Can the US economy afford a Keynesian stimulus?

With all the talk about investing in the future, improving infrastructure and creating a dynamic competitive economy, I don’t think the Obama administration will want to achieve the necessary shift of resources towards the rest of the world by reducing domestic investment.  In fact, in the one area where domestic investment could and should be reduced (residential construction), there is bipartisan support for boosting investment in residential housing.  That leaves an increase in national saving as the only way to achieve the required primary external surplus.   The government is, however, planning to boost its spending and cut taxes.  No increase in public saving therefore can be anticipated for many years to come.

The private sector in the US is, at last, saving.  We have gone from a declining growth rate of private consumption to a declining level of private consumption.  But what do the policy authorities do?  Rising household saving equals falling household consumption equals declining effective demand equals longer and deeper recession. Can’t have that.  Here is a tax cut.  If you can no longer borrow from your bank, we may guarantee your mortgage so you can borrow after all.  Everything that is desirable from a short-run Keynesian aggregate demand perspective (assuming these measures are indeed effective) is a step in the wrong direction from the perspective of restoring external equilibrium and raising the US national saving rate.

One obvious response to this opposition between what is desirable now and what is necessary in the longer run is to say: let’s do now what is desirable now and let’s take care of what is necessary tomorrow.  That might be viable if the US private sector and the US policy makers had the necessary credibility to head south when the destination is north, because they can commit themselves to a timely reversal.  If the authorities go ahead with the short-run Keynesian stimulus without having convinced the global capital markets and domestic producers and consumers that there will be a timely reversal, the policies will not work.

This failure of expansionary fiscal policy is not for Ricardian reasons (Mr. Jean-Claude Trichet gets this wrong all the time – the Ricardian model has as one of its key assumptions that the government always satisfies its intertemporal budget constraint, that is, the government when it cuts taxes or raises spending today, is believed to raise taxes or cut spending by the same amount, in present discounted value, in the future; the second key assumption is that postponing taxes, while keeping their present discounted value constant, does not stimulate consumer demand.  There either is no redistribution (from the young to the old, from those currently alive to the unborn and from those who are constrained by permanent income to those constrained by current income) or this redistribution does not have aggregate spending effects.  Instead the failure of expansionary fiscal policy is because of the fear, uncertainty and higher risk premia caused by the higher risk of sovereign default caused by expansionary policy.

If the government is believed to be fiscally continent (future taxes will be raised and/or future public spending will be cut by enough to safeguard the solvency of the state) but turns out not be so after all, the Keynesian fiscal policy will be effective in the short run (as long as the public believes in the fiscal virtue of the government) but will become highly contractionary once the truth dawns.

Given the bad fiscal position of the US Federal government and given the vulnerability of the external position of the US and its growing reliance on foreign funding, the scope for expansionary fiscal policy in the US is much more limited than president-elect Obama’s advisers appear to realise.  Underneath the effective demand problem is a deep structural rot, especially in household sector and financial sector balance sheets.  Keynesian cyclical policy options that would be open to more structurally sound economies should therefore not be tried on anything like the same scale by the US authorities.