federal Reserve's handling of the economy during these
trying times.

Table 2 - Changes in the Official Supply of Money
              Percent change at seasonally adjusted annual rate M1 M2
               3 Months from Oct 2009 to Jan 2010                0.6 -0.9
               6 Months from Jul 2009 to Jan 2010                3.2 0.6
               12 Months from Jan 2009 to Jan 2010               6.5 1.9
               9 Months from Jan 2010 to Oct 2010                5.9 3.3
                                  Source: US Federal Reserve Bank

During the last quarter of 2009 the Federal Reserve actually worked to decrease the
broader measure of the supply of money by almost one percent. Likewise, the longer term
manipulations of M2 do not fit well into a cooperative model for fighting a recession.
Although the goals of monetary policy are spelled out in the Federal Reserve Act, which
specifies that the Board of Governors and the Federal Open Market Committee (FOMC)
should seek "to promote effectively the goals of maximum employment, stable prices, and
moderate long-term interest rates." [3] , it does not seem that the maximum employment
edict plays any significant role in the overall concerns of the Federal Reserve Board or its
current Chairman. This seeming conundrum can be traced back to the conflict between
the inflation target set by the Federal Reserve and its employment policy as perceived by
the Board. Its overall policies are focused on keeping the US inflation rate somewhere in
the range of 1-2% p.a., thus a non-cooperative model for fighting the current recession
suits the Bank just fine.

It might now, however, be advisable for the Federal Reserve to increase its inflation
target as cautiously and somewhat apologetically mentioned in the Financial Page in The
New Yorker recently "Boosting inflation isn't the right policy, but it may just be the
correct one." [4]

The simple model presented by Keynes makes a serious case for supplanting dwindling
private sector demand and investments by public demand and investment. In order to
maintain the logic inherent in the recommendations derived from that model, fiscal and
monetary policies must be coordinated so that they work together rather than oppose each
other. Although manipulation of the monetary measures play an important role in the
management of the economy, removing huge amounts of domestic private sector funds
from the economy and parking them in the US Treasury vaults is entirely
counterproductive, even if these funds, in a year or two, will appear in a bank near you.

The cooperative model for fighting the recession will, as domestic funds seek private
sector employment, also results in inflationary pressures which might just be what is
needed. There are numerous ways to implement such a model. During recessions, such as
we have experienced over the last two years, one "simple" way to engineer such a policy
is for the US Treasury to not sell the Notes to the domestic public. The Department
should rather only sell their Notes to the Federal Reserve and international investors,
including foreign sovereign wealth funds. The likelihood of such an event, however, is
zero. The expectational hazards involved in this change in the US monetary policies and
the evasive actions taken by our trading partners may work to effectively counteract or
nullify the intended impact of reduced long-term interest rates.

The Minutes from the September 21st, 2010 FOMC meeting and the Banks press release
of November 3, 2010 indicate a slight change of heart among its members. The Fed are
now pouring more money into the US economy by buying Treasury Notes, but the fear of
a significant depreciation of the US dollar in the foreign exchange markets have put our
trading partners in a traditional "beggar-thy-neighbor" accusatorial mode.

End Notes

[1] See e.g., US DOC/BEA: Industry by Industry Total Requirements Summary Table after Redefinitions, 2007

[2] The American Recovery and Reinvestment Act of 2009

[3] The Federal Reserve System - Purposes & Functions, Ninth Edition, June 2005

[4] James Surowiecki, In Praise of Inflation, The New Yorker, September 27, 2010, p.31