JUNE
2009

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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06-25-09

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The Problems We Wish We Had


We're trying to shorten the recession with rapid growth in the money supply and with federal tax cuts and spending increases. But that means, once the recovery is well underway, we'll have two new problems to deal with: the potential for inflation and the consequences of big budget deficits.

The Federal Reserve has reduced the main interest rate it controls to near zero. It does this by buying Treasury bonds from banks, which then have more money to lend. To attract customers, the banks reduce their interest rates. Businesses and consumers borrow money and spend it, and people are hired to produce these added goods and services.

Where does the Fed get the money to buy bonds? The Fed creates the money. The money supply increases when the Fed cuts interest rates.

Or it would, if banks would lend the money. Banks have become very conservative with their lending. The Fed has been shoving money out the door, but banks have been locking it in the vault. Bank reserves are at record levels. If banks don't lend, the Fed's new money doesn't get into circulation, and the money supply doesn't grow very much.

With the recovery, though, bank lending will loosen up. Banks will start lending and the money supply will grow. With so many reserves, the money supply could grow a lot. That's where the potential for inflation comes in. Prices will rise if the money supply grows faster than the production of goods and services. The old saying is true: too much money chasing too few goods causes inflation.

Ben Bernanke, the chair of the Fed, recognizes this coming inflation problem. In a Feb. 18 speech to the National Press Club, he said, “When credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply..." (You can read this speech on the Fed's Web site, at http://www.federalreserve.gov. Click on News and Events, then scroll down to Testimony and Speeches.)

In other words, when the time comes, the Fed will reverse the growth in the money supply to prevent inflation. That could be a tricky business. Tighten policy too slowly and we get inflation. Tighten too fast and we could return to recession.

The Federal government's 2009 budget deficit will be 13 percent of Gross Domestic Product, according to Congressional Budget Office estimates. That's the biggest percentage since World War II. The recession has depressed tax revenue, and the stimulus bill cut tax rates and will increase spending.

Lower taxes give people more after-tax income to spend. The government buys goods and services, and pays wages to its new employees. This stimulates the economy, because businesses hire more people to produce what consumers and the government want to buy.

Lower taxes won't pay for the new spending. The Treasury borrows the difference. That's not such a problem during recession. Businesses are reluctant to borrow, and lenders are reluctant to lend, so government borrowing doesn't "crowd out" borrowing by businesses.

Come the recovery, the budget deficit is expected to get smaller. The Congressional Budget Office projects that the deficit will drop to 3.9 percent of GDP by 2013. But, under the proposed budget, it will grow from there, to 5.5 percent, by 2019. (You'll find these numbers on the CBO's Web site, http://www.cbo.gov.)

That much borrowing during an expansion is a problem. Businesses will want to borrow for new buildings and equipment, but the government will be first in line at the bank. Government borrowing will crowd out business investment. Less investment means a smaller stock of buildings and equipment to work with, and that can slow down economic growth over the long haul.

The solution to a deficit, of course, is lower spending and higher taxes. Congress often has trouble enacting those policies, though.

Inflation's not a problem now. Prices are actually lower today than they were a year ago. The deficit is not a problem now. The Treasury is borrowing money that would not be lent otherwise, so it's not crowding out private investment.

These things won't be problems until the economy recovers. Since we really want the economy to recover, they're the problems we wish we had.

 

 

Writer: Larry DeBoer
Editor: Olivia Maddox