The Federal Reserve’s Stimulus Bill

The U.S. federal government’s one-trillion-dollar stimulus spending failed to jump-start the economy, contrary to demand-side doctrine. The demand-side policy believed by many economists, journalists, and politicians, says that when government spends an extra dollar, national output leaps up by several dollars.

The demand-side doctrine presented by the British economist John Maynard Keynes says that people use less of their income for consumption as their income rises; this is the “consumption function”. With less consumption there is less demand for output, so we get less production and less future income. So to increase output and employment, if folks don’t spend because they are saving instead, the government can step in, create or borrow funds, and spend the money. Those who sell the extra goods use the revenue to buy other goods, and so the initial government spending gets multiplied into much greater output.

The flaw in this argument is that economic investment, in more capital goods, comes from savings, so normally greater savings gets put to use in greater investment. But now in November 2010, Americans are saving more, yet industry is not investing enough. In 2011, with the Tea-Party-influenced Republicans in control of the House of Representatives, there will not be any new federal demand-side spending, although some infrastructure programs will likely be passed, as this will please the Republicans who now control more state governments.

Since Congress will do nothing to restore the economy, the chiefs of the Federal Reserve System are stepping in with a plan to buy treasury bonds with $600 billion of new dollars. The purpose of the bond purchase is to keep long-term interest rates low. This helps the federal government finance its big deficit, and puts funds into the banking system. The extra funds act like more savings to keep interest rates low. Low price inflation and low interest rates should create a favorable environment for business, and this policy has already boosted the stock market. American companies are also getting a boost from more exports as the rest of the world economy is recovering swiftly, while the U.S. lags behind.

So why is unemployment still high, and why is the economy recovering so slowly? Because even though interest rates are low, other costs will be rising. Taxes are scheduled to rise sharply in 2011. New regulations such as more 1099 tax forms have increased the costs of business. New medical insurance mandates have made labor more expensive. There was also “regime uncertainty,” as entrepreneurs have faced turbulent policy changes. The possibility of ever greater taxes and restrictions, combined with continuing governmentally-imposed credit constraints, have limited new economic investment.

What is needed to jump-start the economy is the supply-side policy of reducing the costs of enterprise. Government has imposed costs by restricting and taxing enterprise. Government subsidies also impose a cost on the economy, as the loss from taxation is greater than the gain to consumers. Supply-side policy cuts taxes and eliminates arbitrary restrictions.

The tea-party Republicans now in Congress will initiate legislation to reduce government intervention, but the Senate will block these acts, and those acts that do get passed will get a veto from the president. So don’t expect much supply-side policy.

The chiefs of the Fed are well aware that their $600 billion money expansion will have a future bill, increased price inflation, and that is actually intended. They think that higher inflation will get people to spend more today as prices will be higher tomorrow. But higher inflation will also increase nominal interest rates, as measured in the quoted rate or the money paid. Higher nominal interest rates will increase the cost of servicing the federal debt, increasing the federal budget deficit.

The new money could spark much higher price inflation, and indeed commodity prices have been rising. The Fed heads say they will unwind the money creation later, selling the bonds, but that too could have bad consequences, such as higher interest rates.

The reality is that greater output comes from production, and output increases when costs fall. Higher tax costs offset lower interest rate costs. Tax cuts will increase the budget deficit, but a tax shift will reduce tax costs without adding to federal debt. Everybody is talking about tax increases and tax cuts, but almost nobody is talking about tax shifts. The economy needs an “efficiency tax shift,” sharply cutting income taxes, shifting public revenue to land value. A tax on land value does not hurt production, since land is not being produced, and it does not increase rent, since higher rent creates vacancies and zero income for landlords.

Only an efficiency tax shift will create a swift and lasting recovery, and perhaps, by paradox, that is why nobody is talking about it.