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Library of Congress Cataloging-in-Publication Data
Names: Seidman, Laurence S., author.
Title: How to combat recession : stimulus without debt / Laurence Seidman.
Description: New York, NY : Oxford University Press, [2018]
Identifiers: LCCN 2017053675| ISBN 9780190462178 (hardcover : alk. paper) | ISBN 9780190462192 (epub)
Subjects: LCSH: Recessions—United States. | Monetary policy—United States. Classification: LCC HB3743 .S45 2018 | DDC 339.5/20973—dc23
LC record available at https://lccn.loc.gov/2017053675
Printed by Sheridan Books, Inc., United States of America
CONTENTS
1. Introduction | 1
2. How Would a Benevolent Ruler Combat a Recession? | 7
3. What Is Stimulus without Debt? | 17
4. Do Tax Rebates Work in a Recession? | 58
5. What about Other Kinds of Fiscal Stimulus? | 97
6. Would Stimulus without Debt Be Inflationary? | 127
7. Would Stimulus without Debt Weaken the Fed’s Balance Sheet? | 137
8. Would Stimulus without Debt Undermine the Fed’s Independence? | 150
9. Can’t Monetary Stimulus Overcome a Severe Recession? | 157
10. Can Stimulus without Debt Be Used by Other Countries? | 173
11. What Have Others Written about Stimulus without Debt? | 179
12. Can Stimulus without Debt Combat Secular Stagnation? | 195
13. Would Stimulus without Debt Work in a Plausible Model? | 200
14. Are We Ready for the Next Severe Recession? | 211
REFERENCES | 221 INDEX | 227
HOW TO COMBAT RECESSION
Chapter 1
Introduction
Are we ready to combat the next severe recession? We can be, but we’re not. A severe recession always involves a plunge in aggregate demand for goods and services that compels producers to sharply cut back production and employment. To recover from the recession, aggregate demand must be boosted all the way back up to normal. Economic analysis and experience shows that waiting for the free market to reverse the plunge in aggregate demand takes much too long—usually half a decade to a full decade. Monetary stimulus— cutting interest rates to zero—is much too weak to induce a huge boost in demand because experience shows that sensible consumers and business managers aren’t willing to go deeper in debt by borrowing to spend in a severe recession. Fortunately, a huge boost in demand can be achieved by a large fiscal stimulus—a temporary large increase in tax rebates for households, federal grants to state and local governments, tax credits to partly reimburse firms for purchases of capital goods, and government spending on infrastructure maintenance projects.
So why do I say we aren’t ready? Because a large fiscal stimulus has always in the past required large borrowing by the Treasury and therefore a large increase in government debt. Experience shows that any policy that requires a large increase in government debt is strongly opposed by many policymakers and citizens. This is especially true in a severe recession, because the recession itself causes a plunge in tax revenue that forces the Treasury into huge borrowing to avoid large cuts in government spending, thereby sharply increasing government debt, which alarms policymakers and citizens. It is hardly surprising, then, that in a severe recession a proposal for a large fiscal stimulus that requires even more borrowing would be met with intense opposition. That, of course, is exactly what happened during the Great Recession in the United States, when the fiscal stimulus proposed in early 2009 met stiff resistance. Yes, despite opposition, a two- year fiscal stimulus was enacted in early 2009 and was large by historical standards. But simple calculations at the time showed that the fiscal stimulus needed to be at least twice as large in 2009 and 2010 to overcome this severe recession, and later calculations showed that it needed to be three times as large. Yet even most advocates of fiscal stimulus didn’t dare propose a larger fiscal stimulus because even they worried about making the increase in government debt even larger. Despite the continuing weak recovery, after 2010 fiscal stimulus was made much smaller, not larger, because of worry about government debt. So it took until 2016 for the unemployment rate to return to normal.
The lesson, therefore, is sobering: As long as a large fiscal stimulus requires a large increase in government debt, Congress won’t make it large enough to successfully combat a severe recession. The one policy—large fiscal stimulus— that has the capacity to overcome a severe recession won’t be used to its full potential strength. So we are indeed not ready to combat the next severe
recession as long as it assumed that fiscal stimulus must increase government debt.
The stimulus- without-debt proposal, however, is not simply a tactic for getting a large fiscal stimulus enacted in a severe recession. It is certainly better for stimulus to be implemented without a large increase in government debt. Large government debt— that is, government debt that is a large percentage of GDP—may generate negative economic consequences and risks in the future. If government debt becomes a high percentage of GDP, the government may incur a heavy interest burden if interest rates rise, forcing cuts in worthwhile government programs or tax increases. Moreover, as I will explain later, there is a possibility of an anxious reaction by financial investors around the world to US government debt that is high and rising as a percentage of GDP, which may lead to a US recession or a financial crisis. Thus, I have two reasons for proposing stimulus without debt. The first is political: a large fiscal stimulus is unlikely to be enacted by Congress if it causes a large increase in government debt as a percentage of GDP. The second is economic: government debt that is large and rising as a percentage of GDP may have negative economic consequences and risks.
Fortunately, the assumption that fiscal stimulus requires an increase in government debt is false. In fact, it is astonishingly easy to implement even a very large fiscal stimulus without any increase in government debt. All it takes is this: When Congress enacts fiscal stimulus, the Federal Reserve can decide to make a transfer (not loan) to the Treasury roughly equal to the fiscal stimulus so the Treasury doesn’t have to borrow. That’s it. Moreover, the large stimulus would be phased out as the economy approaches full employment, so it would not be inflationary.
But isn’t the paper money injected by the Fed also government debt? The answer is no. Paper money is not counted in official government debt. Nor should it be. Government paper money
was government debt in the era when the government promised gold to any holder of government paper money who requested it. But when the government nearly a century ago removed its promise to provide gold or anything else to the holders of paper money, the paper money ceased to be government debt. By contrast, government bonds are government debt because the government promises to pay government paper money—principal plus interest—on schedule to all holders of government bonds.
Another question arises: Does fiscal stimulus really work? Most empirical studies find that the answer is yes. Moreover, just think about it using common sense. Suppose Congress decides, as it should, that the main component of the fiscal stimulus package will be tax rebates to each household. Suppose that the US Treasury mails out two rebate checks to each household— one in June, one in December—each check for $6,000. Is there anyone who seriously believes that households, in a severe recession when most employees haven’t received a raise and some have been laid off, would save the $12,000? In a recession, doesn’t it seem more likely that hard-pressed households would spend a substantial portion within six months? The best empirical studies support common sense: in a recession households do indeed spend about two thirds of their tax rebates within six months.
Similarly, does anyone seriously think that in a severe recession, when state and local tax revenues plunge, that cash grants from the federal government would be saved instead of used to maintain normal state and local government expenditures? If you managed these governments during a recession, would you really save the grants, and then do lots of borrowing or slashing of expenditures? Most empirical studies of state and local government behavior in a recession support common sense: federal grants are mainly used to keep state and local governments from
cutting spending or raising taxes, so federal grants prevent a fall in spending by state and local governments and a fall in spending by consumers who would not spend as much if their state and local taxes were raised. So the grants prevent a fall in aggregate demand for goods and services.
In this book I explain how a temporary large fiscal stimulus can be implemented without any increase in government debt or inflation. I also present analysis and evidence that fiscal stimulus works in a recession—it increases aggregate demand for goods and services, which in turn leads to an increase in production and employment.
Stimulus without debt isn’t the only thing that must be done when a severe recession hits. The Fed, Treasury, and FDIC must perform financial rescues of key firms and inject funds into financial firms to keep credit from freezing up. These essential interventions are not addressed in this book. Some analysts believe that these interventions are all that’s needed in a severe recession. I strongly disagree. A severe recession always involves a plunge in aggregate demand for goods and services, and once that plunge occurs, it will not be reversed simply by rescuing key firms and restoring the flow of credit.
Several things are needed to make us truly ready for the next severe recession. First, a lot of economists, policymakers, members of Congress, financial market participants, and others must learn that it is possible to implement a large fiscal stimulus without any increase in government debt. Second, they have to be persuaded that fiscal stimulus—particularly, a tax rebate to every household— works. Third, they have to be convinced that a large transfer from the Federal Reserve to the Treasury during recession won’t be inflationary. Fourth, Congress must enact an amendment to the Federal Reserve Act empowering the Federal Reserve’s Open Market Committee to decide whether to make a
large transfer (not a loan) to the Treasury to finance a fiscal stimulus enacted by Congress. If these things happen, we will be truly ready to combat the next severe recession.
The purpose of this book is to help make all these things happen.
How Would a Benevolent Ruler
Combat a Recession?
In this book I will propose “stimulus without debt,” a policy to combat recession that is designed for our actual institutions: Congress, the Treasury, and the Federal Reserve. These institutions impose important constraints on the design of a practical policy. But before I turn to stimulus without debt for our actual institutions, I want to set the stage by considering how a benevolent ruler with complete power, who takes the place of the Federal Reserve, Congress, and the Treasury, could combat a recession without increasing government debt. The policy that is implemented by a benevolent ruler will serve as useful guide for a stimulus without debt policy that is implemented by the Federal Reserve, Congress, and the Treasury.
Government Money Held by the Public Is Not Government Debt
Before I turn to the benevolent ruler, I need to make a fundamental point: government paper money held by the public is
not government debt. When government paper money was introduced during the past three centuries, it was usually “backed” by gold (or silver)— that is, if any holder of paper money wanted the government to exchange it for gold, the government promised to make the exchange. Thus, the government owed gold to any holder of paper money, and the government had to be ready to provide gold to any holder of paper money who requested it. Because of this promise, government paper money held by the public was viewed as government debt and included in the liability column of the government’s balance sheet. This promise to pay gold was probably necessary to win the acceptance of government paper money by the public.
But in the last century, the public in most economically advanced countries gradually gained confidence in government paper money. The governments of these countries gradually withdrew their promise to provide gold to any holder of paper money who requested it. Despite the withdrawal of this promise, most of the public continued to be willing to hold paper money and use it in transactions. One reason for this public willingness was that the government guaranteed that the public could use its paper money to pay taxes; another was that the government stated that its paper money could be used by the public to pay off private debts. But it is possible that even without these guarantees by the government, the public would have been willing to hold and use government paper money because of confidence gained over decades of use for transactions.
Thus, it is now the case that in most economically advanced countries, the government does not owe anything to holders of its paper money. Paper money held by the public is therefore no longer government debt. By contrast, each government bond held by the public is government debt because the government promises to pay its paper money to holders of bonds according to the schedule of interest and principal on the bonds;
the government therefore owes paper money to the holders of government bonds.
Nevertheless, current central-bank accounting has ignored the fundamental change that occurred when the government withdrew its promise to pay gold (or silver) to any holder of its paper money. Paper money held by the public continues to be listed in the liability column of the central bank’s balance sheet. Moreover, when the accountants produce the consolidated balance sheet of the government and the central bank, paper money held by the public continues to be included in the liability column of the consolidated balance sheet. This inclusion causes the liabilities of the central bank, and of the consolidated government, to be greatly overstated.
By contrast, official government debt correctly includes government bonds held by the public and correctly excludes paper money held by the public. The official government debt correctly focuses attention on the government’s obligation to pay money to bondholders and ignores paper money held by the public because the government has no obligation to pay anything to the holders of paper money.
Some economists, however, not just central-bank accountants, continue to call government paper money held by the public “government debt,” usually without giving any justification for using the term “debt.” Why do they do this? One reason may be inertia: government paper money was indeed government debt when the government promised to pay gold to anyone holding the paper money who wanted gold. Another reason may be an intuition that there can’t be a “free lunch.” It seems like a free lunch when the government writes checks to members of the public and prints enough paper money to pay check recipients who request paper money. Surely it must be true, some think, that the government is incurring a debt when it prints pieces of paper to give to the public; it can’t really be that easy for the government
to create an asset, paper money, without also creating a debt. But in a paper money system, it really is that easy.
Although paper money held by the public is not government debt, injecting too much paper money into an economy that is already at full employment of resources will make aggregate demand for goods and services exceed potential output and therefore generate rising prices—inflation. Injection of money into the economy should not cause concern about government debt, but should cause concern about inflation if the economy is already at full employment. The policy I will call “stimulus without debt” prescribes injecting money only in a recession when employment is below its potential, so that, as I’ll explain later, an increase in demand for goods and services will cause an increase in output, not an increase in prices.
Stimulus without debt in the Benevolent Ruler’s Economy
In the benevolent ruler’s economy, money consists of official paper notes, and all transactions in this economy occur in official government paper notes. These paper notes were once backed by gold, but are no longer backed by gold or anything else, so they are not government debt. Assume the benevolent ruler’s economy is initially at full employment. Now suppose a recession occurs because of a fall in aggregate demand for goods and services. There are several possible causes of a fall in aggregate demand. Consider a fall caused by a dramatic and sustained plunge in the stock market. In response, anxious consumers with less stock market wealth cut their spending, so consumer demand for goods and services falls. Producers of these goods and services respond by cutting production and employment. Managers in firms making consumer goods or providing consumer services react by cutting
their demand for equipment to produce more consumer goods or services, so producers of equipment—investment goods— cut production and employment. Thus, in response to the fall in consumption and investment demand, most firms cut back production and employment, so the economy falls into recession. To combat a recession caused by a fall in aggregate demand for goods and services, a policy must be implemented that will increase aggregate demand.
To increase aggregate demand for goods and services, the ruler deposits a specific amount of paper notes in the bank account of each household. The deposit is a transfer from the government to the household, not a loan that the household must repay. The ruler calls the transfer to each household a “tax rebate” because it gives back some of the tax that the household paid in the previous year.
The tax rebates are called “fiscal stimulus” because they are a government expenditure (“fiscal”) that increases (“stimulates”) consumer demand for goods and services. Households spend a portion of their tax rebates and save the rest, and the portion they spend causes producers of consumer goods and services to increase their production and employment. As managers in firms making consumer goods or services observe the revival of consumer demand, they spend more to increase their equipment, so producers of these investment goods raise their production and employment.
But how does the benevolent ruler obtain the paper notes needed to give tax rebates to households? Assume that at the beginning of the year the ruler has no notes on hand. The ruler’s adviser points out that when other governments have faced a similar situation, some of these governments have borrowed from the public by selling government bonds to the public to obtain the paper notes. But the ruler replies that there is no need to sell bonds and thereby incur government debt. Instead, the ruler
simply orders the printing of the amount of paper notes required to give the tax rebates. As explained in the previous section, paper money issued by the government and held by the public is not government debt. Thus, to combat the recession, the benevolent ruler implements “stimulus without debt.” The ruler keeps paying out tax rebates with new paper money until the economy approaches full-employment output. As this happens, consumer and business confidence gradually rises, enabling the ruler to gradually phase out the tax rebates.
The ruler’s adviser concedes that the ruler’s policy (stimulus without debt) has worked, but points out that when other governments have faced a similar situation, some have printed money and used the money not for tax rebates but to buy government bonds from the public in “the open market.” These are bonds the public previously bought from the government but which some members of the public now want to sell. These governments have called this bond buying “open-market operations” and asked their central bank to carry it out.
The ruler replies that using new money to buy government bonds in the “open market” is a much less efficient to way to increase aggregate demand for goods and services than using new money to give tax rebates to households. The reason, says the ruler, is that in a recession households will very likely spend a larger share of the tax rebates they receive than bond sellers would spend. Why? When a household receives a tax rebate, the household knows it can spend some of it, save some of it, and use some of it to pay down debt; the household instinctively realizes that the tax rebate has increased its wealth, enabling it to do more of all three. By contrast, when someone sells a government bond, the seller instinctively realizes that his wealth hasn’t changed: the seller knows he now has more cash, but he also knows he no longer has the government bond. Why did he sell the government bond? Although his wealth is the same, he
may have wanted to replenish his declining checking or savings account, or buy a corporate bond, or a corporate stock, or pay taxes, or pay down debt, or buy goods or services, and he was willing to give up the bond to do it. The typical bond seller has much higher wealth and income than the typical tax-rebate recipient. It seems likely that money used to send tax rebates to households will increase aggregate demand for goods and services much more than if that same money were used to buy government bonds from bondholders willing to sell some bonds.
After full-employment output is achieved by the stimuluswithout-debt policy, confidence has returned to normal, and the tax rebates to households have been phased out, there will be more money in the economy than before due to the tax rebates. If the ruler thinks this extra money might cause too much spending and therefore inflation, the ruler can remove it from the economy by temporarily cutting government spending so it is less than tax revenue, or by temporarily raising tax revenue so it is greater than government spending. Either action results in more money coming into the government than the government spends. The government can remove this surplus money from the economy until money in the economy is back to normal. Then government spending can be set equal to tax revenue.
Whose Writing Guided the Benevolent Ruler?
When the benevolent ruler was asked whose writing was most influential, the ruler replied that the greatest influence came from two economists: John Maynard Keynes and Abba Lerner. The ruler said Keynes (1936) taught the crucial importance of aggregate demand for goods and services: if aggregate demand falls, it causes the economy to go into recession, so demand must be raised. Keynes warned that in a recession monetary
stimulus—lowering interest rates— would prove too weak to raise demand up to normal. He therefore recommended that the government increase its spending.
The ruler said that Lerner specifically recommended printing money to pay for fiscal stimulus (an increase in government transfers to households, an increase in government purchases of goods and services, and/or a decrease in taxes on households) to combat a recession. Lerner said that government should practice “functional finance,” not “sound finance,” and explained why in his “functional finance” chapter in each of his two books (Lerner 1944, 1951). The title of his 1944 book is The Economics of Control, and the title of his 1951 book is The Economics of Employment. The ruler also cited chapter 1 of his 1951 book, entitled “The Economic Steering Wheel,” as particularly clever and insightful. Lerner wrote that if the unemployment rate is above normal, the government should decrease taxes so households spend more, or increase its own spending and pay for the excess of spending over taxes by printing money instead of borrowing. But won’t printing money be inflationary? Lerner said it would indeed be inflationary if it were done when there is already full employment. Why? Because with full employment each firm can attract employed workers away from other firms only by raising wages, which increases costs and compels firms to raise prices. But if it were done when unemployment is high, firms would be able to attract unemployed workers without raising wages, so there would be no cost increases, and no need for firms to raise prices.
Lessons for Combating Recession with Actual
Institutions
It should be possible to implement stimulus without debt under our actual institutions because the benevolent ruler was able to
do it. Congress and the president should control government spending, taxes, and fiscal stimulus, with the Treasury as their administrative agent. The Federal Reserve should control the printing of money and its injection into or withdrawal from the economy. With this institutional separation of powers, how would stimulus without debt be implemented in a recession?
The Federal Reserve would decide whether to give a transfer (not loan) to the Treasury to be used for fiscal stimulus, and if so, how much. The Fed would make its decision by estimating the depth of the recession and the magnitude of the fiscal stimulus needed to combat it. If all transactions were conducted using Federal Reserve notes (not by writing checks or crediting bank accounts), the Fed would print new Federal Reserve notes in the amount it wanted to transfer to the Treasury. In practice, the Fed would either write a check to the Treasury or credit the Treasury’s checking account at the Fed, and print the amount of new Fed notes needed to meet requests for Fed notes from banks and the public. The Fed would continue to use its standard instruments of monetary policy such as sales or purchases of government bonds in the open market, and decide how to adjust these sales and purchases in light of the Fed’s transfer to the Treasury for fiscal stimulus.
Congress and the president would decide how much fiscal stimulus to enact in light of the magnitude of the transfer the Fed was willing to give to the Treasury for fiscal stimulus. They could enact a larger fiscal stimulus than the Fed’s transfer to the Treasury, but the Treasury would have to borrow the difference. If they enacted a smaller fiscal stimulus than the Fed’s transfer to the Treasury for fiscal stimulus, some of the Fed’s transfer would go unused and be returned to the Fed. Congress and the president would decide the composition as well as the size of the fiscal stimulus. As I will explain shortly, I recommend that a large portion of the fiscal stimulus be tax rebates to households.
Conclusion
The most important point is this: fiscal stimulus does not require an increase in government debt. To get high unemployment down to normal, the government should implement fiscal stimulus: increase its spending (mainly tax rebates to households, but also some purchases of goods and services and other expenditures) and/or cut taxes. When the government does this, it doesn’t need to borrow. It can get the money it needs from its printing press. As long as it does this only when unemployment is high, it will not be inflationary. Thus, when unemployment is high, fiscal stimulus can be implemented without debt and without causing inflation.
What Is Stimulus without Debt?
“Stimulus without debt” is a policy that would increase aggregate demand for goods and services in a recession without increasing government debt. Stimulus without debt consists of a transfer (not loan) from the central bank to the nation’s treasury so that the treasury does not have to borrow to finance fiscal stimulus enacted by the legislature. In most of this book I illustrate stimulus without debt with reference to the United States, but stimulus without debt can be implemented in other countries and in the eurozone.
The Strategy behind Stimulus without Debt
Most recessions, including the US Great Recession of 2008, involve a fall in demand for goods and services. When the US housing bubble burst in 2007, followed by the plunge in the stock market and the failure of firms like Lehman Brothers in 2008, consumer wealth and confidence fell sharply. Anxious consumers cut back their spending, so consumer demand for goods and
