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MOSLER'S LAW: There is no financial crisis so deep that a sufficiently large tax cut or spending increase cannot deal with it.

Re: Tax cuts may heighten deflation risks – NY Fed study

Posted by WARREN MOSLER on February 23rd, 2009


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(email exchange)

It doesn’t make sense in any model this side of sanity. Comments below:

>   
>   On Sun, Feb 22, 2009 at 7:47 PM, Steve wrote:
>   
>   Does this make sense in your model of fiscal policy?….interesting
>   counter intuitive argument…
>   

Tax cuts may heighten deflation risks- NY Fed study

Feb 18 (Reuters) — Cutting taxes to try to stimulate the economy could do more harm than good in a zero interest rate environment as it can heighten the risk of deflation, according to a recent New York Federal Reserve study.

Policies that are aimed at increasing the supply of goods can be counterproductive when the main problem is insufficient demand, New York Fed economist Gauti Eggertsson said in a research paper entitled “Can tax cuts deepen the recession?”

Increasing the supply of public goods is never contractionary. Though wise investment can bring down real costs and prices and thereby increase productivity and our real standards of living.

“The emphasis should be on policies that stimulate spending,” Eggertsson said, adding that his research found the impact of tax cuts is “fundamentally different” with interest rates near zero.

“At zero short-term nominal interest rates, tax cuts reduce output in a standard New Keynesian (economic) model. They do so because they increase deflationary pressure,” he wrote. Eggertsson’s study focused primarily on labor taxes and some sales taxes.

There’s the problem- the standard ‘new Keynesian model’ is garbage.

Cutting payroll taxes, for example, would create an incentive for people to work more. But if there are not enough jobs, this could have a negative effect: creating more demand for work and thus driving down wages.

Huh? First of all, for me personally at least, when my income is cut I tend to work more to at least try to make the same income. And when taxes are cut I certainly don’t work more. But that’s just anecdotal.

The main point is there are already millions of unemployed so even if somehow cutting payroll taxes so people struggling to make ends meet can better do so causes a few more people to seek work the pressure on wages can hardly go up.

And maybe the strongest point, these new people supposedly seeking work due to a cut in payroll taxes will only work at the higher wage as a point of this (convoluted) logic which is far different from a market and wage level pressure point of view than the millions of others willing to work at current wages who can’t find work.

Last, the notion that changes in payroll tax could measurably alter wage seekers is extremely far fetched at best and not statistically significant in any case.

And with interest rates near zero, the Fed cannot cut rates further to fight deflation.

As if cutting rates does or ever has fought deflation.

If anything the causation is reversed. The new Keynesian model has this all wrong.

President Barack Obama on Tuesday signed into law a $787 billion package of measures to lift the recession-mired U.S. economy that included about $287 billion in tax cuts.

Eggertsson’s findings counter the argument that cutting taxes to put an extra buck in consumers’ pockets will boost their spending. Instead, given the current economic backdrop, it is likely people would save money from temporary tax cuts,

Yes, this is likely, and not a ‘bad thing’ as it means taxes can be cut at least that much further and/or spending increased further.

given the recession and expectations that tax increases are inevitable in the future.

This is the ‘Ricardian Equivalent’ argument put forth by some of the ‘new Keynesians’ and has largely been dismissed as nonsensical by most. The idea that tax cuts do nothing because people automatically expect higher taxes later as they ‘know’ the budget must eventually be balanced, taken to the extreme, means totally eliminating taxes does nothing for demand which of course is ridiculous.

He said that while a number of economists have argued that aggressive tax cuts are needed to revive the U.S. economy, policy-makers should “view with a great deal of skepticism” studies that use post World War Two data — a period characterized by positive interest rates.

Interest rates have nothing to do with the effect of tax cuts. And history (and all other theory) has shown that tax cuts add to demand, tax increases lower demand.

The best ways to stimulate spending, according to Eggertsson’s study, is through traditional government spending and a credible commitment to boosting inflation, creating an incentive to spend now before prices rise. (Reporting by Kristina Cooke; Editing by Diane Craft)

Good old ‘inflation expectations theory’ again from the new Keynesians, which is also nonsense. It’s a ‘plug’ due to no other theory of where the price level comes from, as they have yet to recognize the currency itself is a public monopoly, and monopolists are necessarily price setters.


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9 Responses to “Re: Tax cuts may heighten deflation risks – NY Fed study”

  1. Scott Fullwiler Says:

    NK model, like all Neoclassical models, blames unemployment on the unemployed, since they just won’t take a job at a lower wage. The deflation in this paper is actually GDP enhancing, as workers willing to work for a lower wage shifts out the AS line . . . they forgot to mention that, somehow. Anyway, completely ridiculous, as you point out very nicely.

    Reply

  2. Jim Baird Says:

    OT, but i wanted a sanity check on today’s from Krugman:

    http://www.nytimes.com/2009/02/23/opinion/23krugman.html?ref=opinion

    Am I correct in assuming the Krugamn doesn’t know how banking works? Especially this: “Arguably, the only reason they haven’t already failed is that the government is acting as a backstop, implicitly guaranteeing their obligations. But they’re zombie banks, unable to supply the credit the economy needs.”

    “Backstop” or not, doesn;t a bank only fail when the regulators say it has failed? As long as they can go the discount window, the can always remain liquid and service their debts, and make new loans. Am I missing something here?

    Reply

    RSG Reply:

    There is solvency risk and there is liquidity risk. The fed has essentially taken liquidity risk off the table with their various financing programs, namely guaranteeing bank debt. Krugman is making the case that some of the banks assets are worth less than their liabilities (or less than enough to put capital below regualtory standards). Krugman has never presented any data to back up this premise but he and a number of other pundits seem to have drawn the same conclusion.

    The fed/treas also has the ability to remove solvency risk if they choose by simply guaranteeing the assets in question at current book value, but of course this brings up the issue of moral hazard, i.e., bailing out the bank shareholders; or they could simply state that banks can operate below historic capital adequacy levels. But to your point, there is no reason banks can’t operate (make loans, create deposits) if the fed/treas/regulators want them to.

    The dilemna is if you believe banks are insolvent (a big if in my mind) do you wipe out equity holders and recapitalze or do you let the gov’t balance sheet hold the risk in order to keep private capital in the system. By simply swapping bank toxic assets at book for treasuries for let’s say 3 years, with the gov’t being able to put back the assets to banks at the same price would alleviate a lot of the guess work surrounding solvency, as after 3 years or more we will probably have price discovery on thoses assets and the banks will have retained enough earnings to pay back the gov’t should their be a deficiency in value.

    Reply

    Jim Baird Reply:

    I guess what I was saying was in response to the fear the “the banks are in danger of going insolvent if the gov. doesn’t do something”. But since the only thing that can couse a bank to become insolvent is for government to “do something”, I just don’t get what the big deal is. If the Feds think it would be too disruptive to allow them to fail. they always have the option of doing nothing.

    Don’t get me wrong, I’m all in favor of throwing the current bums out (mostly out of pure vindicitiveness on my part, I admit…) and reorganizing the big banks (preferably into much smaller, regional and local ones. I don’t see any public purpose being advanced by banks the size of Citi and BofA), but it’s all just papaer reshuffling – ultimately, as BofA and Citi have been saying in their full page ads in the NYT and WSJ, they continue to be able to lend in any amount they want. The real problem is the lack of creditworthy borrowers, and “fixing the banks” is irrelevant to that…

    Reply

    RSG Reply:

    agreed, commercial banking is a procyclical business. but the optics of bank stock prices at all-time lows doesn’t inspire public confidence in the system.

  3. Dave Begotka Says:

    It’s simple if you look at it from the “people on the take’s” side. They want the tax money to spend on there illegal, immoral wars, and to support the cesspool they live and thrive in. Spend money is the message and the banks want the people to spend barrowed money so they get there interest. If they spend money that comes from a tax break they get cut out of the pie! So simple to see!

    Reply

  4. knapp Says:

    “Increasing the supply of public goods is never contractionary. Though wise investment can bring down real costs and prices and thereby increase productivity and our real standards of living.”

    Warren,

    My takeaway from your comments on the Eggertsson article above and from past comments is that unlike many other Keynesians, New or Old or Post, you always keep your eyes on the prize which is increasing our real standard of living. Productivity is good, imports are a benefit etc… If a model says otherwise, it’s a bad model.

    Reply

  5. RichW Says:

    Govt deficits add to net private saving increasing private wealth. Under what model does increasing private wealth lead to deflation? Next we’ll find that govt surpluses increase the risk of inflation…

    Reply

    Scott Fullwiler Reply:

    Good one! The “catch” is that they don’t understand deficits create net financial assets for the private sector, of course.

    Reply

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