Berkeley Political Economy Major Overview Document DRAFT
In Celebration of a DMCA Takedown Notice: I Link to Elizabeth Kolbert on “SuperFreakonomics”

A Macro Policy Catechism

From my perspective, deciding whether to tighten or ease is easy. It involves asking and answering a few questions:

Q: What is the current forecast for unemployment? A: It is that unemployment will stay around 10% for a year or more, and then slowly decline.

Q: Is that the path that we want unemployment to be on? A: No. We wish that unemployment would fall more rapidly.

Q: What should we do to make unemployment fall more rapidly. A: We should stimulate the economy through one of three tools--monetary expansion, support for the banking system, or larger short-term fiscal deficits--depending on which would work.

Q: Would monetary expansion work? A: Almost surely not. With short-term Treasury rates at zero, monetary expansion is all tapped out.

Q: Would further support for the banking system work? A: Quite possibly--but at the cause of greatly reinforcing incentives for moral hazard in the future, and voters appear really unhappy with the idea of giving Lloyd Blankfein more of the public's money to play with.

Q: Would larger fiscal deficits work? A: Almost surely yes.

Q: But wouldn't they greatly increase the national debt and exceed America's debt capacity? A: No. You know that the debt capacity of a country is about to be exceeded when the term structure of interest rates slopes upward very steeply--when interest rates on government debt are high and expected to keep rising. There is no sign of that right now.

But Greg Ip doesn't agree. He writes:

THE American government reported on Thursday October 29th that gross domestic product rose at an annualised rate of 3.5% in the third quarter compared with the second. This was the first increase since the second quarter of 2008. It backs up other evidence that the recession ended in the third quarter or just before, though the official decision, by the National Bureau of Economic Research, a group of academic economists, is still some way off. Robert Gordon, a member of this group, is confident that the recession, which began in December 2007, ended in June. But at 18 months that would still make it the longest since 1933....A lot of third-quarter growth was the result of temporary government stimulus. Consumer spending grew by 3.4%, the best since early 2007, largely because people were buying new cars in July and August with federal “cash for clunkers”. Sales have since fallen back. Residential construction leapt by 23.4%, the first advance since the end of 2005, helped by an $8,000 tax credit for buyers of new homes. But new-home sales dipped by 3.6% in September, as the deadline to qualify for the credit passed....

Calls for a new round of stimulus look premature. Temporary effects aside, growth in the third quarter reflects the dynamics of a genuine recovery. Exports and equipment investment both rose. Companies ran down inventories at a slower pace, a contributor to growth that should continue for at least two more quarters. Construction is so low that, even with sales so depressed, the inventory of unsold new homes has hit a 27-year low. This suggests that construction should expand further. And Mr Gordon notes that employment is still falling because, following the pattern of recent recessions, firms have slashed costs deeply so that productivity has grown even as sales have fallen. Profits seem to have turned around already and Mr Gordon predicts employment will follow by the first quarter of 2010.

More stimulus now would add to an already dangerously high deficit. There may be greater need for it in a year’s time, when the inventory boost will be waning and this year’s $787 billion stimulus plan is about to expire. Even then, more stimulus should be considered only if a deficit-reduction plan is in place. In the meantime, monetary policy can assume the burden of safeguarding growth.

The markets expect the Federal Reserve to start raising interest rates by May, and there is speculation that at its policy meeting on November 3rd and 4th it will water down its current commitment to near-zero rates for “an extended period”. Given downward pressure on inflation, the Fed could instead stay on hold all next year, providing a safety cushion for the economy and taking some pressure off the battered federal budget.