Wednesday, June 20, 2012

Why the Fed Can't Help

The Lehmann Letter (SM)

The Federal Reserve's Federal Open Market Committee reports today. Hopes and expectations are high that the Fed will reduce long-term interest rates to further stimulate the economy.

Problem is: Temporary additional borrowing and spending by the federal government would probably be more effective at boosting the economy than whatever rate reductions the Federal Reserve announces today.

We are in a liquidity trap and lower rates won't help much. In 1936 John Maynard Keynes publicized the liquidity trap in "The General Theory of Employment Interest and Money." According to Lord Keynes, reducing interest rates is not effective once they have fallen below a certain low level. In a climate of generally weak aggregate demand, in which interest rates are already depressed, further rate reductions do not stimulate additional borrowing and spending. Those who won't - or can't - borrow and spend confront obstacles other than borrowing costs.

For instance: Households' current balance-sheet difficulties prevent them from borrowing and spending to purchase new housing. Their limited liquidity, high debt and reduced net worth - not high interest rates - impede the recovery in residential real estate. And that sits like a boulder in the road, forestalling robust economic expansion.

Meanwhile we abandoned prematurely the direct stimulus that could have prevented additional job loss. If the federal government had borrowed more and provided additional funding to local governments, that could have prevented mass layoffs of local-government workers. While many of us believe that government employment has recently grown, an article in today's New York Times says that it has fallen by over half a million jobs.,

“Public Workers Face Continued Layoffs, Hurting the Recovery”

Here are some excerpts from the article:

“Government payrolls grew in the early part of the recovery, largely because of federal stimulus measures. But since its postrecession peak in April 2009 (not counting temporary Census hiring), the public sector has shrunk by 657,000 jobs. The losses appeared to be tapering off earlier this year, but have accelerated for the last three months, creating the single biggest drag on the recovery in many areas…….

“So while the federal government has grown a little since the recession, and many states have recently begun to add a few jobs, local governments are making new cuts that outweigh those gains……..

“If governments still employed the same percentage of the work force as they did in 2009, the unemployment rate would be a percentage point lower, according to an analysis by Moody’s Analytics. At the pace so far this year, layoffs will siphon off $15 billion in spending power. Yale economists have said that if state and local governments had followed the pattern of previous recessions, they would have added at least 1.4 million jobs.”

It is probably true that, for political and ideological reasons, the federal economic stimulus went as far as it could go. But that does not mean that it would not have been effective. It probably would have been far more effective at boosting the economy than whatever rate reductions the Federal Reserve announces today.

(To be fully informed visit

© 2012 Michael B. Lehmann

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