Thursday, December 16, 2010

Why Fed May Not Be Able to Stimulate Economy

There is currently a lot of discussion about the ability of the Fed to stimulate the economy and prevent price deflation. Some argue that this will only produce inflation. Similarly, there is debate about the need for government borrowing and spending to stimulate the economy. The above link is to a presentation by a Japanese economist who compares our current situation with that of Japan. Our situations are remarkably similar and Japan is still trying to deal with price deflation after 10 years of ultra low interest rates.

His basic point is that low interest rates don't work as long as households and businesses are saving and paying down debt. The private economy in Japan created savings that were not being borrowed by the private sector. The public sector must borrow these savings and spend them or the economy will not grow. This can be done without causing interest rates to rise and it does not lead to inflation. Fiscal stimulus worked in Japan but it was politically difficult to sustain the spending since it increased budget deficits beyond the political comfort zone.

If we look carefully at our situation we see the same issues. Major corporations are holding close to $2 trillion in retained earnings (savings) and households are paying down debt and spending less (savings). Banks are sitting on record reserves and they do not have creditworthy customers demanding enough loans to reduce their reserves. Our political focus has shifted from using fiscal policy to compensate for the lack of private spending to dealing with our longer term debt issues. We may be headed down the path that the Japanese have been on.

The presentation may be too technical for some people but the graphs tell the story pretty well.

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