The current situation in the US can be summarized in the following way: the economy is growing again, although not yet as fast as steady state, and unemployment is still high. Most sectors are doing kind of OK except for the construction sector, which operates roughly at half capacity. Budgets deficits are very high, but not at record level once you factor in cyclical effects. Inflation is moderate and on target around 2%, including its expectations. Everyone is sitting on a lot of cash and nominal interest rates are minimal. The crisis has been going on since 1997, 4.5 years.
What is the Federal Reserve doing? Keep in mind that it cannot address structural issues in the economy and cannot only boost the economy in the short term, if at all. Bernanke and co. are keeping interest rates rock bottom until at least 2014. That would be seven years of emergency measures. If you want to instill some confidence in the economy, you do not go about telling everyone the economy needs to stay in the emergency room three more years.
And by the way, if inflation is targeted at 2% and nominal interest rates are at zero for the foreseeable future, that means real interest rates are negative. Take any model and throw in negative real interest rates. The result are pretty ugly, especially if this is more than temporary. Yet this is what the Fed seems to be advocating.
And why would you need such low interest rates? A Taylor rule would call for low interest rates if inflation (or inflation expectations) are too high (correction: too low). They are not. Or if output is below potential. That may well be the case, but I do not think it is to the extend that the Fed believes it is. The rhetoric coming from the Board indicates that the potential output is simply a continuation of the trend line from before the crisis. I do not think it is adequate. The construction sector is gone, and is going to be gone for a while because of an oversupply of residences and structures. Most households suffered a significant wealth shock that is not going to recuperate soon, and consumption has shifted down. Long time unemployed are simply not employable because of sectoral reallocation. Potential GDP has suffered a permanent shock, and while it will get back to the usual trend growth, it will not get back of the previous path.
For the Fed, this means that it is currently chasing a target it will never be able to reach. Its estimate of potential GDP is much too excessive. And the difference is due to structural issues the Fed does not have the means to address.
Which brings us to fiscal policy. Temporary tax cuts of various sorts are good to address temporary weaknesses in consumption. They work best when targeted towards people with high propensities to consume. These are the poor, and more generally the liquidity constrained. These are not the rich, and certainly not everyone. And if the loss in consumption is permanent, then this cannot be address with such temporary measures. You just have to accept it and live with it. Thus: taxes need to go back up, especially for the rich, also because they got an unnecessary free ride in the past years.
And then there is the sectoral problem. Construction is in the dumps. If you want to do something about it, you target public spending towards construction. Not general tax cuts, not across the board stimulus. And the US could actually need some serious infrastructure replacement and improvements. Actually, it is the perfect time to catch up on lost time here: costs are low, interest rates are low.
Now there is of course the stimulus package. But it has had no impact because it was not sufficiently targeted towards infrastructure, It went to state governments, which just used this manna to avoid getting into debt. It went into all sort of pet projects, very few of which had anything to do with construction. And if there was some construction, it went into initiatives that have such long horizons that they are not going to help anytime soon.
So what needs to be done? Washington needs to acknowledge that the targeted path is too ambitious. Bring interest rates back up, This will entice people and businesses to do something with all the cash they are sitting on. The US Treasury needs to focus on infrastructure spending and restructure tax rates. And do not tell me we first have to wait until the presidential election is over.
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