Monthly Archives: June 2017

The State of the Economy

After the financial crisis central banks lowered interest rates as far as they could. This has the effect of stimulating more lending, which creates more money, which then gets spent. The idea is that the money will be invested and this should stimulate the economy because that investment will entail employing people, utilizing resources, building, doing, etc. It should put the spare capacity in the economy to work.

The problem is that that’s not what happened with most of that money. A little leaks out into the real economy, but in general there’s no profit in investing in expanding productive capacity, because our whole problem is that demand is too weak. If factories are already operating at half capacity, why invest in building new factories? So instead of being spent on investments that require buying goods and services, it’s been spent on buying assets. It’s spent on real estate, stocks, gold, bitcoin, bonds, etc. This can be a great financial decision for the investors, but buying more of all that stuff doesn’t put any spare capacity in the economy to work, it just raises the price of that asset class.

So now we have gigantic bubbles in every conceivable asset class, but still a lot of spare capacity in the economy. The Fed is raising interest rates because they’re worried about those bubbles, while people who care about the real economy are saying “Are you crazy? You’re reducing the stimulus now when the economy’s still so fragile?” This is a hard decision for the Fed, since there’s no action they can take that won’t make one of those two major problems worse.

Luckily for those of us who don’t work at that Fed, there is a silver bullet we can use to solve this problem. It’s just not anything the Fed has access to. The way to fix things is with fiscal rather than monetary stimulus. Rather than throwing up our hands and saying “How can we possibly get businesses to use this spare capacity?” we just have the government use it directly. This can come in the form of handing out money to people through the welfare state in order to boost both demand and their living standards, or in the form of spending government money on the infinity of badly needed public goods that have gone underfunded for decades.

You might say “But wait! How can we afford all this?” That’s a stupid question! Just kidding. But seriously, the federal government is in charge of money. It owns the literal and metaphorical printing presses. It’s literally not possible for it to be unable to afford things. The only limitation is that printing too much money can cause inflation. Luckily though we have a great tool for combatting inflation: raising interest rates! As you may remember, that’s what the Fed desperately wants to do now even though inflation has remained low, because it’s what’s needed to deflate these crazy asset bubbles.

This has all been about our specific current situation, but it’s also a thesis on a shift we need to make in how we think about government spending. Currently the idea is that the Fed sets interest rates at the sweet spot where it utilizes the economy’s spare capacity without going overboard and causing inflation and bubbles. Government spending is treated as just one more source of demand in the economy among others, and is constrained by the need to borrow money at whatever interest rate the Fed sets. What we need to do is have government spending come first. We spend as much as is needed to make sure that the economy is running at full capacity all the time. And then we use interest rates to control bubbles and inflation without worrying that if rates go high it will result in wasted capacity and the accompanying unemployment and economic distress that comes with it.