Simple thoughts about stimulus

If every American saved the rebate and invested it in equities, we might be (ever so slightly) better off.  Government can borrow at a low interest rate for us.  Of course we’re being told to spend the money.

Most fundamentally, more aggregate demand is not the answer because insufficient aggregate demand was not the problem in the first place.  Just as a social framing effect (and lots of fraud) led subprime loans to be perceived as
"not very risky," right now social framing effects — call them collective fear — are causing lower asset prices, some degree of
credit constipation, and higher risk premia.  The economy is undergoing a sectoral shift toward less risky assets and that can bring an economic downturn.  The shift itself is costly, it brings thorny coordination problems (e.g., sudden insolvencies, overturning of credit expectations), and lower-yielding assets also mean less wealth.  Lack of liquidity simply is not the fundamental problem. 

Arguably there is a secondary negative aggregate demand shock at work, mostly because asset prices are lower from the sectoral shift.  Monetary policy should offset this secondary effect, to keep things from getting worse, but still monetary policy won’t and indeed can’t set things right again.   

More speculatively, you might argue that boosting aggregate demand may convince people to postpone their adjustments to the sectoral shift, thereby making the coordination problems last longer.  Maybe, but I won’t push that on you for lack of evidence.  Another speculative argument is that boosting aggregate demand can push us all back into optimistic expectations but that is unlikely. 

The bottom line: Our expectations from the Fed or a stimulus plan should be very modest, even if the boosts to aggregate demand are done perfectly.


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