Government deficits don’t correct recessions because the increase in spending; for however long it may be drawn out is never intended to be permanent. Without the general acknowledgment that the increase in government outlay is always going to be there and at the elevated level, consumers will treat the cashflow as temporary. And according to Milton Friedman, increases in disposable income, be it through transfer payments or tax cuts, that are not perceived as permanent will not translate into increased consumption, but instead will lead to an increase in savings.
Taking a look at what happens when deficits are pursued for the hell of it we find some things to be more surprising then others. Governments can fund deficits in two main ways: first (if the option is available) it can borrow from the pool of domestic savings by selling bonds, notes, and bills to the public, however, this has the effective of a dog chasing its own tail. In Laments terms the government borrows the savings of the public, then pays them either to do a job, redoing a a previous job just to stimulate the economy or worst yet, for just being a citizen. The income is then saved because its not expected to be a permanent cashflow stream, and the government then later borrows those savings to further perpetuate its deficit. This trend slows inflation over time until real rates of return are higher than nominal returns and then you have deflation. Deflation is very beneficial to savers as the purchasing power of their savings increases and so encourages them to save even more, all while forcing the government to take further action to stimulate spending.
Usually, monetary policy takes the lead in the attempt to correct a recession with falling interest rates. If interest rates hit their natural limit of zero and fail to spur a sufficient increase in the level of investments, then the economy can end up in a liquidity trap. This basically occurs when borrowing rates are so low (near zero) that corporate borrowers commit borrowed funds to savings vehicles (usually government debt) and earn some spread, instead of making capital investments. To better understand this you must keep in mind that the nominal interest rate minus the rate of inflation is equal to the real interest rate. For example, if a corporation borrows funds to make some capital investment, and inflation goes up, then the real interest rate paid on the loan goes down as each repayment amount is worth less than the one before it. Inversely, if a corporation borrows funds to make some capital investment, and inflation goes down, then the real interest rate paid on the loan goes up as each repayment amount is worth more than the one before it.
Once in this particular situation, raising interest rates would only stifle out whatever little investments there are with higher borrowing costs, or decreasing government spending would drive down the yields on government debt closing to spread that corporations rely on for income, putting some out of business and negatively affecting employment levels (which would require more government spending to deal with). Needless to say, this is quite the precarious scenario to get an economy out of: see Japanese economy from the 1990s to present.(With the fastest aging population the government will have its hands full)
The second way governments can fund deficits is by borrowing in international capital markets. However, this approach does have its natural inhibitors. The increased government outlay, if again viewed as temporary would only increase the savings rate and not necessarily consumption. The increased supply of government debt in the international capital markets would (in normal times) drive the yield on the instruments up, which effectively raises long-term borrowing rates for the economy which is not a good way to incubate growth.
Again, monetary policy should have lead the way in the bout to correct the recession with interest rates. But, monetary policy only controls the short end of the yield curve, fiscal policy controls the medium and long ends. Being that most investment loans are multi-year loans, their rates would most likely be tied to some level of government borrowing cost. For example most corporate debt instruments are priced as a some spread above treasurys of similar maturity, or mortgage rates as a spread above the 10 year treasury note rate. The increase in long maturity borrowing costs would definitely put a damper on both private and corporate investments. In this case, the fact that government borrowing to fund its deficit absorbs so much of the international savings pool that the cost of borrowing increases across the board, it results in a crowding out effect where basically there isn’t enough capital left over for businesses and households to tap for their long-term investment needs. This leaves only the marginal increase that would have occurred in the domestic savings pool from the increased government outlay for businesses and households to compete over which means higher money market rates to savers, which is an incentive to save more and consume less as a result (also bad for economic growth).
Matters of business cycle management need to be left in the hands of a capable, credible, [and this is key] independent central bank. I hope I don’t live to regret this statement but, monetary economics works, its too fragmented and filled with confused arguments, but it works. I hope I haven’t given anyone the impression that I, in my “infinite wisdom” am against government deficits in response to a recession, because that is not the case. Government deficits are necessary in my eyes during a recession because there is a human element to every economic downturn. When unemployment increases by one percentage point, hundreds of thousands of people no longer have a source of income to support there lives. That is where the government deficit is needed and where it should be directed. And not sold to the public as a means of getting an economy in recession back to growth.
I believe that to move an economy out of recession and back into growth, monetary policy needs to flirt with the specter of inflation through an expansionary policy which should in some extreme cases include quantitative easing. I refer you back to the concept that the nominal interest rate minus the rate of inflation is equal to the real interest rate, and the example of a corporation borrowing funds to make some capital investment. If inflation goes up, then the real interest rate paid on the loan goes down as each payment is worth less than the one before it. This is the type of scenario that is an incentive to businesses to invest, as well as to households to consume instead of save because they expect rising prices which devalues their savings.
As in both types of recessions, whether normal or deflation plagued, there is an approach that a central bank can use to get an economy back to normal growth levels. Quantitative easing is only to be used after standard monetary policy of lowering interest rates has been exhausted. It’s basically the central bank printing money to purchase illiquid assets from large financial institutions through repurchase agreements. Which are agreements where the central bank purchases the assets from the institutions, and the institutions agree to repurchase those assets back at a later date, which frees up cash for the institutions. The goal is to have so much cash on corporate balance sheets that it catalyzes positive inflation expectation. In the face of expected inflation, businesses invest and households consume, which gets an economy growing again. The increase in business investment and personal consumption will lead to more employment, more wages and rising price levels, to which the central bank would have to respond by first slowly eliminating its quantitative easing procedures and later normalizing interest rates.
Its understandable that government likes to get involved to feel like its making a difference, but it should not for a minute forget that its role in certain matters of economic importance is secondary, and only of social importance.
