Friday, October 9, 2009

New Keynesian Theory and the Stimulus Package

Economic problems are one of the most pressing issues in America today. Part of the reason for this is the fact that usually accepted economic theories are being tested, and some are failing. What used to be considered fact, such as the Neoclassical theory of economics, is now being thrown away for more accurate and usable theories. New Keynesian theory, or the belief in moderate government intervention when necessary, is becoming increasingly popular because of its ability to accurately predict and solve economic issues. Obama’s stimulus plan, an application of this theory, is the best answer to the United States’ current economic difficulties because it is the solution most capable of shortening and tempering the financial crisis, making it bearable for the American people.

Until this major financial crisis, Neoclassical theory was the most widely accepted economic theory, almost to the point of being considered fact.  Neoclassical theory is the belief that allowing the market to operate on its own is the best option. Neoclassical economists believe that government intervention causes more harm than good, and that in free market economics, everything will right itself in the long run. The chief economist of the International Monetary Fund (IMF) declared in 2008 that there had been a "'broad convergence of vision’” (Krugman 1). It was believed that Neoclassical economics was an exact enough science that it could prevent major economic problems, and that though there would be booms and recessions, these recessions would be minimal and best responded to by governmental inactivity. However, this assumption proved incorrect. Alan Greenspan, a proponent of Neoclassical economics, “was in a state of ‘shocked disbelief,’ because ‘the whole intellectual edifice’ had ‘collapsed’” (Krugman 3). The recent economic crisis is too intense, and on too large of a scale, to be predicted or prevented by the previously accepted principles of economics. As outrageous as it seems today, it was believed that there would never be another depression after the Great Depression, which now seems entirely possible. Even in the long run, market forces are not necessarily strong enough to bring the U.S. economy out of its major recession, especially given the fact that the world economy is suffering as well. The long term could extend so far into the future that, without a strong governmental solution, the economy may continue to spiral downward. This leaves most economists who were confident in Neoclassical economics searching for a new way of thinking.

One possible alternative is Keynesian theory. This is the belief that the government should regularly intervene in the economy to guard against mistakes made by the private sector and prevent and solve major crises. This involves strong, consistent fiscal and monetary policy meant to keep wages and prices steady and consistent with changing variables. Keynesian theory is also used to predict major crises, ignoring the classical assumption that only small-scale recessions are possible. Although applications of Keynesian theory could prove useful in the current economic crisis, strong Keynesian policies fail to fully consider how they will affect the economy in the long run. According to Keynesian theory, government intervention should be persistent and applied often. In this case, however, if Keynesian expansionary policies were applied until the economy righted itself, the United States budget deficit would increase severely. Our economy needs a push in the right direction, not a full-scale attack on the current problems until they are solved. Otherwise, there could be extreme long-term consequences.

The answer is New Keynesian theory. This theory assumes that in the long run, changes in the money supply are neutral. However, prices are sticky. This means that prices and wages don’t automatically respond to market forces, and it can cause hardships within the population in the short run. Though the market will right itself in the long run, the long run can be extraordinarily long, which makes these hardships unbearable. In the case of the current crisis, it could take up to a decade for the world economy to right itself and for unemployment to return to the natural rate, as “economic contractions associated with financial crises tend to be deeper and last longer than recessions not associated with a financial shock” (Brown 44).  In addition, since many members of the private sector have lost confidence in the market, investment levels could stay low despite the extremely low interest rates, which will slow the return to economic prosperity. The International Monetary Fund and World Bank have done little to improve the situation, in contrast to previous global recessions. “In previous international financial crises…these international financial institutions, especially the IMF, played a prominent and active role to resolve the crises” (Park 126). This puts a higher burden on the United States government to solve the problem. And as economic difficulties continue across the globe, countries such as the United States and China have established protectionist policies that could further inhibit economic growth. For all these reasons, government intervention is necessary, and it is clear that a mix of President Obama’s stimulus package and strong monetary policy is an excellent solution.

The first tool of New Keynesians is monetary policy. This involves the Federal Reserve Bank, and includes changing the amount of money available, as well as interest rates. Though our Federal Reserve Bank has been working endlessly to try to fix the current crisis, it is simply not enough. The current interest rate is almost 0%, and cannot be lowered to further spur investment. The truth of the matter is that the private sector does not want to invest. Until recently, it was thought that investments were smart and risk-free. Though they are usually a wise decision, they are definitely not risk-free. Now that these risks have been outlined, it is difficult for people to see the benefit in investing. They would rather save their money than risk losing it again, as many did in even the “safest” markets, such as the housing and bond markets. Though the Federal Reserve Bank should continue its strict monetary policy, it should be in coordination with fiscal policy, as that is the last possible option to boost our economy.

Fiscal policy includes taxation and government spending. Because consumers are saving rather than consuming or investing, the economy has no way of recovering. The government is the only one with the means to borrow a substantial amount of money and inject it into the economy. Though New Keynesians usually rely on monetary policy to correct the economy, they have accepted that this is the best available alternative. Currently, “U.S. unemployment is already at a 25-year high, and may exceed and remain above 10% for some time” (Brown 44). To save our economy from a major depression and long term suffering, heavy government spending must occur.

An argument, however, is where the $787 billion dollars of the federal stimulus package should have been allocated. Though the tax breaks do lessen the burden on the American people, they are likely to have a marginal effect on the economy, as people are more likely to save the extra money rather than spending it. Many also argue that not enough is being spent on restructuring our economy so that it can provide long-term growth. Another issue with the stimulus package is how long it is taking the money to actually enter the economy, and how slow new jobs are being created. In fact, “Critics maintained that its job-creating efforts would not largely be in place until 2010” (Burke 598). This is hardly a relief for the American people, as unemployment is causing hardships today.

Although there are arguments about how the money should be spent, that is an issue not everyone can politically agree on, and the main point is that the money is being pumped into the economy in a productive way. There are both benefits and drawbacks to the non-immediate release of the money. Though the economy needs fixing now to prevent the United States from entering a full-scale depression, we are not quite ready to fully receive the stimulus package and utilize it in the best possible way. This is because “unemployment will be structurally higher in the near term and only decline slowly over many years as adjustments are made in the skills of the labor force. This prediction stems from the inherent mismatch between skills available in the labor force currently…and the skills necessary to drive sustainable growth over the next five to 10 years” (Brown 44). The United States has a lot of long-term organizing to do, or structural unemployment will persist. Education must be altered, as citizens must be trained in the skills that are useful to America today. If we do not reorganize our workers and our economy, the stimulus package will be nothing but a weak, short-term fix. That is helpful to reduce suffering, but given the high contribution to the deficit, it should be able to provide some long-term benefits.

In response to the concern about raising the deficit or creating hyperinflation, those are both moderate concerns rather than pressing issues. The common concern is that we can “continue to spend beyond our means for a bit longer, but this will not persist indefinitely…The legacy of past policies already posts a significant roadblock for economic growth going forward” (Brown 49). Carrying a major deficit inhibits economic growth, which is important in the long run. Though the deficit is something that needs to be watched closely and, eventually, decreased, the time to do so is not during the largest recession since the Great Depression. Given that the deficit is increasing drastically, there should be attempts to correct it after the global economy rights itself. Taxes do need to be raised in the future, and while this may have a negative effect on future generations, it is not something that can be solved during an economic crisis of this scale. In addition, it must be noted that this is the only stimulus package that will be used to combat this recession. It is a one-time increase in the size of the deficit. Without the constant government intervention dictated by Keynesian theory, the budget deficit will not increase dramatically. Hyperinflation is also far from a pressing concern. Deflation has become a bigger issue than inflation as of late, making moderate inflation beneficial, and there is little to no empirical evidence that government spending causes hyperinflation. Overall, these concerns are relatively insignificant when compared to the suffering that could occur during a depression.

President Obama’s stimulus package will not provide perfect results. The sudden downfall of many accepted economic principles makes it difficult to determine the best possible solution, as many economists are still contemplating the answer. In addition, there are many policies the government needs to make to supplement this plan, such as restructuring, improving bank regulations, and continuing to place importance on technological advances. However, to prevent the current recession from spiraling into depression, the government must intervene in the market. It is difficult to say where the economy is headed, but given the New Keynesian policies being implemented, it may become the next widely accepted economic theory. And, hopefully, it can right our economy effectively.

Brown, G., and C. Lundblad. "The U.S. Economic Crisis: Root Causes and the Road to Recovery. " Journal of Accountancy  208.4 (2009): 42-48. ABI/INFORM Global, ProQuest. Web.  8 Oct. 2009.

Burke, J.. "The Obama Presidential Transition: An Early Assessment. " Presidential Studies Quarterly  39.3 (2009): 574-604.  Research Library Core, ProQuest. Web.  8 Oct. 2009.

Krugman, Paul. "How Did Economists Get It So Wrong?." New York Times (2009): 1-8. Web. 9 Oct 2009.<  >.

Park, Y.. (2009). The Role of Financial Innovations in the Current Global Financial Crisis. Seoul Journal of Economics, 22(2), 123-144.  Retrieved October 9, 2009, from ABI/INFORM Global. (Document ID: 1826025051).

No comments:

Post a Comment