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Keynesian Economics and the Recession
hotlunch
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I'm not a big student of economics or anything, just was having a discussion with friends about the recession and stimulus package. To my understanding, the government spending a bunch of money is in accordance with Keynesian economic theory, spending money and lowering taxes to combat stagflation. But how does the government spend money when they get less income from lower taxes?
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At least, that's my understanding of it. As for taxes, any strong government, or a country with a strong GDP, will essentially have no problem with money -- which is why countries still buy our treasury bonds. If the US were to potentially default on a loan, they'd just raise taxes. Since there's currently no threat of defaulting on our loans, there's no immediate reason to increase taxes to pay for it.
Furthermore, if businesses and individuals earn more money, they end up paying more in taxes anyway, so it's advantageous for the government to boost individuals and businesses during recessions, in order to shorten the recession and get more money flowing -- because the more money flows, the more it's taxed.
But we don't have stagflation -- the inflation rate has been essentially 0 for the past year or more. That's why you heard all that stuff in the news about Social Security not increasing benefits this year.
As an addition to what some other folks said, I believe that stagflation was not accounted for in original Keynesian economic theory, but explanations for it have been developed in the newer versions of economic theory derived from it. Stagflation is a combination of a stagnating economy with high inflation. One theory for what can cause stagflation is a supply side shock, causing a contraction in aggregate supply. A potential example of this would be the oil crises and OPEC embargo with the stagflation in the 1970s.
Right now economic conditions are more similar to those in the Great Depression, where you have high unemployment and inflation at very low levels, with the potential risk of deflation. Here the idea is that you can use government spending to temporarily boost aggregate demand without it just causing a big spike in inflation like could happen in more normal times or in boom periods.
If government action leads to an increase in inflation and a devaluation of the dollar that would mean that it was either actually working and serving its purpose or working too well and giving us a different set of problems to worry about.
So this is a pretty basic equation for GDP: Y = I + C + G + (X-M). X-M is net exports, so we can ignore that for this basic explanation. I is business investment, C is consumption, and G is government spending. During a recession I and C drop for completely rational reasons, but government has the ability to increase G, government spending, to partially offset the drop in C and I.
And Keynesian economics largely revolves around the case for why the government should do that.
We borrow it from other countries (mostly China), by selling Treasury bonds at an interest rate.
So if someone buys a $100 dollar bond, in 10 years (or some other time frame) the US has to pay them $105. OR, they can offer, hilariously, a $105 bond to the person which might be worth $111 in yet another 10 years.
In long term economics this is generally considered a sound investment.
It's a political issue today because
1) We do it a lot
2) The primary buyer of these bonds is China, and Chinese financial interests, which are not overtly hostile to America, but theoretically dangerous
It's actually dangerous right now, because when a nation like China own such a huge amount of American debt, it weights their currency against ours, making it harder for us to recover from a recession, since lower paying jobs don't find their way back to America because as our dollar gets cheaper, ditto the Yuan.
we also talk about other random shit and clown upon each other
that's why we call it the struggle, you're supposed to sweat
To expand on the last point in this post, the Chinese have been manipulating their currency such that it follows the dollar. When the dollar is devaluated, it means it loses purchasing power relative to other currencies. This matters a lot in terms of trade balance, as a weaker dollar means that imports are relatively more expensive because imports kept at a constant cost in their native currency cost more in terms of dollars due to the changing exchange rates. Conversely, exports from the US to other countries become relatively less expensive, as they can buy more for the same amount of their native currency.
The US trade balance has been horribly out of whack in recent years, where we have had massive amounts of imports and been leaking out dollars and debt to pay for them. This would suggest that one of the more natural ways to deal with this imbalance would be for the dollar to weaken against other currencies, though this is hard to do when other countries want to devalue their currencies too to boost exports, and a big nightmare when China has the power and desire to manipulate their currency to match the dollar on its way down.
Also, big problem looking ahead is that a weaker dollar is going to really put the squeeze on us if the oil producing countries decide to start selling oil in other currencies (right now it is mostly traded denominated in US dollars), so we are going to need to do something about our oil dependence if we don't want to get totally wrecked.
It's not actually dangerous. Keynesian economics doesn't call for constant deficit spending. Only if necessary during times when the economy is shrinking. During an expanding economy, taxes are suppose to be raised to offset spending during bad periods and to prevent the economy from growing too fast. The problem is we've only been living in one half of the Keynesian plan since Reagan because no one will consider raising taxes.
we also talk about other random shit and clown upon each other
On the other hand, what the US has done is basically spend spend spend (on war) during a boom, and spend spend spend (on saving the economy) during a bust. So its not really following Keynesian economic theory, but rather is just building on the deficit before it had a chance to pay it down at all.
I agree, I just wanted to seperate are current deficit problem from Keynesian economics.
They borrow it.
It's not quite that simple of course. The Federal Reserve is a bank. Their primary customer, is the US Government. If the government needs money, they take out a loan. They've been doing this for a very, very long time.
In theory the government is supposed to be running a balanced budget. New spending is supposed to be balanced by increased income or cuts in other spending. The problem is that Congress, well, cheats. Take the Alternative Minimum Tax, or AMT. Every year, Congress passes a "patch" which prevents the AMT from applying to a bunch of middle income taxpayers. But when they calculate the amount of income the government receives, they don't count the patch because it's not supposed to occur and won't occur without direct action every year from Congress.
So they borrow to make up the difference. So far, a lot of stupid people have been very, very willing to buy US Treasury Notes (the US debt).
Someday, in the far future, we'll have to fight a war with China and Japan because we're eventually going to default on the debt, and they'll be wiped out. They are buying huge amounts of US debt, and the likelihood we'll ever be able to pay it down shrinks every year.
You should definitely ignore this person.
we also talk about other random shit and clown upon each other
No. Just no. This isn't how it works at all. Except for the part where the government spends more than it takes in in revenue and has to borrow to make up the difference. But the Federal Reserve doesn't "give the government a loan," they issue treasury bonds as described by Jasconius above.
The worst scenario probably just involves the chinese (or whoever) deciding they don't really want to keep re-upping their bond purchases because they don't need dollars anymore. Which would lead in fairly short order to a massive curtailing of federal spending, and/or ridiculous tax increases.
that's why we call it the struggle, you're supposed to sweat
Mutual Funds and China vie for 2nd place, at near $800 billion each. Though Japan was the biggest foreign holder of debt up til last year and is still north of $750 billion.
The U.S. Treasury issues U.S. Treasury instruments. And the Fed is the biggest buyer of them, in exchange for those nice Federal Reserve Notes you have in your wallets/purses.
If there weren't enough cash to pay the coupon there's no need to go to war: more reserve notes can be printed. I'm sure the Fed would still buy Treasury notes no matter the rate offerred. Also as a bonus, China cannot "call in the debt" it doesn't work that way, they might could dump it somehow (though that's hardly in their best interests).
There's not much concern that China will become the largest creditor as I believe there are plans for the Fed to buy another trillion in the next year or so.
Mostly countries don't "buy" US debt, they accept Treasury notes so as to cover the currect account deficit (see here); we bought more of their tvs and computer componentry then they bought of our airplanes and cigarettes. I mean yeah, China did buy Treasuries over and above what's needed to cover the trade imbalance and they'll likely continue to so so, but as a form of currency manipulation so they could keep the price of their exports artificially low, not so they can say "gimme California or I'll foreclose on your ass."
...I...I think this is wrong, but that may just be how you've phrased it.
So heres the problem: the dollar has been overvalued for a while relative to other currencies. Part of this is that it's a popular investment, particularly due to China. China creates a lot of demand by buying up a lot of our T-bills. Doing this serves three purposes for China:
This has actually started changing recently as the wealth of the average Chinese family (at least in and surrounding urban centers) has increased and they become consumers -- Chinese consumers pay more for imports because of their supremely undervalued currency. So they're trying to strike a careful balance about maintaining an overvalued US dollar but improving the buying power of the Renminbi. We, meanwhile, are on the opposite side of the coin in that we recognize the dollar is overvalued, and that is preventing our goods from being cost competitive against the domestically-produced and other foreign-produced alternatives in foreign markets, thereby hurting our trade. But we also judge the strength of our economy on consumerism, and a lot of American consumerism today is based on service and retail industries selling cheap foreing goods, so we want to keep the dollar strong enough to support the consumerism in our markets which, along with government spending, fuels GDP.
Y = output = income = GDP
Y = C + I + G - NX
NX = Imports - Exports
Higher NX means lower Y so no selling cheap foriegn goods doesn't translate into fueling GDP, if anything it has an opposite effect. I'd also contend with your 1st assertion, no foriegn entity controls money supply in the United States. The Fed does, as simple as that. Real money supply = Nominal money supply/Price Level (M/P). Real money supply isn't being affected by the Chinese because they buy treasury bills at the pleasure of the Fed and if the Chinese did sell treasury bills theres a strong argument that money demand will adjust itself back to the initial interest in the asset market.
"This has actually started changing recently as the wealth of the average Chinese family (at least in and surrounding urban centers) has increased and they become consumers -- Chinese consumers pay more for imports because of their supremely undervalued currency. So they're trying to strike a careful balance about maintaining an overvalued US dollar but improving the buying power of the Renminbi."
Ummmm, I'd be real careful about asserting that. Migrant workers are the most politically dangerous portion of the population right now, most susceptible to the business cycle and most dissatisfied with the status quo. Keeping the yuan undervalued allows these workers to enjoy the standard of living that they do (10 yuan can get you through a day on filling meals, which in dollars is about 1.50).
The whole Keynesian economics argument with the recession involves a whole discussion about labor, assets, and goods markets. I'm at work right now so I can't type out a whole lengthy explanation. Basically though you have to first look at what government is trying to do are they going to try to keep output at the same level as full employment output? Or are they trying to keep interest rates steady? If they are trying to hold Y constant then Keynes said government must raise M/P (real money supply) in order that the asset market reaches a lower interest rate equilibrium point. This, in turn, shifts the LM curve outwards in general markets to a point on the IS (investment savings curve, given by goods market equilibrium which in this case willbe lower because of a recession) equal to output at general market equilbrium (when full employment = IS = LM). This requires a reduced interest rate which will cause inflation, etc, etc. Also full employment shifts to the left because of the reduction in labor demand (labor market). Classical economists assume perfect information in the short run so that general equilibrium is always reached. Keynesian economics assume something called the Misperceptions short run aggregate supply (For anyone that cares, this is given by the lucas curve, full employment output - b(P-P^e). In the short run government can act to change output or interest rate to some desired level in the general economy but in the long run markets always reach general equilibrium.
And yes ignore Gothiclargo, for the love of God. You can see this simply:
T^f/1+r + T = G^f/1+r + G
Future discounted taxes + current taxes = future discounted government spending + current government spending
There's a whole thing called Ricardian equivalance involving this equation which states that a rational consumer won't increase spending with tax cuts but that doesn't hold and isn't really relevant to this discussion.
It is only really an issue during the recession because when the economy is doing well and unemployment is low Americans don't want to do the low level manufacturing jobs, but once Americans start losing their jobs the lower paid positions that they previously gave up look more attractive than being unemployed.
EDIT: There are apparently some major faults with what I've said in this post, see post on next page where I'm corrected.
I really like the fact that you're looking at the domestic influence on international relations, it really does offer a far richer view. But you're ignoring one side of the equation. I don't think China is keeping the yuan artificially low because of an interest in competitive advantage but because domestic politics makes it a necessity. The Solow Model gives economic growth in the steady state as population growth + productivity growth. I don't want to go into the whole explantaion but in GDP in effective worker terms = Y/AN, which means in the steady state Y must grow at the rate of A and N (a + n). True, China is far from the steady state but because of diminishing returns its economic growth is bound to decrease gradually to a point at n + a which is unacceptable to the most politically dangerous of the population. So it's not a calculation of competitive markets, relative gains, but rather one of political self preservation.
Alright, I'm willing to admit when I'm a bit out of my comfort zone. I haven't ever taken a real economics class - I'm about half way through a course on Global Political Economy, and wrote an essay on the Chinese approach to globalization for a comparative politics course, but thats about where my knowledge of Chinese politics/economics ends. I really have no idea what you just said.
How do you think China has pegged its currency to the dollar? It doesn't happen just cause they say so, they actually have to act in a way that affects the relational value of the currencies in question. Artificially pegging your currency to another instead of allowing it to float is definitively currency manipulation. The US only cares about it w/r/to China cause it's also destroyed* our industrial capacity since it's all been exported to China. Like we care that India artifically sets the exchange rate to the rupee.
A little confused by what you're saying here. China's keeping its currency undervalued is helping the purchasing power of the Chinese? How?
*Edit: Assisted in its demise and continues to put pressure against any resurgence would be a less inflammatory way to put it.
I meant more manipulation in the sense that they don't maintain the devalued status of their currency by buying up/producing Yuan to try to adjust demand for it, like other governments do when they want to manipulate the value of their currencies.
It'll still be there, it just won't be as ridiculously cheap as it is now.
Just look at oil -- even if the dollar is weak, oil goes up and down in price. Currency fluctuation will affect some of those prices, especially for commodities, but it's only one part of the equation.
If the yuan doubles in value but everything in China drops to half price, then the only people making money are those companies that make price stickers.
Ok, wow no.
I'm a finance and economics specialist and reading some of the things in this thread has really made me cringe, unfortunately my macro knowledge is not thorough enough to really explain everything.
However, with exchange rates you don't just "lock" the value of a currency to the dollar.
So lets say the Chinese government chooses to peg the RMB (yuan is incorrect as its a denomination and not a currency) at a certain exchange rate to the dollar. To keep this rate credible the country's central bank has to be able to "defend" the rate so that the set exchange rate equals the market exchange rate.
Imagine two curves, one upward sloping representing supply of US dollars and another downward sloping representing the demand for US dollars in China. The point at which these two curves intersect is the equilibrium where the market exchange rate should be.
Now if the Chinese government wishes to set the exchange rate of RMB to US dollar higher than the actual market rate (i.e. make the RMB artificially weaker) then the supply of US dollars will exceed the demand for US dollars in China. Why would people exchange RMB for US dollars at such an unfavourable rate? To maintain this rate the Chinese Central Bank has to buy up foreign exchange to clear excess supply on the market. And thats the reason the Chinese hold something like 2 trillion in foreign reserves.
Also it goes without saying that if the Chinese government wanted to set the exchange rate of RMB to US dollar lower than the actual market rate (i.e. artificially stronger) there would be excess demand for US dollar, shortage of supply in US dollar and the central bank would have to sell foreign exchange to clear the market.
Here's a graph to better show what I mean:
Notice that when when the exchange rate is at E1 which is above the market rate of E (i.e. RMB to Dollar rate is higher than it should be or artificially weaker) that the supply of US dollar exceeds demand. So to bring the market to equilibrium at that rate the central bank needs to buy up that excess supply.
you're wrong factually on the euro, but that doesn't change your (correct) point any.
http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html
Alright, thanks for clearing that up. I'm assuming the prof either didn't understand this or was just simplifying it for political science students.
As someone who has worked professionally in politics, I assure you that I've yet to meet any poli sci majors who were ever taught how anything actually works, except maybe legislative process.